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Self-serving disclosures bychairpersons of failing UKcompaniesClive Lennox aa Hong Kong University of Science and TechnologyPublished online: 29 May 2012.

To cite this article: Clive Lennox (2001) Self-serving disclosures by chairpersons offailing UK companies, Asia-Pacific Journal of Accounting & Economics, 8:2, 63-81, DOI:10.1080/16081625.2001.10510590

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Self-serving disclosures by chairpersons of failing UK companies

Clive Lennox* Hong Kong University of Science and Technology

Received July 2000; Accepted August 2001

Abstract

This paper investigates information disclosures made by the chairpersons of boards of directors in 120 failing UK companies. There are four main findings. Firstly, chairpersons excessively blame poor performance on exogenous factors rather than managerial decisions. Secondly, almost half of chairpersons do not candidly disclose problems that are apparent when they write their statements. Thirdly, prospective disclosures are more optimistic than disclosures about past performance de­spite significantly worse performance after the chairpersons' statements. Finally, chairpersons' com­pensation is negatively associated with bad news disclosures. Overall, the results indicate that chair­persons in failing companies hide bad news, and they have incentives to do so. ©City University of Hong Kong.

JEL Classifications: M41 and G33

Keywords: self-serving; disclosure; failing

1. Introduction

This paper examines whether' chairpersons of failing companies make excessively op­timistic information disclosures in an attempt to cover up poor performance. Companies that file for bankruptcy are sampled for two reasons. Firstly, corporate failure triggers a flow of information from sources that are potentially less biased than chairpersons' state­ments. The candour of chairpersons' statements is evaluated using information from the Financial Times ("FT") news items and from insolvency practitioners' letters to creditors.

' Correspondence to Clive Lennox, Department of Accounting, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong. Tel: (852) 2358 7571; E-mail: accl@ust.hk. Financial support from the Nuffield Foundation is gratefully acknowledged. This paper has benefited from the helpful comments of an anonymous reviewer, Mike Adams, Vivien Beattie, Terry Cooke. Elisabeth Dedman. Mike Jones and participants at the British Accounting Association (2001 ).

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64 Clive Lennox I Asia-Pacific Journal <~/'Accounting & Economics 8 (2001) 63-81

Secondly, chairpersons of failing companies may have particularly strong incentives to make self-serving disclosures in order to avoid loss of office or lower compensation (Gilson, 1989, 1990).

The evidence is consistent with the hypothesis that chairpersons cover up poor per­formance. Firstly, the reasons cited by chairpersons for poor performance are compared with the reasons cited by theFT and insolvency practitioners. The evidence indicates that chairpersons are excessively willing to blame exogenous causes of stress (e.g. recession) rather than disclose problems caused by managerial actions (e.g. unprofitable acquisi­tions). Secondly, 42 companies are identified in which problems are apparent when the chairpersons write their statements. Only 22 out of the 42 chairpersons in these companies candidly reveal existing problems. Thirdly, chairpersons' statements about past perform­ance are compared with their statements about future prospects. Since past performance is verifiable while future performance is uncertain, chairpersons have more scope for mak­ing overly optimistic statements about future prospects rather than about past perform­ance. Consistent with this, it is found that chairpersons' prospective disclosures are significantly more positive than their disclosures about past performance, even though actual performance is significantly worse after chairpersons' statements.

There are two potential sources of bias that may understate the extent to which chair­persons cover up poor performance. Firstly, the information obtained from FT news items and from insolvency practitioners' letters may be biased in directors' favour because FT journalists and insolvency practitioners obtain some of their information from directors. However, journalists and practitioners get information from other sources as well, such as institutional investors. 1 Moreover, their professional reputations mean they have incen­tives to critically evaluate information obtained from directors. As discussed in the next section, practitioners sometimes demonstrate their independence by disagreeing with di­rectors' estimated recovery rates. To the extent that FT news items and practitioners' let­ters are biased in favour of directors, this paper's methodology is biased against finding that chairpersons cover up poor performance. Secondly, the results may be biased because the sample only consists of soon-to-be-bankrupt companies. If withholding bad news in­creases the likelihood of survival, the paper's results are biased against finding that chair­persons cover up poor performance.

