The Disciplinary Role of Financial Statements: Evidence from Mergers and Acquisitions of Privately Held Targets

• DOI: http://doi.org/10.1111/1475-679X.12256
• Published date: 01 May 2019
• Date: 01 May 2019
• Author: CIAO‐WEI CHEN

DOI: 10.1111/1475-679X.12256

Journal of Accounting Research

Vol. 57 No. 2 May 2019

Printed in U.S.A.

The Disciplinary Role of Financial

Statements: Evidence from Mergers

and Acquisitions of Privately Held

Targets

CIAO-WEI CHEN

∗

Received 17 August 2016; accepted 21 December 2018

ABSTRACT

This study examines whether requiring the disclosure of audited financial

statements disciplines managers’ mergers and acquisitions (M&As) decisions.

When an M&A transaction meets certain disclosure thresholds, the Securities

∗University of Illinois at Urbana-Champaign.

Accepted by Douglas Skinner. This paper is based on my dissertation completed at the

University of Iowa. I am indebted to my dissertation cochairs Dan Collins and Rick Mergen-

thaler for their invaluable guidance and support. I thank my dissertation committee members

Paul Hribar, Dave Mauer, and Anand Vijh for their helpful feedback. I also received construc-

tive comments and suggestions from Darren Bernard, Nerissa Brown, Dave Burgstahler, Ted

Christensen, Rich Frankel, Cristi Gleason, Brad Hepfer, Todd Kravet, David Koo, Laura Li,

Xiumin Martin, Sarah McVay, Mike Minnis, Michelle Nessa, Phil Quinn, Steven Savoy, Abbie

Smith, Theo Sougiannis, Steve Stubben, Oktay Urcan, an anonymous referee, and workshop

participants at Arizona State University, College of William and Mary,ESSEC Business School,

HEC Paris, Texas A&M University, University of Arizona, University of Arkansas, University at

Buffalo, University of Connecticut, University of Illinois at Chicago, University of Illinois at

Urbana–Champaign, University of Iowa, University of Georgia, University of Nebraska, Uni-

versity of Utah, University of Washington, and Washington University in St. Louis, and confer-

ence participants at the 2018 Journal of Accounting Research conference. I thank Amit Shah and

Sarah Xiao for their excellent research assistance. All the data are publicly available from the

sources indicated in the paper.I gratefully acknowledge generous financial support from Uni-

versity of Illinois at Urbana–Champaign, the Gies College of Business, and the Tippie College

of Business at the University of Iowa. An online appendix to this paper can be downloaded at:

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

391

CUniversity of Chicago on behalf of the Accounting Research Center,2019

392 C.-W.CHEN

and Exchange Commission (SEC) requires the public acquirer to disclose

the target’s audited financial statements after the merger is completed. Us-

ing hand-collected data, I find that the disclosure of private targets’ financial

statements is associated with better acquisition decisions. Furthermore, I find

that this disciplining effect of disclosure is more pronounced when monitor-

ing by outside capital providers is more difficult and costly, and when other

disciplining mechanisms are weaker. Finally, these findings are robust to sev-

eral alternative explanations, such as monitoring from blockholders and vol-

untary disclosures. In sum, the evidence suggests that the ex post mandatory

disclosure of private targets’ accounting information disciplines managers’

acquisition decisions and improves acquisition efficiency.

JEL codes: G34; M40; M41; M48

Keywords: disclosure; mergers and acquisitions; disciplinary role; private

firms

1. Introduction

This paper examines the disciplinary/governance role of financial re-

porting in the context of mergers and acquisitions (M&As). I investigate

whether ex post mandatory disclosure of a private target’s audited finan-

cial statements disciplines acquiring managers in their acquisition deci-

sions, resulting in better acquisition outcomes. To answer this research

question, I exploit differences in the disclosure requirements under Reg-

ulationS-X(or17C.F.R.§210). If an acquisition exceeds a defined sig-

nificance level (Rule 3–05 [b]), Regulation S-X requires public acquirers

to disclose audited financial statements of the target after the transaction is

completed. To determine the significance of the acquired entity, the Reg-

ulation uses the following three ratios: (1) the acquirer’s share of the tar-

get’s total assets relative to the acquirer’s total assets (the asset test), (2)

