Does the Threat of Takeover Discipline Managers? New Evidence from the Foreign Investment and National Security Act

• In Event: Financial II

Abstract

Prior literature suggests a strong takeover market accentuates earnings management but these findings 1) are drawn from confounded settings and 2) conflict with evidence that the takeover market is a managerial disciplining mechanism. In this paper, I describe a credible exogenous shock to the takeover market, the Foreign Investment and National Security Act (FINSA), which suppressed takeover activity in a subset of U.S. industries comprising one-third of the Compustat universe. I exploit this exogenous decline in takeover activity to investigate the effect of the takeover market on financial reporting quality using a difference-in-differences (DiD) research design with firm and year fixed effects. I find FINSA-affected firms boost income through accruals after FINSA, but record fewer unsigned discretionary accruals. Fewer income-decreasing discretionary accruals with no change in income-increasing accruals drive this effect. The effect is economically large. The reduction in income-decreasing discretionary accruals boosts net income by 8.5% on average, or by 0.42% of total assets. Using a triple-DiD research design I show the effect varies predictably. Firms more (less) likely to be taken over pre-FINSA should be more (less) affected by changes in the takeover market and I find that firms more likely to be taken over pre-FINSA drive my main result. Using this triple-DiD specification, I further find FINSA-affected firms record fewer income-decreasing special items and fewer write-downs after FINSA. Relatedly, I find FINSA-affected firms exhibit lower financial reporting conservatism after FINSA. My inferences are robust to several alternate discretionary accrual models, and specifications that address recent concerns about discretionary accrual model confounds. Overall, I show that stronger takeover markets curb, rather than accentuate, earnings management.

Author

• David Godsell, University of Illinois-Urbana-Champaign