Arthur Andersen Center for Financial Reporting Research Workshop

Arthur Andersen Center for Financial Reporting Research Workshop Friday, February 14, 2020 11:00 a.m. – 12:30 p.m. 4151 Grainger Hall The Effect of Financial Reporting for Restructuring on Firm Choice of Divestiture Form Diana Weng Doctoral Candidate University of Florida FACULTY Ph.D. STUDENTS W. Choi T. Ahn M. Covaleski J. Ariel-Rohr F. Gaertner I. Baek E. Griffith A. Carlson S. Laplante D. Christensen T. Linsmeier Z. King D. Lynch M. Liang E. Matsumura B. Osswald B. Mayhew C. Partridge T. Thomas L. Rousseau D. Wangerin D. Samuel T. Warfield M. Vernon J. Wild K. Walker K. Zehms E. Wheeler The Effect of Financial Reporting for Restructuring on Firm Choice of Divestiture Form Diana Lynn Weng Fisher School of Accounting Warrington College of Business University of Florida Gainesville, FL 32611 Office phone: (352) 273-0227 February 2020 ** Do not quote without the author’s permission ** I thank my dissertation committee members Bobby Carnes, Marcus Kirk, Mike Ryngaert, and Jenny Tucker (chair) for guidance; Elia Ferracuti, Jennifer Glenn, Patrick Kielty, Jeffery Piao, and Mark Zakota for comments; and Jonathan Urbine for his assistance with the SEC filings. The Effect of Financial Reporting for Restructuring on Firm Choice of Divestiture Form ABSTRACT I examine whether financial reporting for restructuring influences managers’ choice of divestiture form. Firms have three major divestiture form options: a firm can sell a unit to another firm in a sell-off; sell a percentage of shares in a unit to new shareholders in an equity carve-out; or separate a unit and pro-ratably distribute the new unit’s shares to existing shareholders in a spin-off. My study is set around a financial reporting change, adopted in FAS 146 in 2002 and FAS 141(R) in 2007 for two different types of restructurings, that delays the recognition of restructuring charges until the costs are incurred. Prior to this reporting change, firms could recognize restructuring charges before they were incurred—a “big bath” opportunity that may enable financially struggling firms, which tend to divest through sell-offs, to show improvement after the completion of a restructuring. After the reporting change, firms must delay the recognition of restructuring charges until they are incurred, thereby reducing the opportunity for a “big bath.” I predict and find that the accounting change makes the sell-off divestiture form less desirable and therefore increases the likelihood of divestiture through a spin-off. Overall, my findings suggest that financial reporting for restructuring influences managers’ choice of divestiture form. This paper contributes to the literature on the real effects of accounting by providing evidence that financial reporting rules influence execution of a decision. Keywords: restructuring, divestiture, financial reporting Data availability: Data publicly available from the sources identified in the paper. JEL classification: M41; G34; L22 1. Introduction I examine whether financial reporting for restructuring affects managers’ choice of divestiture form. How accounting choices affect a firm’s real decisions is an important issue. Prior research finds that financial reporting choices influence whether firms execute a decision, for example, whether firms allocate resources to research and development (Graham, Harvey, and Rajgopal 2005; Shroff 2017). There is limited research, however, that investigates the effect of financial reporting choices on how firms execute their decisions. Financial reporting for restructuring likely affects divestiture form choices because restructurings and divestitures are intertwined. A restructuring involves changing a firm’s business strategy or structure and a divestiture results in contracting the firm’s existing boundaries (Weirich 1995; Rahman 2011). If a firm divests, the divestiture is considered a part of a restructuring plan that culminates in the divestiture. Therefore, I expect financial reporting for restructuring to influence managers’ choice of divestiture form. Examining the effects of accounting choices on the selection of divestiture form addresses how firms execute existing decisions and provides new insights into the real effects of accounting choices. A restructuring with a divestiture as the outcome typically includes two steps. First, the firm creates and commits to a restructuring plan. Second, the firm executes the plan by changing its business structure to prepare to divest and then divesting the unit. If the restructuring plan involves a merger & acquisition (M&A), the firm first expands its business through an M&A, changes its business structure to integrate the acquired units, and then divests unwanted units. Regarding the divestiture portion of a restructuring, a firm first decides whether to divest a unit and then decides how to divest that unit (i.e., the divestiture form). 