The Effect of SFAS 141 and 142 on the Market for Corporate Control

Transcription

1 The Effect of SFAS 141 and 142 on the Market for Corporate Control Ashiq Ali and Todd Kravet Navin Jindal School of Management, University of Texas at Dallas September 27, 2012 Abstract We investigate the effects of accounting rule changes that eliminate the pooling method (SFAS 141) and goodwill amortization (SFAS 142) on the form of acquisition financing and on a firm s takeover probability. The primary requirement to qualify for the pooling method is structuring the transaction as a stock-for-stock exchange. We find that before the new accounting rules, target firms step-up value is positively associated with the probability of using stock-for-stock as against partial stock financing. After the new rules, this association decreases significantly and is indistinguishable from zero. These results suggest that in the pre SFAS 141 period, greater use of stock-for-stock exchanges for target firms with larger step-up values was motivated by the favorable effect of the pooling method on the reported income of the acquirer, and this motivation to use stock-for-stock exchanges goes away with the elimination of the pooling method. The new rules also resulted in a greater decrease in takeover probability for firms with larger step-up values than for firms with smaller step-up values, presumably due to the elimination of the pooling method. When the step-up value of a firm is composed primarily of goodwill, the above effect is attenuated, consistent with the elimination of goodwill amortization. Overall, the study uses a natural experiment to provide a novel finding that accounting methods have significant effects on the form of acquisition financing and on takeover probability. We appreciate the helpful comments of Jarrad Harford, Bob Holthausen, and workshop participants at Hong Kong University of Science and Technology, London Business School, London School of Economics, State University of New York at Buffalo, and the University of Houston.

2 The Effect of SFAS 141 and 142 on the Market for Corporate Control I. INTRODUCTION This study investigates the effects of Statement of Financial Accounting Standard (SFAS) 141 and 142, enacted in 2001, on the form of financing used for corporate takeovers and on the probability of a takeover. These standards eliminated the pooling-of-interests method of accounting for acquisitions (SFAS 141) and amortization of goodwill (SFAS 142), representing the most significant change to acquisition accounting in at least three decades. 1 When these standards were proposed, there was substantial debate over the effect these standards would have on financial statements and acquisition activity. Over 500 comment letters were received by the Financial Accounting Standards Board (FASB) related to the original and revised Exposure Drafts 201-A and 201-R that preceded these standards. Both houses of the US Congress held hearings on the elimination of pooling with most congresspersons arguing against its elimination or concurrently eliminating goodwill amortization (US House 2000; US Senate 2000; Ramanna 2008). While supporters of pooling method elimination argued that the pooling method results in less useful financial statements, the opposition argued that managers would forgo some business combinations without the pooling method option. 2 We examine the validity of the opposition s claim. Prior literature provides evidence that managers have incentives to structure stock-forstock financed acquisitions as pooling acquisitions instead of purchase acquisitions and are 1 Hereafter, we refer to the pooling-of-interests method simply as the pooling method and acquisitions using the pooling and purchase method as pooling acquisitions and purchase acquisitions, respectively. The terms acquirer and target refer to the two parties in the acquisition transaction. 2 FASB comment letter from Dennis Powell, CISCO Corporate Controller, states We believe the retention of pooling of interests accounting is particularly critical considering the adverse impact its elimination will have on the merger activity in the United States... 1

3 willing to incur significant costs to achieve this goal, including paying higher acquisition premiums and accepting restrictions on stock repurchases (e.g., Lys and Vincent 1995; Aboody et al. 2000; Ayers et al. 2002; Weber 2004). 3 The benefits of pooling method accounting are shown to be related to the reporting of lower total assets and higher net income relative to the purchase method. Under the purchase method, acquirers consolidate the financial statements using the purchase price of the target s net assets. The target s identifiable assets and liabilities are recorded at their fair value and any portion of the purchase price that cannot be specifically attributable to an identifiable asset or liability is recorded as goodwill. In pooling acquisitions, the target s net assets are combined with the acquirer s financial statements at book value. Therefore, even if the purchase price exceeds the net book value of assets, pooling acquisitions result in no goodwill amortization expense and other assets (e.g., fixed assets and inventory) are expensed at lower amounts relative to purchase acquisitions, leading to higher reported income. The greater the difference between the purchase price and the target s book value of net assets, referred to as the step-up value, the larger is the difference in reported net income between the two methods. The primary requirement to qualify for the pooling method is structuring the transaction as a stock-for-stock exchange as against a partial stock exchange or 100 percent cash payment. If firms structure acquisitions as stock-for-stock exchanges to satisfy the pooling method requirements, then we expect that elimination of the pooling method under SFAS 141 would decrease stock-for-stock financed acquisitions, especially of targets with large step-up values. We also predict that SFAS 141 and 142 affect a firm s takeover probability. Elimination of the pooling method under SFAS 141 makes acquisitions less attractive because compared to 3 Stock-for-stock financed acquisitions refer to the use of only common stock as consideration to acquire target firms common stock. 2

