Directory UMM :Data Elmu:jurnal:J-a:Journal Of Business Research:Vol49.Issue1.2000:
Security Market Reaction to Purchase
Business Combinations at the First
Earnings Announcement Date
Kathleen Blackburn Norris
UNIVERSITY OF TENNESSEE
Frances L. Ayres
UNIVERSITY OF OKLAHOMA
Accounting for purchased goodwill in mergers and acquisitions has been
a hotly debated issue for many years because of the increasingly large
impact of goodwill amortization on the reported earnings of acquiring
firms and its implications for the subsequent performance of the combined
entity. There is evidence that top management of firms seeking to acquire
other companies attempts to avoid purchase accounting when possible to
avoid the hit to earnings associated with goodwill amortization. However,
since there may be no economic cash flows associated with the goodwill
amortization, it is not immediately apparent that the required goodwill
amortization has a negative effect on stock prices. This study examines
the extent to which increases in purchased goodwill are negatively associated with the security prices of acquiring companies at the time of the
first earnings announcement following the completion of the merger. The
results indicate that firms exhibit negative abnormal returns around the
first quarterly earnings announcement date following a purchase business
combination and that the size of the reaction is negatively related to the
amount of goodwill associated with the purchase. Thus, the results support
the concerns expressed by the financial press that reporting large amounts
of goodwill is bad news at the time of earnings announcements. These
results are not inconsistent with the findings of earlier work suggesting
that goodwill is positively valued by the market. Rather, our results suggest
that while goodwill may be viewed positively as an asset, the earnings
impact of the amortization of goodwill is bad news to the market. J BUSN
RES 2000. 49.79–88. 2000 Elsevier Science Inc. All rights reserved
its implications for the subsequent performance of the combined entity. Top management of firms seeking to acquire
other companies attempts to avoid purchase accounting when
possible to avoid the hit to earnings associated with goodwill
amortization (Lys and Vincent, 1995). However, since there
may be no economic cash flows associated with the goodwill
amortization, it is not immediately apparent that the required
goodwill amortization has a negative effect on stock prices.1
On the other hand, there is substantial anecdotal evidence
to suggest that managers believe that goodwill amortization
hurts their company’s performance and act to minimize its
effect (e.g., Laderman, 1989; Wechsler, 1989a; Linden, 1990;
McGoldrick, 1990, 1997). A recent article by Beth McGoldrick
in the Institutional Investor discusses the efforts made by management of acquiring firms to structure business combinations
as poolings of interest in order to avoid the negative earnings
impact associated with goodwill amortization noting that,
When Paramont Communications failed in its $11 billion
bid to purchase Time in 1989, one often cited reason
was that the deal would have included $9.2 billion of
accounting goodwill. This staggering load was expected to
depress the earnings of the acquiring company—and its
stock price—for years to come (McGoldrick, 1997, p. 145).
1
A
ccounting for purchased goodwill in mergers and acquisitions has been a hotly debated issue for many years
because of the increasingly large impact of goodwill
amortization on the reported earnings of acquiring firms and
Address correspondence to K.B. Norris, University of Tennessee, Department
of Accounting and Business Law, 603 Stokely Management Center, Knoxville,
TN 37996-0560 .
Journal of Business Research 49, 79–88 (2000)
2000 Elsevier Science Inc. All rights reserved
655 Avenue of the Americas, New York, NY 10010
The intangible asset goodwill can only arise when a business combination
is accounted for by the purchase method. If any cash is paid for the acquisition,
the purchase method, rather than the pooling-of-interests method, combination is required. U.S. accounting rules require that the goodwill be amortized
over its useful life but not more than 40 years. However, prior to the Revenue
Reconciliation Act of 1993 (OBRA 93), the Internal Revenue Code did not
allow for the amortization of goodwill for tax purposes. Consequently, the
required amortization of goodwill implemented in 1970 by APB Opinion
No. 17 penalized reported earnings but had no direct cash flow effects.
Even now, not all goodwill can be amortized for tax purposes. Goodwill
amortization for tax purposes requires that the business combination be
taxable.
ISSN 0148-2963/00/$–see front matter
PII S0148-2963(98)00118-0
80
J Busn Res
2000:49:79–88
In another example, Gillette Company acquired Duracell
International Inc. in a stock-swap intentionally structured as
a pooling-of-interests. A report of the deal emphasized how
accounting rules seemed to motivate management’s behavior:
Gillette executives deliberately structured the deal to cater
to Wall Street’s simplistic emphasis on reported earnings
per share. They chose an accounting treatment that would
appeal to the Street—even though it may cost shareholders
more money. So important was the accounting strategy
that one Gillette adviser says the company would have
walked away had Duracell insisted on a cash deal (Maremont, 1996, p. 36).
Proponents of the perception that the required amortization
of goodwill is detrimental to company valuation also have
asserted that it is affecting the international competitive ability
of U.S. firms bidding against foreign firms (An Edge to Foreign
Buyers?, 1988; Dieter, 1989; Wechsler, 1989b; Davis, 1992).
However, despite the concerns voiced by the financial
press, no empirical evidence has substantiated that the noncash write-off to earnings caused by goodwill amortization
negatively impacts stock prices. Davis (1996, p. 58) reviews
extant literature and concludes that, “There is thus no reason
for firms to hide goodwill and, as yet, no conclusive evidence
that the non-cash reduction in reported income caused by
goodwill amortization harms stock prices.”
This study examines this issue. Specifically, we examine the
extent to which increases in purchased goodwill are negatively
associated with the security prices of acquiring companies at
the time of the first earnings announcement following the
completion of the merger. The results indicate that firms exhibit negative abnormal returns around the first quarterly
earnings announcement date following a purchase business
combination and that the size of the reaction is negatively
related to the amount of goodwill associated with the purchase. Thus, the results support the concerns expressed by
the financial press that reporting large amounts of goodwill
is bad news at the time of earnings announcements. These
results are not inconsistent with the findings of earlier work
suggesting that goodwill is positively valued by the market.
Rather, our results suggest that while goodwill may be viewed
positively as an asset, the earnings impact of the amortization
of goodwill is bad news to the market.
The remainder of this article is structured as follows. In
the next section, previous literature examining the market
response to goodwill disclosures is examined. Then, the research hypotheses are developed. The fourth section discusses
the methodology and presents the results. The final section
summarizes the results and presents conclusions.
Prior Literature
Hong, Kaplan, and Mandelker (1978) compared tax-free poolings and purchases over the period 1954–1964 and found no
K. B. Norris and F. L. Ayres
evidence that abnormal returns were negative for firms using
the purchase method during the period after the merger.
Using a sample of 97 poolings and 27 purchases, the authors
examined abnormal stock returns by using the market model
and monthly returns for the period from 12 months before
the merger date until 11 months after the merger date. The
results indicated generally insignificant returns for firms using
poolings and positive abnormal returns in the post-announcement period for purchase acquisitions. Davis (1990) replicated
Hong, Kaplan, and Mandelker over the 1971–1982 time period by using weekly returns and found similar results. Both
of these studies focused on average market reactions of pooling
and purchase firms relative to the merger announcement date.
In contrast, in this study we focus on returns during the
period surrounding the first earnings announcement following
the merger and its relation to goodwill amortization.
Davis (1990), Robinson and Shane (1990), and Vincent
(1997) provided evidence that merger premia are greater for
poolings than purchases. These findings are consistent with
the reluctance of acquiring firms to book large amounts of
goodwill. That is, in cases where it is likely that goodwill
is greatest, it appears that efforts are made to structure the
combination as a pooling of interest. Vincent concluded that
there is support for the concern that purchase method accounting has negative valuation implications.
Several studies provide evidence that goodwill values are
viewed as assets by the market (e.g., Vincent, 1997; Wang,
1993; McCarthy and Schneider, 1995; Jennings, Robinson,
Thompson, and Duvall, 1996). Jennings, Robinson, Thompson, and Duvall examined the relation between equity values
and reported goodwill for the period 1982–1988. They found
that when goodwill was regressed against the market value of
equity, a strong positive relation was found for each of seven
years after the acquisition. The size of the coefficient decreased
each year consistent with goodwill being a wasting asset.
Jennings, Robinson, Thompson, and Duvall also examined
the relation between market values and goodwill amortization
in the seven post-merger years. The results are mixed depending upon the form of the model but provide some evidence that goodwill amortization is negatively associated with
market value.
Summarizing the status of current research findings, it
appears that reported goodwill is viewed as an economic
resource by market participants, but at the same time, there
is evidence that the unreported goodwill associated with pooling-of-interest accounting is even higher. This is consistent
with the hypothesis that managers concerned with the negative
hit to earnings associated with goodwill amortization will
expend resources to avoid this cost. While the above studies
provide indirect evidence that the goodwill amortization
would be expected to be associated negatively with returns,
they do not directly test this conjecture.
