2010-53
Market Reactions to Accounting Policy Choices for
Mergers and Acquisitions: Evidence for the Japanese
Adoption of International Accounting Standards
Tadanori Yosano Yoshinori Shimada

Market Reactions to Accounting Policy Choices for Mergers and Acquisitions:
Evidence for the Japanese Adoption of International Accounting Standards

Tadanori Yosano
Associate Professor
Graduate School of Business Administration of Kobe University, 2-1, Rokko-dai cho,Nada-ku, Kobe, 657-8501, Japan
Yoshinori Shimada
Ph.d Candidate
Graduate School of Business Administration of Kobe University, 2-1, Rokko-dai cho,Nada-ku, Kobe, 657-8501, Japan1

Market Reactions to Accounting Policy Choices for Mergers and Acquisitions:
Evidence for the Japanese Adoption of International Accounting Standards

Abstract
The purpose of this paper is to explore, through M&As accounting policies, whether
the Japanese adoption of IFRS is favorable for market participants. M&As are excellent
prototypes for this study, because they have a substantial impact upon firms’ financial
statements. Additionally, Japanese M&A accounting standards still maintain theamortization period within twenty years, which is practical in creating a sharp contrast
comparison with the impairment approach outlined by the IFRS 3 and SFAS141/142.
We focus on how the recognition and implementation of three different
measurement rules, such as the pooling-of-interests, purchase with the amortization of
goodwill, and purchase with the immediate expensing of goodwill, influence investors’interpretations of earning numbers. First, we found that investors interpreted earning
figures congruently despite the different accounting policies used. This phenomenon isconsistent with the functional fixation hypothesis, which suggests that investors arebottom-line oriented. Second, we found that acquiring firms’ who choose to expenseentire goodwill values within the current fiscal year in order to alleviate investors’

2concerns that the M&A would negatively impact bottom-line earnings, and we havefound that this is done successfully, convincing investors to regard the immediate
write-off as an irrelevant item to the firm’s future earnings.

Key words
Mergers and Acquisitions; Purchase method; Pooling-of-interests method; Goodwill;
Amortization; IFRS adoption3

1. Introduction
The purpose of this paper is to explore, through M&As accounting policies, whether
the Japanese adoption of IFRS is favorable for market participants. M&As are excellent
prototypes for this study, because they have a substantial impact upon firms’ financial
statements. Additionally, Japanese M&A accounting standards still maintain theamortization period within twenty years, which is practical in creating a sharp contrast
comparison with the impairment approach outlined by the IFRS 3 and SFAS141/142.
In this paper we analyze how the recognition and implementation of three different
measurement rules, such as the pooling-of-interests, purchase with amortization of
goodwill, and purchase with immediate expensing of goodwill, influence investors’interpretations of earning numbers. The accounting method’s influence is especially
important in mergers and acquisitions (M&As), because the cost of the M&A premium(or goodwill) is one of the most substantial accounting items on the financial statement.
Until recently, there have been no consistent comprehensive accounting rules
regarding M&As in Japan, even though researchers have often indicated that there
should be more consistency especially for firm disclosures. For example, there was arule which required parent companies to disclose a consolidated statement given thecondition that the subsidiary companies maintained their legal status after mergers, but

4

no rule has been applied in cases where company mergers with subsidiary firms resulted
in the termination of their legal status. This difference between case specific regulations
raises the potential inconsistency of having a consolidated financial statement when theparent company owns 100% of the subsidiary firm’s shares, and having another
different financial statement when the parent company legally merges with thesubsidiary firm terminating its shares.
After more than three years of deliberation, the Business Accounting Council issued
the “Accounting Standards for Business Combinations” on October 31, 2003, which
finalized a series of important changes that are collectively referred to in Japan as the
Accounting Big Bang. This trend for standardization was emphasized starting in thelatter half of the 1990s until the beginning of the 21st century in order to enhance thetransparency of financial statements. This accounting standard was effective from theApril 1, 2006 fiscal year. However, there were still some significant differences between
the Japanese GAAP, and the Western IFRS 3 and SFAS141/142. Japanese firms that met
specified criteria could utilize the pooling method, and some firms would cleverly
reorganize the M&A contractual terms in order to meet the outlined stipulations and use
the pooling method. Firms that did not meet these criteria had to follow the purchasemethod prescriptions that require the recognition of goodwill with a subsequent5

amortization period between two and twenty years.
In 2004, taking into consideration the great differences in M&A policies between theJapanese GAAP and IFRS 3, the Committee of European Securities Regulators (CESR)
in conjunction with the EU’s equivalence assessment, required that the inconsistency
amongst business combination standards be remedied by all Japanese firms which
publicly issue stocks and bonds in European nations, bringing them into accordancewith IFRS 3. The CESR demanded the supplement pro-forma based summary financial
statement for cases employing the pooling method.
Since the Tokyo Agreement with IASB in August 2007, the Accounting Standards
Board of Japan (ASBJ) has been working on eliminating major accounting differences
and issued a new accounting standard for business combinations in December 2008.
This standard eliminates the pooling method and complies with the purchase method toconverge with the IFRS 3 and SFAS141/142. However, the new standard still maintains
the amortization period within twenty years, rather than adopting the impairment
approach used in the IFRS 3 and SFAS141/142. The IFRS and SFAS stipulate that all
firms involved in mergers and acquisitions shall use the purchase method, not thepooling-interest method, and the goodwill shall not be written off in the fiscal period ofacquisition unless it is impaired.

6

In this study, we are concerned with the effects of the accounting methods andamortization periods on the subsequent market performance. Our base assumption isthat investors estimate firms’ intrinsic value based on forecast numbers of bottom-line
future earnings, and buy or sell the stock accordingly, which is in line with thefunctional fixation hypothesis. Therefore, it is imperative to understand how accounting
methods affect future bottom line earnings and affect the investors’ reaction.
In order to examine the role of accounting methods and amortization periods on
subsequent market performances of M&As, we assess each accounting procedure
differential influence following the effective date of M&As. The accounting methods
include: (1) pooling-of-interests, (2) purchase with amortization of goodwill, and (3)purchase with immediate expensing of goodwill. Typically in Japan, firms listed inemerging stock exchanges 1 adopted the purchase with immediate expensing of
goodwill method, which has been prohibited since 20062. This method mitigates thecurrent bottom line earnings, but does not affect future bottom-line earnings. This1such as in JASDAQ, MOTHERS in the Tokyo Stock Exchange, or HERCULES in the
Osaka Stock Exchange
2
The introduction of the M&A accounting standard, which was effective since April
2006, ASBJ discussed whether they should accept the accounting practice of writing off
the entire goodwill value within the first fiscal year. ASBJ concluded, however, thatwriting off the entire excess cost value of an acquired entity within the current fiscal
year would produce unrealistic results, because this goodwill might contribute to aseries of future earnings. Therefore, ASBJ prohibited the immediate write-off of
goodwill for reasons similar with the SFAS 141 (paras, B69-70).