4 the pooling method, the purchase method results in less favorable financial statements of the acquirers. On the other hand, replacement of goodwill amortization with annual impairment testing under SAS 142 would attenuate the unfavorable effect of the elimination of the pooling method on takeover probability. This is because under SFAS 142 reported income of the acquirers under the purchase method are likely to be higher given that goodwill amortization expense is not recorded and managers would have considerable discretion to defer the reporting of goodwill impairments (Beatty and Weber 2006; Ramanna 2008; Ramanna and Watts 2012). First, we empirically examine the effect of the new accounting rules on the use of stockfor-stock financing for acquisitions. We find that before the new accounting rules, target firms step-up value is positively associated with the probability of using stock-for-stock as against partial stock financing, consistent with acquirers greater incentive to report the acquisitions using the pooling method when the target s step-up value is higher. After the new rules, this association decreases significantly, consistent with the elimination of the pooling method. The effect on stock-for-stock financing is also economically significant. Before the new rules, the interquartile difference in step-up value of target firms is associated with an 18 percent greater likelihood of stock-for-stock financing. This difference decreases significantly and becomes indistinguishable from zero after the new rules. Finally, the decrease in the use of stock-for-stock financing is unlikely to be driven by other incentives related to the use of equity as against cash, because we do not obtain similar results when we repeat our analysis after replacing the dependent variable stock-for-stock versus partial stock financing with partial stock versus 100 percent cash financing. Next, we examine the effect of the new accounting rules on corporate takeovers. We use a sample consisting of firms that were taken over and control firms matched on industry and firm 3

5 size. We find that the new accounting rules are associated with a significantly greater decrease in takeover probability for firms with higher estimated step-up values and that this effect is less pronounced for firms that are likely to report a greater component of their estimated step-up value as goodwill. These results suggest that the elimination of the pooling method had a negative effect on takeover probability and the elimination of goodwill amortization attenuated this effect for firms with estimated step-up values composed primarily of goodwill. The effect on takeover probability is also economically significant. Before the new rules, the interquartile difference in expected step-up value of firms is associated with a 2.4 percent lower probability of a takeover, and after the new rules, it is associated with an additional 3.5 percent lower probability of a takeover. However firms with estimated step-up value composed primarily of goodwill experience an insignificant effect on the probability of takeover due to the new rules. The enactment of SFAS 141 and 142 coincided with the boom period during the latter half of the 1990s and the market crash in In order to rule out any related confounding effects, we perform additional analyses. First, we include several market-wide variables as controls in our form of acquisition financing and takeover probability models. Second, we allow for the association between the dependent variable and each of the control variables to differ before and after the new accounting rules. Third, we repeat our analyses after deleting observations from 1994 to 2001 in order to rule out the possibility that our results are driven by the abnormally high stock prices during this period. Finally, we repeat our analyses after deleting high technology firms from all of our sample periods. These tests rule out the possibility that the extreme changes in stock prices of high technology firms during our sample period are responsible for our results. Our results are robust to all of these tests. 4

6 Our study makes the following contributions. It contributes to the literature on the economic consequences of accounting method changes by documenting that the elimination of the pooling method option (SFAS 141) affected the form of acquisition financing. Specifically, SFAS 141 decreased the likelihood that an acquisition is financed by stock-for-stock exchange as against partial stock exchange or only cash consideration, especially of targets with large step-up values. Prior related studies do not examine the effect of accounting method changes on the form of acquisition financing. Aboody et al. (2000) and Ayers et al. (2002) examine the effect of managerial incentives related to earnings-based compensation plans and debt contracts on the decision to structure stock-for-stock exchange transactions as pooling acquisitions instead of purchase acquisitions. 4 Their sample consists of only stock-for-stock acquisition transactions. Hence, it was not possible to examine the effect of accounting method on the form of acquisition financing in their setting. Another related study, Lys and Vincent (1995), uses anecdotal evidence to show the effect of accounting method on the form of acquisition financing. They point out that AT&T stated in their merger agreement with NCR that if pooling is not allowed, it would change the payment form from 100 percent stock to only 60 percent stock. Our study contributes beyond Lys and Vincent (1995) by using a large sample and a natural experiment of mandated accounting rule changes to provide a more generalized conclusion that acquisition accounting method influences the form of acquisition financing. Our study contributes further to the literature on the economic consequences of accounting method changes by documenting that the elimination of the pooling method (SFAS 4 Earlier literature, such as Gagnon (1967), Copeland and Wojdak (1969), and Anderson and Louderback (1975), limit their sample either to only stock-for-stock acquisitions or where stock makes up at least 80% of the consideration offered and test the incentive to make pooling versus purchase acquisitions. Hence, it was not possible to examine the effect of accounting method on the form of acquisition financing in their setting as well. 5

