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Abstract:
I examine the market's efficiency in processing manipulated accounting reports and provide an explanation for the post-merger underperformance anomaly. I find strong evidence suggesting that acquiring firms overstate their earnings in the quarter preceding a stock swap announcement. I also find evidence of a reversal of the stock price effects of the earnings management in the days leading to the merger announcement. However, the pre-merger reversal is only partial. There is evidence of a post-merger reversal of the stock price effects of the pre-merger earnings management. The results suggest that the extant evidence of post-merger underperformance by acquiring firms is partly attributable to the reversal of the price effects of earnings management. The study also suggests that the post-merger reversal is not fully anticipated by financial analysts in the month immediately following the merger announcement. However, consistent with suggestions in the financial press that managers guide analysts' forecasts to "beatable" levels, the effect of the earnings management reversal seems to be reflected in the consensus analysts' forecasts by the time of the subsequent quarterly earnings releases.

earnings management, merger, analyst forecast, market efficiency, rational expectations, long-term performance, accruals

Abstract:
I examine the market's efficiency in processing manipulated accounting reports and provide an explanation for the post-merger underperformance anomaly. I find strong evidence suggesting that acquiring firms overstate their earnings in the quarter preceding a stock swap announcement. I also find evidence of a reversal of the stock price effects of the earnings management in the days leading to the merger announcement. However, the pre-merger reversal is only partial. There is evidence of a post-merger reversal of the stock price effects of the pre-merger earnings management. The results suggest that the extant evidence of post-merger underperformance by acquiring firms is partly attributable to the reversal of the price effects of earnings management. The study also suggests that the post-merger reversal is not fully anticipated by financial analysts in the month immediately following the merger announcement. However, consistent with suggestions in the financial press that managers guide analysts' forecasts to "beatable" levels, the effect of the earnings management reversal seems to be reflected in the consensus analysts' forecasts by the time of the subsequent quarterly earnings releases.

earnings management, merger, market efficiency, rational expectation, analysts' forecasts, long-term performance

Abstract:
We provide evidence suggesting that both the post-repurchase long-term abnormal returns and the reported improvement in operating performance documented in prior studies are driven, at least partly, by pre-repurchase downward earnings management, rather than genuine growth in profitability. The average firm reports significantly negative abnormal accruals prior to open-market repurchases. The extent of the downward earnings management increases with the percentage of the company that managers repurchase and CEO ownership. The pre-repurchase abnormal accruals are also significantly negatively associated with both future operating performance and future stock performance, and the negative associations are driven almost exclusively by those firms that report the largest income-decreasing abnormal accruals prior to the repurchases. The study suggests that one reason firms experience post-repurchase abnormal returns is that the post-repurchase realized earnings growth exceeds expectations formed on the basis of the pre-repurchase deflated earnings numbers.

Share repurchase, Earnings management, Operating performance, Stock performance

Abstract:
We provide evidence suggesting that both the post-repurchase long-term abnormal returns and the reported improvement in operating performance documented in prior studies are driven, at least partly, by pre-repurchase downward earnings management, rather than genuine growth in profitability. The average firm reports significantly negative abnormal accruals prior to open-market repurchases. The extent of the downward earnings management increases with the percentage of the company that managers repurchase and CEO ownership. The pre-repurchase abnormal accruals are also significantly negatively associated with both future operating performance and future stock performance, and the negative associations are driven almost exclusively by those firms that report the largest income-decreasing abnormal accruals prior to the repurchases. The study suggests that one reason firms experience post-repurchase abnormal returns is that the post-repurchase realized earnings growth exceeds expectations formed on the basis of the pre-repurchase deflated earnings numbers.

Share repurchase, Earnings management, Operating performance, Stock performance

Abstract:
Prior studies document that, on average, analysts issue optimistic forecasts one year prior to the earnings announcement and revise their forecasts downward as the earnings announcement date approaches. We hypothesize that the initial analyst forecast is biased because analysts do not fully adjust their forecasts for conservatism. Consistent with our hypothesis, we find that the initial analyst forecast error is negatively associated with proxies for conservatism measured before the forecast is issued. That is, on average, analysts do not include in their initial forecasts information about conservatism even though that information is available at the time of the forecasts, contributing to the optimistic analyst forecast bias.

