Do Mandatory Accounting Disclosures Impair Disclosing Firms’ Competitiveness? Evidence from Mergers and Acquisitions Daniel W. Collins Tippie College of Business, The University of Iowa Jaewoo Kim* William E. Simon School of Business, The University of Rochester Heejin Ohn Tippie College of Business, The University of Iowa March 2018 Abstract This paper examines whether mandatory accounting disclosures in financial reports impair disclosing firms’ competitiveness by inducing competitors to take actions. To capture firm-level variation in product market competition, we rely on the product similarity measure developed by Hoberg and Phillips (2016). Using M&A-related disclosures that are mandated by materiality thresholds, we find that disclosing firms experience a disproportionate increase in product similarity subsequent to M&A transactions relative to non-disclosing M&A firms. Cross-sectional analyses reveal that the effect is more pronounced when the firms obtain greater synergy gains via M&A or achieve greater product differentiation in the year of an M&A. We also document that rivals of disclosing firms are more likely to engage in an M&A transaction in the following year relative to rivals of non-disclosing firms, and that competition between an acquirer and rivals increases both when the acquirer discloses and when rivals conduct M&A. Collectively, our findings suggest that mandatory M&A-related sales and profit disclosures have an adverse impact on disclosing firms’ competitiveness in product markets. JEL Classification: G34; M41 Keywords: Real Externalities; Proprietary Cost of Disclosures; M&A; Product Market Competition; Product Similarity; Materiality
We gratefully acknowledge helpful comments from Steven Baginski, Ramji Balakrishnan, Rebecca Hann, Brad Hepfer, Sam Melessa, Lillian Mills, Suyong Song, Todd Kravet (discussant), Annika Wang (discussant), Jerry Zimmerman, workshop participants at the University of Iowa and University of Rochester, the participants of the 2016 AAA Annual Meeting, and the participants of the 2018 FARS Annual Meeting. Financial support is provided by the Tippie Business School at the University of Iowa and the Simon Business School at the University of Rochester. *Corresponding author. Tel: 585-275-0790; email:
[email protected].
Electronic copy available at: https://ssrn.com/abstract=3138584
Do Mandatory Accounting Disclosures Impair Disclosing Firms’ Competitiveness? Evidence from Mergers and Acquisitions
1. Introduction Do mandatory disclosures in financial reports induce competitors to take actions that harm disclosing firms’ competitiveness? 1 Answering this question is central to the justification of financial reporting and disclosure regulations. Managers often oppose the idea of expanding financial reporting and disclosures by asserting that expanded disclosure reveals proprietary information to their competitors, thus eroding their competitiveness in product markets. On the other hand, regulators advocate expanded disclosure arguing that providing more detailed firmspecific information reduces information asymmetry between managers and investors, thus improving the allocation of capital and social welfare. However, there is little direct empirical evidence on the real externalities of mandatory disclosures and their impact on disclosing firms’ competitive advantage (see Admati and Pfleiderer, 2000; Leuz and Wysocki, 2016). The argument that expanded disclosure creates negative externalities for disclosing firms also underpins a long-standing literature on the proprietary cost hypothesis of disclosures. Despite extensive research over the past 20 years, the evidence is mixed on whether firms' voluntary (or mandatory) disclosures impose significant proprietary costs on firms. 2 Such mixed evidence raises the question of the empirical validity of the maintained hypothesis underlying this strand of research that competitors use proprietary information to gain market share, thus adversely affecting disclosing firms’ competitiveness. Lang and Sul (2014) echo this point by stating that “we know relatively little empirically about the likely prevalence and magnitude of proprietary costs in
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In this paper, we use competitors, rivals, and peers interchangeably. In reviewing the literature on voluntary disclosure, Beyer et al. (2010) conclude: “There is no clear empirical evidence to date on how proprietary costs, as proxied by the level of competition in an industry, are related to voluntary disclosure (p. 306).”
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1 Electronic copy available at: https://ssrn.com/abstract=3138584
practice (p. 265).” Our paper fills this void by providing direct evidence on whether mandatory disclosures of subject firms affect rivals’ actions, and whether such actions impair disclosing firms’ competitiveness in product markets subsequent to disclosures (i.e., posterior competitiveness). 3 Although product competition is multifaceted, i.e., product substitutability, market size, and entry costs (Raith, 2003), we focus mainly on product substitutability in this paper. The disclosure setting we select focuses on firms that engage in M&A and the varying amount of M&A-related disclosures that firms provide surrounding these transactions. The M&A setting enables us to assess the effect of accounting disclosures on competition that stems from product substitutability as firms often engage in M&As to differentiate themselves from rivals and thus improve competitiveness in product markets (e.g., Hoberg and Phillips, 2010). In response, rivals likely seek information that facilitates learning about courses of action to stay competitive in product markets. 4 An added benefit of the M&A setting is that, unlike other forms of investment such as capital expenditures, M&As are the most visible type of corporate investment to both rivals and researchers (because they are often publicly announced), which allows us to document the leadlag relation between firms’ decision to engage in M&As and related disclosure decisions and rivals’ decision to enter their product market space and/or take actions such as an M&A mimicking strategy. To capture mandatory disclosures that potentially carry proprietary costs in the M&A setting, we examine two specific disclosures of acquiring firms. First, we identify whether acquiring firms provide pro forma revenue and profit information in financial statement footnotes
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A “subject firm” is the firm that engages in an M&A transaction and whose disclosures, or lack thereof, we examine. If a firm provides detailed M&A-related disclosures, we refer to that firm as a disclosing firm. 4 Indeed, Bernard et al. (2015) find that firms download competitors’ SEC filings from the SEC EDGAR database more when competitors engage in M&A.