7 141) and the elimination of goodwill amortization (SFAS 142) have affected the likelihood of takeover of a firm. Specifically, elimination of the pooling method decreased the likelihood of takeover, particularly for firms with large estimated step-up values, and the elimination of goodwill amortization attenuated this effect, particularly for firms with estimated step-up values composed largely of goodwill. 5 To date, there has been little evidence in the literature on the effect of acquisition accounting methods on takeover probability. Prior studies show that managers are willing to incur significant costs, such as higher acquisition premiums and restrictions on stock repurchases, to structure stock-for-stock financed acquisitions as pooling acquisitions instead of purchase acquisitions (e.g., Aboody et al. 2000; Ayers et al. 2002; Weber 2004). However, no prior study has examined whether accounting method effects are strong enough to affect the decision to acquire or not. Finally, our study contributes to the finance literature on the determinants of the likelihood of a takeover and on the determinants of the form of acquisition financing. Prior studies have focused on fundamental economic factors, e.g., operational synergies and riskiness of the combined firm. Betton et al. (2008) provide a survey of this literature. Our study is the first to show that acquisition accounting methods also play a significant role in the takeover decision and in the decision on the form of acquisition financing. The remainder of the paper is organized as follows. Section 2 describes the old and new acquisition accounting rules, discusses the related prior literature, and then presents our hypotheses. Section 3 reports results of the analyses of the effect of the changes in accounting rules on acquisition financing. Section 4 presents results of the analyses of the effect of the 5 We are silent on whether acquisition decisions are more or less efficient after the implementation of SFAS 141 or 142. It is an interesting issue, but would require a rather detailed analysis. Thus, we leave the examination of this issue for future research. 6

8 changes in accounting rules on takeover probability. Section 5 discusses the robustness of our results and Section 6 concludes. II. HYPOTHESIS DEVELOPMENT Accounting Principles Board (APB) Opinion 16 was issued in 1970 and established the criteria for the pooling and purchase method of accounting, until SFAS 141 became effective on June 30, To qualify for the pooling method under APB 16, the acquirer needed to issue voting common stock in exchange for at least 90 percent of the outstanding voting common shares of the target firm (AICPA 1970a) and had to satisfy 13 other restrictions. These restrictions mostly relate to changes in equity interests of the target and acquirer for two years before the acquisitions. 7 The acquirer was also restricted from agreeing as part of the transaction to issue or repurchase equity after the acquisition. 8 However, there are no requirements that the target should be of a similar size to the acquirer. Transactions not satisfying the requirements of the pooling method had to be accounted for using the purchase method. The pooling method reports the assets and liabilities of the acquirer and target at their book values. The assets of the target firm are expensed at their historical cost. In addition, target net income from the beginning of the fiscal year is included in the net income of the combined firm. The purchase method reports the assets and liabilities of the target firm at their fair value and the difference between the purchase price and the fair value of the identifiable net assets is 6 Leftwich (1981) describes the development of these two standards which similar to SFAS 141 and 142 involved substantial controversies with the APB initially arguing for the elimination of the pooling method and then backing down because of political pressure. 7 The standard does allow for dividends to be paid that are consistent with previous regular dividend payments and for repurchases directly related to stock option, compensation plans, and the part of a repurchase plan that began two years before the acquisitions initiation. 8 SAB 96 restricted firms from repurchasing shares for up to two years following pooling acquisitions. 7

9 recorded as goodwill. Also, target net income from the acquisition date onwards is included in the net income of the combined firm. SFAS 141 eliminated the pooling method and required all business combinations to be accounted for using the purchase method. This standard primarily carries forward the majority of APB Opinion 16 s implementation of the purchase method with a few changes, such as the fair value of stock payments is determined on the acquisition date rather than at managers discretion any date between the acquisition agreement and completion date. 9 SFAS 142 superseded APB Opinion 17 and certain parts of SFAS 121. Under APB Opinion 17 goodwill is amortized over its useful life or 40 years whichever is smaller. Impairment tests under SFAS 121 are not required regularly, but are triggered by impairments in the underlying assets and only recorded when the undiscounted cash flows of the assets are less than the carrying value. The principal changes SFAS 142 instituted are elimination of goodwill amortization and the requirement of annual impairment testing of goodwill. 10 For fiscal years beginning after December 15, 2001, firms are required to annually test for goodwill impairment at the reporting unit level by first comparing the reporting unit s fair value with the carrying amount of net assets. If the fair value is less than the carrying amount of net assets, the reporting unit s fair value of goodwill is compared with the book value, and that determines if impairment is recorded. 11 This standard creates the potential for managers to use their discretion to avoid 9 SFAS 141(R) replaced SFAS 141 for acquisitions completed in fiscal years with beginning dates after December 15, Two important changes under SFAS 141 (R) are recognizing non-controlling interests at fair values and disallowing the immediate write-down of capitalized in-process research and development costs. While these changes generally make the financial reporting effect of the purchase method less favorable, they apply to only a small number of acquisitions in our sample. This standard also changed the official terminology from purchase method to acquisition method due to a longstanding argument that the former is a misnomer (see footnote 2 of APB Opinion 16). 10 SFAS 142 also eliminated amortization of intangible assets with indefinite useful lives. 11 Accounting Standards Update (FASB 2011) allows firms to use qualitative factors to assess whether a goodwill impairment is more likely than not, and if the answer is yes then the firm should perform the quantitative two-step goodwill impairment test instituted in SFAS 142. This standard is effective for fiscal years beginning after 8

