Importing Accounting Quality: The Case of Foreign Reverse Mergers

• In Event: Reverse Mergers

Abstract

The recent influx of foreign companies to the U.S. capital markets through the mechanism of a reverse merger, which bypasses the rigorous scrutiny of an IPO and results in a company whose ownership, management, employees, and auditors are typically foreign, has raised concerns about the quality of financial reporting by these companies. These concerns have been heightened by recent accounting scandals. We examine the quality of reverse merger companies’ financial reports using a comprehensive sample of reverse mergers occurring in 1992-2010 and an array of “accounting quality” measures. These encompass several aspects of reporting quality including accrual behavior, earnings management and conservatism. The results indicate that the reporting quality of foreign reverse mergers, particularly those involving Chinese acquirers, is of a significantly lower quality than that of their domestic industry peers. On average, investors appear to recognize this quality differential and discount the equity of these companies accordingly. The findings have implications for investors, market regulators and auditors. They are also relevant for the discussion on the costs and benefits of the harmonization of accounting standards.

Authors

• ben lourie, University of California, Los Angeles

• Carla Hayn, University of California, Los Angeles

• Dan Givoly, The Pennsylvania State University