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as mandated by GAAP (i.e., Accounting Standard Codification 805). If the acquisition is deemed to be material to the acquiring firm’s operations, GAAP calls for the acquiring firm to provide pro forma sales and profits of the combined entities under the assumption that the acquisition had taken place at the beginning of the fiscal year preceding the M&A firm-year after removing any effects of intercompany transaction between the two firms. This information can enable rivals to assess the potential synergies of M&A at an early stage following the transaction and to project pro forma growth rates of revenues and income based on operations of the newly combined entity. Second, we identify whether acquirers provide quantitative information on how the acquisition affected year-over-year sales growth of the consolidated entity in the year of the acquisition. Under SEC Regulations (Item 303 of Regulation S-K), acquiring firms are mandated to disclose, if material, what proportion of sales or sales growth in the year of acquisition is due to targets that they acquire or merge with in the MD&A section of 10-Ks. This information can allow rivals to more accurately evaluate the growth potential of the newly formed entity and to isolate acquired growth from internal growth (i.e., segregate organic versus non-organic growth). Overall, we maintain that both disclosures, which are mandatory in nature, can impose significant proprietary costs on disclosing firms if rivals use this information to enter the disclosing firms’ product market space. 5 Note that after the year of the acquisition, these detailed revenue and profit effects of the acquisition that are outlined above are lost as the impact of the acquired firm’s operations are folded into the consolidated totals of the acquirer. A key aspect of our study is that we use a time-varying firm-level measure of competition. 6
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See Appendix A for examples. Although prior work in the disclosure literature usually uses industry concentration measures (e.g., HerfindahlHirschman type indices) to capture the level of competition that firms face, this measure is difficult to interpret both empirically and theoretically. Lang and Sul (2014) specifically note that “there are at least three potential links between industry concentration and proprietary costs: through intensity of industry competition, innovation, and information content. However, while there are theoretical reasons to expect that there might be a link between proprietary costs and industry structure, the direction of the predicted relation is more complicated [emphasis added].” 6
3
Specifically, we use the product similarity measure developed by Hoberg and Phillips (2010; 2016) that compares how similar two firms’ product descriptions are in the business description section of 10-Ks (see Section 4.2 for details). This measure is particularly well-suited for our study for several reasons. First, this measure captures the product substitutability dimension of competition, which is our construct of interest. Second, Hoberg and Phillips (2010) use this measure in the context of examining how M&As affect firms’ competitiveness and find that M&A transactions decrease acquirers’ product similarity with respect to rivals, suggesting that M&As are a way of increasing firms’ competitiveness by differentiating its products. We use two versions of product similarity: (1) total similarity and (2) a pairwise similarity. Total similarity captures how similar a subject firm’s product space is relative to its top 20 product market peers, whereas pairwise similarity measures how similar a subject firm’s product space is relative to each of its competitors. We use total similarity in our acquirer-level analyses to proxy for the aggregate competition that a subject firm faces from its major rivals in its product market space. We use pairwise similarity in our acquirer-rival-level analysis to proxy for competition that a subject firm faces against each of its rivals conditional on rivals engaging in an M&A in the following year. We conduct both acquirer-level and acquirer-rival-level analyses. For acquirer-level analyses, we construct two sets of samples: (1) the Full sample and (2) the RavenPack sample, where we can control for the number of M&A-related articles that occur in the public press following the M&A announcement. We use this latter sample in an attempt to sort out the effect of the merger-related accounting disclosures outlined above from other public press coverage of the acquisition that might also attract competition from rival firms. To capture the mandatory nature of M&A-related disclosures (and thus address
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endogeneity concerns of strategic non-disclosures 7) we use an instrumental variable (IV) two-stage least squares approach. In our first-stage specification, we find that the materiality thresholds, which are measured by the ratio of deal size to acquiring firm size (our instrument), are significantly related to M&A-related disclosures. In the second-stage regression, we document that for the Full sample the predicted M&A-related disclosures based on our IV instrumentation are significantly positively related to changes in acquiring firms’ total product similarity subsequent to subject firms’ acquisitions (the result is only marginally significant for the RavenPack sample likely due to lower power with this smaller sample). This finding supports the notion that disclosures of proprietary-sensitive merger-related information adversely affects disclosing firms’ competitiveness by attracting greater competition into their product market spaces. We also conduct two cross-sectional analyses that reinforce the core relation between M&A-related disclosures and disclosing firms’ competitiveness. First, we follow the literature that measures the synergy gains from M&A transactions (e.g., Savor and Lu, 2009) and find that the effect of M&A-related disclosures on acquiring firms’ total product similarity is more pronounced for a subset of acquirers that create greater synergy gains via M&A. Second, we show that the effect is stronger for a subset of acquirers that achieve greater product differentiation through M&A. In short, these results provide further evidence on the adverse effect of disclosures of proprietary merger-related information on disclosing firms’ competitiveness. Next, we turn to the acquirer-rival-level analyses to explore a specific action that rivals can take upon observing M&A-related disclosures. In response to the subject firms’ M&A and disclosures, rivals can take several actions. First, competitors can quickly engage in M&As as a mimicking strategy to sustain competitiveness. Second, they can rely on internal product
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While both forms of disclosures are mandatory in nature, firms seem to exercise some discretion over the degree to which they comply with these disclosure regulations (see Beyer et al., 2010).