Accounting conservatism, analyst forecast error

Abstract:
We hypothesize that both the post-earnings announcement drift and the abnormal accrual anomaly are related to earnings management. We find that the underreaction to earnings changes and overreaction to abnormal accruals are consistent with a situation where (1) firms with large positive earnings and large positive earnings changes manage earnings downward to create reserves and (2) firms with large negative earnings changes manage earnings upward, particularly, to avoid reporting losses. In particular, we find no evidence of a positive post-earnings announcement drift for those firms with large positive earnings changes that are least likely to have managed earnings downward or a negative post-earnings announcement drift for those firms with large negative earnings changes that are least likely to have managed earnings upward. That is, for these firms, there is no evidence of an underreaction to earnings changes. In contrast, a trading strategy consisting of taking (1) long positions in those firms with large positive earnings changes that are most likely to have managed earnings downward and (2) short positions in those firms with large negative earnings changes that are most likely to have managed earnings upward yields an average return of approximately 25% over the two quarters after the earnings announcement. In addition, consistent with the earnings management hypothesis, we find that the drifts are associated with discretionary accruals as opposed to nondiscretionary accruals.

Market anomalies, post-earnings-announcement drift, (abnormal) accrual anomaly, earnings management, earnings smoothing

Abstract:
Prior studies suggest that managers use their reporting discretion to signal their private information. Because managers are often assumed to use their discretion to mislead investors, we conjecture that, without a second corroborating signal, discretionary accruals are likely to be regarded as opportunistic. The extant literature suggests that managers split their stock when they are optimistic about their firms' future prospect, but also suggests that a stock split is only partially effective as a signal. Hence, we posit that, if managers use their reporting discretion to signal favorable private information, they are likely to do so in conjunction with stock splits. The reporting signal reinforces the stock split signal whereas the stock split signal lends credibility to the reporting signal. Consistent with our conjectures, we find that managers report significantly positive discretionary accruals in the quarter prior to a stock split and that the split announcement abnormal returns are positively correlated with the pre-split abnormal accruals. We also find no evidence that the pre-split abnormal accrual is associated with the post-split long-term abnormal return. The results suggest that, on average, at the split announcement, the market construes the pre-split discretionary accrual as a signal of managerial optimism rather than managerial opportunism.

Discretionary accruals, Earnings management, Stock split, Signaling

Abstract:
Prior studies suggest that managers use their reporting discretion to signal their private information. Because of the litigation risk associated with inflating earnings, we conjecture that managers are more likely to use their reporting discretion to signal favorable private information when they are very confident that future performance will meet the expectations raised by their reports. In addition, because managers are often assumed to use their discretion to mislead investors, we also conjecture that, without a second corroborating signal, discretionary reporting is likely to be regarded as opportunistic. The extant literature strongly suggests that managers split their stock when they are optimistic about their firms' future prospect. However, existing studies also suggest that a stock split is only partially effective as a signal. Hence, we posit that, if managers use their reporting discretion to signal favorable private information, they are likely to do so in conjunction with stock splits. The reporting signal reinforces the stock split signal
whereas the stock split signal lends credibility to the reporting signal. Consistent with our conjectures, we find strong evidence indicating that managers use accruals in conjunction with stock splits to signal good performance. The evidence also suggests that the signal is deemed
credible by the market.

Stock split, earnings management, signaling, market efficiency, income smoothing

Abstract:
I analyze the effect of auditor choice on acquirers' market values around merger announcements and the factors affecting the interaction between auditor size and the market reaction to the merger announcements. Surprisingly, I find that acquirers audited by the largest accounting firms significantly under-perform those audited by smaller firms at merger announcements. The results indicate that the clients of the major firms under-perform the clients of the smaller firms significantly more at merger announcements if the targets are privately-held companies. There is also some indication that the small audit firm effect is more pronounced as the likelihood that the auditors play a prominent advising role in the merger process increases. These effects are significantly stronger in cash acquisitions as opposed to stock swaps and are robust to controlling for the usual factors affecting the market reaction to merger announcements and potential self-selection biases. While the major auditing firms are usually assumed to offer better services than the smaller ones, the study suggests that small audit firms have a comparative advantage in serving their clientele. The study also has implications for the small audit firms' arguments for an exemption of their merger consulting activities from the provision of Section 201 of the Sarbanes-Oxley Act that prohibits auditing firms from providing clients "appraisals, valuations and fairness opinions."