7

accounting procedure deserves our attention, because it yields the same future
bottom-line earnings as firms who use the purchase with impairment method prescribedby IFRS 3 and SFAS 141/142.
The next section describes the history of M&As in Japan and the characteristics of
our sample. The third section presents our hypotheses regarding the market reaction toaccounting policy differences. The fourth section describes our methodologies andresults, which will be discussed in the final section along with our research conclusions.

2. Characteristics and Long-term Performance of M&As in Japan(1) History of M&As in Japan
Figure 1 shows the number of all public and private M&As in Japan from 1996 to
2007. After the introduction of stock swap and stock transfer schemes in 1999, thenumber of M&As rose sharply from 661 in 1998 to 1,251 in 2001. The universally
applied Accounting Standards for Business Combinations became effective on April 1,
2006, and the cases of M&As rose to a record high of 1,897 (total value was 11,749
billion yen) in 2006. In the past three years, the average annual number of M&As has
been 1,911 (Data Source; RECOF MARR (Mergers and Acquisitions Research Report)
CD-ROM).

8

[Figure 1]

What accounts for the dramatic increase of M&As over the last ten years? First,
corporate managers in Japan have become more aware of the importance of identifying
suitable targets and implementing efficient restructuring following M&As. Both of these
efforts are used to improve financial performance and recover from a deteriorated levelof capital caused by the most severe and prolonged recession to hit the Japanese
economy since World War II.

Even though the 10-year long recession ended in 2005,

it left the Japanese economy vulnerable for the following few year. Second, theintroduction of stock swap and stock transfer schemes facilitated a smoother M&A
process.

(2) Sample Characteristics
Table 1 shows our sample characteristics for both tender offers and merger bids
organized by calendar year. Our sample includes M&A transactions from January 1996
to December 2006 (available from the RECOF MARR CD-ROM database) that meetthe following criteria:

9(a) Both the acquirer and target are listed in the stock exchange in order to exclude
small cases.
(b) The acquirer and/or target are not financial institutions, nor involved in a bailout
takeover where the transaction is a result of the target suffering financial distress.
(c) The accounting procedure of the M&A transaction is identifiable from annual
reports as either the purchase method or the pooling-interest method.
(d) The amortization period is identifiable in the financial statement.
Financial data was collected from the Nikkei NEEDS-Financial QUEST and stock
price data was collected from the Nikkei Portfolio Master, both of which are part of
Nikkei Media Marketing, Inc. Three hundred five M&A transactions satisfied the above
criteria. For tender offers, the number of listings for targets and acquirers dramaticallyincreased from the single digits to double digits after the introduction of the stock swap
and stock transfer schemes in 1999. The annual number of tender offers exceeded thirty
in 2002.
The merger bid cases in our sample used the stock payment method, which is totallydifferent from the U.S. and U.K. payment method typified with a half stock payment,
half cash payment in merger bids transactions3.
3

In the U.S. between 1977 and 2000, there were 1,218 stock and 1,542 cash payment
cases (Rhodes-Kropf et al., 2005, p. 569, Table 1). In the U.K. from 1985 to 2000, there10

In tender offers cases, Japanese listed firms used a mix of cash and stock payment.
From 2000 to 2003, the number of firms which used the stock payment method
exceeded the number of firms that used cash payments. However, the cash payment
method also increased during the period 2005 to 2007.
The financial attributes of the acquirers and targets in our sample included thefollowing: market equity (which represents firm size), book-to-market ratio, financial
leverage, and ROE. Our data was based on figures that were available on the M&A
effective dates.
The median market equity value of the acquiring firms (¥100,121 million) is 13.74
times greater than the medium market value of the target firms (¥7,286 million). The
acquirers are typically large, and our sample acquiring firms’ median stock value isconsiderably higher than the median stock value listed on the stock exchange (¥100,121
million vs. ¥13,604 million).
The median book-to-market ratios of the acquirers and targets are 0.7459 and 1.0167
respectively. The medium financial leverage of the acquirers and targets are 0.6417 and
0.6173 respectively. The median ROE of the acquiring firms (4.790%) is 1.59 times
greater than the medium ROE of the target firms (3.009%). The book-to-market ratio iswere 84 stock and 134 cash payment cases (Abhyankar et al., 2005, p. 682, Table 1).

11

widely interpreted as a measure of the firm’s growth. The acquirers’ median
book-to-market ratio (0.7459) is much lower than the median book-to-market ratio of all
the listed firms (0.8818), and the medium ROE of the acquirers (4.790%) is muchhigher than the medium ROE of all listed firms (4.092%). Therefore, the acquirers inour sample have a high profitability and characteristics of growth stocks (i.e., low
book-to-market ratio). In other words, the acquirers possess a great amount of potential
for growth.
Table 2 shows our sample’s characteristics sorted by industry (Nikkei Medium
Classification Industry Code). 45% of acquiring firms in our sample are highly
concentrated into four sectors. These four sectors are services (15.17%), wholesale trade(11.26%), retail trade (9.89%), and electrics/electrical equipment (8.51%). Construction(6.44%) and Machinery (5.98%) are ranked as the fifth and sixth most competitive
sectors. In the service, wholesale trade, and retail trade sectors, there were more
intra-sector M&As (non-diversified) compared to inter-sectors (diversified: between
sections) acquisitions. Electric/electrical equipment, construction, and machineryindustries, on the other hand, showed equal proportions of diversified andnon-diversified M&As.
Table 3 shows our sample’s characteristics as well as premiums sorted according to12

firms’ accounting policies. Japanese M&As have a very low average 2.530% premium(value-weighted premium is 9.61%; see Table 3, Panel (A)), in comparison to the highaverage 63.41% and 45% premiums found in the U.S.,4 and U.K.,5 respectively. For
merger bids alone, the average premium is negative (-1.054%). Firms that adopted thepurchase with amortization of goodwill method had the largest sized firm of the threeaccounting methods. In our sample, all three accounting policy groups wereconsiderably larger than the average listed firm, and are considered to be growth stocks(i.e., have low book-to-market ratios). We interpret acquiring firms’ low book-to-market
ratio to mean that certain acquiring firms have a greater amount of opportunity to target
other firms’ resources and expand their business positively. In other words, firms whichhave minimally prosperous opportunities or are operated under crude management
unable to make the most of the firm’s resources (high book-to-market ratio) could
become a target of M&As. Previous research has indicated that the long-term stock
performance of either large or high growth possibility firms is generally lower than thestock performance of their smaller and lower growth possibility counterparts (e.g.,
Fama and French, 1992, 1993). Our sample of acquiring firms show median market