10 recording impairment losses because the implied fair value of goodwill is estimated. Several studies present evidence consistent with managers using their discretion to defer the reporting of goodwill write-downs under SFAS 142 (e.g., Beatty and Weber 2006; Ramanna 2008; Li and Sloan 2010; Bens et al. 2011; Li et al. 2011; Ramanna and Watts 2012). With no goodwill amortization expense and considerable discretion to defer the impairment of goodwill, the effect of SFAS 142 on reported income is expected to be favorable. The primary incentive to qualify for the pooling method is to increase reported net income. If the fair value of target firms assets exceeds book values, that is, the step-up value is positive, then the expenses recorded related to those assets are greater under the purchase method than the pooling method. The fair values of liabilities are generally not expected to be systematically biased in any direction relative to their book values. Overall, target firms with positive step-up values will report a smaller net income of the combined firm using the purchase method relative to the pooling method. Ayers et al. (2000) show that the pro-forma net income effect of eliminating the pooling method on acquisitions from 1992 to 1997 is economically significant. They estimate that step-up values of targets make up approximately 66 percent of the purchase price. Furthermore, eliminating the pooling method decreases these firms earnings per share and return on equity by 13 and 22 percent, respectively. Prior studies provide results consistent with managers having incentives to structure stock-for-stock transactions as pooling acquisitions rather than purchase acquisitions because of higher reported income. Aboody et al. (2000) and Ayers et al. (2002) find that managers are more likely to use the pooling method for stock-for-stock financed acquisitions when the step-up value of the target is larger. Several earlier studies, based on relatively small samples of stock- December 15, 2011, which is after our sample period, and therefore does not apply to our sample. In any case, this accounting standard update does not affect the direction of our predicted relations. 9

11 for-stock financed acquisitions over various periods, from the 1950s to the 1980s, also find that the likelihood of a pooling acquisition is positively associated with step-up values (e.g., Gagnon 1967; Copeland and Wojdak 1969; Anderson and Louderback 1975; Nathan 1988). Aboody et al. (2000) also shows that among stock-for-stock financed acquisitions, incentives related to earnings-based compensation plans and debt contracts are determinants of the pooling acquisition choice. However, none of these studies examine how acquisition accounting standards influence the choice of acquisition financing. Their sample consists of only stock-forstock financed acquisitions; hence it was not possible for them to examine the effect of accounting method on the form of acquisition financing. Our study addresses this issue by examining the effect of the mandated acquisition accounting rule changes on the form of acquisition financing, 100% stock, versus partial stock or all cash. Prior studies have also shown that firms incur significant costs to structure a stock-for-stock financed acquisition as a pooling acquisition. Ayers et al. (2002) and Robinson and Shane (1990) find that among stock-for-stock financed acquisitions, managers pay higher acquisition premiums for pooling acquisitions than for purchase acquisitions. Hong et al. (1978) and Davis (1990) find that investors do not react favorably to pooling acquisitions. Finally, Weber (2004) investigates the effect of SAB 96, which disallows share repurchases in the two years following pooling acquisitions, on firms with pending pooling acquisitions. He finds that managers generally elected to use the pooling method and forgo share repurchases and that investors view this decision as costly. However, none of these prior studies has examined whether the cost associated with the choice of accounting method are substantial enough to influence the decision on whether to acquire or not. Our study addresses this issue by examining the effect of the mandated acquisition accounting rule changes on takeover probability. 10

12 Overall, prior studies indicate that there are strong incentives to structure stock-for-stock transactions such that they qualify for the pooling method. We argue that these same incentives may influence managers to use stock-for-stock exchanges rather than partial stock exchanges or only cash consideration, in order to qualify for the pooling method. These incentives are expected to be stronger when the difference in net income under the pooling method versus the purchase method is greater, and this occurs when the step-up value of the target firm is larger than when it is smaller. Hence incentives related to reported income are likely to influence managers to a greater extent in the use of stock-for-stock exchanges rather than partial stock exchanges or only cash consideration when target firms have larger step-up values. Accordingly, we propose the following hypothesis: Hypothesis 1: The elimination of the pooling method under SFAS 141 led to a greater decrease in stock-for-stock exchanges in acquisitions of target firms with higher step-up values than of target firms with lower step-up values. The elimination of the pooling method is likely to decrease management incentive to acquire firms, because reported income under the purchase method tends to be lower. This concern is expressed by parties opposing the elimination of the pooling method, including US Senators (Abraham 2000) and corporate executives, such as Cisco s Corporate Controller (Powell 1999) and Goldman, Sachs & Co. s Vice President of Accounting Policy (Mills 1999). In response to this concern, FASB proposed that goodwill amortization be replaced with annual impairment testing and recording of impairment losses if needed (FASB 2001a). The elimination of goodwill amortization removes an unconditional periodic expense, mitigating the negative effect on reported income from pooling method elimination (Ramanna 2008; Li and Sloan 2010; Ramanna and Watts 2012), and thereby attenuates the negative effect of the elimination of the pooling method on acquisition activity. Moreover, for acquisition transactions 11