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development to introduce new products to stay competitive (e.g., R&D, advertisement, and capital expenditures). Our findings provide weak support for rivals using the M&A mimicking strategy over the internal approach for remaining competitive. To provide more direct evidence on the effect of rivals’ M&A on disclosing firms’ competitiveness, we investigate whether the effect of rivals’ M&A on pairwise similarities between a subject firm and each of its competitors is strengthened by the presence of M&A-related disclosures of the subject firm. We find, albeit weakly, that this is indeed the case. Interestingly, neither rivals’ M&A activities nor the subject firm’s disclosures alone have any bearing on pairwise similarities. The results highlight the interactive effect between the subject firm’s disclosures and rivals’ M&A actions that maps into competition between the subject firm and each of its rivals. Our paper makes several contributions to the literature. First, we extend the literature on real externalities of firms’ disclosures (e.g., Badertscher et al. 2013; Beatty et al., 2013; Bernard, 2016; and Shroff, 2016) by providing evidence on the effect of M&A-related (mandatory) disclosures on disclosing firms’ competitiveness in product markets, as well as rival firms’ M&A mimicking actions. Moreover, our investigation answers a call from Shroff (2016) for research that investigates how firms’ disclosure decisions (either mandatory or voluntary) induce rivals to enter and exit the market. Second, we contribute to the literature that tests the proprietary cost hypothesis of disclosures where the evidence is rather mixed. 8 We provide evidence that disclosures of proprietary-sensitive information indeed increases the competition that disclosing firms face in their product markets, consistent with the maintained hypothesis underlying this strand of research.
8
See Verrecchia (2001) and Beyer et al., 2010 for a review.
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Finally, we extend the work of Hoberg and Phillips (2010), which provides evidence that firms acquire assets through M&A transactions to exploit synergies to create new products that increase product differentiation with peers. Our study extends the Hoberg and Phillips results by documenting that M&A-related disclosures at least partially impair acquirers’ competitiveness gained through M&A. The remainder of the paper is organized as follows. Section 2 discusses related research and institutional background concerning M&A-related disclosures. Section 3 develops our predictions. Section 4 describes our sample and key variables measurements. Section 5 describes the research design and presents the results and Section 6 concludes. 2. Related Research and Institutional Background of M&A-Related Disclosures 2.1 Real Externalities of Financial Reporting and Disclosures on Peer Firms A sizeable component of the disclosure literature examines real externalities or spillover effects of disclosures where a firm’s financial reporting and disclosures affect real actions of that firm’s peers. For example, Badertscher et al. (2013) show that private firms’ investments are more sensitive to sales growth (a proxy for growth opportunities) when they operate in an industry with more public firms. They interpret this result as suggesting that public firms’ disclosures improve private firms’ investment efficiency. Studies also examine externalities and spillovers on rival firms’ investments in specific settings such as restatement announcements (Durnev and Mangen, 2009) and accounting fraud (Beatty et al., 2013). Durnev and Mangen (2009) document that peers reduce investment significantly after a competitor (subject firm) announces a restatement, suggesting that a subject firm’s restatement announcement causes peers to revise their investment strategies. Beatty et al. (2013) focus on periods when subject firms commit accounting fraud (but remains undetected) and show that peer firms’ investments increase during fraud periods. These results suggest that subject firm’s distorted financial reports cause peers to make inefficient 7
investment decisions. Our study is related to this line of research that examines the effects of a subject firm’s disclosures on peer firms’ investment or operating decisions, but differs in one important respect. We go beyond simply documenting the effect of a firm’s disclosures on peers’ actions by providing evidence on whether the actions of peers adversely affect the disclosing firms’ competitiveness in product markets, thus making overall product markets more competitive. Such evidence has important implications for the debate over the potential costs and benefits of financial reporting and disclosure regulations. Absent externalities of financial reporting and disclosure regulations, the need for mandatory disclosure is questionable as economic theory suggests that firms have incentives to provide the information voluntarily by trading off the costs and benefits of disclosure (see Admati and Pfleiderer, 2000; Leuz and Wysocki, 2016). 9 2.2 The Proprietary Cost Hypothesis of Disclosures A long-standing literature in accounting posits and tests the proprietary cost hypothesis of disclosures. Theoretical work assumes that some information produced by firms is proprietary, and if disclosed, would affect competitors’ actions (e.g., enter the product market), thus doing harm to disclosing firms’ competitive position (e.g., Verrecchia, 1983, 1990; Darrough and Stoughton 1990; Wagenhofer, 1990; Darrough, 1993; Hayes and Lundholm, 1996). For example, Verrecchia (1983) states: “… the release of a variety of accounting statistics about a firm (e.g., sales, net income, costs of operation, etc.) may be useful to competitors, shareholders, or employees in a way which is harmful to a firm’s prospects even if (or perhaps because) the information is favorable,” and Darrough (1993) states that “detailed disclosure about new products conveys information about the future prospects of a firm to its shareholders. But it might also reveal
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We offer the caveat, however, that our evidence is based on a specific disclosure setting (M&A-related disclosure) rather than market-wide regulations governing disclosures more broadly.