4

In the United States from 1980 to 1991, there was a calculated 45.05% median and63.41% average for firm premiums (Rau and Vermaelen, 1998, p. 235, Table 2).
5
In the U.K., from 1985 to 2004, there was a calculated 40% median and 45% averagefor firm premiums (Antoniou et al., 2008, p. 272, Table 1).

13values (¥39,245 million for pooling-interest method, ¥104,582 million for purchase withamortization of goodwill method, and ¥53,655 million for purchase with immediate
incurrence of goodwill method) that are all considerably higher than the median market
value (¥13,604 million) for all listed firms on the stock exchange. Our sample ofacquiring firms has a median book-to-market ratio of 0.8945 for pooling-interest
method, which is very close to the median book-to-market ratio (0.8818) for all firms
listed on the stock exchange. However, our sample’s median for the purchase withamortization of goodwill method (0.6997), and for the purchase with immediate
incurrence of goodwill method (0.5722) are significantly lower than the median
book-to-market ratio for all listed firms. Therefore, if we focus only on our sample’s
financial characteristics and considerably lower average premiums, disregarding M&A
events, we can expect that our sample’s acquiring firms will have a long-term stock
performance that is lower than the bench mark reference portfolio.

[Table 1][Table 2][Table 3]14

3. Market Reaction to Accounting Policy Choices(1) Purchase with Amortization of Goodwill Method vs. Pooling-Interest Method
If a business combination is structured in such a way that the tax consequences areunaffected by the accounting method choice, then the future direct cash flows are also
unaffected. In these cases, if investors are homo economicus, variance between
accounting methods regarding business combinations should not affect the investors’
estimate of the firms’ intrinsic value. However, the results of previous research arecontrary to rational thinking (an anomaly), and are explained through psychology or
behavioral economics. For example, investors focus on bottom-line earnings andautomatically respond to events that will affect future earnings regardless of theaccounting policy. This reflexive response is known as the mechanistic hypothesis or
the functional fixation hypothesis. The functional fixation hypothesis maintains thatinvestors routinely interpret earnings numbers without considering the accounting
procedure used to calculate them, evincing a direct, positive relationship between
bottom-line earnings and subsequent stock performances (Leftwich, 1980; Watts andZimmerman, 1986).
Previous research (Hopkins, 1996; Hirst and Hopkins, 1998; Maines et al., 2000;

15

Hopkins et al., 2000) also suggests that financial analysts focus primarily on the raw
accounting numbers in the body of a financial statement, even though they could adjust
the accounting numbers by using information in the footnotes. For example, in the
Hopkins et al. (2000) study, financial analysts were provided with different accounting
numbers attributable to disparate accounting policies regarding business combinations,although in reality the actual economic transactions of the hypothetical M&A wereidentical. In their study, the financial analysts estimated a lower intrinsic value for firms
which adopted the purchase with amortization method than firms which adopted thepooling-interest-method. They tended to estimate a firm’s intrinsic value without
adjusting for the different accounting policies between the pooling-interest and purchasewith amortization methods, even if they were able to do so by using information in thefootnotes. Therefore, we propose hypotheses 1 as follows:

Hypothesis 1: The purchase with amortization of goodwill method has a negative
impact on the future EPS, whereas the pooling-interest method has a favorable impact
on it. Therefore, the long-term stock performance of a firm which uses the purchasewith amortization of goodwill method will be lower than a firm which uses thepooling-interest method.

16

(2) Purchase with Amortization of Goodwill Method vs. Immediate Incurrence ofGoodwill Method
In the United States, when acquiring firms use merger bids or tender offers to takeover firms such as high-tech or pharmaceutical companies, the acquirers often allocate asubstantial portion of the accounting acquisition premium to ongoing research anddevelopment and then immediately record it as an expense (Deng and Lev, 1998). In
Japan, on the other hand, until the Japanese Accounting Standard for Business
Combination was implemented in 2006, no comprehensive accounting rules existed.
Acquiring firms often adopted the immediate incurrence of goodwill method, especiallythose listed in stock exchanges for emerging stocks. Although specific accounting
practices vary between the two countries and are used in different contexts, they resultin the same consequence: the amount of goodwill is immediately expensed.
When Japanese firms adopted the immediate incurrence accounting procedure, theyusually emphasized that the charge to the income was temporary and atypical. Therefore,
we have reasoned that in the purchase with amortization of goodwill method, investors
realize the immediate expense of goodwill as an extraordinary item for the current
fiscal year and regard it as an irrelevant item to the firm’s future EPS. Conversely,17

investors see the amortization cost of goodwill as an ordinary item, and regard it as aconstant affect to the firm’s future EPS. Accordingly, the estimated future EPS should
be higher with the immediate incurrence of goodwill method compared to theamortization of goodwill method. Henceforth, we propose our second hypothesis asfollows:

Hypothesis 2: The long-term stock performance of firms that use the purchase withamortization of goodwill method will be lower than firms that use the immediate
incurrence of goodwill method.