13 that would not have qualified for the pooling method before the new rules, elimination of goodwill amortization is likely to affect reported income favorably, and thereby contribute favorably to management incentive to acquire firms. The decrease in takeover probability of a firm due to the elimination of the pooling method is likely to be greater for firms with larger predicted step-up value, because the acquirers of these firms would experience a greater decrease in reported income due to this accounting method change. Furthermore, this effect is likely to be attenuated to a greater extent by the elimination of goodwill amortization, when more of the predicted step-up value is made up of goodwill. Accordingly, we propose the following hypothesis: Hypothesis 2: The new acquisition accounting rules led to a greater decrease in the takeover probability of firms with higher predicted step-up values, and this effect is less pronounced for firms in which more of the predicted step-up value is made of goodwill. III. STOCK-FOR-STOCK FINANCING OF ACQUISITIONS Research Design To test the effect of elimination of the pooling method under SFAS 141 on firms acquisition financing choice (hypothesis 1), we estimate a model of stock-for-stock financed acquisitions versus partially stock-financed acquisitions. 12 This method allows us to test that conditional on a firm deciding to finance an acquisition at least partially with stock, did the elimination of pooling decrease the likelihood of using a 100 percent stock-for-stock exchange 12 We classify acquisitions as stock-for-stock financed when the consideration is 100% common stock. However, APB 16 allows use of the pooling method in certain situations when the consideration includes at least 90% common stock. Pooling acquisitions with consideration including less than 100% common stock are classified as partial stock acquisitions in our sample and, therefore, bias against our predicted results. In any case, there are only 17 observations out of 269 with the percentage of stock consideration between 90% and 100% in our sample. 12

14 differentially across target firms with high and low step-up values. Specifically, we estimate the following logistic regression to test this hypothesis: 100% STOCK i,t = β 0 + β 1 D_POST i,t + β 2 STEPUP i,t + β 3 STEPUP i,t *D_POST i,t + β 4 ACQUIRER_BTM i,t + β 5 ACQUIRER_RET i,t + β 6 ACQUIRER_INST i,t + β 7 Ln(ACQ_CASH) i,t + β 8 ACQ_LEVERAGE i,t + β 9 ACQUIRER_MV i,t + β 10 TARGET_MV i,t + β 11 REL_DEALSIZE i,t + β 12 TARGET_ROA i,t + β 13 ΔS&P500 i,t + β 14 TARGET_INST i,t + ε i,t (1) where 100% STOCK i,t is an indicator variable equal to one if an acquisition is 100% stock-forstock financed and zero if it is a partial stock financed acquisition. Step-up in book value, STEPUP i,t, is calculated as the difference between the transaction value, obtained from the SDC database, and the book value of the target firm s common equity, deflated by the combined total assets of the acquirer and target firm as of the end of the fiscal quarter before the acquisition announcement. D_POST i,t, is an indicator variable which is equal to one if the acquisition is announced after the effective date of SFAS 141, June 30, 2001, and is zero otherwise. Before SFAS 141, we expect acquisitions of target firms with higher step-up values are more likely to be financed with stock-for-stock exchanges, so that they could qualify for the pooling method and thereby avoid the larger negative impact on the acquirer s reported net income that would arise under the purchase method. Therefore, we predict a positive coefficient on STEPUP. We use the interaction of STEPUP and D_POST to test whether the adverse effect of SFAS 141 on the use of stock-for-stock exchanges for acquisitions is greater for target firms with higher stepup values than for target firms with lower step-up values. Since the benefit from using the pooling method is greater for acquisitions of target firms with higher step-up values, the incentive to finance acquisitions with stock-for-stock exchanges is greater. Consequently, elimination of the pooling method is expected to result in a greater reduction of stock-for-stock 13

15 financing for such acquisitions. Hence, we predict a negative coefficient on the interaction of STEPUP and D_POST. Based on the prior literature (e.g., Jung et al. 1996; Martin 1996; Erickson 1998; Ayers et al. 2004; Dong et al. 2006), we include several control variables in equation (1). ACQUIRER_BTM i,t is the ratio of book value of equity to market value of equity at the end of the fiscal quarter prior to the acquisition announcement. ACQUIRER_RET i,t is firms 12-month buyand-hold stock return over the period ending at the end of the fiscal quarter prior to the acquisition announcement minus the average 12-month buy-and-hold return for that firm s size decile. ACQUIRER_INST i,t and TARGET_INST i,t are the acquirer s and target s percentage of institutional investors at the end of the calendar quarter prior to the acquisition announcement. Ln(ACQ_CASH) i,t is the acquirer s inflation-adjusted natural logarithm of total cash and shortterm investments at the end of the fiscal quarter prior to the acquisition announcement. 13 ACQ_LEVERAGE i,t is the acquirer s ratio of long-term debt to total assets at the end of the fiscal quarter prior to the acquisition announcement. ACQUIRER_MV i,t and TARGET_MV i,t are the acquirer s and target s inflation-adjusted market value, respectively, at the end of the fiscal quarter prior to the acquisition announcement. REL_DEALSIZE i,t is the transaction value of the acquisition divided by the market value of the acquiring firm at the end of the fiscal quarter prior to the acquisition announcement. TARGET_ROA i,t is the target firm s net income divided by total assets for the last fiscal quarter prior to the acquisition announcement. ΔS&P500 i,t is the change in the Standard and Poor s (S&P) 500 index over the 12 months preceding the acquisition announcement. We also include year fixed effects which control for any year-specific macro factors affecting the financing of acquisitions, including the capital gains tax rate. Industry fixed 13 To adjust for inflation we use the consumer price index for all urban consumers (CPI-U), where the base period for the adjustment factor is