Auditing, merger, audit quality, auditor size, auditor clientele, private target, Sarbanes-Oxley

Abstract:
We analyze whether the nondisclosure of accrual information at earnings announcements might contribute to the abnormal accrual anomaly. Prior studies draw inferences about the pricing of (abnormal) accruals at earnings announcements and around the filing dates through analyses of the long-term stock performance of high and low (abnormal) accrual firms. In this study, we take a more integrated approach by directly analyzing the pricing of abnormal accruals around the earnings announcement, around the SEC filing, and over the year subsequent to the SEC filing, conditional on whether a firm discloses accrual information at the earnings announcement. We find no evidence of accrual mispricing for firms that disclose accrual information at the earnings announcement. For these firms, the market is able to differentiate the discretionary from the nondiscretionary components of the earnings surprise. In contrast, as expected, the market fails to distinguish between the discretionary and the nondiscretionary components of the earnings surprise for firms that do not disclose accrual information at the earnings announcement. These firms experience some stock price correction around the filing date. However, the correction appears to be only partial, resulting in a post-filing drift.

Discretionary accruals, ERC, SEC filing, disclosure, mispricing

Abstract:
We analyze whether the nondisclosure of accrual information at earnings announcements might contribute to the abnormal accrual anomaly. Prior studies draw inferences about the pricing of (abnormal) accruals at earnings announcements and around the filing dates through analyses of the long-term stock performance of high and low (abnormal) accrual firms. In this study, we take a more integrated approach by directly analyzing the pricing of abnormal accruals around the earnings announcement, around the SEC filing, and over the year subsequent to the SEC filing, conditional on whether a firm discloses accrual information at the earnings announcement. We find no evidence of accrual mispricing for firms that disclose accrual information at the earnings announcement. For these firms, the market is able to differentiate the discretionary from the nondiscretionary components of the earnings surprise. In contrast, as expected, the market fails to distinguish between the discretionary and the nondiscretionary components of the earnings surprise for firms that do not disclose accrual information at the earnings announcement. These firms experience a stock price correction around the filing date. However, the correction is only partial, resulting in a post-filing drift.

Discretionary accruals, ERC, SEC filing, disclosure, mispricing

Abstract:
There are at least two plausible explanations for the post-merger underperformance: information asymmetry and performance extrapolation. The first hypothesis maintains that acquirers are over-valued before the mergers, while the second one maintains that acquirers become over-valued as a result of the mergers. Based on a book-to-market analysis, Rau and Vermaelen (1998) conclude that the performance extrapolation hypothesis is more consistent with the data than the information asymmetry hypothesis. The evidence provided in this study leads to the opposite conclusion. Consistent with the information asymmetry hypothesis, I find evidence of long-term underperformance in failed as well as successful bids. More importantly, controlling for potential sample selection biases and other relevant variables, I find no evidence that bidders' long-term abnormal returns are related to the success of the bids. I also find that the book-to-market effect, provided by Rau and Vermaelen (1998) as evidence in support of the performance extrapolation hypothesis, is driven by firms in the banking industry. In general, the results of the study are consistent with the information asymmetry hypothesis and inconsistent with the performance extrapolation hypothesis.

merger, book-to-market ratio, failed bid, information asymmetry, performance extrapolation, earnings mis-pricing

Abstract:
We analyze the impact of the press on the behavior of various economic agents by examining how media exposure of board ineffectiveness affects corporate governance, investor trading behavior, and security prices. Our focus on board quality is motivated by the strong media criticism to which corporate boards and corporate America, in general, have been recently subjected. The results indicate that media releases of (noisy) information have significant economic consequences. In particular, media exposure of board ineffectiveness forces the targeted agents to take corrective actions and enhances shareholder wealth. Individual investors appear to react negatively to the media exposure whereas investment firms act as if they anticipate the targeted firms' corrective actions.

Media, Public exposure, Board effectiveness, Corporate governance, Behavioral economics, Individual and institutional investor trading

Abstract:
We analyze the impact of the press on the behavior of various economic agents by examining how media exposure of board ineffectiveness affects corporate governance, investor trading behavior, and security prices. The results suggest that media releases of (noisy) information have significant economic consequences. In particular, media exposure of board ineffectiveness forces the targeted agents to take corrective actions and enhances shareholder wealth. Individual investors appear to react negatively to the media exposure whereas investment firms act as if they anticipate the targeted firms' corrective actions.