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strategic information to competitors, thereby reducing the disclosing firm's competitive advantage.” Admati and Pfleiderer (2000) state: “Since disclosure reveals information to competitors or others who interact strategically with the firm, it may cause the firm to lose competitive advantage or bargaining power in various contexts.” To our knowledge, there is little direct empirical evidence on these propositions. Theory papers predict that proprietary sensitive information imposes costs on firms that deter a full-disclosure equilibrium even in the presence of adverse selection (see Verrecchia, 2001; Beyer et al., 2010 for a review). While the theoretical predictions are intuitive, existing empirical evidence on whether firms actually incur proprietary costs if they disclose is, at best, mixed (Berger, 2010; Lang and Sul, 2014). For example, several papers suggest that firms that operate in industries where most of industry sales are concentrated among a few firms are less likely to provide more disaggregated segment disclosures (Harris, 1998; Botosan and Harris, 2000; Berger and Hann, 2007) and management earnings forecasts (Bamber and Cheon, 1998). 10 In contrast, Verrecchia and Weber (2006) find that firms in more concentrated industries are less likely to redact potentially harmful proprietary information from their SEC filings. In an IPO setting, Boone et al. (2016) find that the likelihood of redacting information in the IPO prospectus is higher for firms that face greater product market competition measured by product market fluidity (Hoberg et al. 2014) and have greater R&D expenditures. Such mixed evidence raises the question of whether proprietary sensitive disclosures have an economically significant adverse impact on disclosing firms by inviting greater competition. Surprisingly, there is little direct empirical evidence on this premise (Lang and Sul, 2014). Our paper fills this gap in the literature by demonstrating a positive relation between M&A-related sales and profit disclosures, which are
10
As noted by Lang and Sul (2014), the theoretic relations between industry concentration and competition are ambiguous.
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arguable valuable for competitors to know, and subsequent movement of these rival firms into the disclosing firm’s product market space. 2.3. The Effect of M&A Events and Related Disclosures on Product Markets Our paper is also related to research that examines the effect of M&A events, per se. (not disclosures) on acquiring firms’ products (services) and competitiveness. Krishnan et al. (2004) use data from the U.S. hospital industry and find that merging hospitals reconfigure their productmix from low-profit services to high-profit services following a merger. Hoberg and Phillips (2010) investigate the effect of M&As on acquiring firms’ product outcomes using a broader set of industries. Specifically, they develop a product similarity measure based on similarity of the language used in firms’ product descriptions in 10-K filings and show that acquisitions are more successful when acquirers buy targets that use similar product market language. Moreover, they show the synergy gains from acquisitions are greater when targets have unique products and are more dissimilar to acquirers’ rivals. A key takeaway from the Krishnan et al. (2004) and Hoberg and Phillips (2010) papers is that firms engage in M&A transactions to differentiate their products from rivals and thus enhance competitiveness in product markets. An unexplored but important topic in this literature is whether, and to what extent, rivals respond to subject firms’ M&A transactions and what role, if any, acquiring firms’ M&A-related financial disclosures play in stimulating rivals’ reaction. The next section describes the regulatory and GAAP disclosure requirements related to M&As and the particular M&A-related disclosures that we use in this paper. 2.4. Institutional Background for M&A-Related Financial Reporting and Disclosure Rules The annual reports of acquirers are subject to extensive disclosure requirements in the year that a firm completes an M&A. Among these regulatory requirements are the GAAP disclosures
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concerning business combinations (currently ASC 805: Business Combinations). While U.S. GAAP for business combinations has gone through several major changes including the discontinuation of the pooling of interest in 2001 (SFAS 141) and the harmonization with the IFRS in 2008 (SFAS 141(R)), the disclosure requirements for acquirers were extensive even prior to these amendments and remain so today. One salient disclosure that we focus on in this paper is the supplemental pro forma information (generally provided in the mergers and acquisitions footnote) on merger-related sales and profits that is required if the acquisition is deemed to have a material effect on the acquiring firm’s operations. GAAP requires acquirers to provide two consecutive years of revenues and net income of the combined entity under the assumption that M&A had taken place at the beginning of the prior fiscal year. 11 While pro forma footnote information for business combinations was first mandated in 2001 (SFAS 141), our examination reveals that a substantial portion of acquirers provided similar information “voluntarily” prior to this date, indicating that they deemed this information to be material and because of strong capital market demands for this information. 12 One important aspect of this form of disclosure is that fully combined financial statements along with the pro forma sales and profit information described above become available to rivals only after the acquirers’ fiscal year in which the acquisition occurs ends. The SEC Regulation S-K that governs disclosures provided in the MD&A section of 10Ks is another important regulatory source that requires information about the effect of M&A on acquirer’s performance, in particular the effect of the M&A on the acquiring firm’s revenues in
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ASC 805 requires “where a material business combination has occurred during the current fiscal year, pro forma disclosure shall be made of the results of operations for the current year up to the date of the most recent interim balance sheet provided (and for the corresponding period in the preceding year) as though the companies had combined at the beginning of the period being reported on. This pro forma information shall, at a minimum, show revenue, income before extraordinary items and the cumulative effect of accounting changes, including such income on a per share basis, net income attributable to the registrant, and net income per share.” 12 When we repeat all our tests using the post-2001 data, all inferences remain unaffected.
