English National Health Service Foundation Trusts are subject to a regulatory regime in which the level of monitoring and intervention is determined by performance against two key performance metrics: a 'financial risk rating', based on a number of performance metrics (such as the reported surplus and return on assets), and a 'prudential borrowing limit', a measure of borrowing capacity. In this paper we investigate the variation in financial reporting quality, proxied by discretionary accruals, with the incentives introduced by this regime. We find: first, that discretionary accruals are managed to report small surpluses; second, that, consistent with the avoidance of regulatory intervention in both the short and medium term, discretionary accruals are more positive/negative when pre-managed performance is below/well above intervention triggering thresholds; third, that, despite a move away from financial breakeven as the primary performance objective, there remains an aversion to small loss reporting. We further find that the level of discretionary accruals is driven by two metrics of strategic significance: the surplus margin (a measure of retained earnings) and the prudential borrowing limit, a measure of borrowing capacity.
We study clauses in private lending agreements requiring auditors to assure lenders of borrowers' compliance with financial covenants. Auditors are required under general purpose financial reporting to review covenant compliance. However, by informing lenders directly that they have no knowledge of default, auditors may increase their litigation risk. We find that auditor covenant compliance assurance clauses are significantly associated with more complex contractual adjustments to net income, the extent of reliance on accounting information in the contract, intangibility of borrowers' assets, the number of lenders and loan maturity. We provide novel evidence of the audit market enhancing efficient contracting.
This paper exploits the availability of pre-audit financial statements in UK local government to investigate firstly, the scale and incidence of audit adjustments and secondly, the association between audit adjustments and audit fees in Wales. We find that adjustments to the general fund, the balance on which is both politically and legally sensitive, represent a significant proportion (approximately half) of all adjustments to the income statement; that audit fees are sensitive to adjustments to the general fund but not to the income statement and that there is considerable variation in the scale and incidence of adjustments between local authorities. Finally, consistent with prior research, we find that audit adjustments on average result in more conservative reporting of the surplus/deficit and of the balance on the general fund, with the number and value of downward adjustments exceeding those of upward movements.
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