Do Managers Manipulate Earnings Prior to Management Buyouts?

In the paper, Do Managers Manipulate Earnings Prior to Management Buyouts?, which was recently made publicly available on SSRN, we investigate accounting manipulation prior to buyout transactions in the UK during the second buyout wave of 1997 to 2007. Prior to management buyouts (MBOs), managers have an incentive to deflate the reported earnings numbers by accounting manipulation in the hope of lowering the subsequent stock price. If they succeed, they will be able to acquire (a large part of) the company on the cheap. It is important to note that accounting manipulation in a buyout transaction may have severe consequences for the shareholders who sell out in the transaction: if the earnings distortion is reflected in the stock price, the stock price decline cannot be undone and the wealth loss of shareholders is irreversible if the company goes private subsequent to the buyout. Mispriced stock and false financial statements are still issues frequently mentioned when MBO transactions are evaluated. The UK’s Financial Services Authority (FSA, 2006) ranks market abuse as one of the highest risks and suggests more intensive supervision of leveraged buyouts (LBOs). The concerns about mispriced buyouts are therefore a motive to test empirically whether earnings numbers are manipulated preceding buyout transactions.

Whereas the manipulation of financial statements prior to US MBOs has occasionally been detected in the academic literature over the past 20 years, we examine whether accounting manipulation has occurred/still occurs in the second most important buyout market, namely that of the UK which is subject to different regulation and enforcement. We focus on the period since the start of the second LBO wave: 1997-onwards, which also coincides with the tightened corporate governance regulation (Guo et al., 2011) and enhanced reporting integrity (Botsari and Meeks, 2008). We investigate two types of incentives for accounting manipulation in an LBO/MBO context. On one hand, managers may opt to present lower earnings if they are likely to participate in a prospective buyout transaction and will subsequently stay with the company. Negative earnings manipulation or earnings understatement is induced by the management engagement incentives. On the other hand, managers’ incentives to misrepresent the earnings may be related to the financing of the future transaction. A typical LBO is traditionally financed with 60 to 90 percent debt (Kaplan and Strömberg, 2009)—although this ratio has decreased to 50-60 percent since the recent financial crises. Low earnings (cash flow) numbers would reduce the amount of debt that a firm could bear at the relevering stage. Thus, managers who prepare a corporate sale by means of an LBO could manipulate earnings upwards in order to facilitate the buyout transaction—this is the external financing incentive. We distinguish here between MBOs whereby the pre-transaction management remains (financially) involved in the company subsequent to the transaction, and LBOs, which we define as transactions without subsequent involvement of the incumbent management.

We not only concentrate on whether and why manipulation occurs but also on how earnings manipulation can occur by considering accrual management and real earnings management preceding the buyouts. Whereas accrual-based earnings management activities have no cash flow consequences, real earnings management refers to managerial activities, which deviate from normal business practices and affect cash flows. We advance an industry-adjusted buyout-specific approach to capture the abnormal accounting numbers which proxy for accounting manipulation. In this context, we also study asset revaluations and transfers across reserve accounts on the balance sheet as a means of external financing manipulation.

The contributions to the literature are the following: First, there is little evidence on earnings manipulation outside the US buyout market, which raises the question as to whether dishonest accounting management is a phenomenon that other markets also suffer from? Moreover, most studies have examined a sample belonging to the first MBO wave of the 1980s. Since then, the corporate governance regulation has been tightened (Guo et al., 2011), and accounting standards became stricter in terms of transparency. For instance, in 2003, the revised Combined Code on Corporate Governance (currently called: the UK Corporate Governance Code) was implemented to improve financial reporting quality, which raises the question as to whether accounting management is still as pronounced. Second, earnings manipulation comprising accrual management and real earnings management is analyzed in the context of buyout transactions, but the management may also resort to (tangible) asset manipulation (asset revaluations and transfers between reserve accounts). We thus investigate multiple manipulation techniques. Third, while raw abnormal accruals are usually calculated in the earnings management literature, they still comprise accruals influenced by specific corporate events and are different across different industries. Therefore, we adjust the raw abnormal accruals for the mean abnormal accruals of non-buyout firms of the same size-group, industry and ex ante performance. In addition to the traditional approach of contrasting buyout firms with a control group of non-buyout peers matched by firm characteristics, we contrast MBOs to LBOs as both types of buyouts induce different incentives for earnings manipulation. We hence compare the adjusted abnormal accounting figures of MBOs and LBOs. In so doing, we provide a test of accounting manipulation directly attributable to manager engagement incentives around the buyout event. Fourth, we analyze the underlying incentives for accounting manipulation and address the endogeneity issue of using the (ex-post) buyout type as a proxy for management engagement incentives by means of a two-staged IV approach. In the first stage, we model the decision to undertake an MBO or LBO using firm characteristics in the year proceeding the accounting manipulation year. In the second stage, we use the predicted MBO as a proxy for the management engagement incentive. We show that the causality is more likely to flow from the management engagement decision to the accounting manipulation decision.

We find that downward earnings management, both in terms of accrual and real earnings management, has been widely used in the UK since the start of the second buyout wave. Our industry-adjusted approach shows that the abnormal accrual figures are significantly more negative than those of non-buyout firms of the same industry and with similar size and ex ante performance. For buyout companies, the accruals decline in the manipulation year (the year prior to the deal announcement) whereas non-buyout companies are generally subject to positive accrual management, as positive manipulation can affect managers’ bonuses and the likelihood of meeting or beating analysts’ expectations which may trigger a positive market reaction. Second, in MBOs, there is evidence of more real earnings manipulation (through production costs and sales revenues) than in LBOs. The external financing incentive is not supported by our analysis. This may be explained by the fact that during the second LBO wave it was easier to attract external funds, considering the growth in the high yield bond market (by more than 600% since 1997). Credit market conditions rather than company characteristics may determine the financing capacity. Third, besides income statement manipulation, we show that when managers are more likely to revaluate assets upwards, the magnitude and frequency is small. The evidence on asset reserves revaluation is consistent with the insignificance of the external financing incentive. Fourth, the revised Corporate Governance Code of 2003 has had a significant impact on both accrual and real earnings manipulation. Accrual management did indeed decline after 2003. In contrast, other manipulation techniques (regarding production costs and asset revaluations) are more frequently used since the tightening of the corporate governance regulation, which may due to the fact that these manipulation methods are more difficult to detect. This finding is consistent with some recent US evidence: after the adoption of SOX, companies shifted from accrual management to real earnings management (Cohen et al., 2008). However, in MBOs, both accrual and real earnings manipulations are reduced after 2003. Overall, our findings imply that more stringent accounting rules have been effective in curbing dishonest earnings management in management buyout transactions.

The full paper is available for download here.