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the year of acquisition. Item 303 of this regulation mandates firms to disclose, if material, information about components of revenues that is necessary to understand the acquiring firm’s results of operations. Despite not being a disclosure requirement specific to acquirers, this regulation renders revenue components attributable to M&A to be mandatory in nature because M&As are the largest source of revenue growth in most years when firms engage in M&A activities (Collins and Kim, 2017). Moreover, knowledge of this source of revenue growth is critical to understanding the combined entity’s revenue trajectory going forward because merger-related revenue growth is not as persistent as organic revenue growth (Collins and Kim 2017). This revenue information provided in MD&A disclosures is different from information included in the pro forma footnotes described above. While the supplemental pro forma information disclosed in footnotes provides users with information about revenue growth and profitability that acquirers could have experienced if the combination had been completed as of the beginning of the previous fiscal year, the revenue component information called for under Regulation S-K delineates how much of the year-over-year revenue growth of the acquirer came from the target, which in turn allows for isolation of acquired revenue growth from organic revenue growth. Overall, both forms of M&A-related disclosure are largely mandatory (conditional on nebulous materiality criteria) and have the potential to impose proprietary costs on the disclosing firm (acquirer) if it invites greater product market competition from rivals. The objective of this paper is to investigate whether M&A-related disclosures of both forms outlined above induce rivals to take actions that adversely affect disclosing firms’ competitiveness in product markets. 3. Empirical Predictions 3.1. The Effect of M&A-related Disclosures on Product Similarity Firms are constantly competing against rival firms that operate in their product market
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space. They seek information about competitors that helps them better understand rivals’ strategies, their profitability and financial condition, and prospects for future growth via development of new product markets. Rivals’ incentives to seek information are even stronger when other firms in the same product market engage in M&A transactions. M&As are a key channel through which firms strengthen competitiveness in product markets (Krishnan et al., 2004; Hoberg and Phillips, 2010). Consistent with this prediction, Bernard et al. (2015) find that firms’ information demand about peers (i.e., firms’ search activity for peer’s 10-K filings) is more pronounced when peers engage in M&A transactions. Both forms of M&A-related disclosures described in the previous section provide rivals with potentially important proprietary information about acquiring firms that can be used to successfully compete in the disclosing firms’ product markets. For example, the pro forma income statement information provided in footnotes allows competitors to calculate growth rates of revenues and income based on operations of the newly combined entity. These pro forma growth rates are relevant to the combined entity going forward more so than the nominal annual growth rates reported by the acquirer in the consolidated income statement that are inflated by M&A transactions. 13 Competitors can also glean information about the initial synergies between the two combined entities from the pro forma income statement information. Information about organic versus non-organic (acquired) sales growth in the MD&A, on the other hand, makes transparent the effect of M&As on the acquirer’s revenue growth, and thus allows competitors to more accurately assess the contribution of the existing operations of the parent versus newly acquired operations of the target to the sales growth of the combined entity in the year of acquisition. Collectively, both forms of disclosures provide unique proprietary information that can potentially
13
See Collins and Kim (2017) for a more complete discussion of the distortion in year-over-year revenue and profit growth when a firm engages in an M&A.
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help rivals make strategic adjustments to product markets in reaction to the acquirers’ product/service reconfiguration. The above discussion leads to our first prediction: P1. Acquirers that are mandated, by materiality thresholds, to provide detailed quantitative M&Arelated revenue and profit disclosures in their annual reports experience a greater increase in product similarity subsequent to acquisition compared to acquirers that do not provide such disclosures. 3.2. Cross-Sectional Analyses of the Effects of M&A-Related Disclosures Next, we develop cross-sectional predictions that corroborate our main prediction. Our cross-sectional predictions build on the vast literature that provides evidence on synergy gains from M&As (see Eckbo, 2014 for a review). For example, Hoberg and Phillips (2010) find that acquirers engage in M&A transactions to differentiate their product offerings from competitors and improve their competitiveness in the market place. However, not all M&A successfully deliver synergy gains in the form of product differentiation. Rather, prior studies find that many M&A result in large value-destruction (e.g., Moeller et al., 2005). When M&A are unsuccessful, rivals are less likely try to emulate acquiring firms’ actions and seek to enter the new product spaces of the acquirer even if they have better information about the sales growth and profit potential of the new products that the acquiring firm has entered into via M&A. Thus, we maintain that M&Arelated disclosures impose higher proprietary costs on disclosing firms and are more detrimental to disclosing firms when M&As create greater synergy gains and specifically when M&As help acquiring firms differentiate themselves more from peers through the acquisition. This discussion leads to our cross-sectional predictions stated in alternative form:
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P2a. The effect of M&A-related disclosures on acquiring firms’ product similarity is more pronounced when the acquiring firm obtains greater synergy gains through M&A. P2b. The effect of M&A-related disclosures on acquiring firms’ product similarity is more pronounced when the acquiring firm achieves greater product differentiation through M&A. 3.3. Competitors' Responses As our final prediction, we examine how M&A-related disclosures can affect possible actions that rivals can take in an attempt to compete with subject firms that engage in M&As to increase product differentiation. Upon observing M&A transactions of a subject firm, rival firms can take several possible actions to remain competitive. Among those actions are two alternative strategies: (1) increase expenditures on internal development of product markets that the subject firm has entered into; and/or (2) engage in M&As, which allows rivals to quickly increase their product offerings in the product market space of the subject firm (e.g., Hoberg and Phillips, 2010). 14 We maintain that rivals are more likely to engage in internal development (e.g., R&D and capital expenditures) and to more frequently engage in M&A activity in an effort to remain competitive when subject firms provide detailed M&A-related disclosures. This leads to the following prediction stated an alternative form: P3. The incidence of rivals engaging in internal development and/or in M&A transactions in the year following a subject firm’s acquisition is positively associated with detailed M&A-related disclosures being provided by the subject firm.