From a policy perspective, it is important to determine if
in fact, the hit to earnings associated with goodwill amortiza-
Security Market Reaction to Purchase Business Combinations
tion is associated with a negative stock market reaction. If it
is not, then managers may be spending resources to structure
transactions as poolings of interest for reasons not related to
the impact on shareholders.2
Hypotheses
Valuation of acquiring firms involved in merger has been
investigated in finance and accounting research. Jensen and
Ruback (1983) reviewed over 40 studies in the merger and
acquisition literature. In the majority of these studies, successful bidding firms experienced negative abnormal returns
around the date the merger was finalized (Langetieg, 1978;
Dodd, 1980; Asquith, 1983; Malatesta, 1983). Although goodwill amortization alone most likely does not fully explain the
price declines to bidding firms, the required amortization may
be a partial factor in explaining those declines.
The first research hypothesis tests the assertion that the
release of information related to the earnings impact of goodwill is associated with a decrease in firm valuation:
H1A: Acquiring firms recording a business combination
by the purchase method that results in an increase
in goodwill will exhibit negative unexpected returns
at the time period surrounding the first earnings
release after the merger.
We also examine the relation between the change in goodwill and abnormal returns by using a cross-sectional regression
model. If the amount of goodwill recognized is associated
with the stock returns of the acquiring firm, then differing
impacts might be observed among firms depending on the
size of each firm’s goodwill change. The second hypothesis
tested in this study is:
H2A: For acquiring firms recording a business combination by the purchase method, those with a proportionately larger change in goodwill experience a
greater decrease in returns around the earnings announcement period.
Rejection of the null hypothesis in this case would be
an indication of a negative association between the goodwill
change and the market valuation of the firm and provide
additional support for the contention in the popular press
that the required amortization of goodwill in the United States
has negative valuation consequences. From a policy perspective, support for H2A suggests that U.S. firms may be disadvantaged in international capital markets relative to countries
that do not require goodwill amortization.
2
One possibility is that managers are reluctant to express that their true
concern is with the impact on earnings-based compensation plans and assessments of their performance and that they use allegations of negative market
price reactions as an excuse for their actions.
J Busn Res
2000:49:79–88
81
Methodology
Event Date
The first time at which the results of the acquisition and its
effect on earnings is reported in the financial statements of
the company is the first quarterly earnings report after the
acquisition becomes effective.3 At this date, the effects from
the purchase combination accounting method are known with
certainty, and the reported earnings figure reflects the impact
of the required accounting for goodwill.4 Prior to that time,
even if the amount of goodwill has been reported, its impact
on earnings is uncertain.
Data
A list of acquisitions was compiled from Accounting Trends
and Techniques (1987–1991) and from the delistings of stocks
from the Daily CRSP Stock file, for the years 1984–1990. This
seven-year sample period covers a range of years in which the
income-statement impact of goodwill amortization had become
more significant (Davis, 1992, exhibit 4), and the sample controls for the post-1970 and pre-1993 regulation time periods.
Acquisitions were limited to those which were paid with all
cash5 or with a mixture of cash and less than 50% common
stock, to control for tax status and method of payment.6
The total price paid for the acquisition, the goodwill
amount, the amortization period, and the effective date of the
acquisition for accounting purposes were obtained from the
footnotes of the acquiring company’s annual report. The Wall
Street Journal Index (WSJI) was examined to obtain the date of
the first quarterly earnings announcement after the acquisition
was complete. A further review of the historical sequence
of announcements in the WSJI eliminated dates with other
significant announcements during the test period. Both the
annual reports and the WSJI provided data on whether the
acquisition was initiated as a tender offer or a merger/acquisition of company assets or stock.
Finally, complete firm data for computing regression model
variables had to be available from the COMPUSTAT Industrial
or Industrial Research databases and complete monthly or
daily security returns for the estimation and test periods had
to be available from the CRSP Stock files. At the end of these
processes, 157 acquisitions out of an original 1,004 remained
in the sample.
3
The SEC requires that the results of the acquisition be reflected in the Form
10-Q for the quarter in which the transaction was consummated.
4
Bernard (1989) suggests that capital market studies involving accounting
policy choices focus on earnings announcement days when method choices
have their impact.
5
If the consideration paid for the acquisition included debt instruments,
the acquisition was not included in the sample in order to restrict the method
of payment for the acquisition.
6
Prior research has classified samples with acquisitions paid for with less
than 50% stock as taxable, cash acquisitions. This classification is the same
as that employed by Brown and Ryngaert (1991) and Travlos (1987).
82
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2000:49:79–88
K. B. Norris and F. L. Ayres
Table 1. Summary of Sample Selection
Cross-Sectional Regression Analysis
Selection Criteria
No.
Purchase combinations from ATT
Possible additional purchase combinations from
CRSP delistings
Initial sample
481
523
1004
Not a majority cash purchase combination,
confounding announcements found, missing
annual report disclosures, or no event dates
Incomplete data from CRSP and COMPUSTAT
Insignificant goodwill impact
Final sample
(754)
(93)
(41)
116
The sample was further reduced to those acquisitions where
GW/NI was at least 1% by computing the ratio of the new
amount of goodwill to be amortized in the year after the
merger to the net income of the firm in the year before the
merger (GW/NI). The final sample consisted of 116 acquisitions. Table 1 describes the sample selection.
Table 2 reports descriptive statistics for the total sample.
The average purchased goodwill amount is more than half of
the average price paid. Goodwill increases substantially as a
percentage of net income during the year of the acquisition.
On average, this percentage increased from 41% in the year
prior to the acquisition to 110% in the year of the acquisition.
The 36-year average amortization period indicates that firms
tend to maximize the amortization period. Table 3 illustrates
that there is a wide range of industries represented in the
sample with the largest number of acquisitions occurring in
publishing, chemicals, machinery/equipment, and engineering.
Event Study Analysis
To evaluate the performance of the stock prices associated
with the merger period, we employed standard event date
methodology. Using the single-index market model, we estimated abnormal returns per firm (AR). Then average abnormal
returns per test sample (AAR) and cumulative average abnormal returns per test sample (CAAR) were computed.7 The
statistical significance of the return metrics was determined
using a parametric mean test. The test statistic Z for the average
abnormal returns and for the cumulative average abnormal
returns was computed following the procedures of Dodd and
Warner (1983).
Cross-sectional regression using weighted least squares was
employed to obtain additional insights into the price effects
associated with the goodwill change by using the individual
firm CAART1,T2 as the dependent variable. The independent
variable investigated in this study is the change in goodwill
(DGW). It was measured as the total amount of goodwill
recorded from the specific business combination of interest
and was obtained from the footnote disclosures of the firm’s
annual report. Control variables included those for which
evidence of a significant relation to abnormal returns around
merger dates was found in previous studies, change in depreciation (Hayn, 1989), relative size of the acquisition (Asquith,
Bruner, and Mullins, 1983), and type of acquisition (Jensen
and Ruback, 1983).
A control variable was included for the tax benefit from a
change in the depreciable asset base after merger. The assets
of the target firm are valued at fair market value in a purchase
combination. The depreciable asset base of the acquiring firm
is often increased, providing a tax advantage. Even though,
like goodwill amortization expense, the increased depreciation
expense has a negative impact on net income, depreciation
expense increases cash flows to the acquiring firm in the form
of tax savings.8 To derive the tax benefit (cost) associated with
the increased (decreased) asset base, we computed change
in depreciation, DDEPR, as the change in depreciation and
amortization from period t-1 to t multiplied by the statutory
corporate tax rate for the year of the merger event.
The relative size of the acquisition was included to allow
for the impact the acquisition has on the acquiring firm and
to account for differences in abnormal returns due to the size
of targets relative to bidders reported by Asquith, Bruner, and
Mullins (1983). Evidence from that study demonstrated that
the larger the target firm in relation to the bidding firm, the
larger the price response of the bidding firm. Size of the acquisition, SAQ, was measured by the ratio of the price paid for
the acquisition to the corresponding market value of the bidding
firm’s common equity at the beginning of the event period.
Finally, since there is some evidence that in acquisitions
initiated as tender offers returns to bidding firms have generally been higher than those in merger bids (Jensen and Ruback,
1983), a dichotomous variable was employed to allow for
8
7
The monthly estimation period used in this study is 60 months, ending 13
months prior to each event date. The daily estimation period is 255 trading
days, ending six weeks before the announcement date of the impending
acquisition in order to exclude announcement period returns from the estimation periods for the later two dates. For acquisitions with no published
announcement date, eight months before the effective date (which is present
for every observation) is computed as the end of the estimation period. This
end date was chosen because of the 99 firms with announcement dates
present, only six did not announce within seven months of the effective date.
Hayn (1989) found a significant positive relation between the increase in
assets and the cumulative abnormal returns of acquiring firms involved in
taxable mergers at the acquisition announcement. However, Hayn’s stepup in asset base variable included an estimate of accumulated accelerated
depreciation since accelerated methods are usually used for tax reporting
rather than the straight-line methods typically found in financial statements.