corporate governance, investor trading behavior, media, public exposure

Abstract:
Proponents of comprehensive income maintain that comprehensive income "identifies all (recognized) sources of value created in one number as a measure of value added." In this study, I present an economic analysis of one of the major components of comprehensive income, the foreign translation adjustment. The analysis suggests that, in general, the translation adjustment is not a source of value added for firms in the manufacturing sector because the accounting rules governing foreign currency translations generally produce results opposite to the economic effects of exchange rate changes. Consistent with existing economic theories, I find that, on average, a positive translation adjustment is associated with a loss of value instead of a creation of value. I also find that the negative association between the translation adjustment and change in value is largely attributable to those firms that are the most labor-intensive. Because such firms are likely to have the most rigid (or "sticky") input factor prices, economic theories predict that they should be the most affected by currency fluctuations. The study raises questions about an accounting income computation that recognizes a positive translation adjustment as an increase in income.

comprehensive income, foreign translation adjustment, foreign exchange, international accounting, value relevance, multinational firms

Abstract:
Proponents of comprehensive income maintain that comprehensive income identifies all the sources of value-added in a firm. However, the economics of the foreign translation adjustment, which is a major component of comprehensive income, suggests that this is not necessarily the case. When a foreign currency appreciates, both the production costs and the revenues of U.S. manufacturers operating in the host country tend to increase. But, because input prices are stickier than output prices, in general, the cost effect dominates the revenue effect. Hence, U.S. producers get hurt when the currencies of their host countries appreciate. However, under the current rate method, the foreign currency appreciation implies an adjustment gain rather than a loss because net assets are translated at a higher rate. Consistent with the economic rationale, I find that the translation adjustment is negatively associated with firm value. This implies that the translation adjustment is value relevant, but not in the direction generally assumed.

comprehensive income, foreign translation adjustment, international accounting, value relevance

Abstract:
We examine allegations that sharp increases in equity-based compensation in the 1990s bubble encouraged managers to inflate earnings and that managers' reporting choices succeeded in keeping stock prices high and rising. We find that managers generally inflate earnings before selling shares. Moreover, the magnitudes of the price correction experienced by particular stocks after the bubble burst are strongly associated with the abnormal accruals the firm reported during the bubble. We conclude that heightened incentives and consequent earnings inflation contributed to the bubble.

equity incentives, insider trading, financial reporting, smoothing

Abstract:
We analyze the effect of external financing concerns on managers' financial reporting behavior prior to management buyouts (MBOs). Prior studies hypothesize that managers intending to undertake an MBO have an incentive to manage earnings downward to reduce the purchase price. We hypothesize that managers also face a conflicting reporting incentive associated with their efforts to obtain external financing for the MBO and to lower their financing cost. Consistent with our hypothesis, we find that managers who rely the most on external funds to finance their MBOs tend to report less negative abnormal accruals prior to the MBOs. In addition, the relation between external financing and abnormal accruals is tempered when there are more fixed assets that can serve as collateral for debt financing.

MBO, earnings management, reporting incentives, debt financing

Abstract:
We analyze the effect of external financing concerns on managers' financial reporting behavior prior to management buyouts (MBOs). Prior studies hypothesize that managers intending to undertake an MBO have an incentive to manage earnings downward to reduce the purchase price. We hypothesize that managers also face a conflicting reporting incentive associated with their efforts to obtain external financing for the MBO and to lower their financing cost. Consistent with our hypothesis, we find that managers who rely the most on external funds to finance their MBOs tend to report less negative abnormal accruals prior to the MBOs. In addition, the relation between external financing and abnormal accruals is tempered when there are more fixed assets that can serve as collateral for debt financing.

MBO, earnings management, reporting incentives, debt financing

Abstract:
There is a positive association between stock-for-stock acquirers' pre-merger abnormal accruals and post-merger announcement lawsuits. The market only partially anticipates the effects of post-merger announcement lawsuits at the merger announcement and post-merger announcement long-term market underperformance is largely limited to litigated acquisitions. Overall, the evidence indicates that lawsuits are a contributing factor to post-merger announcement long-term underperformance, which is an important finding, given the puzzling nature of the underperformance and the heightened interest in explaining this phenomenon. The evidence also suggests that it is important that investors not only undo the direct stock price effects of earnings management but also factor the contingent legal costs associated with earnings management.