4. Sample and Key Variables Measurement 4.1. Sample
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Competitors yet have another choice to implement an exit strategy by forgoing a portion of their product market. Since we select 20 closest competitors, it is less likely that firms completely exit the market in the short-run. Also, to the extent that the majority of competitors take an exit strategy, it works against us observing rivals’ actions.
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From the intersection of COMPUSTAT and CRSP firm years over the period 1997–2012, we identify 3,120 firm-years from the SDC Mergers & Acquisitions data base where a firm is identified as an acquirer in an M&A transaction for that year and for which information about deal values is provided by the SDC M&A database. Of those 3,120 firm-years, we identify 10-Ks for 2,913 firm-years with required information to make a determination about disclosures with respect to revenue (growth) in the MD&A section and pro forma year-over-year revenue and profit disclosures in footnotes. We further impose three additional data requirements for these 2,913 firm-years: (1) observations have product similarity measures provided in the Hoberg-Phillips Data Library; (2) observations have at least 20 peers identified by Hoberg and Phillips (2016); and (3) observations have additional variables used in regressions described below. Imposing these requirements results in 1,209 firm-years, which we label the acquirer-level subject firm sample (i.e., the Full sample). In subsequent analyses, we also require firms to be in the RavenPack dataset when we control for the number of M&A-related articles. This additional requirement leads to 967 firm-years, which we refer to as the RavenPack sample. 4.2. Key Variables Measurement Two key constructs in this paper are whether a subject firm provides the detailed M&Arelated disclosures described in Section 2.4 and product similarity. To classify an acquiring firm as providing M&A-related disclosures, we read the results of operation section of the MD&A and the footnote related to business combination in the 10-Ks. As described in detail in Section 2.4, we require acquirers to disclose both the supplemental pro forma information on revenue and profits of the combined entity in the mergers and acquisitions footnotes and the quantitative decomposition of the acquiring firm’s total revenues into acquired revenues and organic (internal) revenues in the MD&A section of the 10-K. Of the 1,209 firm-years in our main sample, we
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identify 532 firm-years (44.0%) that provide the detailed quantitative information about the decomposition of acquired revenues in the MD&A section, whereas 926 firm-years contain the supplemental pro forma information in the footnotes (76.6%). There are 464 firm-years (38.4%) that provide both types of disclosures. For these observations, the DISC variable is coded as 1, and zero otherwise. 15 The other key construct in our analysis is the level of competition that a subject firm faces in their product markets. We capture this with the product similarity measure developed by Hoberg and Phillips (2016). Hoberg and Phillips (2016) define two types of product similarity: (1) a pairwise similarity and (2) total similarity. Both measures use key word matches from product descriptions (typically in Item 1 or Item 1A) in firms’ 10-Ks. Pairwise similarity measures the overlap of product mixes between firm pairs, subject firm i and rival firm j.16 We use the pairwise similarity for two purposes. First, we use it to identify close competitors (rivals) of each subject firm in our main sample. Specifically, we select twenty firms with the highest pairwise similarity scores with each acquirer subject firm i. 17 These main rival firms are identified in the year immediately preceding (t−1) the subject firm’s acquisition in period t. By using the scores prior to acquisition, we are able to avoid the potential confounding effect of M&As on the identification of competitors and focus on a set of main rivals that already existed before the acquisition took place. Second, we use the pairwise similarity to measure the level of competition between a pair
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In unreported tests, we also repeat all of our analyses by using one of the two disclosures separately (not both). The results are similar to those reported in this paper with the following exception. When we use pro forma footnote disclosures, we do not find a significant relation between rivals’ propensity to conduct M&As and disclosure as in Table 6. 16 The pairwise similarity is essentially an example of a cosine similarity. Cosine similarity is a standard approach in information science literature to measure semantic similarity of two documents. The pairwise similarity summarizes the product descriptions into two normalized vectors that indicate product noun appearances and take the dot product of these vectors to quantify the similarity. 17 Alternatively, we define competitors as either the 5 or the 10 closest firms and obtain similar results in all our subsequent analyses.
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of firms (subject firm i and rival firm j) and changes therein. Total similarity is another key measure in our study. To test P1 and the two cross-sectional predictions (i.e., P2a and P2b), we need a composite measure of competition that each acquirer faces against all of its main competitors. We operationalize this composite measure as total similarity. Following Hoberg and Phillips (2016), we calculate total similarity as the averages of the pairwise similarities between an acquiring firm and its twenty closest competitors. 5. Research Design and Empirical Results 5.1. Testing the Effect of M&A-Related Disclosures on Product Market Competition (P1) 5.1.1 Research Design A concern with testing our first prediction about the effect of M&A-related disclosures on the degree of competition that disclosing firms face in its product markets is that the disclosures are not fully mandatory in nature—i.e., there is an element of choice involved that may reflect firms’ cost-benefit trade-off considerations. As described in Section 2.4, although both forms of M&A-related disclosures are mandated by GAAP (ASC 850) and Regulation S-K, managers seem to exercise discretion over whether to provide the disclosures based on their subjective judgement as to whether materiality thresholds are satisfied and/or cost benefit assessments of doing so. This raises the possibility that the association between M&A-related disclosures and disclosing firms’ competition may be endogenously determined. It could be that managers of acquiring firms make disclosure decisions in anticipation of the impact that such disclosure might have on rivals’ actions and how this might affect the subject firms’ competitiveness. If so, the observed disclosurecompetitiveness relation in the data is the equilibrium outcome of managers’ trading off the costs and benefits of M&A-related disclosures. Thus, we need to remove the voluntary aspect of whether or not firms provide M&A-related disclosures to identify the effect of the mandatory disclosure.
