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Financial reporting and conflicting managerial incentives: The case of management buyouts

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes from Paul E. Fischer and Henock Louis from the Smeal College of Business at Pennsylvania State University)

In our forthcoming Management Science paper, Financial reporting and conflicting managerial incentives: The case of management buyouts, we analyze the effect of external financing considerations on manager’s financial reporting behavior prior to management buyouts (MBOs). Our main motivation for choosing the MBO setting is the potential conflicting financial reporting incentive associated with external financing considerations. Managers planning to undertake an MBO want to purchase their firms? equity at as low a price as possible. Consequently, previous studies hypothesize that managers have an incentive to release less favorable earnings reports to equity market participants prior to an MBO in an attempt to reduce the MBO purchase price. We consider the possibility that managers have a conflicting earnings management incentive prior to MBOs that is attributable to external financing concerns, which are thought to be substantial.

In the framework we employ for our analysis, the financing related reporting incentive is driven by management’s concerns regarding their ability to obtain MBO financing from external parties and their desire to obtain that financing at a favorable cost. The financing incentive conflicts with the equity market incentive because the financing incentive suggests that managers should manage earnings upward. Consequently, to the extent that an external financing incentive exists, we expect it to temper the equity market incentive. Based upon our framework, we hypothesize that financing related earnings management incentives are more pronounced when the funds needed to execute the buyout must be raised to a greater extent from external parties. In addition, we hypothesize that the increase in financing related incentives arising from increased external financing is greater when there are fewer fixed assets available to secure loans.

Using a sample of 138 MBOs that occurred between 1985 and 2005, we find evidence consistent with both hypotheses. We find that firms that use more external funds to finance their MBO report less negative abnormal accruals. We also find that the positive effect of external financing on earnings management decrease as the amount of fixed assets increases, which is consistent with the conjecture that the effect of external financing on the marginal cost of managing earnings down prior to MBOs increases as the firm has fewer physical assets that it can use as collateral.

The full paper is available here.

Full post as published by The Harvard Law School Corporate Governance Blog on August 29, 2008 (boomark / email).