the acquirer’s investment in and advances to the target firm relative to the

acquirer’s total assets (the investment test), and (3) the acquirer’s share

of the target’s net income relative to the acquirer’s net income (the in-

come test). If any of these three ratios exceeds 20%, the acquirer must dis-

close the target’s audited financial statements after the M&A transaction is

completed.1

This disclosure mandate offers several features that make it an advan-

tageous setting to investigate the disciplinary role of financial disclosure.

First, the disclosure requirement is applicable to private targets. This is par-

ticularly interesting considering that U.S. private firms are not required

to publicly disclose their financial statements. Therefore, unless the M&A

transaction meets one of the disclosure thresholds, private targets’ ac-

counting information is generally unavailable to outside shareholders of

1See section 2.2 for a description of Regulation S-X and the online appendix for further

information.

DISCIPLINARY ROLE OF FINANCIAL STATEMENTS 393

the acquirer. Second, when disclosure is required, the target’s accounting

information becomes publicly available after the acquisition is completed.

Third, the disclosure policy is mandatory and, therefore, acquirers face neg-

ative consequences for noncompliance, such as a Securities and Exchange

Commission (SEC) enforcement action or restricted access to capital mar-

kets.2Based on these features, I exploit variation in acquirers’ disclosures

to examine the impact of this mandatory disclosure policy on acquisition

performance.

I construct a sample of private target acquisitions from 1997 to 2009 us-

ing the Securities Data Company’s (SDC) M&As database. Then, in order

to identify whether the acquirer discloses the target firm’s audited financial

statements, I search each acquirer’s SEC EDGAR filings. I measure acqui-

sition performance using the acquirer’s three-day announcement returns,

postacquisition operating performance, and postacquisition stock perfor-

mance (Loughran and Vijh [1997], Chen, Harford, and Li [2007], Masulis,

Wang, and Xie [2007], Francis and Martin [2010], Harford, Humphery-

Jenner, and Powell [2012]). In line with my predictions about the disci-

plinary benefits derived from having access to the private targets’ financial

statements, I find the disclosure of private targets’ audited financial state-

ments is associated with a better acquisition performance. The coefficient

estimates suggest the disclosure of private targets’ financial statements is as-

sociated with a 3.3% (15.0%) higher operating (stock return) performance

in the three years after the completion of the acquisition. Furthermore, the

disclosure of targets’ financial statements is associated with a lower proba-

bility of subsequent goodwill write-downs and divestitures. These findings

suggest that the ex post disclosure is associated with more efficient acquisi-

tion decisions.

Two empirical challenges exist in this mandatory disclosure setting be-

cause the SEC’s disclosure thresholds are based on the size of the target

relative to the acquirer. First, my main results may be caused by the relative

size of the target. Because transactions that meet the disclosure require-

ments have a larger impact on the acquirers’ operations, these firms are

likely to devote more resources to M&A due diligence, which, in turn, may

result in better acquisition outcomes. Therefore, the difference in acqui-

sition performance that I observe might be a consequence of this relative

size effect. The second empirical challenge is a correlated omitted variable.

This concern is salient in my setting, because the M&A deals requiring tar-

get financial disclosures can considerably differ from the deals that do not

require such disclosures.

I conduct several tests to mitigate these concerns. First, I perform falsifi-

cation tests using (1) a sample of private target acquisitions in the United

2See the online appendix for an example of Accounting and Auditing Enforcement Re-

leases (AAER) related to Rule 3-5(b) of Regulation S-X. In this example, the acquirer struc-

tured the acquisition to avoid disclosing the target firm’s audited financial statements.