There is only one other paper that investigates information disclosures in stressed com­panies. Frost ( 1997) examines a sample of 81 UK companies that receive modified audit opinions between 1982-1990. She finds that managers are generally forthcoming about bad news although a number of prospective disclosures are overly optimistic compared to ex-post outcomes. While Frost ( 1997) samples companies that receive modified audit opin­ions, this paper samples companies that file for bankruptcy. The difference in sampling methodology is important because managers may have less incentive to make opportunis­tic disclosures if they expect to receive modified audit opinions. As Frost ( 1997) acknowl­edges, managers may "perceive the advantages of withholding negative news to be minimal,

1 For example, the FT details the comments of institutional investors when Dominion International collapses following a boardroom dispute.

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Clive Lennox I Asia-Pacific lou mal of Accounting & Economics 8 (2001) 63-81 65

possibly because they believe that the adverse news will soon be publicly known [in modi­fied audit opinions] with or without their disclosure." Since only 20-25 per cent of UK companies receive modified audit opinions prior to failure, Frost's results may not be representative of stressed companies in general (Citron and Taffler ( 1992), Lennox (1999)).2

Although there is little extant research on news management in stressed companies, there is a much greater amount of literature on earnings management. Earnings manage­ment studies test the cover up hypothesis by examining whether managers in poorly per­forming companies choose income-increasing accounting policies (e.g. Murphy and Zimmerman, 1993). Existing evidence does not support the view that stressed companies hide bad news. For example, DeAngelo et al. ( 1994) find that stressed companies choose income-reducing accounting policies that reflect poor performance rather than opportun­ism. Since income-increasing accounting policies automatically reduce future reported income, self-serving managers may be reluctant to increase current reported income if they are uncertain about future incomes or about the income levels that trigger dismissal (Murphy and Zimmerman, I 993). Since information disclosures do not have this auto­matic reversal property, self-serving behaviour may be less evident in earnings manage­ment than in news management.

The next section describes the sample and provides descriptive statistics. Section 3 reports tests of whether chairpersons withhold unfavourable news and investigates the impact of negative news disclosures on chairpersons' compensation. The concluding re­marks are provided in Section 4.

2. The sample

2.1 Data sources

There are three bankruptcy procedures for UK companies - liquidation, receivership and administration - all of which result in termination of directors' employment con­tracts.3 CGT Capital Losses (FT Information, 2000) is used to identify publicly-traded UK companies that file for bankruptcy between 1988-1999. Shareholders' voluntary fil­ings are excluded as these companies are typically non-stressed. After a company files for bankruptcy, insolvency practitioners send letters to creditors detailing the events leading up to bankruptcy. Section 47 of the 1986 Insolvency Act requires directors to prepare a Statement of Affairs, which provides an estimate (as at the bankruptcy date) of how much is likely to be recovered for creditors. Insolvency practitioners are required to check State­ments for omissions and to comment where they disagree with directors' estimates of recovery rates. Practitioners attach their letters to directors' Statements and copies of both documents are generally filed at Companies House. The sample consists of I 20 failing companies for which practitioners' letters are available from Companies House and share

1 Frost ( 1997) investigates all press release disclosures while this paper only considers chairpersons' final annual statements. Press releases cannot be included in this study as Frost's information source (Extel) is no longer commercially available.

-' In the US. nearly half of directors retain office during Chapter II (Gilson. 1989 ).