16 effects at the 2-digit SIC level are also included. Continuous variables are winsorized at the 1 st and 99 th percentile, except for variables bounded between zero and one. Sample Our sample consists of all completed acquisitions for the period 1983 to 2009 reported in the Securities Data Company s (SDC) Mergers and Acquisitions database, meeting the following criteria: transaction value is available, acquirer is a public company, and SDC identifies the acquisition as a merger (M) or acquisition of assets (AA). The sample begins in 1983 because SDC has limited coverage of acquisition data in prior years. We also limit our sample to acquisitions for which acquirers and target firms are public companies and we exclude acquisitions where SDC indicates the type of financing is unknown. We exclude acquisitions where the transaction value divided by the market value of the acquirer as of the end of the fiscal quarter prior to the acquisition announcement is less than 5 percent, ensuring a sample of acquisitions that are economically important to the acquirer. We also exclude financial firms. Our final sample consists of 994 acquisitions made by 725 unique firms. Panel A of Table 1 presents the frequency of acquisitions by year. The number of acquisitions increases in the mid-1980 s and the late 1990 s. There are 395, 269, and 330 acquisitions that have stock-for-stock, partial stock, and 100 percent cash financing, respectively. We also provide in parenthesis the average percentage stock component for partial stock acquisitions. For the full sample, 56 percent of acquisition value is paid in the form of stocks, suggesting that the stock component is substantial in partial stock acquisitions. 14 Panel B presents descriptive statistics of the variables in equation (1). D_POST has a mean value of 14 SDC does not provide the percentage of stock used for 18 observations they indicate as including a partial stock payment. 15

17 0.336, indicating that around 34 percent of the acquisitions in our sample are announced after the effective date of SFAS 141. STEPUP has a mean (median) value of (0.170), indicating the average step-up of the target firms net book value is 30 percent of the pre-acquisition total assets of the combining firms. REL_DEALSIZE has a mean (median) value of (0.294), indicating that the acquisitions are on average economically significant events for acquiring firms. Results The regression results from estimating equation (1) are presented in Table 2. Column 1 results are based on the sample consisting of acquisitions with REL_DEALSIZE greater than 5 percent, and Column 2 results are based on a sample consisting of acquisitions with REL_DEALSIZE greater than 25 percent. The second sample ensures that the acquisitions are clearly important investments for the acquiring firms. In column 1, the coefficient on STEPUP is significantly positive, suggesting that in the pre-sfas 141 period the likelihood of stock-forstock financed acquisitions is greater for target firms with greater step-up values, presumably to qualify as pooling acquisitions. The coefficient on STEPUP*D_POST is significantly negative, supporting the hypothesis that after the elimination of the pooling method, the positive association between the likelihood of stock-for-stock financed acquisitions and target step-up values decreased significantly. Column 2 results are consistent with the results in Column 1, and are stronger, as expected. The coefficient on STEPUP is significantly positive and the coefficient on STEPUP*D_POST is significantly negative. 15 Overall, the above results suggest that the 15 Several events occurred around the enactment of SFAS 141, such as the market crash during 2000 and 2001 and the passage of the Sarbanes-Oxley Act of A priori it is not clear that these other events would influence the coefficient on the variable STEPUP*D_POST. Nevertheless, as a sensitivity test we also include in the model interactions of each variable with D_POST to control for any change in the association of the likelihood of stockfor-stock financing with any of the control variables between pre- and post-sfas 141 periods. On including these additional interactions in the model, the results remain qualitatively the same. Specifically, the coefficients (un- 16

18 changes in accounting method for acquisitions had a significant effect on the form of acquisition financing. To illustrate the economic significance of the results, we report the change in the probability of a stock-for-stock acquisition due to an increase in each independent variable from the 1 st to 3 rd quartile (from 0 to 1 for indicator variables), holding the other variables at their mean value. For the sample REL_DEALSIZE >25%, before SFAS 141, an increase in STEPUP from the first to third quartile is associated with an increase in the use of a stock-for-stock acquisition financing by 18 percent. The magnitude of the coefficient on STEPUP*D_POST is about the same as that of the coefficient on STEPUP, suggesting that the effect of STEPUP on the use of stock-for-stock acquisition financing essentially disappears after SFAS 141. Thus, the change in accounting standards had an economically significant effect on the form of acquisition financing. 16 Focusing on the control variables, we observe that for coefficients that are significant, the signs are in general consistent with the prior evidence in the literature. The coefficient on institutional ownership is negative. This result suggests that institutional monitoring prevents managers from making poor acquisition decisions, and stock-for-stock financed acquisitions are poor decisions as they tend to experience negative announcement and post-acquisition stock returns (Martin 1996; Agrawal and Jaffe 2000; Andrade et al. 2001; Fuller et al. 2002). The negative coefficient on leverage in column 1 is consistent with Harford et al. (2009) who explain that acquirers paying with equity are more likely to have larger growth opportunities and, thus be tabulated) on STEPUP and STEPUP*D_POST are (p-value < 0.001) and (p-value = 0.043), respectively. 16 Ai and Norton (2003) provide an alternative computation for calculating the directional effect and statistical significance of interactions in nonlinear models. However, Greene (2010) concludes that an overall statistical inference cannot be obtained from the Ai and Norton (2003) measure. Furthermore, Kolasinski and Seigel (2010) argue that it is appropriate to draw inferences from the interaction term in nonlinear models. Therefore, we use the interaction coefficient reported in Table 3 to assess the directional effect and economic significance of our results. 17

