The Impact Of Post-Merger Accounting Integration On Long .

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The Impact of Post-Merger Accounting Integration on Long-TermM&A SuccessTom Adamsthomas.adams iii@uconn.eduYouree Kimyouree.kim@uconn.eduTodd Kravettodd.kravet@uconn.eduUniversity of ConnecticutSchool of Business2100 Hillside Road, Unit 1041AStorrs, CT 06269-1041Preliminary and IncompleteCurrent Draft: July 2018We thank Jenny Luchs, Sarah Parsons, and workshop participants at the University ofConnecticut for helpful comments. We also thank the University of Connecticut for financialsupport.

The Impact of Post-Merger Accounting Integration on Long-TermM&A SuccessABSTRACT: M&As involve a substantial amount of accounting work from due diligence tointegration accounting. In this study, we investigate whether accounting-related integrationissues during the immediate post-merger period are associated with internal information qualityand the combined entity’s long-term M&A success. We expect that firms with greateraccounting-related integration issues, which includes purchase price allocation and theintegration of accounting systems, will experience poorer internal information and long-termpost-acquisition operating performance. We first document that our inverse measures ofaccounting-related integration quality, abnormally high audit fees and audit report lags inacquisition years, are positively associated with management EPS guidance error. We thendocument that our measures are negatively (positively) associated with long-term changes inacquirer cash flows (post-M&A goodwill impairments). Our results are consistent withintegration quality, in the period immediately following deal completion, affecting both thequality of information produced from the acquirer and target’s newly integrated accountingsystem as well as long-term post-M&A financial outcomes.JEL codes: G34, M42Keywords: Mergers & Acquisitions, Accounting Integration, Audit Fees, Audit Report Lags,Management Guidance, Goodwill Impairments

I. INTRODUCTIONThe integration process immediately after mergers and acquisitions are completed isexpected to be important in realizing the synergies from combing the acquirer and target firm.Once the acquisition is completed, the acquirer then starts integrating accounting systems of thetwo entities, focusing on setting up common controls for various operational segments such ascompliance, reporting, or procurement, in order to operate as one company. Internal informationproduced from the merged accounting system of the acquirer and target provides feedback tomanagement about the progress of the integration and is used to make decisions about theintegration. We expect difficulties with the integration that are related to accounting systems tobe particularly important because these issues likely result in worse internal informationavailable to managers and worse post-acquisition outcomes.In this study, we examine whether accounting-related integration issues are associatedwith firms’ post-merger internal information quality and their long-term acquisition outcomes.Accounting-related integration issues are complications in the integration of a target into theiracquirer that affect the accounting system of the combined entity and can include operationalintegration issues that affect financial reporting or issues directly stemming from the combiningof accounting systems and applying acquisition accounting under SFAS 141, BusinessCombination (FASB, 2001a).1 We posit that quality of information produced from theaccounting system is important during the integration period as this is a critical time for settingthe stage for the combined entity’s operation (Haspeslagh et al. 1991). In line with this notion,Feldman and Spratt (1998) argue that the first 100 days (i.e., approximately one quarter of a1The accounting standards effective during our sample period are SFAS 141, Business Combinations, and SFAS142, Goodwill and Other Intangible Assets. (FASB 2001a, 2001b). SFAS 141 is revised and replaced by SFAS141R after 2009 (FASB 2007).1

