International Mergers and Acquisitions Laws, the Market for Corporate Control, and Accounting Conservatism

• Author: INDER K. KHURANA,WEI WANG
• Date: 01 March 2019
• DOI: http://doi.org/10.1111/1475-679X.12247
• Published date: 01 March 2019

DOI: 10.1111/1475-679X.12247

Journal of Accounting Research

Vol. 57 No. 1 March 2019

Printed in U.S.A.

International Mergers and

Acquisitions Laws, the Market for

Corporate Control, and Accounting

Conservatism

INDER K. KHURANA

∗AND WEI WANG

†

Received 12 October 2015; accepted 5 October 2018

ABSTRACT

Exploiting the staggered enactment of country-level mergers and acquisi-

tions (M&A) law as an exogenous increase in corporate takeover threat, this

paper examines how a disciplinary market for corporate control affects ac-

counting conservatism. Following M&A law adoption, we find increased ac-

counting conservatism, with more pronounced effects in countries with weak

shareholder protection and in those experiencing larger growth in takeover

activity. Further analysis reveals that elevated takeover threats increase con-

servatism through changes in capital structure and investment decisions

as well as improvements in board monitoring. Our findings highlight the

∗School of Accountancy, Robert J. Trulaske Sr., College of Business, University of Missouri;

†Department of Accounting, Fox School of Business, Temple University.

Accepted by Philip Berger. We appreciate the helpful comments of an anonymous

referee, Felipe Bastos Gurgel Silva, Sudipta Basu, Jeff Boone, Jere Francis, Matt Glendening,

Weishi Jia, Xi Li, Valeri Nikolaev, K.K. Raman, Abdel-Khalik Rashad, Marco Trombetta,

John Wang, Holly Yang, and participants at the 2016 AAA Annual Meeting, 2016 EAA

Annual Meeting, 2016 FARS Midyear Meeting, Singapore Management University, and The

University of Texas at San Antonio. An online appendix to this paper can be downloaded at

https://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

241

CUniversity of Chicago on behalf of the Accounting Research Center,2018

242 I.K.KHURANA AND W.WANG

importance of the market for corporate control in shaping financial-

reporting outcome.

JEL codes: G34; K22; M41

Keywords: international M&A laws; takeover threat; accounting conser-

vatism; corporate governance

1. Introduction

Economic theory on the market for corporate control indicates that the

threat of takeover is an important governance mechanism, constraining

managers and directors from undertaking actions contrary to shareholder

interests (Manne [1965], Fama and Jensen [1983], Safieddine and Titman

[1999]). The disciplinary effect arising from potential takeover activity can

be particularly relevant for nations aiming to bolster capital market growth

through enhanced corporate governance (Nenova [2006], Bris and Cabolis

[2008]). A separate stream of research posits that accounting conservatism,

by imposing timelier recognition of economic losses relative to gains in fi-

nancial statements, can serve as a viable governance mechanism that limits

managerial opportunism (Basu [1997], Watts [2003], Ball and Shivakumar

[2005]). While the market for corporate control and accounting conser-

vatism are intricate parts of the nexus of a firm’s governance structures,

the precise channels are not well understood, particularly in countries

where institutions in place need not necessarily offer strong protection for

investors.

In this paper, we study the effect of market for corporate control on

accounting conservatism in a cross-country setting and evaluate several

economic explanations. Our identification strategy exploits variations in

takeover threats firms face due to the staggered adoption of mergers and

acquisitions (M&A) laws in their home countries. During our sample pe-

riod, many countries passed legislation aimed at promoting takeover activ-

ity in the domestic markets by reducing legal barriers to M&A transactions

and facilitating an orderly process of changes in corporate control (Nenova

[2006]). In many ways, these regulatory shocks offer an ideal setting for our

analysis. They alleviate reverse causality concerns, as firm-specific level of ac-

counting conservatism is unlikely to have an impact on country-level M&A

laws. Moreover, exploiting the staggered passage of M&A law in different

countries allows us to disentangle the effect of M&A law from regulatory

and macroeconomic events that could otherwise bias the estimation.

Using a panel data set of more than 70,000 publicly listed firms in 34

countries from 1992 through 2005 and employing Basu’s [1997] mea-

sure of asymmetric timeliness of loss recognition, we show that enacting

M&A law leads to greater conservatism in firms’ financial reports. This

finding is robust to two alternative regression specifications: the first with

a difference-in-differences (DiD) estimator, which compares changes in

the degree of accounting conservatism for firms subject to M&A law (the

THE MARKET FOR CORPORATE CONTROL 243

treatment group) to firms not subject to M&A law (the control group);

and second, utilizing an event-study framework, which traces the dynamics

of conservatism over a tight four-year window around the promulgation of

each M&A law. Our results are also robust to (1) inclusion of treatment-

specific time trends that absorb any differential trends between treatment

and control groups in the DiD design, (2) alternative measures of account-

ing conservatism, and (3) alternative matching schemes that pair treated

firms with observationally similar control firms.

We identify two plausible mechanisms through which an increased

takeover threat evokes greater conservatism. First, firm managers facing

increased takeover pressure have an incentive to increase leverage and de-

crease capital spending to defend against unwanted takeover bids. These

real activities can, in turn, alter firms’ financial-reporting behavior (the

“real effects channel”). This view draws on the large capital structure lit-

erature, which reports that in the face of increased takeover threat, firm

management increases leverage to credibly commit to shareholder wealth

(Jensen [1986], Zwiebel [1996]) and, consequently, make it more difficult

for bidders to complete the takeover (Berger, Ofek, and Yermack [1997],

Noaves [2002]). In addition to boosting the proportion of debt in the

firm’s capital structure, the incumbent management is positioned to cut

inefficient capital investments, preempting the bidder’s wealth gain po-

tentially arising from the takeover (Hendershott [1996], Safieddine and

Titman [1999], Servaes and Tamayo [2014]). Increases in leverage and

reductions in wasteful capital spending often accompany timelier loss

recognition, because accounting conservatism reduces informational fric-

tion and agency conflict underlying corporate restructuring (Bushman,

Piotroski, and Smith [2011], Garcia Lara, Garcia Osama, and Penalva

[2016]).

Second, an active takeover market can motivate boards of directors,

who might have gotten cozy with management, to step up monitoring ef-

forts, as the board itself could be dismissed by a successful acquirer who

views its monitoring decisions to be inadequate (Fama and Jensen [1983],

Hirshleifer and Thakor [1998]). In theory, since directors do not fully in-

ternalize the benefits of costly monitoring, they tend to avoid the effort un-

less there is external impetus, such as a takeover bid (Shleifer and Vishny

[1997], Kumar and Sivaramakrishnan [2008]). Lel and Miller [2015] find

that directors are more likely to lose board seats following corporate con-

trol events and that country-level M&A law enactment improves directorial

oversight. Ahmed and Duellman [2007] show that directors characterized

as more vigilant monitors, such as outside directors owning a larger share of

the firm, prefer management to report more conservatively. The rationale

is, by imposing more stringent and verifiable requirements for economic

gains relative to losses, conservatism drives managers to be more forthcom-

ing about adverse news, enabling directors to intervene sooner in poorly

performing projects and better evaluate executive compensation policies.

Conceivably, as greater takeover threats create incentives for directors to