The price of a company’s stock frequently drops after it makes an acquisition, but a new study finds that the stock decline could also be a signal that a financial restatement lies ahead.

The initial drop in the stock price may turn out to be anything but a temporary setback and instead become the precursor to manipulation of earnings by company managers, culminating in a financial restatement and the dismissal of the CEO. A new study in the journal Accounting Review, published by the American Accounting Association, examined 2,300 companies that made corporate acquisitions. A trio of accounting professors from the University of Arizona's Eller College of Management found  that firms in the lowest quartile in terms of stock market response to the news were approximately 50 percent more likely than other acquirers to misstate and then need to restate their subsequent finances. The firms frequently failed to apply accounting rules properly or in some cases even engaged in outright fraud.

In addition, 34 percent of the CEOs in that lowest quartile of the acquirers were dismissed within five years after the merger, compared to 20 percent of the chiefs in the top quartile.

In sum, the paper finds "a negative association between M&A announcement returns and the probablility of issuing materially misstated financial statements following the M&A transaction."
While most executives responsible for badly received acquisitions don't misstate earnings in the post M&A period, even those who provide an accurate accounting tend to issue overly optimistic earnings guidance. Both of these dodges, the study found, mitigate the increased likelihood of CEO dismissal following a negatively received acquisition, but the effect proves only temporary once misstatements or overoptimistic forecasts are exposed.

"The study ought to serve as a warning to shareholders and corporate directors about the possibly dire implications of an initially negative market response to an acquisition," said Professor Daniel Bens, who carried out the research with his colleagues Theodore Goodman and Monica Neamtiu from the Eller College of Management. "At the very least, a substantial dip in stock price should evoke caution and vigilance and ought not to be simply shrugged off as simply a transient phenomenon."

The paper's findings are based on an analysis of 2,293 corporate acquisitions by U.S. public companies during the 12-year period 1996 through 2007, in all instances of which deal values amounted to at least 5 percent of acquirers' market capitalizations. Investor response was gauged by the market-adjusted change in acquirers' stock price in the three-day period extending from the day before M&A announcements through the day after. For the sample as a whole, this consisted of a rise of 0.9 percent, while for the lowest quartile of responses it meant a mean drop of 2.3 percent.

To capture financial misreporting related to negative market reaction and not to something else, the study was restricted to misstatements that began within a year of the conclusion of a merger, although the misreporting typically lasted for several years before being discovered and then restated. The professors allowed for a one-quarter buffer period between the M&A date and the beginning of the restatement measurement window to ensure that the acquirer's management had time to comprehensively evaluate the implications of the recent acquisition.

Overall, approximately 13 percent of the 2,300 companies in the sample issued financial restatements in the post-M&A period. Among the companies in the lowest quartile in terms of market reaction, about 18 percent did so, compared to a little under 12 percent for the remaining three-fourths of the sample. While the study's findings are based on the first acquisition undertaken in the 12-year period covered by the study, the results were robust enough to remain unchanged, even when the professors expanded the scope of their analysis to include muiltiple transactions per acquirer.

Noting that "acquisitions are among the most significant corporate resource-allocation decisions that managers make over their careers," the professors explained that, "unlike annual stock returns which can vary for many reasons that are not controllable by a firm's management, the announcement of an acquisition provides insight into shareholders' reaction to a specific managerial decision...Managers who face heightened career concerns from a negatively received M&A transaction have strong incentives to report value creation in the acquisition implementation stage...Overall, [our] findings indicate that managers are more likely to issue misstated financial statements following poorly received M&A events in an attempt to improve post-M&A performance."

Some of the companies in the sample that experienced slowdowns or downturns in the years following a poorly received acquisition included the global electronics manufacturer Solectron Corp., whose stock declined by more than 12 percent over three days when it announced a major acquisition late in 2000. Solectron later restated its earnings in 2005 for three previous years. Pharmaceutical company Chiron Corp. saw its stock decline about 2 percent at the time of an acquisition announcement in 2003. Chiron restated its earnings two years later. The stock price of real estate giant Macerich declined more than 4 percent at the time of an announcement in 2004. Macerich restated its finances in 2008.

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