year) is when all the critical actions should be launched, as this is likely to be the outer boundaryof the patience of the related parties of the combined firm such as customers and investors. Weexpect accounting-related integration issues to adversely affect firms’ internal information and,thus, disclosure quality. We also expect accounting-related integrations issues to be associatedwith less successful acquisitions for two reasons. First, underlying operational integration issuesthat affect accounting systems can cause acquirers not to realize expected synergies. Second,poorer internal information stemming from accounting-related integration issues results in worsemanagerial decision-making with respect to the integration. Quality of accounting during thisearly post-merger period can be important because management is critically dependent on theaccounting information as this information provides data-driven input to their integrationdecisions.We use two measures of accounting-related integration issues based on abnormal auditfees and abnormal audit report lags in the fiscal year the acquisition is completed. Thesemeasures are based on prior audit research (Bamber et al. 1993; Knechel and Payne 2001;Ashbaugh et al. 2003; Krishnan and Yang 2009) and capture instances where, during theaccounting integration period, either (1) the acquirer paid higher than expected audit fees or (2)the acquirer’s auditor took longer than expected to sign its audit opinion. We argue that higherthan expected fees and/or longer than expected audit report lags capture difficulties experiencedby the acquirer in integrating the target company’s financial reporting and internal controlsystems into its own. These two measures have a positive but modest correlation indicating theycapture different aspects of accounting-related integration issues. These also capture ex-postactual integration issues that allow us to test whether acquirers and investors can predict whichacquisitions are likely to have integration issues.2

We first test our argument that accounting-related integration issues decrease the qualityof accounting information produced from the newly integrated financial reporting and internalcontrol systems. We proxy for the quality of accounting information using management guidanceerror (Rogers and Stocken 2005; Feng et al. 2009). Consistent with our predictions, we find thatboth our proxies of accounting-related integration issues are positively associated withmanagement guidance error. This association is consistent with accounting-related integrationissues leading to worse internal accounting information and, thus higher management EPSguidance error. Because accounting-related integration issues lead to lower internal informationquality we expect it also to result in worse decision-making during the integration and, thuspoorer post-acquisition outcomes.We next test whether accounting-related integration issues are associated with long-termpost-acquisition outcomes. Specifically, we examine changes in acquirer cash flows andgoodwill impairments for the three-year period following the acquisition. We expect that whenpost-acquisition accounting integration goes well (poorly), the newly integrated financialreporting and internal control systems will produce higher (lower) quality information, whichwill then be used by management to make better post-acquisition operational decisions. If good(bad) information is used in these decisions, we expect to observe good (bad) long-termoutcomes. Underlying operational integration issues can also result in accounting integrationissues and cause poorer long-term outcomes. Consistent with our argument, we find that ourmeasures of accounting-related integration issues, abnormal audit fees and abnormal audit reportlags in the fiscal year of the acquisition, are negatively associated with post-acquisition changesin cash flows. We also find that accounting-related integrations issues are positively associatedwith goodwill impairments indicating that acquiring managers are more likely to overpay in3

acquisitions with integration issues. This result suggests that acquiring managers are not able toforesee these integration issues because otherwise they would have lowered the purchase priceand avoided an impairment. Overall, our empirical results are consistent with accounting-relatedintegration issues affecting both the quality of information produced from the newly integratedfirm’s accounting system and its long-term outcomes.Prior research investigates whether various pre-acquisition acquirer accounting-relatedcharacteristics are associated with acquisition performance based on acquirer announcementreturns (e.g., Biddle and Hilary 2006; McNichols and Stubben 2008; Biddle et al. 2009; Francisand Martin 2010).2 A majority of these studies are based on the argument that acquisitions aresettings where managers’ incentives can diverge from shareholders resulting in agency costs butthat higher-quality or more informative accounting can increase monitoring and, thus decreaseagency costs. Our tests examine ex-post integration, rather than ex-ante acquirer accountingcharacteristics expected to affect monitoring, and our arguments relate to the importance ofsuccessful integration of accounting systems in the combining of business. Importantly, ourfindings that ex-post accounting-related integration issues are positively (negatively) associatedwith managerial forecasts errors (post-acquisition profitability) are incremental to the effect ofex-ante acquirer characteristics, such as acquirers’ internal control weaknesses and earningsquality. In further tests, we find that acquirer announcement returns cannot predict accountingrelated integration issues suggesting that while investors are aware that acquirer characteristics2Another branch of research looking at the pre-merger accounting quality at the target firm gauges its overallinfluence on M&A deal characteristics and on the profits to shareholders of the merging parties (Raman et al. 2013;Skaife and Wangerin 2013; Marquardt and Zur 2015; McNichols and Stubben 2015; Chen et al. 2017). For example,Marquardt and Zur (2015) find that target firm accounting quality influences the structure of the deal as well as thespeed and the likelihood of deal completion. Skaife and Wangerin (2013) find that acquirers offer higher premiumsfor targets with low quality financial reporting, and that low quality financial reporting increases the likelihood ofdeal renegotiation. Chen et al. (2017) find that target firm accounting comparability is positively associatedacquisition profitability.4