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66 Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81

prices are available from Datastream. There are I 02 companies that enter receivership, 17 that enter administration and one is immediately liquidated.4

In 12 companies, it is found that the directors' Statements are not attached to practi­tioners' letters and so estimated recovery rates are unavailable. In a further four compa­nies, practitioners state that the directors' estimated recovery rates are over optimistic.5

This is consistent with directors attempting to hide poor performance and with practition­ers critically evaluating the information that they obtain from directors. Estimated recov­ery rates in these four companies are treated as missing observations because practitioners do not disclose their own estimates. To summarise, reliable estimated recovery rates are available for 104 of the 120 sample companies.

Figure 1 shows the time line for the sample. Data on operating profits and market values of equity are obtained for the last two accounting year-ends (t = -3, -2). In addition, market values of equity are collected for share trading suspension dates (t = -1). For bank­ruptcy filing dates (t = 0), data are collected on directors' estimated recovery rates and information is collected from the FT and practitioners' letters about the causes of failure. "Past" and "future" performance is defined using the final annual statements as the point of reference. The "past" refers to the year leading up to the final year-end (from t = -3 to t = -2) while the "future" refers to the subsequent period prior to bankruptcy (from t = -2 tot= 0).6 The mean (median) period between final reports (t = -2) and bankruptcy (t = 0) is 309 (289) days. The mean (median) period between suspension (t = -1) and bankruptcy (t = 0) is 40 (7) days.

Figure 1 The Time Line for Failing Companies

t=-3 t=-2

Penultimate Final

year-end year-end

t=-1

Suspension of

share trading

t=O

Bankruptcy

filing date

Unsurprisingly, corporate failure occurs most frequently during the 1990-1991 reces­sion (five companies fail in 1988-1989,56 in 1990-1991,27 in 1992-1993, 11 in 1994-1995, seven in 1996-1997 and 14 in 1998-1999). There are 64 failures outside of the

"The large number of receiverships compared to administrations is consistent with secured creditors pre­empting administration by appointing receivers (Franks and Torous, 1992).

'The receivers of Allied Partnership state directors' estimates of£ 12.5 million realisable from subsidiary investments are "wholly unrealistic". The receivers of Chelsea Artisans state, "It is our view that the majority of the estimates in the Statements of Affairs are significantly over-estimated given the position of the company and the general economic climate." The receivers of Conder Group state "realisations estimated by directors from sale of property are probably overstated ... [and] ... the call made under cross guarantees in respect of borrowings of subsidiary companies will be larger than that shown in the directors' statement of affairs". The receivers of Musterlin state "realisations from subsidiary companies are unlikely to amount to the directors' estimate of £5 million".

6 So "future" includes the period between final year-ends and chairpersons' statements.

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Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81 67

1990-1991 period, indicating that endogenous as well as exogenous factors are important drivers of poor performance in the sample. There are 30 (25 per cent) companies with activities in the property sector, which is consistent with high interest rates and declining property values accounting for a relatively large number of failures in the early 1990s (Lennox, 1999).

2.2 Descriptive statistics

Table 1 reports descriptive statistics for market values (V;,), operating profits (P;) and estimated recovery rates (REC;

0). Not surprisingly, sample companies have poor perform­

ance between penultimate and final year-ends. Mean (median) operating profits fall from £6.12 million to £3.76 million (from £1.30 million to £1.14 million). Although mean mar­ket values increase from £48.51 million to £48.96 million, median market values fall from £15.14 million to £10.22 million.

Table 1 Performance Variables

Mean Median Min

Market values of equity(£ million)

vi-.1 48.51 15.14 0.91

vi-2 48.96 10.22 0.82

vi-I 7.70 2.15 0

t:.vi_, 0.23 -0.13 -0.95

6.Vi_1 -0.61 -0.77 -1.00

Operating profits(£ million)

pi-.1 6.12 1.30 -15.33

pi-2 3.76 1.14 -67.04

!:>Pi_, 0.01 -0.01 -3.38

Estimated recovery rates (%)

RECio

Notes: Observations

vi-.1 vi-2

vi-I llV,_2

llVi_1

pi-.1 pi-2

llPi_, RECi

24.80 12.82 0

= 120 (except for RECio where observations= 104). = Market value of equity at the penultimate year-end (£ million). =Market value of equity at the final year-end(£ million). =Market value of equity at the suspension date (£million).