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We overcome this problem by implementing an instrument for the M&A-related disclosure using a proxy for materiality. We maintain that the size of M&A deal relative to acquirer asset size is a reasonable proxy for the materiality of the M&A transaction. 18 To be a valid instrument, the relative size of the deal should meet two criteria often referred to as relevance and exclusion (Wooldridge 2010; Roberts and Whited 2013). Relevance requires that the relative deal size have high partial correlation with M&A-related disclosures after netting out correlations with all controls included in the second stage regression (described below). As described previously, firms are mandated to disclose material information concerning M&A events by Regulation S-K and by GAAP (see Heitzman et al., 2010). Thus, the critical materiality threshold that triggers disclosure likely increases with the size of the M&A deal relative to acquirer size. Related to relevance, we provide the first-stage estimation and run a statistical test to confirm that our proxy for materiality (MATERIAL) is highly correlated with acquiring firms’ decision to provide detailed M&A-related disclosures. 19 Exclusion, on the other hand, requires that relative size of the deal affect the dependent variable in the second stage regression only through its effect on the disclosure. Although we cannot directly test the exclusion condition (Roberts and Whited, 2013), as we demonstrate later, the partial correlation between MATERIAL and changes in total similarity in t+1 (i.e., the outcome variable in the second stage) is small and insignificant. Furthermore, we carefully assess the
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While the M&A-related disclosures we examine are not subject to any bright-line rule, other mandated M&A disclosures are subject to rules and regulations (e.g. Regulation S-X or 170 CFR 210) that provide bright-line cutoffs based on relative size based either on assets or on sales. 19 We also buttress the validity of our IV by running statistical tests. The Durbin-Wu-Hausman (DWH) test of endogenous regressors tests the null of whether endogeneity of DISC is severe enough that the OLS inconsistency warrants the use of the 2SLS (Larcker and Rusticus, 2010; Baum et al., 2003). Our result in Table 2 shows that the null is rejected at the 5% level. The second test directly tests the relevance condition of our IV choice. The F-statistic (34.92) from the Kleibergen-Paap (2006) Wald test exceeds the benchmark critical value of 20 (Stock and Yogo, 2002, 2005). While statistical test results per se cannot justify our instrument and thus should be interpreted with caution (Larcker and Rusticus, 2010), jointly with the above economic justification for our instrument, the results increase assurance of our 2SLS estimation.
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possibility that the relative size of M&A deal directly influences acquiring firms’ competitiveness in some other way other than the disclosure channel. One concern is that acquiring larger targets allows a subject firm to achieve greater product differentiation and that competitors respond to such differentiation without observing the subject firm’s disclosures by conducting similar M&As. If this is the case, the size of M&A deal relative to acquirer size could have a direct effect on the subject firm’s posterior product competitiveness absent the disclosure channel. This possibility, however, is remote as we find that MATERIAL has no relation with changes in total similarity in year t, the year of acquisition (i.e., the extent of product differentiation). The correlation is 0.0010 (p-value=0.9718). Another possibility is that firms in the same industry during certain time periods engage in M&A activities (i.e., merger waves). If a firm’s acquisition of larger targets is followed by competitors’ acquisition of similar targets, we could observe a direct effect of MATERIAL on the subject firm’s product competitiveness absent the subject firm’s disclosures. To remove the effect of industry-specific, time-varying merger waves, as robustness tests, we include industry × year fixed effects in the second stage regression and find that our results remain unaffected (unreported). Notwithstanding the above considerations, we acknowledge that the size of M&A deal relative to acquirer size does not generate random variation in M&A-related disclosures and thus can be confounded by unobservable factors. For example, the materiality of the deal is potentially related to the likelihood that deals are covered by additional information sources (e.g., firm’s alternative disclosures, the media, or equity analysts). If so, MATERIAL could be correlated with the change in the subject firms’ competition absent the subject firms’ M&A-related disclosures. Although we control for alternative information sources (i.e., changes in analyst following and the
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number of M&A-related articles), we cannot rule out the possibility that our results may be driven by both the subject firms’ M&A-related disclosures and other uncontrolled sources of information. In short, while it is a necessary research design choice to use the relative deal size as an instrument to capture the mandatory aspect of M&A-related disclosures, we acknowledge that a causal interpretation of our results must be caveated. We test P1 (M&A-related disclosures impair disclosing firms’ competitiveness) by estimating a two-stage-least-squares (2SLS) regression that implements materiality (MATERIAL) as an instrument: 1st stage 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑖𝑖,𝑡𝑡 = 𝛾𝛾0 + 𝛾𝛾1 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑖𝑖,𝑡𝑡 + 𝑋𝑋𝑖𝑖,𝑡𝑡 𝛿𝛿 + +𝜖𝜖𝑖𝑖,𝑡𝑡 �𝚤𝚤,𝑡𝑡 + +𝑋𝑋𝑖𝑖,𝑡𝑡 𝛿𝛿 + +𝜀𝜀𝑖𝑖,𝑡𝑡+1 2nd stage ∆𝑆𝑆𝑆𝑆𝑆𝑆𝑖𝑖,𝑡𝑡+1 = 𝛽𝛽0 + 𝛽𝛽1 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