19 less leveraged. The negative coefficient on acquirer firm size is consistent with Erickson (1998), who argues that firm size captures access to debt markets (Rajan and Zingales 1995). The positive coefficient on target firm size is consistent with the notion that the acquirer s risk from the acquisition increases with target firm size, and stock financing makes the target shareholders bear some of the risk of the combined firm (Hansen 1987; Martin 1996; Ayers et al. 2004). Finally, the coefficient on relative transaction size is negative. This result is consistent with the univariate evidence in Martin (1996) and Eckbo et al. (1990), however, they do not provide any explanation for it. 17 To provide further support that the change in the association between step-up value and stock-for-stock exchanges is driven by the elimination of pooling acquisitions rather than by change in managers preference for equity-based financing due to some other factor 18, we compare partially stock-financed versus 100 percent cash-financed acquisitions. Because firms cannot qualify for the pooling method with partially stock-financed acquisitions we do not expect to find similar results as above, if elimination of pooling is driving the results. Table 3 reports regression results of a model for which the dependent variable is PARTIAL_STOCK, an indicator variable equal to one if the acquisition is financed partly with common stock and zero if it is 100 percent cash financed. For this estimation, we use the sample of acquisitions that are either partially stock-financed or 100 percent cash financed. As in Table 17 We also use alternative control variables for acquirers incentive to use equity financing when stock prices are overvalued (Shleifer and Vishny 2003; Rhodes-Kropf et al. 2005; Ang and Cheng 2006; Dong et al. 2006) by replacing the acquirers book to market ratio with both industry-adjusted book to market ratio and Rhodes-Kropf et al. s (2005) firm-specific overvaluation measure and our conclusions remain the same. We also control for firm s deviation from target leverage and our conclusions remain the same (Harford et al. 2009). 18 There are alternative explanations for an association between equity financing and step-up value. Martin (1996) finds that target firms with higher Tobin s Q (which is positively correlated with step-up value) are more likely to be acquired with stock, because this results in risk-sharing between the acquirer and target. Dong et al. (2006) find a positive association between the target s market to book ratio (also positively correlated with step-up value) and the use of stock-financing arguing that acquirers are more likely to use equity when target firms are overvalued. However, why this preference for equity financing would change coincident with the new accounting rules is not clear. 18

20 2, column 1 and 2 results are based on the sample of acquisitions with REL_DEALSIZE greater than 5 and 25 percent, respectively. In both the columns, the coefficient on STEPUP is not significant. This result suggests that the positive association between step-up value and stockfor-stock financing in the pre-sfas 141 period is driven primarily by the incentive to qualify for pooling accounting and not by some other incentive to use equity financing for acquisitions of firms with large step-up values. Furthermore, the coefficient on STEPUP*D_POST is not significant in both the columns. This result indicates that the decrease in the association between step-up value and stock-for-stock financed acquisitions after SFAS 141, observed in Table 2, is not explained by a general decrease in the incentive to use stock for acquisitions of firms with large step-up values, but is more likely due to the elimination of the pooling method for 100 percent stock-for-stock exchange transactions. IV. PROBABILITY OF TAKEOVER Research Design We examine whether SFAS 141 and 142 decreases the takeover probability of firms with larger predicted step-up values relative to firms with smaller predicted step-up values and whether this effect is less pronounced for firms that have a greater component of predicted stepup value as goodwill (hypothesis 2). From the SDC sample of completed acquisitions from 1983 to 2009 described above, we identify public firms that receive takeover bids. We use a matched control sample, which consists of all firms in Compustat in the same 4-digit SIC code that have a market value between 50 percent and 150 percent of the market value of the takeover firm at the fiscal year end prior to the acquisition announcement. Firms that are acquired at any point are excluded from the control sample. 19