= cvi_,- v,_) 1 v,_3

=evi-l- vi_,l 1 vi_, =Operating profits at the penultimate year-end(£ million). =Operating profits at the final year-end(£ million).

=(Pi_,- Pi_3) IV,_, =Estimated recovery rate for creditors at the bankruptcy date (=Estimated realisable assets I Face value of creditors' claims).

Max

1219.45 1519.73 226.35 19.09 2.42

236.20 164.10 3.34

99.72

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68 Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81

Between final year-ends and suspension, mean (median) equity values fall from £48.96 million to £7.70 million (£10.22 million to £2.15 million) and mean (median) growth in equity values is -61 per cent (-77 per cent). Although mean (median) equity values are £7.70 million (£2.15 million) at suspension, equity is generally worthless at bankruptcy since recovery rates in all companies are estimated to be less than 100 per cent. Mean (median) estimated recovery rates are only 24.80 per cent (12.82 per cent) implying that creditors lose most of their money when companies fail. Overall, Table 1 shows that most companies fail very quickly and recovery rates are usually small, which is consistent with investors having little information about the value of their investments before companies file for bankruptcy.

In order to appreciate how quickly and unexpectedly companies often fail, it is helpful to consider two examples. Polly Peck discloses operating profits of £148 million in its final annual report (dated 17 April 1990) and the chairperson (Nadir) writes, "1989 was a remarkable year for Polly Peck International. It was a fitting conclusion to a decade in which we were one of the fastest growing industrial and commercial companies, an achieve­ment that was crowned by the purchase of two ofthe world's leading brand names". Con­cerning future prospects Nadir writes, "I am confident that 1990 will be an exciting start to a second decade of growth for the Group, and that the strategy we develop in the 1990s will be as successful as that implemented during the 1980s". Consistent with these favour­able disclosures, Polly Peck's value remains buoyant for several months following the release of its final annual report. Between 13 August 1990 and its suspension three weeks later, Polly Peck's value falls from £1,785 million to £468 million and it filed for bank­ruptcy on the 25 October 1990 with an estimated recovery rate of 21 per cent.

Polly Peck and Maxwell Communications are the largest companies in the sample and the financial press has detailed the alleged fraudulent circumstances involving their col­lapses.7 However, many small companies also fail quickly and with little prior warning in chairpersons' statements. For example, Yellowhammer's final report discloses an increase in operating profits (from £2.2 million to £2.91 million) and the chairperson (Summerill) writes, "I am pleased to be able to report another year of great progress for your com­pany". Regarding future prospects he writes, "We must be capable of exploiting the mar­ket opportunities that will prevail in the 1990s. Thanks to the hard work of all the staff in the group, I am confident that we will be in a strong position to do so and ensure the continued growth of your company. So I look forward eagerly to another exhilarating year of further developments". In contrast to these comments, Yellowhammer's value falls from £16 million at 8 December 1989 to £4 million ten weeks later. Yellowhammer files for bankruptcy on the 6 August 1990 with an estimated recovery rate of only 1 per cent.

In summary, many companies fail quickly and investors appear to have little warning about the true values of their investments prior to bankruptcy. The next section investi­gates whether chairpersons cover up poor performance in their final annual statements.

7 The results are not sensitive to eliminating these two cases from the sample.

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Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81 69

3. The cover up hypothesis

3.1 Chairpersons' propensity to blame exogenous factors

There is surprisingly little extant evidence on whether managers are to blame for fi­nancial stress. One exception is John et al., (1992) who find that managers of 46 US companies most frequently cite the economy as an exogenous cause of poor performance. The most common "endogenous" causes are over-expansion and lack of accounting con­trols. John et al. (1992) find that managers blame exogenous factors more often than en­dogenous factors, but do not investigate whether managers' explanations are self-serving. In particular, managers may be more reluctant to disclose the causes of problems that they could have prevented than problems caused by exogenous factors. This is investigated by comparing chairpersons' explanations for poor performance with the reasons cited in the FT and practitioners' letters.