While the depreciation expense reported in COMPUSTAT is computed for
financial statements, there is no ex ante reason to believe a systematic difference
in depreciation expense occurs among firms selected in the random sample for
this study. Consequently, it was expected that these measurement differences
would on average not confound inferences drawn from the sample.
Security Market Reaction to Purchase Business Combinations
83
J Busn Res
2000:49:79–88
Table 2. Descriptive Statistics for Sample Acquisitions
Panel A: Number of acquisitions by year
1984
8
1985
12
1986
25
1987
13
1988
22
1989
23
1990
13
Total acquisitions
116
Panel B: Sample means and medians
Variable
Mean
Deviation
Minimum
Maximum
Median
Year 5 t
Price paid
Goodwill amount
Amortization period (years)
Market value of equity
NI
New GW Amortization/NI
605.52
362.88
35.77
2689.12
188.50
1.10
1519.98
1171.12
8.70
6452.17
472.49
4.16
0.146
0.116
5
5.08
(639.3)
0.004
12900
11600
40
48949
2697
24.26
182.30
86.55
40
1016.02
65.39
0.034
Year 5 t 2 1
Market value of equity
NI
New GW Amortization/NI
2370.13
135.80
0.406
4971.2
445.5
1.45
4.95
(1669.)
0.010
33172
2410
11.00
890.38
45.44
0.043
N 5 116; t 5 effective year of acquisition. NI 5 net income.
these differences. Type of acquisition is scaled TYPE 5 0 for
merger proposals and TYPE 5 1 for tender offers.
When valuing firms are involved in acquisitions, market
participants may have additional considerations. Some acquiring firms borrow to finance acquisitions for which the consideration is paid in cash. Previous capital structure research in
finance has found that leverage-increasing events have positive
announcement effects owing to the increased cash flow from
the added tax shield (e.g., Miller and Modigliani, 1966; Masulis, 1980; and Bradley, Jarrell, and Kim, 1984). A variable
for the tax benefit (cost) of increased (decreased) leverage
(DLEV) was computed as the change in long-term debt from
period t-1 to t, multiplied by the statutory corporate tax rate
for the year of the merger event.9
A second relation, operating income change, proxies for
differences in firm operating economies from pre- to postacquisition, since traditional merger theory assumes acquisitions are undertaken expecting synergistic gains from the combination. Operating income change, rather than net income
change, was considered a less encumbered measurement since
it does not contain gains and losses from other sources,
changes in sales and cost of goods sold, and depreciation and
interest expense changes that could have been a result of the
merger and are captured in other variables.10 The change in
operating income (DOPINC) is the change in earnings before
the depreciation, tax, and interest expenses measured as a
percentage change. It was calculated as operating income at
period t, minus operating income at period t-1, divided by
the operating income at period t-1.
To achieve comparability between firms, DGW, DDEPR,
and DLEV were deflated by the market value of equity (MVE)
of the acquiring firm at the beginning of the period. MVE,
common shares outstanding times price at close of the period,
was computed from data at the end of the year previous to
the business combination event date (t-1).
This resulted in the regression model for individual firm
stock returns shown in the following equation:
9
10
Change in long-term debt, rather than change in interest expense, is employed because it measures the total change in debt at the end of the accounting
period. The change in interest may be affected by how long the debt was
held. If the debt was increased substantially toward the end of the year, the
interest expense for the year might not fully capture the impact of the increased
debt on the future cash flows of the firm.
CAART1,T2 5 b0 1 b1DGW 1 b2DDEPR 1 b3SAQ 1 b4 TYPE 1 b5DLEV 1 b6DOPINC
(2)
(1)
(1)
(1)
(1)
The subscript i is omitted for each individual firm observation. A negative and significant coefficient b1 of the DGW
variable supports the hypothesis that the increase in goodwill
is negatively related to the stock price of the acquiring firm.
Under purchase accounting, the income of the target company would not
be included for the entire merger year. Depending on the time of year, much
of the target’s earnings might not be included in the measurement for operating
income. However, reducing the impact of the target’s income on the combined
company’s income would bias against the hypothesis of a positive relation
between increased operating efficiencies and returns.
84
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2000:49:79–88
K. B. Norris and F. L. Ayres
Table 3. Sample Acquisitions by Industry
SIC
Industry Description
Number
13
14
20
21
22
23
26
27
28
29
30
32
33
34
35
36
37
38
39
40
45
48
49
51
53
54
61
73
87
Total acquisitions
Oil and gas
Mining
Food products
Tobacco
Textiles
Apparel
Paper products
Publishing
Chemicals
Refining
Tires/rubber
Glass/cement
Steel
Metals
Machinery/equipment
Communications
Aircraft
Instruments
Games/sporting goods
Railroads
Airtransportation
Radio/telephone
Natural gas/electric
Nondurable goods
Department stores
Groceries
Financial
Advertising
Engineering
1
1
6
3
2
2
4
12
11
2
3
2
3
9
14
8
8
6
2
1
2
2
1
5
1
2
1
1
19
116
SIC 5 Standard Industrial Classification.
Hayn (1989) found a positive relation between the increase
in asset base and abnormal returns to bidding firms, thus b2
was predicted to be positive. The coefficient b3 was predicted
to be positive, since previous research has shown that the
larger the target in relation to the bidder, the greater the impact
on the bidding firm. A change in debt was hypothesized to
be positively related to returns, indicating a positive coefficient
for b5. A positive b6 was hypothesized because traditional
merger theory assumes acquisitions are undertaken expecting
synergistic gains from the combination of two firms resulting
in a positive relation between the change in efficiency due to
operating economies and firm returns. No prediction was
made about the intercept term.
Empirical Results
Average daily and monthly abnormal returns for the quarterly
earnings report date are reported in Table 4, panel A. Both
the daily and monthly abnormal returns are negative and
significant at p 5 0.01 and p 5 0.10, respectively. The reaction
at the earnings announcement date supports H1A and is consistent with the hypothesis that investors respond negatively
to the earnings impact of goodwill amortization.
Panel B of Table 4 shows the results of the regressions for
the quarterly earnings report date. Collinearity diagnostics
were run for the regressions following the procedures of Belsley, Kuh, and Welsch (1980, p. 112). The daily abnormal
return regression demonstrates no significant coefficients. In
the regression of monthly abnormal returns, the coefficient
of DGW is significantly negative at the 0.05 level. This is
consistent with H2A and indicative of the investors responding
negatively to the amortization of goodwill. DLEV is positive
and significantly related to abnormal returns, consistent with
investors increasing the market valuation of the firm due to
the increased tax shields provided by the increased debt.
DOPINC is marginally significant and positive lending some
support to the hypothesis that increased operating efficiencies
were viewed positively by the market.11,12 The insignificance
of the results in the daily cross-sectional regression is an area
of concern. One explanation may be that the information
about goodwill amortization may become available to market
participants throughout the earnings announcement month
and not just on the day of the earnings release. This is consistent with the finding that the CAAR is greater in absolute
terms when the monthly abnormal returns are used. The
monthly CAAR is 21.19% compared with only 2.60% for
the two-day return on the earnings release date.
If the earnings impact of goodwill amortization is driving
the negative abnormal returns, we would expect the result to
be most pronounced for firms most affected, that is, those
with the greatest amount of new goodwill as a result of the
acquisition. In order to determine if the relation between
goodwill and abnormal returns was greatest for firms with the
largest amounts of reported goodwill, we ranked the sample
on the basis of the impact of the newly acquired goodwill
amortization on earnings, and the monthly regressions were
run by using only firms in the highest and lowest quintile
These results are presented in Table 5. Panel A shows monthly
average abnormal returns for the high and low goodwill sample. None were significantly different from zero.13 However, in
the cross-sectional regression of the relation between goodwill
change and abnormal returns in the announcement month
(panel B), the results indicate that for firms in the high goodwill
quintile there is a strong negative relation between the change
11
In the case that the variable DOPINC was not measuring enough of the
change in operating efficiencies, the monthly regression was replicated using
the change in net income (DNI 5 (NIt 2 NIt-1)/MVE) rather than the change
in operating income (DOPINC). The test results were qualitatively similar in
the month of the earnings report.
12
A post-event date estimation period also was used in the examination
of daily abnormal returns. The estimation period is 255 trading days long
and begins six weeks after the quarterly earnings report date. Results for the
two-day returns were still negative like in the preevent date beta analysis but
insignificant. In the regression analysis, all results were qualitatively the same.
13
For daily returns, we also examined a variety of different cumulation
windows including (21,0), (26,0), (24,0), and (210,11). These average
residuals also were not significantly different from zero.