1 Divestitures are economically significant with deal activity growing from $100 billion in 1993 to over $2.2 trillion in 2018 and in total representing a third of all M&A activity (Brauer and Wiersema 2012; J.P. Morgan 2019). Divestitures are projected to continue in prominence with at least 80% of large companies planning to divest by the end of 2021 (EY 2019). I examine three divestiture forms: sell-offs, equity carve-outs, and spin-offs. In a sell-off, the parent company sells a unit to another company. In an equity carve-out, the parent company sells a percentage of shares in a unit in an initial public offering (IPO) and retains ownership of the remaining shares. In a spin-off, the firm separates a unit from its business, creates a new entity with the unit, and distributes the entity’s shares to existing shareholders on a pro-rata basis. Firms typically weigh two motives in selecting a divestiture form—financial underperformance and strategic motives. The financial-underperformance motive primarily stems from a firm’s need to divest in order to improve financial performance. Firms driven by this motive often divest through a sell-off or equity carve-out (Duhaime and Grant 1984; Allen and McConnell). Sell-offs and equity carve-outs both raise cash; however, a sell-off is the quickest and least costly form of divestiture because it is the only method that does not create a new entity, a process which involves more parties and greater costs. The strategic motive involves repositioning, refocusing, or reducing agency costs (Sudarsanam 2003). This motive is often driven by corporate governance mechanisms (e.g., institutional investors and boards of directors) and the need to reduce information asymmetry between management and other parties. Firms driven by a strategic motive often divest through a spin-off or equity carve-out (Krishnaswami and Subramaniam 1999; Vijh 2002). These divestiture forms allow for the reduction in information asymmetry while allowing original shareholders to maintain ownership in the divested unit. A firm may have some level of each motive, but the dominating motive facilitates the firm’s choice of divestiture form. 2 Investors expect improved financial performance after a restructuring is complete. The pressure to show improvement is even greater for financially underperforming firms because the primary objective of these firms’ restructurings is to address underperformance. In contrast, the objective of strategic divestitures is part of a long-term goal of shifting a firm’s strategy or focus. Therefore, firms with strategic divestitures face less pressure to show performance improvements in the near term. Financial reporting for restructuring can influence a firm’s choice of divestiture form depending on whether an accounting choice allows the firm to meet performance expectations after the completion of a restructuring. One such choice is a “big bath”—shifting the recognition of certain restructuring charges from post-divestiture to pre-divestiture and thus increasing the likelihood of meeting post-divestiture expectations (Moehrle 2002). In other words, firms may overstate restructuring charges (which are considered non-recurring negative items and therefore draw less attention from investors) in the current period to boost earnings in future periods when they avoid recording income-reducing items related to the restructuring (Duncan 2001). In addition, earlier recognition of restructuring charges may allow managers to overestimate restructuring charges and justify the overestimation. A longer time lag between recognition and occurrence of the event means the firm has less information and more flexibility in estimating the charges at the recognition. A firm may use this flexibility and create a “big bath.” Therefore, changes in financial accounting for restructuring that affect managers’ big-bath opportunities may influence their choice of divestiture form. The financial reporting change for restructurings without an M&A (non-M&A firms) occurs at a different time than the change for restructurings with an M&A (M&A firms). For non- M&A firms, firms followed EITF 94-3 since 1995 and were allowed to report restructuring charges 3 as early as the restructuring plan commitment date. FAS 146 “Accounting for Costs Associated with Exit or Disposal Activities,” effective in 2003, requires firms to delay the recognition of restructuring charges until they are incurred and therefore reduce firms’ opportunities to frontload charges. For these firms, I refer to 1995-2002 as the pre-period and 2003-2018 (my final sample year) as the post period. For M&A firms, firms followed EITF 95-3 since 1995 and were

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