Accounting Conservatism and the Choice of Method of Payment in Corporate Acquisitions

Qingfu Chai[1] Dimitrios Vortelinos[2] Huainan Zhao[3]

Abstract

Accounting conservatism refers to a generally accepted accounting principles selection criterion that leads to persistent understatement of income and assets and/or overstatement of expenses and liabilities over a multi-period of time. Previous studies find that such persistent overstatement of debt and/or loss by conservative reporting may lead to a ‘weakened’ appearance of a firm’s financial position and/or profitability, thus, accounting conservatism may exacerbate financial constraints so that it may impede firms accessing debt financing and induce firms’ preference for stock financing. In planning the merger and acquisition financing, acquirer firms with greater conservative financial reporting would less like to use debt financing. We use a large sample of 7505 U.S. merger and acquisitions deals from 1980 to 2012. We find a significantly negative relation between accounting conservatism and the proportion of cash used in the acquisition payment, and we also find that acquirer firms with greater conservative financial reports would be less likely to choose the all-cash payment.

Keywords: Accounting conservatism, Acquisitions, Cash

1. Introduction

This paper examines whether or not accounting conservatism determines the choice of merger and acquisition payment method. Previous studies find that the choice of merger and acquisition payment is determined by management, firm, industry, and macroeconomic levels of non-accounting factors. Study on the relation between merger and acquisition payment and accounting related topics is limited. The purpose of this study is to fill this gap and address the question on whether or not accounting conservatism shows effects on their merger and acquisition financing decisions. We empirically investigate the relation between accounting conservatism and firms’ merger and acquisition payments using a large sample of 7505 deals announced and completed between 1980 and 2012. With various accounting conservatism measurements, we find that the likelihood of mergers and acquisitions that are paid entirely in cash is negatively related to the conservativeness of acquirer firms’ financial reporting, and the fraction of acquisitions paid with cash versus stock is also negatively related to accounting conservatism. These findings support the previous research that firms with conservative financial statements are likely to use equity to finance their investment projects (Lee (2011)).

In textbooks, accounting is called ‘the language of business’, therefore, which approach firms’ accounting information is provided, e.g. aggressive or conservative, should be a factor in determining firms’ investment and financing decisions. Accounting conservatism has a long history in accounting research, and it refers to a generally accepted accounting principles selection criterion that leads to persistent understatement of income and assets and/or overstatement of expenses and liabilities in a long-term. A firm considered as providing conservative financial reporting will continuously make such accounting choice in the longer-term, not temporarily over one or two years.

In the accounting literature, accounting conservatism reduces the cost of capital and benefits lenders and borrowers in external debt contracting (e.g. Ahmed and Duellman (2002), Beatty, Weber, Yu (2008), and Zhang (2008)). Accounting conservatism also reduces the cost of equity (e.g. Kim et al. (2013)). Researchers also find that accounting conservatism induces firms to use cash efficiently (Louis, Sun, and Urcan (2012)), and firms with conservatism exhibit financial inflexibility and are likely to issue equity (Lee, 2012). In merger and acquisition literature, cost of capital, financial flexibility and debt and equity preference are closely related to mergers and acquisitions financing activities (Bharadwaja and Shivdasani (2003) and Martybivaa and Renneboogb (2009)). Therefore, we expect accounting conservatism would affect merger and acquisition payment choices.

Building on the two fields of literatures, the persistent overstatement of debt and/or loss by conservative reporting may lead to a ‘weakened’ appearance of firms’ financial position strength and/or profitability, thus, accounting conservative may exacerbate financial constraint so that it impedes firms accessing debt financing and induces firms’ preference to issue stock (Lee, 2012). In the context of choosing the method to finance their mergers and acquisitions, we predict firms with conservatism are less likely to use all cash or increase the percentage of cash in the payment for the deal.

To empirically test the prediction, we use a large sample of U.S. 7505 merger and acquisition deals[4] from 1980 to 2012. In order to show this long-term and persistent conservative accounting behaviour, we follow previous studies, such as Beatty, Weber, Yu (2008), Zhang (2008), Louis, Sun and Urcan (2012) and Kim et al (2013), to use firm-specific accounting conservatism measures, 3-year-accumulated non-operational accruals; accumulated non-operational accruals and 5-year-average non-operational accrual are the main measurement of accounting conservatism. Besides, we also follow previous research, such as Ahmed and Duellman (2002, 2007 and 2013), Francis and Martin (2010), and Kravet (2014), to use Basu’s (1997) asymmetric timeliness of earnings to measure accounting conservatism.