(3) Market Performance on the Purchase with Goodwill Amortization Method as a
Function of Time (One vs. Three Years Following the M&A Date)
Even though raw accounting numbers may vary as a function of the firm’s adopted
accounting choices, we believe that investors only focus on the bottom line numbers toestimate a firm’s future EPS. Therefore, the time that has elapsed after an M&A should
not affect the estimation of the future EPS. Our argument also holds true for cases
where firms adopt the purchase with amortization method.
Contrary to our view, however, some popular corporate valuation textbooks

18

recommend that investors estimate a firm’s intrinsic value by adding the amortization
charge of goodwill back into the raw earning numbers (White et al., 1997). In fact,
when FASB conducted field visits (as referred in the accounting standards in 1999, para.
B79), they found that investors and creditors regard the amortization charge of goodwill
as not an ordinary but as an extraordinary cost when making investment decisions. Theirrationale, which is contrary to our belief, suggests that investors add back theamortization cost when business combinations occur.
Hopkins et al. (2000) provided limited support for White’s et al. claim, because
their experimental analysis showed investors adding the amortization charge back if
only for a short period after an M&A event; investors do not add the charge back after
relatively long periods of time. Hopkins and his fellow researchers examined theperceptions of fifty financial analysts and found that investors often forget about
goodwill charge with the abundance of newly acquired information, and therefore,
neglect to add it back after long periods of time have passed.
Taking into consideration the Hopkins et al. findings, we should further investigate
whether our argument still holds true for cases where firms adopt the purchase withamortization method leading to our fourth hypothesis as follows:19

Hypothesis 3: The third year stock performance of acquiring firms is no higher than
the first year performance given the condition that their accounting procedure isconsistently the ‘purchase with amortization of goodwill.’

If our data supports hypothesis 3, we are able to reconfirm that investors do merely
react mechanically to bottom-line earnings numbers rather than considering the different
accounting procedures.

4. Methodology and Results(1) Methodologies
In order to measure the long-term stock performance of acquiring firms using theabnormal return, we created a reference portfolio. The reference portfolio wascomprised of companies that shared two risk factors with our sample stock:
book-to-market ratio and size in accord with Fama and French (1992, 1993). The
following procedures were employed in the construction of the reference portfolio:(a) First we identified all stocks which were listed during the same month that each
M&A occurred. We divided these stocks into five groups based on firm size todefine the boundaries of each quintile.

20

(b) Within each quintile, we further sorted the stocks into five groups based on thebook-to-market ratio to define the boundaries of the inner quintile, creating
twenty-five cells. Each acquiring firm’s stock performance was compared to theaverage stock performance of firms in its corresponding cell, yielding its
abnormal return.
Barber and Lyon (1997) and Kothari and Warner (1997) indicated that the
cumulative abnormal return (CAR) compared against market performance may result in
misspecification. This problem implies that the statistical Type I error is more likely, orthat the null hypothesis (that the abnormal return equals zero) is rejected more
frequently by chance alone. In Japan, previous research also indicated that using theabnormal return (AR) with the TOPIX benchmark often has a positive bias. Therefore,
we calculated AR against the mean return of the reference portfolio by applying thebootstrap test in order to avoid misspecification problems. We charted the experimental
distributions using 1,000 samples with the bootstrap method, and we judged thestatistical significance by calculating the p value of our sample from these distributions.

(2) Results
Descriptive statistics for the equal-weighted and value-weighted CARs are reported

21

in Table 4. Panel (A) of Table 4 reports the results of three accounting methods eachtaken over three time periods (1st year, 3rd year, and total 3 years). The performance inour sample, the size of which is indicated by N, is measured by the cumulative abnormal
returns after the effective date of M&As. The top half of Panel (A) shows the results ofequal-weighted CARs, while the bottom half shows the results of value-weighted CARs.
The statistical results of equal-weighted CARs are consistent with the results of thevalue-weighted CARs. Please note that we are only able to test the differentials between
accounting policies for the equal-weighted CARs, the results of which will be
expounded upon in the following paragraph.
The total 3 year performance of all three accounting policy groups are statisticallyhigher than the bench mark reference portfolio. The total 3 year performance of firms
using the pooling-interest method is 18.982% (p value < 0.05, two-tailed), using thepurchase with amortization method reports 5.397% (p value < 0.1, two-tailed), andusing the purchase with immediate incurrence of goodwill method reports 27.763% (pvalue < 0.1, two-tailed). If we focus only on our sample’s financial characteristics anddisregard M&A events, we can expect that the 3 year performance of our sample
acquiring firms will be lower than the bench mark reference portfolio, because oursample acquiring firms’ median market value is considerably higher than the median22market value for all firms listed on the stock exchange and our sample acquiring firms’
median book-to-market ratio is lower than the median book-to-market for all firms
listed on the stock exchange. However, contrary to our expectations based on financial
characteristics, the average 3 year performance (10.191%) is considerably higher thanthe benchmark reference portfolio by a 1% significance level. Therefore, we are able toconjecture that, in Japan, the average investor appreciates the M&As affect positively.
Panel (B) of Table 4 reports t test results for our three hypotheses. First, thelong-term performance of firms using the purchase with amortization of goodwill
method (5.397%) is significantly lower than firms using the pooling-interest method(18.982%) (t value = 1.7495, p value = 0.0410, one-tailed), which supports hypothesis 1.
Secondly, the long-term performance of firms using the purchase with amortization of
goodwill method (5.397%) is significantly lower than firms using the purchase withimmediate expensing of goodwill method (27.763%) (t value = 1.3160, p value =0.0948, one-tailed), which supports hypothesis 2. We further tested market performance
as a function of time (one vs. three years following the M&A effective date) for firms
using the purchase with goodwill amortization method. Our results are consistent withhypothesis 3. The three year performance for firms using the purchase with amortizationof goodwill method (2.518%) is not significantly different from the same firms’ first23

year performance (1.359%) (t value = 0.2955, p value = 0.3839, one-tailed).

[Table 4]

5. Concluding Remarks
In Japan, after the introduction of stock swap and stock transfer schemes in 1999,
the number of mergers and acquisitions (M&As) dramatically increased. This increase
in M&As suggests that corporate managers have become aware of the importance ofidentifying suitable targets, and implementing efficient restructuring strategies
following M&As. Our sample data shows that Japanese managers use stock swap andstock transfer schemes positively when they acquire target firms. Between 1999 and2006, in cases where both the acquiring firms and target firms are publicly traded, thenumber of stock payments (199: 115 mergers plus 84 tender offers) is much greater than
the number of cash payments (92)6.
The financial characteristics of our sample of acquiring firms are as follows: themedian market value is considerably higher than the median market value for all listed
firms, and the median book-to-market ratio is lower than the median book-to-market

6

We could not identify the payment method (cash vs. stock) for 14 cases.