(1) (2)
where DISC is an indicator variable that equals one if an acquirer provides both forms of M&Arelated disclosures described in Section 2.4; ΔSIM is changes in total similarity from t to t+1; MATERIAL is our primary instrument, the size of M&A deal relative to acquirer pre-acquisition �𝚤𝚤,𝑡𝑡 is the DISC instrumented through the first stage regression model. X refers to a asset size; 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 vector of the following acquirer-level control variables that prior studies have found to be related
to the level of competition (Hoberg et al., 2014): levels of average similarity scores prior to M&As (SIM); changes in analyst following (ΔANALYSTS); return volatility (RETSTD); market-to-book ratio (MB); nominal asset growth (NAG); income scaled by assets (INCOME); natural log of total assets (ASSETS); age (AGE); R&D expense relative to sales (R&D); and an indicator for loss years (LOSS). Note that we include changes in analyst following subsequent to the acquisition to control for alternative information sources that might attract competition. For the RavenPack sample, we also add the number of M&A-related articles (ARTICLES) during the fiscal year in which the acquisition takes place. The control vector X is included in both the first and the second-stage specifications to ensure consistent estimation of coefficients (Wooldridge 2010). We also include
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industry- and year-fixed effects in both equations and cluster standard errors by firm and year. In the first-stage regression, we expect MATERIAL to be positively associated with DISC. �𝚤𝚤,𝑡𝑡 ) to be In the second-stage regression, we expect the coefficient on the instrumented DISC (𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 positive, consistent with P1. As indicated by subscript i and t, we estimate equations (1) and (2) at
the acquirer-year level for the Full sample and the RavenPack sample, separately. Detailed definitions of all variables are included in Appendix B. 5.1.2. Empirical Results We begin by discussing descriptive statistics (Panels A and B) and correlations (Panels C and D) for variables in Table 1 used in equations (1) and (2) for the Full and RavenPack samples To mitigate the effect of outliers, we winsorize all continuous variables at the 1st and 99th percentiles. Several descriptive statistics reported in Table 1, Panel A (the Full sample) are noteworthy. First, changes in total similarity for our sample of subject firms from the year of acquisition (t) to the year subsequent to acquisition (t+1) is negative (−0.23), suggesting that firms that engage in M&A, on average, experience a decrease in total similarity. This finding is consistent with the Hoberg and Phillips’ (2010) result that firms engage in M&As to create new products and increase product differentiation, thereby lowering the pre-existing product similarity they have with their rivals. Second, we find that 38% (464/1,209) of our acquirer sample provides detailed M&A-related disclosures for sales and profits as described in Section 2.4. Third, across the entire acquirer-level sample, the average ratio of deal value relative to acquirers’ total assets (MATERIAL) is 21%, ranging from 6% for the first quartile to 31% for the third quartile. Thus, there is wide variation in materiality of the deal size across our M&A sample. When we split the acquirer-level sample into the disclosure and non-disclosure sub-samples, we find significant differences in the materiality of the deal size as would be expected. The average MATERIAL for
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the disclosure sample is 26% with an interquartile range of 12% to 37%, while for the nondisclosure sample, the average relative deal size is 18% with an interquartile range of 4% to 26% (unreported). 20 Clearly, the materiality of the deal size has a bearing on whether acquirers disclose detailed M&A-related sales and profit information, which makes this a viable instrument to use to address endogeneity concerns as we outlined previously. Descriptive statistics for the RavenPack sample (Table 1, Panel B) paints a similar picture. [Insert Table 1] Correlations for our acquirer-level sample are presented in Panels C and D of Table 1. Several correlations for the Full sample (Panel C) are noteworthy. First, the correlation of DISC and our instrument (MATERIAL) that we use in our first-stage regression is 0.22, which is significant at the 5% level, but the correlation between MATERIAL and ΔSIMi,t+1 (the dependent variable in our second-stage regression) is only 0.03 and insignificant. Thus, MATERIAL appears to be a reasonable candidate to use as an instrument to address the potential endogeneity concerns outlined above. Second, a correlation between ΔSIMi,t+1 and SIMi,t-1 is significantly negative (−0.24) at the 5% level, suggesting that product differentiation cannot be sustained due to constant competition amongst firms. Correlations for the RavenPack sample (Table 1, Panel D) lead us to similar inferences. Table 2 presents the results for P1. For the Full sample, we provide the OLS results along with the 2SLS results. The 1st Stage column displays the first-stage regression results and the IV column shows the second-stage regression results. For brevity, we report only the 2SLS results for the RavenPack sample. Consistent with strategic non-disclosures, the OLS results show no relation between M&A-related disclosures and changes in total similarity (ΔSIM). Moving to the 2SLS
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The p-value based on a difference-in-means t-test is less than 0.0001.
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results, the instrument, MATERIAL, is significantly associated with M&A-related disclosures (1st Stage column) (coefficient=0.607 and p-value