Abnormal Returns around the Event
Date Period
Panel A: Abnormal Returns
Period
CAAR
Z
Dailyb (n 5 114)
Monthlyd (n 5 108)
(21, 0)
(0)
20.60
21.19
22.47c
21.4e
Panel B: Cross-Sectional Regression of Individual CAARSf CAAR 5 b0 1 b1DGW 1 b2DDEPR 1 b3SAQ 1 b4TYPE 1 b5DLEV 1 b6DOPINC
Abnormal
Returns
Expected sign
Daily
(n5 109)
Monthly
(n5103)
Dependent
Variable
CAAR (21, 0)
AR (0)
Coefficients for Independent Variables
Intercept
DGW
DDEPR
SAQ
TYPE
DLEV
0.005
(20.83)
20.010
(21.10)
2
20.001
(20.02)
20.095
(21.73)g
1
0.024
(0.03)
20.286
(20.30)
1
20.003
(20.18)
0.010
(0.41)
20.014
(21.10)
20.024
(21.30)
1
0.041
(0.61)
0.201
(2.27)c
DOPINC
F-value
Adj R2
1
0.001
(0.24)
0.009
(1.56)e
0.318
(0.93)
2.156
(0.05)
20.040
Security Market Reaction to Purchase Business Combinations
Table 4. Quarterly Earnings Report Date Abnormal Returns and Cross-Sectional Regression of Individual Abnormal Returns for Purchase Combinations in 1984–1990a
0.064
a
Sample size may vary slightly in each test due to missing returns in the estimation period or missing data for measuring the independent variables.
255-day estimation period ending 6 weeks before the announcement date.
p , 0.010.
d
60-month estimation period ending 13 months before the quarterly earnings date.
e
p , 0.1.
f
t-tests are in parentheses; t-tests for significance of TYPE coefficient are two-tailed; for other coefficients, t-tests are one-tailed.
g
p , 0.05.
DGW, GW/MVE; DDEPR, ((DEPRt 2 DEPRt21) 3 TAXRATEt)/MVE; SAQ, ACQPRICE/MVE; TYPE, 1 5 tender offer, 0 5 merger/acquisition; DLEV, ((LTDEBTt 2 LTDEBTt21) 3 TAXRATEt)/MVE; DOPINC, (OPINCt 2 OPINCt21)/
OPINCt21, where, GW 5 total goodwill from new acquisition; ACQPRICE 5 price paid for the acquisition; MVE 5 market value of common equity; LTDEBT 5 long-term debt; DEPR 5 annual depreciation; OPINC 5 operating
income; TAXRATE 5 statutory corporate tax rate.
b
c
J Busn Res
2000:49:79–88
85
86
J Busn Res
2000:49:79–88
Table 5. Monthly Abnormal Returns and Cross-Sectional Regression of Individual Abnormal Returnsa for High and Low Goodwill Purchase Combinations in 1984–1990b at the
Quarterly Earnings Report Date
Panel A: Abnormal Returns around the Event Date
Abnormal Returns
Low goodwill (n 5 22)
High goodwill (n 5 23)
Period
CAAR
Z
(0)
(0)
0.16
1.64
0.0
1.3
Panel B: Cross-Sectional Regression of Individual CAARSc CAAR 5 b0 1 b1DGW 1 b2DDEPR1b3SAQ 1 b4TYPE 1 b5DLEV 1 b6DOPINC
Abnormal
Returns
Expected sign
Low goodwill
(n5 19)
High goodwill
(n522)
Dependent
Variable
AR (0)
AR (0)
Coefficients for Independent Variables
Intercept
DGW
DDEPR
SAQ
TYPE
DLEV
DOPINC
F-value
Adj R2
20.011
(20.17)
20.017
(1.01)
2
0.343
(0.23)
20.240
(24.36)d
1
1.334
(0.21)
21.877
(21.56e)
1
20.195
(20.90)
0.053
(1.54e)
20.029
(20.30)
20.003
(20.09)
1
0.885
(1.29)
0.328
(3.53)d
1
20.107
(0.83)
0.005
(0.93)
0.317
(0.92)
4.445
(0.01)
20.295
0.496
a
60-month estimation period ending 13 months before the quarterly earnings date. AR, abnormal returns.
Sample size may vary slightly in each test due to missing returns in the estimation period or missing data for measuring the independent variables.
t-tests are in parentheses; t-tests for significance of TYPE coefficient are two-tailed; for other coefficients t-tests are one-tailed.
d
p , 0.001.
e
p , 0.10.
DGW, GW/MVE; DDEPR, ((DEPRt 2 DEPRt21) 3 TAXRATEt)/MVE; SAQ, ACQPRICE/MVE; TYPE, 1 5 tender offer, 0 5 merger/acquisition; DLEV, ((LTDEBTt 2 LTDEBTt21) 3 TAXRATEt)/MVE; DOPINC, (OPINCt 2 OPINCt21)/
OPINCt21, where, GW 5 total goodwill from new acquisition; ACQPRICE 5 price paid for the acquisition; MVE 5 market value of common equity; LTDEBT 5 long-term debt; DEPR 5 annual depreciation; OPINC 5 operating
income; TAXRATE 5 statutory corporate tax rate.
b
c
K. B. Norris and F. L. Ayres
Security Market Reaction to Purchase Business Combinations
in goodwill and abnormal returns in the announcement month.
In contrast, for firms in the low quintile, the cross-sectional
regressions were insignificant. Regressions of the daily abnormal
returns by using the high and low goodwill sample also were
not significant and are not reported here. Overall the findings
are consistent with the hypothesis that goodwill amortization
is viewed negatively by the market as information about its
impact is released. It is also consistent with the hypothesis
that this information becomes available to market participants
gradually during the month leading up to the first quarterly
earnings announcement following the merger.14
Summary
Employing a sample of 116 acquisitions occurring during the
years 1984–1990, we found a negative association between
increased goodwill from a purchase combination and abnormal returns of acquiring firms. Owing to the nature of the
dispersion of goodwill information into the market across time
rather than on one day, the negative association is reflected
in monthly abnormal returns, rather than daily abnormal returns. At the first quarterly earnings announcement after the
acquisition effective date, the market responds negatively, and
this time there is a negative association between abnormal
returns and the change in goodwill. Consequently, it appears
that a negative reaction occurs on the first earnings announcement date in response to the book reduction in reported
earnings from the goodwill amortization. Taken together, this
evidence supports the hypothesis that the market considers the
increase in goodwill when valuing firms involved in purchase
combinations and responds negatively to the earnings impact
of goodwill amortization.15
14
We reviewed Lexis-Nexis for information disclosures during periods surrounding the merger announcement and the first earnings announcement
following the merger. We found a tremendous variance in the amount of
disclosure about the impact of goodwill and its earnings impact. Most typically, however, earnings releases reported operating income before goodwill
amortization if an advance earnings announcement was made. In these cases,
the impact of the merger-related amortization of earnings would not be known
until the issuance of the quarterly financial statements. The wide variation
in disclosures about the impact of goodwill is consistent with that reported
by Duvall, Jennings, Robinson, and Thompson (1992). They examined a large
sample of firms and reported that despite requirements that disclosures be
made about the impact of goodwill on earnings, that in fact disclosures about
goodwill and its amortization varied widely in the degree of disclosure about
goodwill and the amortization periods used.
15
A possible alternate explanation for the observed relation is that the
negative relation between goodwill and returns on the earnings announcement
date signals the extent of overpayment for the acquisition. However, there
is no reason to expect that this effect would be observed on the earnings
announcement date following the merger. Rather, we would expect that if
the market perceived that there had been an overpayment for the acquisition,
the negative impact on returns to the acquiring firm would be observed at
the time of the merger announcement. We examined average daily and
monthly abnormal returns at the merger announcement date and found the
daily returns (CAAR(21,0) 5 21.26) to be significantly negative at less than
the 0.001 level. We also ran cross-sectional regressions by using both daily
and monthly returns on the merger announcement date and the results were
insignificant.
J Busn Res
2000:49:79–88
87
The results from this study support the contentions of
managers and the financial press that stock prices are adversely
impacted by the earnings impact of goodwill amortization
following a purchase combination with large amounts of goodwill. Consistent with the results of Hand (1990) and Shleifer
and Summers (1990), it appears that market participants responded to the earnings impact of the goodwill amortization
rather than to its direct cash flow impact suggesting that
in business combinations form may be as important as the
substance of the transaction.
The authors would like to thank the editor and the anonymous reviewers
for their helpful comments. Any remaining errors belong solely to the authors.
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1988): 7–8.
Asquith, P.: Merger Bids. Uncertainty, and Stockholder Returns.
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Asquith, P., Bruner, R. F.m and Mullins D. W. Jr.: The Gains to
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Brown, D. T., and Ryngaert, M. D.: The Mode of Acquisition in
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Davis, M. L.: Goodwill Accounting: Time for an Overhaul. Journal
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Davis, M. L.: The Purchase Vs. Pooling Controversy: How the Stock
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Dieter, R.: Is Now the Time to Revisit Accounting for Business Combinations? The CPA Journal 59 (July 1989): 4448.