24

ratio for all listed firms. Therefore, if we focus only on our sample’s financial
characteristics and disregard M&A events, we can expect that our sample acquiringfirms’ long-term stock performance will be lower than the bench mark reference
portfolio. However, our results provide the evidence that the average investor
appreciates the M&As’ affect positively: acquiring firms’ long-term stock performanceis considerably higher than the bench mark reference portfolio.
In this study, we analyzed the effect of the accounting method and amortization
periods upon the subsequent market performance. The accounting methods include: (1)pooling-of-interests, (2) purchase with amortization of goodwill, and (3) purchase withimmediate expensing of goodwill. If an M&A is structured such that tax consequences
are unaffected by the accounting method choice, then the method chosen does not
influence the firm’s business or future direct cash flows. Therefore, if investors arehomo economicus, differences amongst accounting procedures in M&As should not
evince a direct, positive relationship between bottom-line earnings and the subsequent
stock performance. However our results, which support our aforementioned hypothesis
1, indicate that the long-term stock performance of firms using the purchase withamortization method is significantly lower than firms using the pooling-interest method.
This suggests that investors respond reflexively. They focus primarily on bottom-line

25

earnings and automatically respond to events that will affect future earnings regardlessof the accounting policy that has been employed.
We included firms using the purchase with immediate expensing of goodwill
method in our sample. This accounting procedure, prohibited after 2006, was typicallyadopted by firms listed in the emerging stock exchange in Japan. These firms deserve
our attention, because their accounting procedure yields the same future EPS as firms
who use the purchase with impairment method prescribed in IFRS 3 and SFAS 141.
IFRS 3 and SFAS 141 require all business combinations to use the purchase with
impairment method, which is ironically not permitted under the Japanese GAAP. Our
results supporting hypothesis 2, indicate that the long-term stock performance of firms
using the purchase with amortization method is significantly lower than firms using thepurchase with immediate expensing of goodwill method. The latter firms, indeed,
generate higher future earnings, suggesting that investors regard the immediate
expensing of goodwill as an extraordinary item for the current fiscal year and as anirrelevant item to the firm’s future earnings.
The Japanese adoption of the IFRS is controversial, but the ASBJ is attempting torequire that all listed firms adopt the IFRS by 2015-2016. This proposal for universal
adoption will be decided upon at the latest by the end of 2012. This study shows that26

since investors are misled by differences in accounting procedures, the current Japanese
GAAP is unfavorable for Japanese firms. The adoption of standard accounting
procedures is necessary to remedy investors’ misperceptions. However, adoption of the
IFRS will create the new controversy that impairment costs are up to the discretion of
the management. The absence of an independent evaluation of impairment costs(goodwill is inherently invisible and intangible and its evaluation is subjective) may
lead to the two consequences of leaving the investors with uncertainty, and giving
managers the flexibility in reporting accounting numbers7.
[2010.10.8 1003]

7

Watts (2003), Ramanna (2008), and Ramanna and Watts (2009) have repeatedly
pointed out these problematic consequences.

27

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31

Figure 1 Historical Chart of the Number of Mergers and Acquisitions Cases in Japan

2500

2000

Total
Total

1500
Japanesemergeror takeover ofDomestic- domestic
Japanese company

1000

Japanesemergeror takeover ofDomestic- foreignforeign company
Foreignor takeover of
Foreignmerger- domestic
Japanese company

500

0Data Source: RECOF MARR (Mergers and Acquisitions Research Report) CD-ROM.

This figure includes all M&As from 1996 to 2007 in Japan. Acquirers and targets were either public
or private.
Domestic-domestic - both acquirer and target are Japanese companies.
Domestic-foreign - the acquirer is Japanese and the target is foreign.
Foreign-domestic - the acquirer is foreign and the target is Japanese.

32

Table 1 Sample Charact2-eristics (by calendar year)
median(mean)
AcquirorTargetYear

Marketequity(¥mln)

Book-tomarket
ratio

Financialleverage

ROE

Marketequity(¥mln)

Book-tomarket
ratio

Financialleverage

ROE

Transaction
value(¥mln)

Total
transaction
value(¥mln)

Premium(Equalweighted)

N oftenderoffersN ofmerger
bids

N of
Non
diversification

No ofDiversification

N of Cashpayment(tenderoffers)No of Stockpayment(tenderoffers)1996

153,756(269,927)

0.5275(0.4685)0.6505(0.6335)

1.625%(4.163%)

11,139(82,721)0.3064(0.1188)0.8309(0.9336)

3.633%(3.401%)

13,288(98,424)

295,272-4.747%(-0.805%)

0

3

2

1

0

0

1997

15,520(54,724)0.6307(0.6964)0.6661(0.6463)4.968%(3.012%)

9,600(63,540)0.6157(0.6137)

0.5291(0.5595)

3.060%(22.455%)

8,940(72,339)

506,372-10.715%(-12.481%)

0

7

6

1

0

0

1998

165,028(3,251,812)

1.0009(1.1008)

0.6643(0.5941)4.280%(4.087%)

13,050(42,192)

1.1186(0.9686)

0.6050(0.6038)

5.922%(10.731%)8,858(32,399)356,385-2.903%(0.738%)

3

8

6

5

3

0

1999

49,330(239,410)

1.0536(1.2437)0.6609(0.5978)2.885%(3.176%)

9,625(18,404)

1.4869(1.4419)0.7383(0.6720)

1.292%(-5.975%)

8,973( 14,791)

295,811-5.741%(-1.613%)

6

14

14

6

5

1

2000

67,003(109,491)

0.6862(0.8897)

0.6985(0.6376)

1.942%(-1.809%)

4,244(22,688)

1.0849(1.4975)

0.6700(0.6607)0.439%(-16.626%)

2,525(20,730)

373,148-5.80%(-3.454%)

12

7

13

6

3

8

2001

83,031(176,845)

0.9208(1.1881)0.4825(0.5087)

4.419%(3.114%)

5,007(24,400)

1.4968(1.6492)

0.5091(0.5225)

2.500%(-4.364%)

7,710(22,005)

550,117-1.220%(1.704%)

12

13

17

8

6

6

2002

98,770(486,778)

0.9235(1.8731)0.6572(0.6334)

3.686%(3.113%)

4,540(17,165)

1.5237(3.5726)0.6803(0.6688)-5.013%(-4.924%)

3,464(16,594)

597,3998.701%(10.376%)

26

11

20

17

10

14

2003

72,713(179,295)

1.0132(1.5858)

0.6745(0.6355)

2.918%(2.383%)

3,218(23,587)