Stock-for-stock merger, earnings management, lawsuit, market efficiency

Abstract:
There is a positive association between stock-for-stock acquirers' pre-merger abnormal accruals and post-merger lawsuits. The probability of lawsuits is also negatively associated with both the market reaction to the merger announcement and the post-merger announcement long-term abnormal returns, indicating that the market only partially anticipates the effects of post-merger announcement lawsuits. Not only are post-merger lawsuits associated with post-merger underperformance, but they are also likely drivers of the underperformance. The study suggests that it is important that investors not only undo the direct stock price effects of earnings management but also factor the contingent legal costs associated with earnings management.

Stock-for-stock merger, earnings management, lawsuit, market efficiency

Abstract:
Abnormally high net insider selling is commonly observed after repurchase tender offer announcements even though firms experience, on average, positive abnormal returns in the years after the repurchases. We explore two potential explanations for this seemingly counterintuitive phenomenon. Under the first explanation, insiders trading for liquidity reasons time their selling activities with the repurchase announcements to minimize potential undervaluation, thereby maximizing their selling price. Under the second explanation, insiders trading on their private information sell shares in response to overpricing due to the market misinterpreting the degree to which certain repurchase announcements act as signals of undervaluation. Our results indicate that, consistent with the notion that fixed-price tender offers are more likely than Dutch-auction tender offers to serve as signals of undervaluation, insider selling after fixed-price tender offer announcements appears to be driven largely by insiders who time their trades with the repurchase announcements. In contrast, selling after Dutch auction tender offers seems to be driven largely by informed traders who exploit mispricing associated with the repurchase announcements.

insider trading, repurchase

Abstract:
Abnormally high net insider selling is commonly observed after repurchase tender offer announcements even though firms experience, on average, positive abnormal returns in the years after the repurchases. We explore two potential explanations for this seemingly counterintuitive phenomenon. Under the first explanation, insiders trading for liquidity reasons time their selling activities with the repurchase announcements to minimize potential undervaluation, thereby maximizing their selling price. Under the second explanation, insiders trading on their private information sell shares in response to overpricing due to the market misinterpreting the degree to which certain repurchase announcements act as signals of undervaluation. Our results indicate that, consistent with the notion that fixed-price tender offers are more likely than Dutch-auction tender offers to serve as signals of undervaluation, insider selling after fixed-price tender offer announcements appears to be driven largely by insiders who time their trades with the repurchase announcements. In contrast, selling after Dutch auction tender offers seems to be driven largely by informed traders who exploit mispricing associated with the repurchase announcements.

insider trading, repurchase

Abstract:
Growth in housing prices leads to higher demand for stocks by individual investors and higher stock prices, inducing thereby cross-regional differences in future long-term stock returns. The evidence is consistent with a market where cross-regional changes in housing prices and home bias induce cross-regional differences in the demand for stocks and where limits to arbitrage or other forms of market imperfections prevent arbitrageurs from completely absorbing the ensuing cross-regional differential pricing. Our findings have implications not only for the literatures on capital asset pricing and home bias but also for the emerging literature on the causes of the recent stock market collapse.

Housing prices, Home bias, Stock mispricing, Trading strategy, Economic crisis

Abstract:
Managers of cash-rich firms who are contemplating an acquisition face a dilemma. On the one hand, if they finance the acquisition with cash, the market could presume that they undertake the acquisition simply because the firm has excess cash (the free cash flow hypothesis). On the other hand, if they finance it with securities, the market could presume that they prefer to use securities, although they have excess cash, because the securities are overvalued (the substitution hypothesis). Consistent with these two hypotheses, we find that the association between excess cash and the market reaction to acquisition announcements is negative for both pure cash and pure noncash acquisitions. It would appear then that the managers of an average cash-rich acquirer have no good option - the market reacts negatively to an acquisition by the average cash-rich firm whether the acquisition is financed with cash or with securities. However, we find evidence suggesting that there is an optimal mix of cash and security financing that enables the average cash-rich firm to undertake acquisitions without eliciting negative market reactions, with the optimal mix tilted toward securities. The results also indicate that the market differentiates between acquirers that apparently opt for mixed financing as a means of distinguishing themselves and those that use mixed financing because of financing constraints.

excess cash holdings, mixed financing, acquisition, substitution hypothesis, signaling

