Earnings Quality of Foreign vs. U.S. Reverse Mergers: Geographical Location or Firm-Level Incentives?

Abstract

We test whether geographical location, audit quality and equity offering play a role in the earnings quality of Reverse Merger (RM) firms. We provide evidence that, contrary to the popular focus by the business press, earnings management happens in both U.S. and international RM companies. We find that firm-characteristics are more indicative of the likelihood to manage earnings than geographical location. The presence of a Big 4 auditor is associated with higher earnings quality and survival rate almost twice as much than for RM audited by a non-Big 4 auditor. Moreover, we find that, though earnings management is common practice at all RM firms, it is especially pervasive for RM firms that are issuing new equity after the reverse merger. Results of tests on these firm-level factors indicate that the differences in earnings quality are both statistically and economically significant and are robust to several sensitivity tests, including the use of different calculations of abnormal accruals.

Keywords: Earnings Quality, SEC, Reverse Merger, Audit Quality

JEL Classification: M41, G34, G38