are associated with acquisition outcomes there is no evidence investors are able to foresee expost accounting-related integration issues. Overall, the results suggest that accounting-relatedintegration issues have an important association with firms’ post-acquisition information qualityand acquisition profitability but these integration issues are difficult for investors and acquiringmanagers to predict ex-ante.This study makes several contributions. First, we contribute to the literature examiningthe importance of accounting quality in acquisitions. While prior research finds that ex-anteacquirer and target characteristics are associated with acquirer announcement returns we focuson ex-post realized integration issues and find that accounting-related integration issues areimportant for the success of acquisitions but are difficult to predict by acquirers and investors.Further, our ex-post measures of accounting integration are incrementally associated withacquisition outcomes relative to ex-ante acquirer accounting characteristics. Second, we extendliterature examining the importance of the integration process in acquisitions. Prior literaturesuffers from noisy measures of integration issues that are often measured ex-ante, such asdiversifying and foreign acquisitions. We develop an alternative measure of integration issuesbased on the integration of accounting systems measured ex-post in the fiscal year the acquisitionis completed. Consistent with the long-standing argument that the acquisition integration processis important, we find that the integration process is associated with ex-post acquisitionperformance. However, we also find that investors are not able to predict at announcementwhether there will be accounting-based integration issues suggesting that it is difficult to foreseewhich business combinations will encounter integration difficulties.Lastly, we extend to the literature investigating the role of audit fees and audit reportlags. Investors are not likely to find the information about the amount of audit and other fees5

disclosed in the proxy statement or 10-K useful, because while audit fee negotiation might haveinformation useful to investors, they do not learn the actual audit fees paid to the auditor untildisclosed in the following year’s definitive proxy statement (Hackenbrack et al. 2014). Also,investors think that the auditor’s opinions and disclosures are often boilerplate and produce a“largely uninformative pass-fail report” (Harris 2017). Therefore, in the context of acquisitions,our study can show a new role of audit fees and audit report lags as predictors for future longterm operating performance of the combined entity, which may be particularly useful toinvestors.The rest of the paper is organized as follows. In section II we discuss related literatureand develop our hypotheses. In section III we discuss research design. In section IV we discusssample selection and results. In section V we discuss the results of path analyses. In section VIwe provide the results from additional analyses. Finally, in section VII we provide concludingremarks.II. RELATED LITERATURE AND HYPOTHESES DEVELOPMENTAccounting in Mergers and AcquisitionsPrior studies suggest that accounting plays an important role and involves a large volumeof work over the course of an acquisition (e.g., Lajoux and Elson 2000; Wangerin 2012; Shalevet al. 2013; Marquardt and Zur 2015). When the acquisition process begins, the acquirer workson the firm valuation to determine the price of the target and conducts preliminary due diligence.In the due diligence phase of a deal, the review of financial statements is considered the “singlemost important aspect of due diligence” (Lajoux and Elson 2000). After the acquisitionagreement is signed, a public disclosure of the acquisition and transactional due diligence follow.6

