Target Firm Earnings Management, Acquisition Premium, and Shareholder Gains

Using a sample of U.S. domestic deals from 1990 to 2016, we find that bidders adjust the amount of premium paid in mergers and acquisitions (M&As) based on the levels of earnings management at target firms. However, the way a firm manipulates earnings upward matters: earnings management via real activities manipulation is more detrimental than discretionary accruals. As a result, target firms that engage in real earnings management receive lower premiums in M&As, while accruals management has no effect on premiums. Correspondingly, we find that the targets' M&A announcement-period cumulative abnormal returns are inversely related to their level of real earnings management, while the returns are not related to accruals management. Further analyses confirm that target shareholders' wealth is not only driven by undervaluation, expected synergy, and managerial hubris, but also reflects bidders' perception of the target firms' earnings quality based on real earnings management.