To What Extent Do Large Listed Uk Firms Manage Earnings to Meet City Earnings Expectations?

To what extent do large listed UK firms manage earnings to meet City earnings expectations? What techniques are used? Should investors worry about earnings management?

Introduction

When it comes to the control of a business, there are two main players involved in the earnings game. There are the principals, these are considered to be the stakeholders that are financially invested in the company, such as the equity shareholders (Weetman, 2002) and then there are the agents. The agents are the managers that are hired to control the business on behalf of the principals (Jensen and Meckling, 1976). The relationship between the two groups is the basis of agency theory (Habbash, 2010) and it involves the conflicting goals that arise when managers wish to further their own wealth through bonuses for current financial success, whereas principals want to maximise the long-run earnings of the company. As the shareholders are usually not involved in the running of the company and the day-to-day decisions, there is a separation of information. This is known as asymmetric information. Thus, the managers are able to use earnings management to control and meet earnings expectations.

This essay uses examples and different sources from both the United Kingdom and the United States of America as both countries can be easily compared due to the “Special relationship” between them (Behr, 2015). The first section will show to what extent UK firms manage earnings to meet analysts’ forecasts. This will be followed by the techniques that are used to smooth, decrease or increase earnings in a given period focusing on “premature revenue recognition”, “accrual accounting” and “the big bath”. Finally, the third section will determine whether investors should worry when using companies’ accounts to compute the relative risk of their investment.

Extent of earnings management in the UK

In this section, the extent of earnings management of large listed UK companies will be discussed. Generally, the degree of earnings management is dependent on the size of the company. This is to say, for some moderately large companies with earnings of less than one billion pounds, earnings management is balanced, whereas for the larger corporations, earnings management is likely to be at a high level.

Listed companies, such as BP PLC and J Sainsbury PLC are the first type of companies whose earnings management are aggressive. Take BP PLC as an example, from 2011, the revenue as well as dividends paid reached a tight consensus with analysts’ forecasts (Financial Times, 2015). For example, in the fiscal year of 2014 (Figure 1), BP met the analysts’ expectations of these main elements.

[pic 1]

 Figure 1

This, to a certain extent, illustrates that BP utilises extensive earnings management in order to meet and beat (MBE) the analysts’ expectations (Walker, 2013). To further prove this idea, the financial statements of BP have been investigated (Fame, 2015). It can be found that BP manages costs each year to meet earnings by increasing or decreasing the accruals in order to manipulate profits (Figure 2). Moreover, provisions and pensions have been changing significantly each year. Studying Figure 4, it is clear that provisions have a significant upward trend; this implies that BP attempts to lower its retained earnings by overestimating its future cost. Similar situations can be detected in other firms such as J Sainsbury PLC (Financial Times, 2015) and Whitbread Group PLC (Financial Times, 2015). Therefore, it can be concluded that these companies have an aggressive approach towards earnings management.

[pic 2]

Figure 2

[pic 3]

Figure 3

[pic 4]

Figure 4

However, for moderately large sized companies, there seems to be a greater proportion whose earnings management is not aggressive. Admiral Group PLC is a typical example. According to analysts’ research, there are relatively huge fluctuations in the company’s revenue, dividends paid and EPS (Financial Times, 2015). For instance, in 2011, it was estimated that revenue would be £377 million compared with the reported £445 million. Moreover, the estimated dividend (£0.6421 per share) was nearly twice as much as the actual dividend paid (£0.3240 per share). In the last five years, its revenue and accruals fluctuated dramatically in line with the general insurance market (PwC, 2013). The volatility of the revenue cannot be controlled due to the fact that there is a minimal provision. This is to say, the earning management of this company is neutral, which causes difficulties in “Meeting and beating (MBE)” the expectation. Other firms such as New Britain Palm Oil Ltd (Financial Times, 2015) have low levels of earnings management.

These are two typical types of large companies in the U.K. To be more specific about the position of these two types of companies, the research carried out by Athanasakou et.al (2011) can be used. According to this research, over 70% of large listed UK companies exploited the methods of managing EPS. This, to a certain extent, implies that for most of them, the extent of earnings management seems to be aggressive. It is true that exceptions exist; such as Admiral Group PLC, yet earnings management is being used extensively by the majority of listed companies.

Techniques Used

There are numerous actions that managers can take to temporarily boost or manage earnings. One of these methods is known as premature revenue recognition. Levitt (1998) describes this process as reporting a sale when the customer still has the right to delay or even void the purchase completely. This is considered to be the major cause for financial restatements (Altamuro et al, 2005). Managers take these actions in order to meet earnings and sales targets and inflate revenue, in some cases at a loss (Landry, 2001). It is possible to see when a company is taking these steps, as trade receivables will increase over time as well as the trade receivables ratio. This is exemplified in General Motors’ financial statements, with an $18,088 million expansion in trade receivables from 2009 to 2014 (Osiris, 2015). This method cannot be maintained in the long run as it is effectively “borrowing” sales from future periods that have to be paid back. If sales do not increase in the following quarters then financial restatements have to be issued, this being the case in MicroStretegy’s downfall. MicroStrategy cut its sales by over $50 million for including sales of updates that clients would need in the future. This had a knock on effect and sent the share price crashing down losing 62 per cent of its value in a single day (Miller, 2000).