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Hand, J. R. M.: A Test of the Extended Functional Fixation Hypothesis. The Accounting Review 65 (October 1990): 740–763.
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Hong, H., Kaplan, R. S., and Mandelker, G.: Pooling vs. Purchase: The
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Jennings, R., Robinson, J., Thompson, R. B., and Duvall, L.: The
Relation Between Accounting Goodwill Numbers and Equity Values. Journal of Business, Finance and Accounting 23 (June 1996):
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Bidding Firms’ Stock Returns. The Journal of Finance 42 (September 1987): 943–963.
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Business Combinations at the First
Earnings Announcement Date
Kathleen Blackburn Norris
UNIVERSITY OF TENNESSEE
Frances L. Ayres
UNIVERSITY OF OKLAHOMA
Accounting for purchased goodwill in mergers and acquisitions has been
a hotly debated issue for many years because of the increasingly large
impact of goodwill amortization on the reported earnings of acquiring
firms and its implications for the subsequent performance of the combined
entity. There is evidence that top management of firms seeking to acquire
other companies attempts to avoid purchase accounting when possible to
avoid the hit to earnings associated with goodwill amortization. However,
since there may be no economic cash flows associated with the goodwill
amortization, it is not immediately apparent that the required goodwill
amortization has a negative effect on stock prices. This study examines
the extent to which increases in purchased goodwill are negatively associated with the security prices of acquiring companies at the time of the
first earnings announcement following the completion of the merger. The
results indicate that firms exhibit negative abnormal returns around the
first quarterly earnings announcement date following a purchase business
combination and that the size of the reaction is negatively related to the
amount of goodwill associated with the purchase. Thus, the results support
the concerns expressed by the financial press that reporting large amounts
of goodwill is bad news at the time of earnings announcements. These
results are not inconsistent with the findings of earlier work suggesting
that goodwill is positively valued by the market. Rather, our results suggest
that while goodwill may be viewed positively as an asset, the earnings
impact of the amortization of goodwill is bad news to the market. J BUSN
RES 2000. 49.79–88. 2000 Elsevier Science Inc. All rights reserved
its implications for the subsequent performance of the combined entity. Top management of firms seeking to acquire
other companies attempts to avoid purchase accounting when
possible to avoid the hit to earnings associated with goodwill
amortization (Lys and Vincent, 1995). However, since there
may be no economic cash flows associated with the goodwill
amortization, it is not immediately apparent that the required
goodwill amortization has a negative effect on stock prices.1
On the other hand, there is substantial anecdotal evidence
to suggest that managers believe that goodwill amortization
hurts their company’s performance and act to minimize its
effect (e.g., Laderman, 1989; Wechsler, 1989a; Linden, 1990;
McGoldrick, 1990, 1997). A recent article by Beth McGoldrick
in the Institutional Investor discusses the efforts made by management of acquiring firms to structure business combinations
as poolings of interest in order to avoid the negative earnings
impact associated with goodwill amortization noting that,
When Paramont Communications failed in its $11 billion
bid to purchase Time in 1989, one often cited reason
was that the deal would have included $9.2 billion of
accounting goodwill. This staggering load was expected to
depress the earnings of the acquiring company—and its
stock price—for years to come (McGoldrick, 1997, p. 145).
1
A
ccounting for purchased goodwill in mergers and acquisitions has been a hotly debated issue for many years
because of the increasingly large impact of goodwill
amortization on the reported earnings of acquiring firms and
Address correspondence to K.B. Norris, University of Tennessee, Department
of Accounting and Business Law, 603 Stokely Management Center, Knoxville,
TN 37996-0560 .
Journal of Business Research 49, 79–88 (2000)
2000 Elsevier Science Inc. All rights reserved
655 Avenue of the Americas, New York, NY 10010
The intangible asset goodwill can only arise when a business combination
is accounted for by the purchase method. If any cash is paid for the acquisition,
the purchase method, rather than the pooling-of-interests method, combination is required. U.S. accounting rules require that the goodwill be amortized
over its useful life but not more than 40 years. However, prior to the Revenue
Reconciliation Act of 1993 (OBRA 93), the Internal Revenue Code did not
allow for the amortization of goodwill for tax purposes. Consequently, the
required amortization of goodwill implemented in 1970 by APB Opinion
No. 17 penalized reported earnings but had no direct cash flow effects.
Even now, not all goodwill can be amortized for tax purposes. Goodwill
amortization for tax purposes requires that the business combination be
taxable.
ISSN 0148-2963/00/$–see front matter
PII S0148-2963(98)00118-0
80
J Busn Res
2000:49:79–88
In another example, Gillette Company acquired Duracell
International Inc. in a stock-swap intentionally structured as
a pooling-of-interests. A report of the deal emphasized how
accounting rules seemed to motivate management’s behavior:
Gillette executives deliberately structured the deal to cater
to Wall Street’s simplistic emphasis on reported earnings
per share. They chose an accounting treatment that would
appeal to the Street—even though it may cost shareholders
more money. So important was the accounting strategy
that one Gillette adviser says the company would have
walked away had Duracell insisted on a cash deal (Maremont, 1996, p. 36).
Proponents of the perception that the required amortization
of goodwill is detrimental to company valuation also have
asserted that it is affecting the international competitive ability
of U.S. firms bidding against foreign firms (An Edge to Foreign
Buyers?, 1988; Dieter, 1989; Wechsler, 1989b; Davis, 1992).
However, despite the concerns voiced by the financial
press, no empirical evidence has substantiated that the noncash write-off to earnings caused by goodwill amortization
negatively impacts stock prices. Davis (1996, p. 58) reviews
extant literature and concludes that, “There is thus no reason
for firms to hide goodwill and, as yet, no conclusive evidence
that the non-cash reduction in reported income caused by
goodwill amortization harms stock prices.”
This study examines this issue. Specifically, we examine the
extent to which increases in purchased goodwill are negatively
associated with the security prices of acquiring companies at
the time of the first earnings announcement following the
completion of the merger. The results indicate that firms exhibit negative abnormal returns around the first quarterly
earnings announcement date following a purchase business
combination and that the size of the reaction is negatively
related to the amount of goodwill associated with the purchase. Thus, the results support the concerns expressed by
the financial press that reporting large amounts of goodwill
is bad news at the time of earnings announcements. These
results are not inconsistent with the findings of earlier work
suggesting that goodwill is positively valued by the market.
Rather, our results suggest that while goodwill may be viewed
positively as an asset, the earnings impact of the amortization
of goodwill is bad news to the market.
The remainder of this article is structured as follows. In
the next section, previous literature examining the market
response to goodwill disclosures is examined. Then, the research hypotheses are developed. The fourth section discusses
the methodology and presents the results. The final section
summarizes the results and presents conclusions.
Prior Literature
Hong, Kaplan, and Mandelker (1978) compared tax-free poolings and purchases over the period 1954–1964 and found no
K. B. Norris and F. L. Ayres
evidence that abnormal returns were negative for firms using
the purchase method during the period after the merger.
Using a sample of 97 poolings and 27 purchases, the authors
examined abnormal stock returns by using the market model
and monthly returns for the period from 12 months before
the merger date until 11 months after the merger date. The
results indicated generally insignificant returns for firms using
poolings and positive abnormal returns in the post-announcement period for purchase acquisitions. Davis (1990) replicated
Hong, Kaplan, and Mandelker over the 1971–1982 time period by using weekly returns and found similar results. Both
of these studies focused on average market reactions of pooling
and purchase firms relative to the merger announcement date.
In contrast, in this study we focus on returns during the
period surrounding the first earnings announcement following
the merger and its relation to goodwill amortization.
Davis (1990), Robinson and Shane (1990), and Vincent
(1997) provided evidence that merger premia are greater for
poolings than purchases. These findings are consistent with
the reluctance of acquiring firms to book large amounts of
goodwill. That is, in cases where it is likely that goodwill
is greatest, it appears that efforts are made to structure the
combination as a pooling of interest. Vincent concluded that
there is support for the concern that purchase method accounting has negative valuation implications.
Several studies provide evidence that goodwill values are
viewed as assets by the market (e.g., Vincent, 1997; Wang,
1993; McCarthy and Schneider, 1995; Jennings, Robinson,
Thompson, and Duvall, 1996). Jennings, Robinson, Thompson, and Duvall examined the relation between equity values
and reported goodwill for the period 1982–1988. They found
that when goodwill was regressed against the market value of
equity, a strong positive relation was found for each of seven
years after the acquisition. The size of the coefficient decreased
each year consistent with goodwill being a wasting asset.
Jennings, Robinson, Thompson, and Duvall also examined
the relation between market values and goodwill amortization
in the seven post-merger years. The results are mixed depending upon the form of the model but provide some evidence that goodwill amortization is negatively associated with
market value.
