The Effect of Takeover Probability on Earnings Management

Marcus V. Braga-Alves, Marquette University
Jesse Ellis
Gershon Mandelker
Chad Zutter

Abstract

In this paper, we test the hypothesis that managers use discretionary accruals to manipulate reported earnings when they face takeover threats. Our sample period includes three years that followed the enactment of the Sarbanes-Oxley Act of 2002, which improved the quality and transparency of financial reports after a series of accounting scandals. Using the modified version of Jones (1991) model before and after adjusting for performance, we provide evidence that managers make income-increasing accounting choices when they face a higher probability of being the target of a takeover. We find that the relation between earnings management and this probability is less economically and statistically significant after the enactment of the Sarbanes-Oxley Act and for larger firms, which are more scrutinized by market participants and specialized press. We also present evidence that the takeover probability decreases when managers make income-increasing accounting choices in the previous year. Our results are consistent with the hypothesis that earnings management is used to influence shareholder perception regarding a firm’s profitability and, consequently, to decrease the probability of a successful takeover.