This paper explores some consequences for economic efficiency of creative accounting practices by merging companies. It assumes semi-strong information efficiency in the markets for capital and for corporate control; and/or the use of executive contracts relating pay to accounting profit. Ahead of takeover, prospective acquirers can flatter their earnings record in order to secure the support of investors for stock-for-stock deals. During takeover, accounting devices have been used to fill "cookie jars" ready to inflate earnings in the years after merger. After takeover, newly appointed managers can take a "big bath", at the expense of their predecessors’ record, enhancing their own apparent performance. The consequences for economic efficiency can include: allocating control of a business to an inferior management team; cheating stockholders by distorting market prices; undermining markets as «dishonest dealings drive honest dealings out of the market » (Akerlof, 1970); creating incentives to undertake mergers which will not boost underlying profitability; and inhibiting the monitoring and control of agents by principals. The paper helps to explain the finding that the typical merger does not enhance operating performance, as shown for example in Ravenscraft and Scherer’s classic study.
Keywords: Mergers, earnings management, creative accounting, agency
Jel Code: L25