Subsequent to the deal closure, the acquirers must allocate the purchase price to all separatelyidentifiable classes of assets acquired and liabilities assumed based on estimated fair values as ofthe acquisition date according to SFAS 141, Business Combinations. Also, under SFAS 142,Goodwill and Other Intangible Assets, any unallocated purchase price is recorded as goodwill toreflect expected synergies and other future economic benefits resulting from the businesscombination. Finally, once the purchase price allocation is done, the acquirer conducts moredetailed work on accounting integration, setting up centralized information flow for variousbusiness segments such as compliance, planning and analysis, and reporting.Quality of Accounting and its Impact on the M&A ProcessPrior research investigating the role of accounting information in acquisitions oftenfocuses on the pre-merger accounting quality and its impact on deal outcomes. Previous studieslinking accounting quality to investment efficiency often look at the acquirer’s pre-acquisitionaccounting quality (Biddle and Hilary 2006; McNichols and Stubben 2008; Biddle et al. 2009;Francis and Martin 2010; Goodman et al. 2014; Kravet 2014; Harp and Barnes 2017). Thesestudies are generally based on the argument that acquirers with higher accounting quality willmake better investment decisions because their investment decisions will be reported moreaccurately and transparently, which facilitates better decision-making and monitoring. Therefore,pre-acquisition accounting quality represents an acquirer characteristic that is expected to beassociated with investment decisions. Biddle and Hilary (2006) relate accounting quality toinvestment cash-flow sensitivity, implying that firms with poor accounting quality are morelikely to rely on internally generated cash flows rather than external financing to fundinvestments. Also, McNichols and Stubben (2008) find that firms that manipulated earnings tendto overinvest during the misreporting period, and Francis and Martin (2010) report that firms7

with more conservative accounting make more profitable acquisitions. Harp and Barnes (2017)find that problems in an acquirer’s internal control environment have negative operationalimplications for acquisition performance. In general, these findings suggest that acquirers’ exante accounting quality improves investment efficiency by reducing information asymmetry andincreasing monitoring. Our study is interested in ex-post integration issues with respect toaccounting systems, which is not necessarily due to or related to agency problems betweenmanagers and other stakeholders. Furthermore, our study differs from this literature to the extentthat integration issues do not arise because of acquirer characteristics but from idiosyncraticfactors related to the specific deal.Another stream of literature focuses on the pre-merger quality of accounting at the targetfirm by investigating (1) the relation between the quality of financial information provided by thetarget and the profits to shareholders of the merging parties and (2) the target financial reportingquality and its impact on the overall acquisition process (Raman et al. 2013; Skaife andWangerin 2013; Marquardt and Zur 2015; McNichols and Stubben 2015; Chen et al. 2018).These studies are limited to acquisitions where the target is a public firm and publicly availabledata is available. For example, McNichols and Stubben (2015) examine the relation betweentarget firm accounting quality and acquirer (target) profit from an acquisition and document apositive (negative) relation between these two components. Marquardt and Zur (2015) contendand find that high quality accounting information at the target firm reduces the costs of theacquisition process, increases the likelihood of deal completion, and predict that targetaccounting quality is negatively (positively) associated with the likelihood of an auction(negotiation). These studies investigate the implications of target firms’ accounting informationquality from the acquirers’ perspective. They focus on how a target firm’s accounting quality can8

influence the acquiring firm’s investment decisions. Overall, this line of research suggests thatthe target firm accounting quality affects deal structures in mitigating adverse selection risk andinfluences shareholder values for both the target and the acquirer.We extend this literature examining the relation between pre-acquisition accountingquality and acquisition decisions by considering how and whether ex-post accounting-relatedintegration issues for the immediate post-merger period, which includes both purchase priceallocation and accounting system integration, is associated with internal information quality andlong-term success of acquisitions. By looking at the ex-post integration period our study capturesa period that is likely critical for the combined entity’s future performance and that cannot becompletely predicted from acquirer and target pre-acquisition characteristics, thereby giving amore complete picture of the importance of accounting integration in acquisitions. We especiallyfocus on operating performance measures rather than short-term measures such as cumulativeabnormal returns surrounding the deal announcement date, because it is not clear if integrationissues can be predicted at acquisition announcements and synergies expected from the deal ca

Quality of accounting during this early post-merger period can be important because management is critically dependent on the accounting information as this information provides data-driven input to their integration decisions. We use two measures of accounting-related integration issues based on abnormal audit

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