1.7415(-7.2212)

0.6489(0.6124)

1.551%(-5.383%)

3,865(16,318)

603,775

3.000%(12.154%)

24

17

26

15

8

15

2004

68,747(190,331)

0.7680(0.8210)0.6502(0.6357)

4.766%(9.783%)

4,238(18,202)

1.0638(1.2155)

0.6477(0.6067)

3.585%(-11.992%)

3,557(11,512)

518,0610.855%(1.995%)

39

7

23

23

17

19

2005

86,130(238,764)

0.5967(0.6990)0.6086(0.5776)6.360%(3.017%)

5,952(34,975)

0.8102(0.8300)

0.5752(0.5531)4.227%(-79.503%)

4,868(58,784)

2,939,175-1.159%(-5.230%)

39

14

31

22

23

13

2006

153,943(463,229)

0.5151(0.5358)

0.6267(0.6145)

8.190%(9.736%)

10,476(45,016)0.6224(0.7071)0.6173(0.5558)4.478%(-83.297%)

7,184(45,762)

1,921,997

5.134%(8.082%)

29

14

26

17

17

8

Total

80,886(271,312)

0.7459(1.0559)

0.6474(0.6083)

4.890%(4.679%)5,898(28,836)

1.0556(0.2631)0.6184(0.6013)2.848%(-29.237%)

4,784(30,468)

8,957,512

1.277%(2.625%)

190

115

184

121

92

84

Market equity, book-to-market ratio, financial leverage, and ROE, transaction value, Premium, Non Diversification, Diversification, cash payment (tender offers), and stock payment (tender offers) are reported
as median values and mean values, by calendar year. In our sample, payment methods of merger bids are all stock payments.
Our sample includes M&A transactions from January 1996 to December 2006 (available from the RECOF MARR CD-ROM database) that meet the following criteria:(a) Both the acquirer and target are listed in the stock exchange in order to exclude small cases.
(b) The acquirer and/or target are not financial institutions, nor involved in a bailout takeover where the transaction is a result of the target suffering financial distress.
(c) The accounting procedure of the M&A transaction is identifiable from annual reports as either the purchase method or the pooling-interest method.
(d) The amortization period is identifiable in the financial statement.

The number of M&A transactions which satisfied these criteria is 305.

33

Table 2 Sample Characteristics (by acquirer's industry)
median(mean)
AcquirorTargetMarketequity(¥mln)

Book-tomarket
ratio

Financialleverage

ROE

Marketequity(¥mln)

Book-tomarket
ratio

Financialleverage

ROE

Foods

97,742(278,114)

0.9600(1.0001)

0.3021(0.3493)4.350%(4.378%)11,014(20,199)

0.9299(0.8741)

0.3737(0.4834)

6.003%(-18.350%)

Textiles

119,058(186,957)

1.1233(1.6465)0.6572(0.5876)

0.418%(-0.551%)

10,355(24,803)

1.1186(1.2333)

0.7651(0.6548)2.066%(-1.274%)

Pulp & Paper

555,437(378,173)

0.7867(0.9136)0.7146(0.6823)

1.136%(0.705%)

12,068(52,692)

0.7927(0.9354)0.8166(0.7896)-5.200%(-12.503%)

Chemicals

135,143(211,826)

0.6726(0.8480)0.6992(0.6963)4.968%(4.600%)8,503(71,898)

1.0845(1.3547)

0.5216(0.5387)

3.060%(5.676%)

Drugs

94,929(302,596)

0.6812(0.9528)

0.3898(0.4208)

7.026%(7.162%)75,389(203,291)

0.9709(1.1755)

0.4350(0.4475)

5.558%(3.223%)

Petroleum

465,891(408,944)

0.9334(0.9599)

0.7467(0.7418)

1.261%(-0.333%)

76,403(132,087)

0.5585(0.8986)

0.8152(0.7798)-4.319%(-6.036%)

Rubber

1,324,285(1,324,285)

0.6412(0.6412)0.6959(0.6959)-0.495%(-0.495%)

33,604(33,604)

0.9662(0.9662)0.5591(0.5591)5.738%(5.738%)Stone, Clay & Glass

17,712(50,738)1.2011(1.4903)0.7050(0.6711)2.836%(0.075%)

3,753(16,009)1.6188(2.1474)

0.6908(0.6632)

0.808%(-14.513%)

Iron & Steel

297,950(523,156)

1.1375(1.0959)

0.8324(0.7838)

2.576%(-2.488%)

8,923(76,295)

1.1366(2.5902)0.7227(0.7146)-4.128%(-5.273%)

Non-ferrous Metal

74,336(184,352)

1.0951(1.4692)

0.5139(0.5558)

2.433%(-24.826%)

4,643(22,599)

1.5594(2.1742)0.5237(0.5437)

1.094%(-16.939%)

Machinery

72,707(198,532)

0.7235(0.9067)

0.6533(0.6260)

5.131%(7.391%)

6,798(23,887)

1.0411(1.5152)

0.5353(0.5278)3.875%(9.981%)

Electric & Electronic
Equipment

64,973(184,771)

0.6467(0.7400)

0.5078(0.4337)5.700%(5.4106%)

5,434(13,015)

1.1295(1.1016)0.5652(0.5929)-1.571%(-25.002%)

Shipbuilding& Repairing

164,087(164,087)

1.0222(1.0222)0.8622(0.8622)3.745%(3.745%)

10,555(10,555)

1.7053(1.7053)

0.5281(0.5281)1.100%(1.100%)Motor Vehicles& Auto Parts

97,483(1,450,899)

1.0995(1.1422)0.6712(0.6458)

6.605%(2.044%)3,430(4,846)1.3749(1.7407)0.6129(0.6760)

1.787%(-46.429%)

Precision Equipment

284,209(307,137)

0.4576(0.3635)

0.6289(0.5453)

6.459%(7.749%)57,358(67,163)0.3274(-0.1985)

0.8877(1.0032)

2.252%(-7.597%)

Other Manufacturing

65,542(98,166)

0.5359(0.6606)

0.5563(0.4724)

9.299%(9.224%)

4,575(18,811)1.3347(1.5985)0.4588(0.4559)3.313%(-11.951%)

Mining

1,532,026(1,532.026)

0.2685(0.2685)0.4269(0.4269)

18.598%(18.598%)

333,531(333,531)

