Merle Erickson

Earnings Management by Acquiring Firms in Stock for Stock Mergers

This study investigates the manipulation of accounting earnings in the period preceding the announcement and completion of stock for stock mergers by a sample of acquiring firms. Results indicate that in the quarters prior to the merger, acquiring firms manage earnings upward. This result is consistent with the conclusion that acquiring firms use accounting procedures in an attempt to increase their stock price prior to stock for stock mergers. Further investigation indicates that unexpected accounting accruals are related to the economic benefits at stake to the acquiring firm and its manager-shareholders. We measure economic benefits to the acquiring firm from increased reported accounting earnings as the deal ratio (deal value as a percentage of the acquiring firms market value) and management ownership of the acquiring firm. Our analysis indicates that acquiring firm income increasing accounting manipulations prior to a merger are positively related to the relative size of the deal.

How Much Will Firms Pay for Earnings that Do Not Exist? Evidence of Taxes Paid on Allegedly Fraudulent Earnings

This paper examines the extent, if any, to which firms pay additional income taxes on allegedly fraudulent earnings. Our sample consists of firms that restated their financial statements in conjunction with SEC allegations of accounting fraud during the years 1996 to 2002. By examining firms that were accused of fraud by the SEC we obtain a relatively clean sample of earnings overstatements and avoid having to rely on models of earnings management. By further focusing on restatements, we are able to estimate how much income tax was paid on the overstated earnings. The estimates in this paper represent the most direct evidence to date that firms are willing to sacrifice substantial cash to inflate their accounting earnings. Our detailed analysis of a sample of firms admitting to large earnings overstatements indicates that the mean firm sacrificed eleven cents in additional income taxes per dollar of inflated pre-tax earnings. In aggregate, the firms in our sample paid

The Effect of Taxes on the Structure of Corporate Acquisitions

320 million in taxes on overstated earnings of about

The effect of transaction structure on price: Evidence from subsidiary sales

3.36 billion. These results illustrate the stark trade-off faced by firms and managers contemplating earnings manipulation - the choice between (non-cash) accounting earnings and (cash) taxes.

Are shareholder dividend taxes on corporate retained earnings impounded in equity prices? Additional evidence and analysis

This paper analyzes tax and non-tax determinants of corporate acquisition structure for 340 acquisitions involving public U.S. acquirers and targets during 1985-1988. The results indicate that the acquiring firms tax and non-tax characteristics significantly affect transaction structure, but the data provide almost no support for the conclusion that potential target shareholder capital gains tax liabilities or target firm tax and non-tax characteristics influence acquisition structure. Detailed analyses of the magnitude of tax and non-tax costs and benefits indicate that built in target shareholder capital gains are not large on average and target shares turnover quickly indicating that the benefits of tax deferral are modest; expected acquiring firm shareholder wealth losses associated with a tax-free stock merger exceed the tax benefits derived from preserving target firm NOLs in most transactions; and the immediate tax cost of stepping-up the basis of the targets assets often exceeds the future tax benefits from such a structure.

Shareholder Income Taxes and the Relation Between Earnings and Returns

We analyzethe effect of tax-based transaction structure on the acquisition price of corporate subsidiaries. For a sample of 200 subsidiary stock acquisitions, the evidence weakly supports the conclusion that acquisition premiums are higher in transactions accompanied by an I.R.C. Statute 338(h)(10) election. Specifically, purchase prices, as manifested in accounting acquisition multiples are higher in subsidiary stock sales accompanied by the Statute 338(h)(10) election than in subsidiary stock sales made in the absence of the election, but not uniformly so. We also find that divesting parent abnormal stock returns are higher in subsidiary stock sales in which the Statute 338(h)(10) election was made than in those deals in which the election was not made. Further, we find that the tax benefits generated by the Statute 338(h)(10) election are positively correlated with divesting parent abnormal stock returns. Finally, a review of corporate disclosures made by acquirers and divesting parent firms in subsidiary stock sales provides compelling anecdotal evidence that acquirers pay a premium to sellers for the tax benefits derived from a Statute 338(h)(10) election. Overall, this study indicates that the tax structure of a subsidiary sale influences the price paid in the transaction, and the tax structure selected is a function of a divesting parents tax basis in the subsidiarys stock and net assets.

Information Uncertainty and Acquirer Wealth Losses

Recently, several studies have concluded that individual investor level dividend taxes on corporate retained earnings are impounded in common stock prices, independent of the timing of dividend payments. We show that the model underlying these studies is internally inconsistent. We also discuss why the model of dividend tax capitalization described in these recent studies is not likely to be descriptive of the taxation of corporate distributions, and we present several reasons, with corroborating data, to believe that common stock prices are not affected by dividend taxes in the manner articulated in these studies. Our empirical results can be summarized as follows. We replicate some of the basic results of prior dividend capitalization studies. We test for evidence of dividend tax capitalization around tax rate changes resulting from the ERTA81, the TRA86 and the OBRA93. Using the same methodology employed in recent research, the evidence does not support dividend tax capitalization across the three tax regimes. We also perform numerous additional data analyses that in general produce results that do not support the conclusions of recent dividend tax capitalization studies. Finally, we find that after controlling for market to book ratios, the main results in prior studies vanish. Overall, the analyses and evidence in this study indicate that shareholder dividend taxes on corporate retained earnings are not impounded in stock prices.

Discussion of Managerial Actions, Stock Returns, and Earnings: The Case of Business-to-Business Internet Firms

The purpose of this study is to investigate if and how shareholder level taxes affect earnings response coefficients (ERCs). Our tests indicate that when the tax rate on dividends increases, ERCs decrease for firms with high dividend yield and whose marginal investor is likely to be an individual. For firms with high share repurchase yield and whose marginal investor is likely to be an individual, an increase in dividend tax rate has no discernable effect on ERCs. These results are consistent with the notion that the tax penalty on dividends, relative to capital gains, reduces the earnings-return relation.

Is There a Link between Executive Equity Incentives and Accounting Fraud

A large body of literature demonstrates that acquisitions are on average value-destroying for the acquirer. We investigate whether the change in the acquirer’s information uncertainty contributes to acquirer wealth losses. Information uncertainty affects the discount rate (the cost of capital), which in turn influences stock price. Our results indicate that acquisitions lead to increases in information uncertainty, as proxied by analysts’ earnings forecast dispersion. We also find that the change in information uncertainty is negatively related to acquirer long-term stock performance, after controlling for the acquirer’s fundamentals. Taken together, the evidence is consistent with the conclusion that increases in information uncertainty resulting from acquisitions contribute to acquirer post-acquisition wealth losses.

Debt-Equity Hybrid Securities

This study contributes to research investigating the effect of non-financial information on stock prices (e.g., Demers and Lev [2000]; Hand [2000]; Rajgopal, Venkatachalam, and Kotha [2000]; and Trueman, Wong, and Zhang [2000]), and consistent with the stated objective of the conference organizers, is multi-disciplinary in nature. The authors analyze the markets short and long-term reaction to over 3,000 individual announcements of various managerial actions, such as customer acquisitions, marketing alliances, and new product introduction. The study focuses exclusively on business-to-business Internet firms through the fall of year 2000. The authors chose not to examine business to consumer firms because