Why Firms Shouldn’t Knock SOX: How the Regulation Impacts M&A
Though many corporate executives balk at the expense created by requirements of the Sarbanes-Oxley Act, a law enacted to head off accounting fraud, not having measures in place could be even more costly for public companies. That’s because weak accounting practices lead to poor M&A decisions, according to new research from Emanuel Zur at the University of Maryland’s Robert H. Smith School of Business and two co-researchers. Mergers and acquisitions are the largest and most visible investments made by companies, with deals totaling more than $1 trillion annually.
A string of corporate accounting scandals that led to the demise of Enron and WorldCom in the early 2000s pushed Congress to enact the Sarbanes-Oxley Act to require public companies to protect against accounting fraud. The law requires CEOs and CFOs to assess the effectiveness of internal controls on financial reporting and have that assessment validated by an outside auditor. Firms with ineffective internal controls must disclose the existence and nature of their internal control weaknesses. Those weaknesses don’t just affect operations, earnings and cost of debt or equity for a firm. Zur’s research reveals they also can lead companies to make poor investment decisions and overpay when acquiring new companies. These firms also see lower stock returns in the period surrounding an acquisition and lower returns in the two years following.
The researchers conclude that companies that have reported weaknesses should stay away from acquisitions until they fix their internal problems. Otherwise, they’ll overpay for the acquisition (an average of extra 6 percent of deal premium) and their stock will perform worse in the months and years after. The market responds more negatively to firms that pay high premiums in acquisitions, suggests the research.
The researchers point to poor quality information generated by ineffective internal controls, or the underlying issues that caused the poor accounting, that hinder management decision-making in M&A deals and drive up the price a firm has to pay to acquire a new target.
Zur and his co-authors also looked at firms that had previously reported weaknesses and had fixed them. They didn’t pay as much to acquire new firms and the market didn’t penalize those companies’ stock returns, providing an incentive for rooting out and correcting financial reporting problems.
Read more: Acquirer Internal Control Weaknesses in the Market for Corporate Control is featured in Contemporary Accounting Research.