Do Material Weakness Disclosures Reduce Information Asymmetry in Mergers and Acquisitions?

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Abstract

I investigate the incremental impact of a target firm’s material weakness (MW) disclosure in the acquisition process relative to non-MW firms with similar propensity for one. I utilize a matched-sample research design to show that reported MWs are associated with an incremental decrease in acquisition premium, decrease in likelihood of completion, and decrease in target firm announcement returns while controlling for other measures of low quality financial reporting. These results provide evidence that reported MWs not only signal low quality financial reporting, but also provide an additional information signal to acquirers in reducing information asymmetry. I validate this explanation by providing evidence that acquirers are less likely to use other mechanisms for reducing information asymmetry when the target discloses MWs. Specifically, I find that acquirers spend less time in transactional due diligence and are more likely to offer a cash-only deal when the target reports MWs. Overall, my findings provide initial evidence on the role of MW disclosure as a mechanism to reduce information asymmetry in M&A transactions as well as new evidence that reported MWs are incrementally informative beyond other measures of low quality financial reporting.

Author

• Michael Jordan Mowchan, Arizona State University