Consistent to our hypothesis, we find a significantly negative relation between accounting conservatism and the proportion of cash used in the acquisition payment, and we also find a significantly negative relation between accounting conservatism and the probability of all cash payment.

This study makes several contributions. First, this study contributes to accounting conservatism literature. Prior well-documented literatures study how conservatism accounting policy mitigates the bondholder and shareholder conflicts and reduces the cost of debt, e.g. Ahmed et al. (2002), and how conservatism accounting policy plays a role in firm’s debt contracting, such as Zhang (2008), Beatty et al. (2008) and Gigler et al. (2009). The relationship between accounting conservatism and corporate decisions ‘is lacking in the literature’[5]. This study fills this gap. A related study by Lee (2012) finds that conservative accounting leads to financial inflexibility and the likelihood of stock financing; however, he does not consider the interplay between investing and financing. This study goes beyond the previous research and explores how the conservatism accounting principle influences firms’ financing choice when they confront acquisitions, the largest corporate investment projects. Other related studies, Francis and Martin (2010), focuses on the association of accounting conservatism and good merger and acquisition outcomes and Kravet (2014) discusses the relation between accounting conservatism and merger and acquisition risks. Our study focuses on the association of accounting conservatism and acquisition financing decisions.

Second, this study also contributes to literature on the effects of accounting on firms’ decisions. Previous studies lack research on the relationship between financial reporting on corporate decisions (Armstrong et al. (2010)). Studies on financial reporting and merger and acquisition decisions are rare. Within the range of my literature knowledge, Erickson and Wang (1999) find that acquiring firms manage earnings upward in the period prior to the stock to stock merger agreement and they also find that ‘the degree of income increasing earnings management is positively related to the relative size of the merger’. This study fills the literature gap by using conservative accounting to explain the interdependence between investment (acquisition) and financing.

Third, this study contributes to the corporate finance literature on the interrelation between financing and investment. Previous studies find that firms would choose cash as the payment for their acquisitions, when the acquirer firms have excess free cash flow, (Jensen (1987)), or they are controlled by a major shareholder, (Amihud et al. (1990), Stulz (1988) and Jung, Kim, and Stulz (1996)), or their managers have large stockholdings (Amihud, Lev, and Travlos (1990) and Martin (1996)), or their managers have information that external investors do not have (Myers and Majluf (1984)), or the acquirer firms are large (Faccio and Masulis (2005)), or the acquirer firms have at least two bidding competitors (Berkovitch and Narayananor (1990)), or the acquirer firms have sufficient debt capacity (Martin (1996) and Faccio and Masulis (2005)), or the acquirer firms are managed by overconfident CEOs (Malmendier and Tate (2008)). On the other hand, acquirers firms would be likely to choose stock as the payment for their acquisition, when the acquirer firms have growth opportunities (Martin (1996)), or acquirer firms use the Pooling of Interest accounting method (Robinson and Shane, (1990, or the relative size of target to bidder is large (Hansen (1987), Martin (1996),and Faccio and Masulis (2005)), or there is market misevaluation (Shleifer and Vashiny, (2003) or acquirer firms’ industries have high M&A liquidity during the merger wave (Harford (2005)), or acquirer firms pre-acquisition leverage deviation is high (Hartford, Klasa and Walcott (2009) and Uysal (2011)). In summary, according to previous studies, the choice of merger and acquisition payment is determined by management-, firm-, industry-, and macroeconomic- level of factors. However, the relation between accounting standards and practice and mergers and acquisitions has been drawn less attention. Ours study fills this gap and explains that conservative accounting policy is an important factor that constrains firms’ debt financing ability and affects firms’ financing decisions for investments.

Finally, this study contributes to the merger and acquisition literature on firms’ bidding behaviour and the choice of payment. Previous studies report that bidder firms’ size (Moeller, Schlingemann, and Stulz (2004)), growth opportunities (Martin (1996)), and leverage (Usyal (2011)) influence the bidding behaviour as well as the payment method of acquisitions. Besides these factors, this study indicates that accounting conservatism leads to a relatively weak financial position so that it reduces firms’ ability to access debt capital. Therefore, it impedes firms from using debt (or cash) to pay for the deal.

The paper is organized as follows. Section 2 provides sample selection. Section 3 provides the empirical findings. Section 4 draws conclusions based on the findings.

2. Data and sample construction

The construction of the full sample is from the Security Data Corporation (SDC) database and we match the sample to Center for Research in Security Prices (CRSP) and Compustat. The procedure of sample selection is detailed in the following four steps.