Summarizing the status of current research findings, it
appears that reported goodwill is viewed as an economic
resource by market participants, but at the same time, there
is evidence that the unreported goodwill associated with pooling-of-interest accounting is even higher. This is consistent
with the hypothesis that managers concerned with the negative
hit to earnings associated with goodwill amortization will
expend resources to avoid this cost. While the above studies
provide indirect evidence that the goodwill amortization
would be expected to be associated negatively with returns,
they do not directly test this conjecture.
From a policy perspective, it is important to determine if
in fact, the hit to earnings associated with goodwill amortiza-
Security Market Reaction to Purchase Business Combinations
tion is associated with a negative stock market reaction. If it
is not, then managers may be spending resources to structure
transactions as poolings of interest for reasons not related to
the impact on shareholders.2
Hypotheses
Valuation of acquiring firms involved in merger has been
investigated in finance and accounting research. Jensen and
Ruback (1983) reviewed over 40 studies in the merger and
acquisition literature. In the majority of these studies, successful bidding firms experienced negative abnormal returns
around the date the merger was finalized (Langetieg, 1978;
Dodd, 1980; Asquith, 1983; Malatesta, 1983). Although goodwill amortization alone most likely does not fully explain the
price declines to bidding firms, the required amortization may
be a partial factor in explaining those declines.
The first research hypothesis tests the assertion that the
release of information related to the earnings impact of goodwill is associated with a decrease in firm valuation:
H1A: Acquiring firms recording a business combination
by the purchase method that results in an increase
in goodwill will exhibit negative unexpected returns
at the time period surrounding the first earnings
release after the merger.
We also examine the relation between the change in goodwill and abnormal returns by using a cross-sectional regression
model. If the amount of goodwill recognized is associated
with the stock returns of the acquiring firm, then differing
impacts might be observed among firms depending on the
size of each firm’s goodwill change. The second hypothesis
tested in this study is:
H2A: For acquiring firms recording a business combination by the purchase method, those with a proportionately larger change in goodwill experience a
greater decrease in returns around the earnings announcement period.
Rejection of the null hypothesis in this case would be
an indication of a negative association between the goodwill
change and the market valuation of the firm and provide
additional support for the contention in the popular press
that the required amortization of goodwill in the United States
has negative valuation consequences. From a policy perspective, support for H2A suggests that U.S. firms may be disadvantaged in international capital markets relative to countries
that do not require goodwill amortization.
2
One possibility is that managers are reluctant to express that their true
concern is with the impact on earnings-based compensation plans and assessments of their performance and that they use allegations of negative market
price reactions as an excuse for their actions.
J Busn Res
2000:49:79–88
81
Methodology
Event Date
The first time at which the results of the acquisition and its
effect on earnings is reported in the financial statements of
the company is the first quarterly earnings report after the
acquisition becomes effective.3 At this date, the effects from
the purchase combination accounting method are known with
certainty, and the reported earnings figure reflects the impact
of the required accounting for goodwill.4 Prior to that time,
even if the amount of goodwill has been reported, its impact
on earnings is uncertain.
Data
A list of acquisitions was compiled from Accounting Trends
and Techniques (1987–1991) and from the delistings of stocks
from the Daily CRSP Stock file, for the years 1984–1990. This
seven-year sample period covers a range of years in which the
income-statement impact of goodwill amortization had become
more significant (Davis, 1992, exhibit 4), and the sample controls for the post-1970 and pre-1993 regulation time periods.
Acquisitions were limited to those which were paid with all
cash5 or with a mixture of cash and less than 50% common
stock, to control for tax status and method of payment.6
The total price paid for the acquisition, the goodwill
amount, the amortization period, and the effective date of the
acquisition for accounting purposes were obtained from the
footnotes of the acquiring company’s annual report. The Wall
Street Journal Index (WSJI) was examined to obtain the date of
the first quarterly earnings announcement after the acquisition
was complete. A further review of the historical sequence
of announcements in the WSJI eliminated dates with other
significant announcements during the test period. Both the
annual reports and the WSJI provided data on whether the
acquisition was initiated as a tender offer or a merger/acquisition of company assets or stock.
Finally, complete firm data for computing regression model
variables had to be available from the COMPUSTAT Industrial
or Industrial Research databases and complete monthly or
daily security returns for the estimation and test periods had
to be available from the CRSP Stock files. At the end of these
processes, 157 acquisitions out of an original 1,004 remained
in the sample.
3
The SEC requires that the results of the acquisition be reflected in the Form
10-Q for the quarter in which the transaction was consummated.
4
Bernard (1989) suggests that capital market studies involving accounting
policy choices focus on earnings announcement days when method choices
have their impact.
5
If the consideration paid for the acquisition included debt instruments,
the acquisition was not included in the sample in order to restrict the method
of payment for the acquisition.
6
Prior research has classified samples with acquisitions paid for with less
than 50% stock as taxable, cash acquisitions. This classification is the same
as that employed by Brown and Ryngaert (1991) and Travlos (1987).
82
J Busn Res
2000:49:79–88
K. B. Norris and F. L. Ayres
Table 1. Summary of Sample Selection
Cross-Sectional Regression Analysis
Selection Criteria
No.
Purchase combinations from ATT
Possible additional purchase combinations from
CRSP delistings
Initial sample
481
523
1004
Not a majority cash purchase combination,
confounding announcements found, missing
annual report disclosures, or no event dates
Incomplete data from CRSP and COMPUSTAT
Insignificant goodwill impact
Final sample
(754)
(93)
(41)
116
The sample was further reduced to those acquisitions where
GW/NI was at least 1% by computing the ratio of the new
amount of goodwill to be amortized in the year after the
merger to the net income of the firm in the year before the
merger (GW/NI). The final sample consisted of 116 acquisitions. Table 1 describes the sample selection.
Table 2 reports descriptive statistics for the total sample.
The average purchased goodwill amount is more than half of
the average price paid. Goodwill increases substantially as a
percentage of net income during the year of the acquisition.
On average, this percentage increased from 41% in the year
prior to the acquisition to 110% in the year of the acquisition.
The 36-year average amortization period indicates that firms
tend to maximize the amortization period. Table 3 illustrates
that there is a wide range of industries represented in the
sample with the largest number of acquisitions occurring in
publishing, chemicals, machinery/equipment, and engineering.
Event Study Analysis
To evaluate the performance of the stock prices associated
with the merger period, we employed standard event date
methodology. Using the single-index market model, we estimated abnormal returns per firm (AR). Then average abnormal
returns per test sample (AAR) and cumulative average abnormal returns per test sample (CAAR) were computed.7 The
statistical significance of the return metrics was determined
using a parametric mean test. The test statistic Z for the average
abnormal returns and for the cumulative average abnormal
returns was computed following the procedures of Dodd and
Warner (1983).
Cross-sectional regression using weighted least squares was
employed to obtain additional insights into the price effects
associated with the goodwill change by using the individual
firm CAART1,T2 as the dependent variable. The independent
variable investigated in this study is the change in goodwill
(DGW). It was measured as the total amount of goodwill
recorded from the specific business combination of interest
and was obtained from the footnote disclosures of the firm’s
annual report. Control variables included those for which
evidence of a significant relation to abnormal returns around
merger dates was found in previous studies, change in depreciation (Hayn, 1989), relative size of the acquisition (Asquith,
Bruner, and Mullins, 1983), and type of acquisition (Jensen
and Ruback, 1983).
A control variable was included for the tax benefit from a
change in the depreciable asset base after merger. The assets
of the target firm are valued at fair market value in a purchase
combination. The depreciable asset base of the acquiring firm
is often increased, providing a tax advantage. Even though,
like goodwill amortization expense, the increased depreciation
expense has a negative impact on net income, depreciation
expense increases cash flows to the acquiring firm in the form
of tax savings.8 To derive the tax benefit (cost) associated with
the increased (decreased) asset base, we computed change
in depreciation, DDEPR, as the change in depreciation and
amortization from period t-1 to t multiplied by the statutory
corporate tax rate for the year of the merger event.
The relative size of the acquisition was included to allow
for the impact the acquisition has on the acquiring firm and
to account for differences in abnormal returns due to the size
of targets relative to bidders reported by Asquith, Bruner, and
Mullins (1983). Evidence from that study demonstrated that
the larger the target firm in relation to the bidding firm, the
larger the price response of the bidding firm. Size of the acquisition, SAQ, was measured by the ratio of the price paid for
the acquisition to the corresponding market value of the bidding
firm’s common equity at the beginning of the event period.
