Earnings management incentives of target firms: An analysis of soliciting and unsolicited targets' accrual accounting choices

Although prior literature suggests that bidders manage earnings upward to benefit from stock-financed acquisitions, the results for target firms are mixed. Given that targets are typically unaware of impending bids, they are unlikely to engage in opportunistic earnings management. In this study I identify a setting in which targets not only know that they are likely to be taken over, but they have relatively strong incentives to consummate a takeover. Specifically I examine the pre-takeover accrual decisions of 240 target firms that publicly announced their intent to seek acquirers or merger partners (soliciting targets) and compare them to the accrual decisions of 277 target firms that received unsolicited takeover offers (unsolicited targets). In contrast to the suggestion in the prior literature that targets have incentives to report positive discretionary accruals to increase their takeover premium, I find that neither soliciting targets nor unsolicited targets appear to make positive accrual choices in the periods leading to the initial takeover announcement. More importantly, the soliciting targets practice income-decreasing earnings management in the year immediately preceding their solicitation announcement. This finding is consistent with soliciting targets facing substantial costs in the market for corporate control if opportunistic earnings management is detected. Instead of endangering their chance of sale, soliciting targets choose to clean up their balance sheets to credibly signal to the market their willingness to seek acquirers or merger partners. Moreover, I find that the managers of soliciting targets show declining propensity to smooth earnings when approaching their solicitation decision, reflecting managers' lessened long-term economic and/or career incentives. My results highlight the importance of controlling for target firms' incentives when examining their accrual accounting choices prior to takeover.