0.4975(0.4975)0.3011(0.3011)5.590%(5.590%)Construction

79,016(265,042)

1.0124(1.3065)

0.5238(0.5964)4.513%(11.507%)

5,398(7,032)

1.5355(1.6391)

0.5946(0.6152)

2.352%(-4.090%)

Wholesale Trade45,862(83,502)0.9004(1.9312)0.7340(0.6817)4.855%(5.546%)

4,917(13,773)

1.0645(2.0754)0.6848(0.6935)

2.239%(1.840%)Retail Trade50,540(411,094)

0.5924(0.6958)

0.6971(0.6510)6.656%(6.236%)

5,594(25,067)

1.0745(-9.1970)

0.6037(0.6084)

5.273%(-0.819%)

Real Estate

39,350(230,146)

0.5638(0.5946)

0.7685(0.7917)12.432%(157.369%)

4,352(6,886)0.7772(0.7029)0.6706(0.6841)-0.381%(-814.671%)

Railroad
Transportation

399,566(419,632)

0.5482(0.5403)

0.8727(0.8612)-3.380%(-8.839%)

22,373(73,300)

0.9283(1.3113)0.8453(0.8298)-7.813%(-13.501%)

Trucking

125,075(125,075)

2.2542(2.2542)0.4336(0.4336)

3.155%(3.155%)5,097(5,097)4.3976(4.3976)0.2572(0.2572)

2.343%(2.343%)

Sea Transportation

554,329(603,980)

0.4672(0.4698)

0.7849(07848)12.758%(15.826%)

2,506(21,467)

0.4775(0.6936)0.7923(0.7947)

4.146%(14.399%)

Air Transportation

298,198(298,198)

0.1562(0.1562)

0.9121(0.9121)-77.015%(-77.015%)

6,101(6,101)0.7452(0.7452)

0.3381(0.3381)7.872%(7.872%)

Warehousing &Harbor Transportation

93,959(93,959)

0.4973(0.4973)

0.4658(0.4658)-23.220%(-23.220%)

6,755(6,755)0.9536(0.9536)0.7020(0.7020)-7.843%(-7.843%)

Communication
Service

31,513(31,513)

3.2221(3.221)0.6230(0.6230)

6.148%(6.148%)7,130(7,130)3.5226(3.5226)

0.0174(0.0174)-7.780%(-7.780%)

Utilities -Electric

940,436(940,436)

0.9976(0.9976)

0.7526(0.7526)

8.618%(8.618%)5,029(5,029)3.8052(3.8052)

0.5613(0.5613)-18.501%(-18.501%)

Services

31,819(70,308)0.4746(0.6571)

0.5053(0.4983)

7.039%(0.056%)

5,664(13,296)

0.4951(0.9708)

0.4629(0.4924)

3.175%(-82.177%)

80,886(271,312)

0.7459(1.0559)

0.6474(0.6083)

4.890%(4.679%)5,898(28,836)

1.0556(0.2631)0.6184(0.6013)2.848%(-29.237%)

Acquiror's
industry

Total

Market equity, book-to-market ratio, financial leverage, and ROE, transaction value, Premium, Non
Diversification, Diversification, cash payment (tender offers), and stock payment (tender offers) are reported
as median values and mean values, by acquirer's industry. In our sample, payment methods of merger bids are
all stock payments.
Our sample includes M&A transactions from January 1996 to December 2006 (available from the RECOF
MARR CD-ROM database) that meet the following criteria:(a) Both the acquirer and target are listed in the stock exchange in order to exclude small cases.

34

Table 2 (Continued)
median(mean)

Transaction
value(¥mln)

Total
transaction
value(¥mln)

Premium(Equalweighted)

N oftenderoffersN ofmerger
bids

N of
Non
diversification

No ofDiversification

N of Cashpayment(tenderoffers)No of Stockpayment(tenderoffers)

Foods

8,688
(19,831)

218,142-3.725%(5.983%)

8

4

8

4

4

2

Textiles

1,499(4,598)41,386-10.732%(-13.535%)

8

3

5

6

3

3

Pulp & Paper

16,034(56,742)453,935-1.398%(-2.684%)

3

5

6

2

0

3

Chemicals

6,901(45,503)

728,0406.858%(13,144%)

12

5

9

6

5

7

Drugs

65,013(234,542)

938,166

8.055%(7.976%)

1

3

2

2

1

0

Petroleum

61,776(103,482)

413,928-8.960%(9.833%)

2

2

4

0

2

0

Rubber

17,461(17,461)

34,921

1.124%(1.124%)

0

2

1

1

3

2

Stone, Clay & Glass

2,643(16,415)

164,153-1.134%(-6.508%)

5

5

7

3

0

5

Iron & Steel

9,013(69,551)

556,404

9.239%(-3.012%)

5

3

2

6

3

3

Non-ferrous Metal

1,825(14,182)

198,545-11.447%(-9.773%)

9

5

6

8

5

2

Machinery

3,583(22,365)

447,298-11.095%(-4.995%)

9

11

12

8

5

7

Electric & Electronic
Equipment

2,626(9,376)140,635-5.684%(-4.144%)

12

5

9

8

0

1

Shipbuilding& Repairing

6,599(6,599)6,599-59.483%(-59.483%)

1

0

0

1

1

5

Motor Vehicles& Auto Parts

2,859(5,095)45,8580.339%(6.608%)

6

3

5

4

2

0

Precision Equipment

20,308(69,104)

207,313-2.624%(-28.632%)

2

1

1

2

3

2

Other Manufacturing

3,176(33,820)

236,740

17.335%(17.931%)

5

2

1

6

4

3

Mining360,596(360,596)

360,5965.134%(5.134%)

0

1

1

0

0

0

Construction

5,026(14,849)

237,576-5.797%(-4.744%)

8

8

11

5

4

3

Wholesale Trade

5,046(12,466)

498,6456.823%(7.108%)

19

21

24

16

8

11

Retail Trade

4,630(61,643)

1,972,563

5.792%(13.978%)

26

9

26

9

16

8

Real Estate

2,442(2,763)

13,814-8.124%(-6.719%)

5

0

1

4

5

0

Railroad
Transportation

18,193(74,478)446,870

0.124%(0.0755%)

6

0

1

5

1

5

Trucking

12,335(12,335)

24,67016.205%(16.205%)

2

0

1

1

0

2

Sea Transportation

1,733(5,539)27,6940.660%(-1.285%)