Finally, since there is some evidence that in acquisitions
initiated as tender offers returns to bidding firms have generally been higher than those in merger bids (Jensen and Ruback,
1983), a dichotomous variable was employed to allow for
8
7
The monthly estimation period used in this study is 60 months, ending 13
months prior to each event date. The daily estimation period is 255 trading
days, ending six weeks before the announcement date of the impending
acquisition in order to exclude announcement period returns from the estimation periods for the later two dates. For acquisitions with no published
announcement date, eight months before the effective date (which is present
for every observation) is computed as the end of the estimation period. This
end date was chosen because of the 99 firms with announcement dates
present, only six did not announce within seven months of the effective date.
Hayn (1989) found a significant positive relation between the increase in
assets and the cumulative abnormal returns of acquiring firms involved in
taxable mergers at the acquisition announcement. However, Hayn’s stepup in asset base variable included an estimate of accumulated accelerated
depreciation since accelerated methods are usually used for tax reporting
rather than the straight-line methods typically found in financial statements.
While the depreciation expense reported in COMPUSTAT is computed for
financial statements, there is no ex ante reason to believe a systematic difference
in depreciation expense occurs among firms selected in the random sample for
this study. Consequently, it was expected that these measurement differences
would on average not confound inferences drawn from the sample.
Security Market Reaction to Purchase Business Combinations
83
J Busn Res
2000:49:79–88
Table 2. Descriptive Statistics for Sample Acquisitions
Panel A: Number of acquisitions by year
1984
8
1985
12
1986
25
1987
13
1988
22
1989
23
1990
13
Total acquisitions
116
Panel B: Sample means and medians
Variable
Mean
Deviation
Minimum
Maximum
Median
Year 5 t
Price paid
Goodwill amount
Amortization period (years)
Market value of equity
NI
New GW Amortization/NI
605.52
362.88
35.77
2689.12
188.50
1.10
1519.98
1171.12
8.70
6452.17
472.49
4.16
0.146
0.116
5
5.08
(639.3)
0.004
12900
11600
40
48949
2697
24.26
182.30
86.55
40
1016.02
65.39
0.034
Year 5 t 2 1
Market value of equity
NI
New GW Amortization/NI
2370.13
135.80
0.406
4971.2
445.5
1.45
4.95
(1669.)
0.010
33172
2410
11.00
890.38
45.44
0.043
N 5 116; t 5 effective year of acquisition. NI 5 net income.
these differences. Type of acquisition is scaled TYPE 5 0 for
merger proposals and TYPE 5 1 for tender offers.
When valuing firms are involved in acquisitions, market
participants may have additional considerations. Some acquiring firms borrow to finance acquisitions for which the consideration is paid in cash. Previous capital structure research in
finance has found that leverage-increasing events have positive
announcement effects owing to the increased cash flow from
the added tax shield (e.g., Miller and Modigliani, 1966; Masulis, 1980; and Bradley, Jarrell, and Kim, 1984). A variable
for the tax benefit (cost) of increased (decreased) leverage
(DLEV) was computed as the change in long-term debt from
period t-1 to t, multiplied by the statutory corporate tax rate
for the year of the merger event.9
A second relation, operating income change, proxies for
differences in firm operating economies from pre- to postacquisition, since traditional merger theory assumes acquisitions are undertaken expecting synergistic gains from the combination. Operating income change, rather than net income
change, was considered a less encumbered measurement since
it does not contain gains and losses from other sources,
changes in sales and cost of goods sold, and depreciation and
interest expense changes that could have been a result of the
merger and are captured in other variables.10 The change in
operating income (DOPINC) is the change in earnings before
the depreciation, tax, and interest expenses measured as a
percentage change. It was calculated as operating income at
period t, minus operating income at period t-1, divided by
the operating income at period t-1.
To achieve comparability between firms, DGW, DDEPR,
and DLEV were deflated by the market value of equity (MVE)
of the acquiring firm at the beginning of the period. MVE,
common shares outstanding times price at close of the period,
was computed from data at the end of the year previous to
the business combination event date (t-1).
This resulted in the regression model for individual firm
stock returns shown in the following equation:
9
10
Change in long-term debt, rather than change in interest expense, is employed because it measures the total change in debt at the end of the accounting
period. The change in interest may be affected by how long the debt was
held. If the debt was increased substantially toward the end of the year, the
interest expense for the year might not fully capture the impact of the increased
debt on the future cash flows of the firm.
CAART1,T2 5 b0 1 b1DGW 1 b2DDEPR 1 b3SAQ 1 b4 TYPE 1 b5DLEV 1 b6DOPINC
(2)
(1)
(1)
(1)
(1)
The subscript i is omitted for each individual firm observation. A negative and significant coefficient b1 of the DGW
variable supports the hypothesis that the increase in goodwill
is negatively related to the stock price of the acquiring firm.
Under purchase accounting, the income of the target company would not
be included for the entire merger year. Depending on the time of year, much
of the target’s earnings might not be included in the measurement for operating
income. However, reducing the impact of the target’s income on the combined
company’s income would bias against the hypothesis of a positive relation
between increased operating efficiencies and returns.
84
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K. B. Norris and F. L. Ayres
Table 3. Sample Acquisitions by Industry
SIC
Industry Description
Number
13
14
20
21
22
23
26
27
28
29
30
32
33
34
35
36
37
38
39
40
45
48
49
51
53
54
61
73
87
Total acquisitions
Oil and gas
Mining
Food products
Tobacco
Textiles
Apparel
Paper products
Publishing
Chemicals
Refining
Tires/rubber
Glass/cement
Steel
Metals
Machinery/equipment
Communications
Aircraft
Instruments
Games/sporting goods
Railroads
Airtransportation
Radio/telephone
Natural gas/electric
Nondurable goods
Department stores
Groceries
Financial
Advertising
Engineering
1
1
6
3
2
2
4
12
11
2
3
2
3
9
14
8
8
6
2
1
2
2
1
5
1
2
1
1
19
116
SIC 5 Standard Industrial Classification.
Hayn (1989) found a positive relation between the increase
in asset base and abnormal returns to bidding firms, thus b2
was predicted to be positive. The coefficient b3 was predicted
to be positive, since previous research has shown that the
larger the target in relation to the bidder, the greater the impact
on the bidding firm. A change in debt was hypothesized to
be positively related to returns, indicating a positive coefficient
for b5. A positive b6 was hypothesized because traditional
merger theory assumes acquisitions are undertaken expecting
synergistic gains from the combination of two firms resulting
in a positive relation between the change in efficiency due to
operating economies and firm returns. No prediction was
made about the intercept term.
Empirical Results
Average daily and monthly abnormal returns for the quarterly
earnings report date are reported in Table 4, panel A. Both
the daily and monthly abnormal returns are negative and
significant at p 5 0.01 and p 5 0.10, respectively. The reaction
at the earnings announcement date supports H1A and is consistent with the hypothesis that investors respond negatively
to the earnings impact of goodwill amortization.
Panel B of Table 4 shows the results of the regressions for
the quarterly earnings report date. Collinearity diagnostics
were run for the regressions following the procedures of Belsley, Kuh, and Welsch (1980, p. 112). The daily abnormal
return regression demonstrates no significant coefficients. In
the regression of monthly abnormal returns, the coefficient
of DGW is significantly negative at the 0.05 level. This is
consistent with H2A and indicative of the investors responding
negatively to the amortization of goodwill. DLEV is positive
and significantly related to abnormal returns, consistent with
investors increasing the market valuation of the firm due to
the increased tax shields provided by the increased debt.
DOPINC is marginally significant and positive lending some
support to the hypothesis that increased operating efficiencies
were viewed positively by the market.11,12 The insignificance
of the results in the daily cross-sectional regression is an area
of concern. One explanation may be that the information
about goodwill amortization may become available to market
participants throughout the earnings announcement month
and not just on the day of the earnings release. This is consistent with the finding that the CAAR is greater in absolute
terms when the monthly abnormal returns are used. The
monthly CAAR is 21.19% compared with only 2.60% for
the two-day return on the earnings release date.
If the earnings impact of goodwill amortization is driving
the negative abnormal returns, we would expect the result to
be most pronounced for firms most affected, that is, those
with the greatest amount of new goodwill as a result of the
acquisition. In order to determine if the relation between
goodwill and abnormal returns was greatest for firms with the
largest amounts of reported goodwill, we ranked the sample
on the basis of the impact of the newly acquired goodwill
amortization on earnings, and the monthly regressions were
run by using only firms in the highest and lowest quintile
These results are presented in Table 5. Panel A shows monthly
average abnormal returns for the high and low goodwill sample. None were significantly different from zero.13 However, in
the cross-sectional regression of the relation between goodwill
change and abnormal returns in the announcement month
(panel B), the results indicate that for firms in the high goodwill
quintile there is a strong negative relation between the change
11
In the case that the variable DOPINC was not measuring enough of the
change in operating efficiencies, the monthly regression was replicated using
the change in net income (DNI 5 (NIt 2 NIt-1)/MVE) rather than the change
in operating income (DOPINC). The test results were qualitatively similar in
the month of the earnings report.