First, we require the acquisitions are announced and complete between the beginning of 1980 and the end of 2012. We also require no missing data in Value of Transaction (SDC: VAL) which is defined as ‘the total value of consideration paid by the acquiror, excluding fees and expenses’. Following Fuller, Netter and Stegemoller (2002) and Uysal (2011), excluding financial firms (6000-6999) and utilities firms (4900-4999).

Second, we follow Uysal (2011) to require the relative size of target to bidder is at least 1%. The Relative Size is calculated as Value of transaction divided by the market capitalization, calculated as share price (CRSP: PRC) multiplies the number of shares outstanding (CRSP: SHROUT), of the bidder one fiscal year prior to the announcement date.

Third, in order to study the proportion of bids paid in cash or stock, we exclude deals whose payment are coded in ‘cash only’ and ‘stock only’ but their corresponding percentage of cash or stock are missing or unequal to 100. And we also exclude those coded in ‘cash and stock combination’ but the sum of percentage of cash and stock is unequal to 100.

Fourth, we require that all observations have sufficient data to calculate primary accounting conservatism measures. This leaves us a total sample of 7505 deals.

Table 1 reports the distribution of the sample of 7505 deals from 1980 to 2012

Like Francis and Martin (2010), the number of acquisitions peaks in 1998. Table 3.1 also shows the trend, which is similar to Dong et al. (2006) who find deals made in the 1990s are more ‘supportive’ of misvaluation hypothesis. After 2001, more deals are paid in cash.

3. Empirical Results

3. 1 Descriptive Statistics

This part provides the winsorized[6] descriptive statistic results of samples. Table 3.2 reports the descriptive statics of firm and deal characteristics in the sample including 7505 deals from 1980 to 2012.

In Table 2, the mean 3-year-accumulated non-operational accruals, Accumulated non-operational accruals and 5-year-average non-operational accrual are 0.115, 0.028 and 0.043 respectively. The mean book leverage and market leverage are 0.209 and 0. 177. Average Log sales is 5.648. The mean of Market to book ratio is 2. The profitability is 0.16. The percentage of cash in the payment is 0.612 and the relative size of target to bid is 0.288. The average percentage of cash component in the deal payment is 0.612.

Table 3 reports the summary statistics of the acquirer sample classified by payment methods.

Overall, during 1980 to 2012, 4131 deals are paid by cash, 2231 by stock and 1142 by cash and stock mix. All firm characteristic variables are measured in the year prior to the deal announcement. The median (mean) of 3-year-accumulated non-operational accruals is 0.056 (0.092) for cash deals, 0.069 (0.141) for stock deals and 0.068 (0.144) for mix deals. The median (mean) of Accumulated non-operational accruals is 0.011(0.021) for cash deals, 0.013 (0.037) for stock deals and 0.014 (0.034) for mix deals. The median (mean) of 5-year average accruals is 0.021 (0.037) for cash deals, 0.028 (0.051) for stock deals and 0.025 (0.055) for mix deals. The results show that stock payment is relating to higher average accounting conservatism proxies indexrs.

The median (mean) of s market to book is 1.866 (1.574) for cash deals, 2.658 (1.969) for stock deals and 2.132 (1.654) for mix deals. Consistent with effects of growth opportunity Martin (1996) and stock market overvaluation, Shleifer and Vishny (2003), higher market to book ratio and higher stock returns increase the probability of stock financing.

The median (mean) of s market leverage is 0.194 (0.144) for cash deals, 0.15 (0.075) for stock deals and 0.166 (0.103) for mix deals. The results of leverage is mixed, the leverage may not be the only factor to determine the payment method.

The median (mean) of s relative size of target to acquirer is 0.193(0.074) for cash deals, 0.341 (0.12) for stock deals and 0.326 (0.141) for mix deals. Consistence to Faccio and Masulis (2005) the relative size and percentage of cash in the payment are negatively related.

More than 40% of subsidiary targets are paid by cash, consistent to Faccio and Masulis (2005), firms ‘selling subsidiaries are often motivated by financial distress concerns or a desire to restructure toward their core competency’, therefore ‘there is a strong preference for cash consideration’.

3.2 The association of accounting conservatism and merger and acquisition payment choices –Accounting conservatism and proportion of cash component in the deal payment

In this section, following Faccio and Ronald (2005), we use tobit regressions to show the relation between accounting conservatism and the proportion of cash component in the merger and acquisition payment.