21 Our takeover probability model is based on the findings of prior studies (e.g., Dietrich and Sorensen 1984; Palepu 1986; Ambrose and Megginson 1992; Cremers et al. 2009; Cai and Tian 2009; Edmans et al. 2012). Specifically, we estimate the following logistic regression to test our hypothesis: TAKEOVER i,t+1 = β 0 + β 1 D_POST i,t + β 2 PRED_STEPUP i,t + β 3 PRED_STEPUP i,t *D_POST i,t + β 4 D_GOODWILL i,t + β 5 D_GOODWILL i,t *PRED_STEPUP i,t + β 6 D_GOODWILL i,t *PRED_STEPUP i,t *D_POST i,t + β 7 Ln(MV) i,t + β 8 LEVERAGE i,t + β 9 ROA i,t + β 10 PPE i,t + β 11 Ln(CASH) i,t + β 12 SALES_GROWTH i,t + β 13 BLOCKHOLDER i,t + β 14 SIZE_ADJ_RET i,t + ε i,t (2) where TAKEOVER i,t+1 is an indicator variable which equals one if firm i receives a completed takeover bid within one year of the end of fiscal year t, and equals zero otherwise. D_POST i,t, defined slightly differently than in equation (1) because this analysis is at the firm-year level, equals one if fiscal year t ends after the implementation of SFAS 141 and 142, June 30, 2001, and zero otherwise. The predicted step-up of firm i, PRED_STEPUP i,t, is calculated as the difference between the market value of equity of firm i and the book value of common equity, deflated by total assets at the end of fiscal year t. We expect a negative coefficient on PRED_STEPUP consistent with acquirers avoiding takeover targets with high step-up values, because of the adverse financial reporting effect of purchase accounting or the cost of qualifying for the pooling method. D_GOODWILL i,t is an indicator variable equal to one if firm i is in an industry characterized by high goodwill levels. We expect that firms in high goodwill industries are more likely to have their step-up value be primarily composed of goodwill. To define high goodwill industries we first rank each four-digit SIC industry by the industry-level percentage of firm-year observations where the ratio of goodwill to total assets is greater than or equal to 10 percent during the pre-sfas 141/142 period ( ). We use all firm-year observations in Compustat with non-negative values of goodwill for this calculation. We then define 20

22 D_GOODWILL i,t equal to one if the industry is ranked in the top tercile, and equal to zero otherwise. 19 We use the interaction of PRED_STEPUP and D_POST as our main test variable. A negative coefficient on PRED_STEPUP*D_POST indicates that for firms not in high goodwill industries the elimination of the pooling method is associated with a greater decrease in takeover probability for firms with larger step-up values than firms with smaller step-up values. We interact D_GOODWILL with PRED_STEPUP*D_POST to test whether the more negative association between step-up values and takeover probability due to the new acquisition accounting rules will be less pronounced for firms with step-up values comprised primarily of goodwill. We expect a positive coefficient, indicating that the new accounting rules led to a more positive effect on the association between takeover likelihood and step-up value for firms in high goodwill industries than for other firms. Based on prior literature, we use several control variables. Ln(MV) i,t is the natural logarithm of inflation-adjusted market value of equity of firm i at the end of fiscal year t. LEVERAGE i,t is the ratio of long-term debt to total assets of firm i at the end of fiscal year t and ROA i,t is net income before extraordinary items for fiscal year t divided by total assets at the beginning of fiscal year t. PPE i,t is property, plant, and equipment of firm i scaled by total assets at the end of fiscal year t. Ln(CASH) i,t is the natural logarithm of inflation-adjusted cash and short term investments of firm i at the end of fiscal year t and SALES_GROWTH i,t is the percentage change in sales from fiscal year t-1 to t. BLOCKHOLDER i,t is an indicator variable 19 Industries in the top tercile have at least 28.6% of firm observations with a goodwill to total assets ratio of 10% or greater. As a robustness test we also defined high goodwill industries based on whether firms goodwill to total assets ratio is 5% or greater and our conclusions remain the same. For this robustness test, the top tercile includes industries having at least 42.6% of firm observations with a goodwill to total assets ratio of 5% or greater. As a further robustness test we also defined high goodwill industries as those in the top tercile when ranking industries by their mean goodwill to total assets ratio and our conclusions remain the same. 21

23 equal to one if firm i has at least one institutional shareholder with a minimum of 5 percent of total common shares outstanding (Thomson-Reuters Institutional Holdings Database), and zero otherwise. SIZE_ADJ_RET i,t is the difference between the firms buy and hold return over fiscal year t-1 minus the buy and hold return for the CRSP value-weighted portfolio of NYSE/AMEX/NASDAQ firms in the same size-decile. Continuous variables are winsorized at the 1 st and 99 th percentile, except for variables bounded between zero and one. We also include year and industry (2-digit SIC level) fixed effects. Results Panel A of Table 4 presents descriptive statistics for the variables used in the takeover probability model. The sample includes 2,308 takeover firms and 8,427 control firms. Panel B presents the regression results from estimating equation (2). We first present the results in column 1 without allowing for differing effects based on whether a firm is in a high goodwill industry by excluding D_GOODWILL and its associated interaction terms. The coefficient on PRED_STEPUP is significantly negative, consistent with acquirers avoiding takeover targets with high step-up values because of the adverse financial reporting effect of purchase accounting or because of the cost of qualifying for the pooling method. The coefficient on PRED_STEPUP*D_POST is significantly negative, indicating that the association between takeover probability and step-up value of the target becomes significantly more negative after the new accounting rules. This result is likely driven by the elimination of the pooling method, which has taken away the option of using book values to report target firm s assets on the combined firm s financial reports PRED_STEPUP, market to book ratio, and Tobin s Q are highly correlated because the components for all these variables are very similar. Prior studies have examined the association between the likelihood of takeover and both 22