Abstract:
The current mortgage foreclosure crisis is presumably related to lax lending policies pursued by financial institutions that extended mortgages to borrowers with questionable credit. These so-called subprime mortgage loans are disproportionately offered in minority communities. Accordingly, some economists argue that the crisis is the result of government regulations, which facilitate mortgage access to minorities. Lenders are profit maximizers and regulations supposedly force them to engage in suboptimal behavior by extending credit to unworthy minorities. However, I find that, while subprime mortgage lending is higher in minority areas, the estimated mortgage foreclosure rate is lower in these areas. This evidence is inconsistent with the contention that regulations encouraging lending in minority areas contribute to the subprime foreclosure crisis. It instead indicates that the loan pricing process is biased against minorities, with lenders charging interest rates in minority areas that are not commensurate with the risk profiles of these areas’ residents. On average, moving from the bottom decile to the top decile of minority representations increases a county’s subprime lending by about 25.25%, but reduces the estimated subprime foreclosure rate by about 27.25%. I find no indication that the minority effect could be due to correlated omitted variables. Further analyses are suggestive of some form of irrational statistical discrimination, whereby unfamiliarity with minorities and stereotyping induce biases in lenders’ assessments of borrowers’ creditworthiness. Overall, the evidence calls for more government regulations of lending practices in minority areas and not less.

regulations, subprime crisis, foreclosure, minority lending, discrimination, market efficiency

Abstract:
A stochastic frontier regression model is used to test interest rate parity with bid-ask spreads for the Belgian franc, the Deutschmark, and the Swiss franc. The forward markets tested have become efficient in the sense that IRP holds well. The bounds provided by IRP do not appear to be binding, however. Evidence is provided that in spite of the overall goodness of fit of the model, the arbitrage margins are sometimes violated, implying possible arbitrage opportunities. The percentage-bid-ask spread is consistently higher for the Belgian franc than for the Deutschmark and the Swiss franc. Spreads are increasing functions of the time to maturity and volatility. Spread-size clustering is more severe than price-level clustering and appears to be inversely related to volatility and positively related to the trading volume. No evidence is found of significant calendar-day effects on spread size.

Interest rate parity, bid-ask spread, Foreign exchange

Abstract:
Signaling is the most commonly cited explanation for stock repurchases in the academic literature. Yet, there is little evidence on whether managers intentionally use repurchases as signaling devices. Using a firm's financial reporting behavior to infer managerial intent, we find evidence suggesting that managers intentionally use fixed-price repurchase tender offers to signal undervaluation. In contrast, we find no evidence that managers use Dutch-auction tender offers to signal undervaluation. Instead, firms engaging in Dutch-auction repurchases act as if they are trying to deflate their earnings prior to the repurchases to further reduce the repurchasing price.

Repurchase tender offer, Signaling, Managerial opportunism, Financial reporting

Abstract:
I analyze the effect of auditor choice on acquirers' values around merger announcements and the factors affecting the interaction between auditor size and the market reaction to merger announcements. I find that acquirers audited by non-Big 4 accounting firms outperform those audited by Big 4 firms. This effect is more pronounced when the targets are privately held and when the likelihood of the auditors playing a prominent advisory role increases. While the largest auditing firms are usually assumed to offer superior services, the study suggests that smaller firms have a comparative advantage in assisting their clients in merger transactions.

Merger, Auditor size, Auditor clientele, Non-audit services, Private target

Abstract:
This study shows that targeted banks that become acquirers generally overpay. The evidence suggests that bank mergers are effective devices against takeovers. Targeted banks that engage in acquisitions are less likely to be taken over than targeted banks that do not engage in acquisitions. However, such a strategy is costly. I find that market reactions to bank mergers involving recently targeted acquirers are significantly more negative than market reactions to mergers involving non-targeted acquirers. This is consistent with the market perceiving acquisitions by targeted banks as being generally defensive in nature.

Bank, takeover threat, merger, premium, defensive merger

Abstract:
There is a significant positive market reaction to merger announcements by acquiring firms that use lower quality external auditors. One explanation for the positive performance of these firms is that their cost-of-capital is reduced as a result of their voluntary submission to the intense scrutiny inherent in the merger process. For the lower quality audit firms, I find that the cost-of-capital effect dominates the over-valuation signaling effect of a stock-for-stock merger previously documented in the literature. I also find that a cash bid conveys to the market a stronger positive signal for low quality audit clients as opposed to high quality audit clients. Because the choice of a high quality auditor is already associated with favorable private information, clients of high quality audit firms tend to benefit less from the announcement of a cash acquisition. The results are robust to controlling for the usual determinants of acquirers' abnormal returns, both acquirers and targets' sizes, and potential sample selection biases.

merger, auditing, market efficiency, information asymmetry, disclosure, cost-of-capital, auditor switch, audit quality