Regulatory incentives and financial reporting quality in public healthcare organisations

Abstract

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.

Audit Adjustments and Public Sector Audit Quality

“…This finding does, however, offer an explanation for the findings of Greenwood et al . () where, in an analysis of published financial statements, a higher than expected level of downwards earnings management was found for Foundation Trusts with high levels of pre‐managed surplus. The highest incidence of downward adjustments, as expected, occurs for large pre‐audit deficits (Quintile 5).…”

“…Liquidity ( liq ) is included as a proxy for audit risk. Liquidity is subject to regulatory monitoring (Monitor , 2011, ) and has the potential to be associated with the exercise of managerial discretion (Greenwood et al ., ) and thus on the potential for audit adjustments.…”

How might harmonization influence the future prevalence of public sector creative accounting?

“…The manipulation of reported earnings may be linked to the setting of financial targets by regulatory authorities. For example, Greenwood et al (2017) report that foundation trusts in the NHS in England use discretionary accruals to increase income when pre-managed results are below intervention thresholds and income-decreasing adjustments when pre-managed results are well above the intervention level.…”

“…On the other hand, a large surplus might also result in criticism on the grounds that a public sector entity is not created to maximise financial returns, and that large surpluses suggest that taxes, levies or prices are excessive. For example, Greenwood, Bayliss, and Tao (2017) report that discretionary accruals are managed by public hospitals in England to report small surpluses, as there is an aversion to reporting small losses. Third, the governance structure of public sector entities will often differ considerably from a private corporation, leading to different costs and incentives.…”

A quest for a small surplus: Accrual and real-based earnings management by UK nonprofits

“…In fact, there is evidence, albeit much limited compared to for-profit firms, that managers of nonprofits opportunistically misreport the accounting numbers that may influence the level of private donations or government funding (e.g. Bouwens et al, 2004;Leone & Van Horn, 2005;Ballantine et al, 2007;Verbruggen and Christiaens, 2012;Yetman & Yetman, 2012;Balsam and Harris, 2014;Ferreira et al, 2013;Greenwood et al, 2017;Beck, 2018). Research on earnings manipulation in nonprofits is predominantly focused on nonprofit hospitals.…”