5

0

3

2

2

3

Air Transportation

10,878(10,878)

10,8787.143%(7.143%)

1

1

0

2

0

0

Warehousing &Harbor Transportation

8,160(8,160)16,320-15.013%(-15.013%)

2

0

0

2

2

0

Communication
Service

2,575(2,575)2,575

0.286%(0.286%)

1

0

0

1

1

0

Utilities -Electric

1,592(1,592)

1,592

38.337%(38.337)%

2

0

0

2

1

1

Services

4,856(12,752)

510,0650.284%(3.113%)

25

16

36

5

15

9

4,784
(30,468)

8,957,512

1.277%(2.625%)

190

115

184

121

92

84

Acquiror's
industry

Total(b) The acquirer and/or target are not financial institutions, nor involved in a bailout takeover where thetransaction is a result of the target suffering financial distress.
(c) The accounting procedure of the M&A transaction is identifiable from annual reports as either the purchasemethod or the pooling-interest method.
(d) The amortization period is identifiable in the financial statement.

The number of M&A transactions which satisfied these criteria is 305.

35

Table 3 Sample Characteristics (by accounting policies)
median(mean)
Marketequity(¥mln)
39,245(171,999)

Acquirer
Book-toFinancial
marketleverage
ratio
0.89450.6574(1.1977)(0.6138)

3.367%(4.156%)

Marketequity(¥mln)
9,364(526,454)

TargetBook-toFinancial
marketleverageratio
1.20790.5702(1.7679)
0.5622

3.119%(2.855)%

Accounting
PolicyNpooling-of-interest method

78

purchase with amortizationof goodwill method

209

104,582(324,921)

0.6997(1.0264)0.6422(0.6111)3.642%(3.713%)

5,151(21,791)

1.0322(2.1566)

0.63600.61491.342%(0.838%)purchase with immediate
incurrence of goodwill method

18

53,655(79,206)

0.5722(0.7844)0.6290(0.5518)

4.496%(4.345%)

4,622(7,464)0.5393(28.2435)

0.54870.61322.000%(1.109%)

Total

305

80,886(271,312)

0.7459(1.0559)

0.6474(0.6083)

3.553%(3.864%)

5,898(28,836)

1.0556(0.2631)0.61840.6013

1.836%(1.370%)

ROA

ROA

Market equity, book-to-market ratio, financial leverage, and ROE of both acquirer and target are reported as median values and mean values, by accounting
policies. In our sample, payment methods of merger bids are all stock payments.
Our sample includes M&A transactions from January 1996 to December 2006 (available from the RECOF MARR CD-ROM database) that meet thefollowing criteria:(a) Both the acquirer and target are listed in the stock exchange in order to exclude small cases.
(b) The acquirer and/or target are not financial institutions, nor involved in a bailout takeover where the transaction is a result of the target suffering financial
distress.
(c) The accounting procedure of the M&A transaction is identifiable from annual reports as either the purchase method or the pooling-interest method.
(d) The amortization period is identifiable in the financial statement.

The number of M&A transactions which satisfied these criteria is 305.

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Table 4 Panel (A)Equal-weighted CAR

Benchmark: Reference Portfolio

Timeframes
Accounting Policies

N

3rd year
performancep -value(1) pooling-of-interest method

78

10.297%0.028(2) purchase with amortizationof goodwill method

209

2.518%(3) purchase with immediate
incurrence of goodwill method

18
305

ALL

1st year
performancep -value

Total 3 years
performancep -value

4.715%

0.233

18.982%

0.035

**

0.127

1.359%

0.308

5.397%

0.089*

12.175%0.132

6.640%

0.315

27.763%0.098*

5.078%

0.025

2.529%

0.261

10.191%

0.007

***

**

**

Value-weighted CAR

Benchmark: Reference Portfolio

Timeframes
Accounting Policies

N

3rd year
performancep -value(1) pooling-interest method

78

14.194%0.042(2) purchase with amortizationof goodwill method

209

0.382%(3) purchase with immediate
incurrence of goodwill method

18
305

ALL

1st year
performancep -value

Total 3 years
performancep -value-3.361%

0.712

16.348%

0.020

0.436

-4.937%0.955-1.340%0.977

7.861%

0.221

1.542%

0.532

19.937%0.055

4.164%

0.088-3.677%0.250

4.556%

0.114

**

*

**

*

Panel (A) of Table 4 reports the results of three accounting methods each taken over three time periods (1st year, 3rd year, and total 3 years).
The performance in our sample, the size of which is indicated by N, is measured by the cumulative abnormal returns after the effective date of
M&As. The top half of Panel (A) shows the results of equal-weighted CARs, while the bottom half shows the results of value-weighted CARs.
In our sample, payment methods of merger bids are all stock payments.
Our sample includes M&A transactions from January 1996 to December 2006 (available from the RECOF MARR CD-ROM database) thatmeet the following criteria:(a) Both the acquirer and target are listed in the stock exchange in order to exclude small cases.
(b) The acquirer and/or target are not financial institutions, nor involved in a bailout takeover where the transaction is a result of the target
suffering financial distress.
(c) The accounting procedure of the M&A transaction is identifiable from annual reports as either the purchase method or the pooling-interest
method.
(d) The amortization period is identifiable in the financial statement.
The number of M&A transactions which satisfied these criteria is 305.
We determined the statistical cut-off points by calculating distributions drawn up experimentally 1,000 times by the bootstrap method.
***, **, * denote that the difference in mean values is significant at the 1%, 5%, and 10% level (two-tailed), respectively, based on thebootstrap test.

37

Table 4 Panel (B)Hypothesis
H1: Purchase with ratable amortization method (Total 1 to 3 years)< Pooling-of-interest method (Total 1 to 3 years)t -statistics(p -value)
1.7495 **(0.0410)

H2: purchase with amortization of goodwill method (Total 1 to 3 years)< purchase with immediate incurrence of goodwill method (Total 1 to 3 years)

1.3160H3: purchase with amortization of goodwill method (Past (3 years ago))< purchase with amortization of goodwill method (RECENT (within 1 year))0.2955*(0.0948)(0.3839)

Panel (B) of Table 4 reports t test results for our three hypotheses.
Predictions are directional by hypotheses 1 to 3, so p-values are one-tailed.
***, **, * denote that the difference in mean values is significant at the 1%, 5%, and 10% level(one-tailed), respectively, based on the bootstrap test.

38