Acquisition-Related Provision-Taking and Post-Acquisition Performance in the UK prior to FRS 7

Abstract:     
Until 1998, UK accounting standards allowed firms to write off goodwill directly against shareholders' equity, bypassing the income statement altogether. Many critics contended that this accounting practice allowed firms to inflate profits in the post-acquisition period by taking unwarranted write-downs and provisions when adjusting the book value of the acquiree's separable net assets to fair value. Although the write-downs and provisions were initially excluded from income under the direct write-off method, the subsequent expiry of the resulting lower net asset base depressed expenses in future periods. Concern over this practice led UK standard setters to enhance provision-related disclosures in 1989 and eventually ban most acquisition-related provisions in 1995.

This paper examines the association between acquisition-related provision-taking behavior and post-acquisition performance for a sample of UK firms that undertook large acquisitions between 1989 and 1995. We find evidence that provision-taking was associated with declining accounting and market-adjusted stock price performance over the three-year period following the fiscal year of the acquisition. This relationship exists after controlling for a variety of factors, including method of payment in the acquisition and post-acquisition cash flow performance. By implication, post-acquisition abnormal returns appear to have been predictable based on publicly available information about the magnitude of the provisions. These findings are consistent with the following scenario: The management of the high provisioners used the provisions to insulate accounting earnings from the effects of declining cash flows. The market belatedly reacted to these firms' declining fortunes when net income was no longer inflated by provision reversals.

Key Words: Acquisitions; Earnings management; Long-run abnormal returns; Market inefficiency

Number of Pages in PDF File: 44

JEL Classification: G34, G14, M41, M44

working papers series