12
A post-event date estimation period also was used in the examination
of daily abnormal returns. The estimation period is 255 trading days long
and begins six weeks after the quarterly earnings report date. Results for the
two-day returns were still negative like in the preevent date beta analysis but
insignificant. In the regression analysis, all results were qualitatively the same.
13
For daily returns, we also examined a variety of different cumulation
windows including (21,0), (26,0), (24,0), and (210,11). These average
residuals also were not significantly different from zero.
Abnormal Returns around the Event
Date Period
Panel A: Abnormal Returns
Period
CAAR
Z
Dailyb (n 5 114)
Monthlyd (n 5 108)
(21, 0)
(0)
20.60
21.19
22.47c
21.4e
Panel B: Cross-Sectional Regression of Individual CAARSf CAAR 5 b0 1 b1DGW 1 b2DDEPR 1 b3SAQ 1 b4TYPE 1 b5DLEV 1 b6DOPINC
Abnormal
Returns
Expected sign
Daily
(n5 109)
Monthly
(n5103)
Dependent
Variable
CAAR (21, 0)
AR (0)
Coefficients for Independent Variables
Intercept
DGW
DDEPR
SAQ
TYPE
DLEV
0.005
(20.83)
20.010
(21.10)
2
20.001
(20.02)
20.095
(21.73)g
1
0.024
(0.03)
20.286
(20.30)
1
20.003
(20.18)
0.010
(0.41)
20.014
(21.10)
20.024
(21.30)
1
0.041
(0.61)
0.201
(2.27)c
DOPINC
F-value
Adj R2
1
0.001
(0.24)
0.009
(1.56)e
0.318
(0.93)
2.156
(0.05)
20.040
Security Market Reaction to Purchase Business Combinations
Table 4. Quarterly Earnings Report Date Abnormal Returns and Cross-Sectional Regression of Individual Abnormal Returns for Purchase Combinations in 1984–1990a
0.064
a
Sample size may vary slightly in each test due to missing returns in the estimation period or missing data for measuring the independent variables.
255-day estimation period ending 6 weeks before the announcement date.
p , 0.010.
d
60-month estimation period ending 13 months before the quarterly earnings date.
e
p , 0.1.
f
t-tests are in parentheses; t-tests for significance of TYPE coefficient are two-tailed; for other coefficients, t-tests are one-tailed.
g
p , 0.05.
DGW, GW/MVE; DDEPR, ((DEPRt 2 DEPRt21) 3 TAXRATEt)/MVE; SAQ, ACQPRICE/MVE; TYPE, 1 5 tender offer, 0 5 merger/acquisition; DLEV, ((LTDEBTt 2 LTDEBTt21) 3 TAXRATEt)/MVE; DOPINC, (OPINCt 2 OPINCt21)/
OPINCt21, where, GW 5 total goodwill from new acquisition; ACQPRICE 5 price paid for the acquisition; MVE 5 market value of common equity; LTDEBT 5 long-term debt; DEPR 5 annual depreciation; OPINC 5 operating
income; TAXRATE 5 statutory corporate tax rate.
b
c
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85
86
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Table 5. Monthly Abnormal Returns and Cross-Sectional Regression of Individual Abnormal Returnsa for High and Low Goodwill Purchase Combinations in 1984–1990b at the
Quarterly Earnings Report Date
Panel A: Abnormal Returns around the Event Date
Abnormal Returns
Low goodwill (n 5 22)
High goodwill (n 5 23)
Period
CAAR
Z
(0)
(0)
0.16
1.64
0.0
1.3
Panel B: Cross-Sectional Regression of Individual CAARSc CAAR 5 b0 1 b1DGW 1 b2DDEPR1b3SAQ 1 b4TYPE 1 b5DLEV 1 b6DOPINC
Abnormal
Returns
Expected sign
Low goodwill
(n5 19)
High goodwill
(n522)
Dependent
Variable
AR (0)
AR (0)
Coefficients for Independent Variables
Intercept
DGW
DDEPR
SAQ
TYPE
DLEV
DOPINC
F-value
Adj R2
20.011
(20.17)
20.017
(1.01)
2
0.343
(0.23)
20.240
(24.36)d
1
1.334
(0.21)
21.877
(21.56e)
1
20.195
(20.90)
0.053
(1.54e)
20.029
(20.30)
20.003
(20.09)
1
0.885
(1.29)
0.328
(3.53)d
1
20.107
(0.83)
0.005
(0.93)
0.317
(0.92)
4.445
(0.01)
20.295
0.496
a
60-month estimation period ending 13 months before the quarterly earnings date. AR, abnormal returns.
Sample size may vary slightly in each test due to missing returns in the estimation period or missing data for measuring the independent variables.
t-tests are in parentheses; t-tests for significance of TYPE coefficient are two-tailed; for other coefficients t-tests are one-tailed.
d
p , 0.001.
e
p , 0.10.
DGW, GW/MVE; DDEPR, ((DEPRt 2 DEPRt21) 3 TAXRATEt)/MVE; SAQ, ACQPRICE/MVE; TYPE, 1 5 tender offer, 0 5 merger/acquisition; DLEV, ((LTDEBTt 2 LTDEBTt21) 3 TAXRATEt)/MVE; DOPINC, (OPINCt 2 OPINCt21)/
OPINCt21, where, GW 5 total goodwill from new acquisition; ACQPRICE 5 price paid for the acquisition; MVE 5 market value of common equity; LTDEBT 5 long-term debt; DEPR 5 annual depreciation; OPINC 5 operating
income; TAXRATE 5 statutory corporate tax rate.
b
c
K. B. Norris and F. L. Ayres
Security Market Reaction to Purchase Business Combinations
in goodwill and abnormal returns in the announcement month.
In contrast, for firms in the low quintile, the cross-sectional
regressions were insignificant. Regressions of the daily abnormal
returns by using the high and low goodwill sample also were
not significant and are not reported here. Overall the findings
are consistent with the hypothesis that goodwill amortization
is viewed negatively by the market as information about its
impact is released. It is also consistent with the hypothesis
that this information becomes available to market participants
gradually during the month leading up to the first quarterly
earnings announcement following the merger.14
Summary
Employing a sample of 116 acquisitions occurring during the
years 1984–1990, we found a negative association between
increased goodwill from a purchase combination and abnormal returns of acquiring firms. Owing to the nature of the
dispersion of goodwill information into the market across time
rather than on one day, the negative association is reflected
in monthly abnormal returns, rather than daily abnormal returns. At the first quarterly earnings announcement after the
acquisition effective date, the market responds negatively, and
this time there is a negative association between abnormal
returns and the change in goodwill. Consequently, it appears
that a negative reaction occurs on the first earnings announcement date in response to the book reduction in reported
earnings from the goodwill amortization. Taken together, this
evidence supports the hypothesis that the market considers the
increase in goodwill when valuing firms involved in purchase
combinations and responds negatively to the earnings impact
of goodwill amortization.15
14
We reviewed Lexis-Nexis for information disclosures during periods surrounding the merger announcement and the first earnings announcement
following the merger. We found a tremendous variance in the amount of
disclosure about the impact of goodwill and its earnings impact. Most typically, however, earnings releases reported operating income before goodwill
amortization if an advance earnings announcement was made. In these cases,
the impact of the merger-related amortization of earnings would not be known
until the issuance of the quarterly financial statements. The wide variation
in disclosures about the impact of goodwill is consistent with that reported
by Duvall, Jennings, Robinson, and Thompson (1992). They examined a large
sample of firms and reported that despite requirements that disclosures be
made about the impact of goodwill on earnings, that in fact disclosures about
goodwill and its amortization varied widely in the degree of disclosure about
goodwill and the amortization periods used.
15
A possible alternate explanation for the observed relation is that the
negative relation between goodwill and returns on the earnings announcement
date signals the extent of overpayment for the acquisition. However, there
is no reason to expect that this effect would be observed on the earnings
announcement date following the merger. Rather, we would expect that if
the market perceived that there had been an overpayment for the acquisition,
the negative impact on returns to the acquiring firm would be observed at
the time of the merger announcement. We examined average daily and
monthly abnormal returns at the merger announcement date and found the
daily returns (CAAR(21,0) 5 21.26) to be significantly negative at less than
the 0.001 level. We also ran cross-sectional regressions by using both daily
and monthly returns on the merger announcement date and the results were
insignificant.
J Busn Res
2000:49:79–88
87
The results from this study support the contentions of
managers and the financial press that stock prices are adversely
impacted by the earnings impact of goodwill amortization
following a purchase combination with large amounts of goodwill. Consistent with the results of Hand (1990) and Shleifer
and Summers (1990), it appears that market participants responded to the earnings impact of the goodwill amortization
rather than to its direct cash flow impact suggesting that
in business combinations form may be as important as the
substance of the transaction.
The authors would like to thank the editor and the anonymous reviewers
for their helpful comments. Any remaining errors belong solely to the authors.
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