As John et al. ( 1992) note, the distinction between exogenous and endogenous factors is somewhat arbitrary since sensitivity to exogenous factors may be partly under manage­ment control. For example, theFT states that British Island Airways was in a more vulner­able position during the recession because it chose not to be backed by a major tour operator. It is inferred from this that British Island Airways fails because of the recession ("exog­enous") and because of poor strategy ("endogenous"). This example also illustrates there are often multiple causes of failure. 8 Table 2 details the exogenous and endogenous causes of poor performance cited by chairpersons and by the FT and practitioners' letters. For example, 58.3 per cent of chairpersons cite the macro-economy or industry-related factors as a contributory cause of poor performance.

There are two important findings from Table 2. Firstly, chairpersons are more likely to disclose exogenous factors relative to endogenous factors compared to theFT and practi­tioners' letters. The ratio of exogenous to endogenous factors is 98:56 in chairpersons' statements, whereas it is 82: 165 in the FT and practitioners' letters. Consistent with the "cover-up" hypothesis, this suggests chairpersons under-report endogenous factors com­pared with exogenous factors. It does not conclusively prove that disclosures are oppor­tunistic, since it is possible that exogenous (endogenous) causes typically become apparent before (after) chairpersons write their statements. The issue of when problems become apparent is addressed in the following section.

Secondly, the total number of bad news disclosures is much lower in chairpersons' statements compared to theFT and practitioners' letters. There are 247 causes cited in the FT and practitioners' letters while chairpersons only mention 154 factors. There are two possible explanations for this difference. Firstly, some problems may only become appar­ent after the chairpersons write their final statements. Secondly, the chairpersons may choose not to disclose problems in order to cover up poor performance. The following section discriminates between these two explanations by identifying problems that are apparent when chairpersons write their statements.

8 Double-counting is avoided when the FT and practitioners· letters disclose the same cause.

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70 Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81

Table2 "Exogenous" and "Endogenous" Causes of Failure

"Exogenous" causes of failure:

Macroeconomic or industry-related factors Gulf War Problems in the Soviet Union Weather Rail strikes Air traffic control delays Problems arising under former chairpersons Fire Liquidation of controlling shareholder Poor health of finance director Conflict of interest between banks Geological problems Vandalism, Fire Total

"Endogenous" causes of failure:

Over-borrowing Expansion into unprofitable activities High costs, inefficiency Problems with customers Problems with suppliers Lack of financial control, accounting, fraud Disruption caused by re-location Poor reputation for product quality Failure to diversify customer base Boardroom disagreements Poor planning Disruptions to production Poor track record of chairperson Failure to hedge foreign currency transactions Loss of key personnel Failed advertising campaign Total

Notes:

Number (%) of causes cited in: Chairpersons'

Statements

70 (58.3%) 4(3.3%) I (0.8%) 5 (4.2%) I (0.8%) I (0.8%)

12 (10.0%) 2 (1.7%)

0(0.0%) 0(0.0%) 0(0.0%) 0(0.0%) 2 (1.7%)

98

6 (5.0%) II (9.2%) 7 (5.8%) II (9.2%) 5 (4.2%) 6 (5.0%) 4(3.3%) 0(0.0%) 0(0.0%) 2(1.7%) 3 (2.5%) 0(0.0%) 0(0.0%) I (0.8%) 0(0.0%) 0(0.0%)

56

Practitioners' Letters or FT

66 (55.0%) 4 (3.3%) 0(0.0%) 3 (2.5%) 0(0.0%) I (0.8%) 4 (3.3%) 0(0.0%) I (0.8%) I (0.8%) I (0.8%) I (0.8%) 0(0.0%)

82

30 (25.0%) 47 (39.2%) 13 (10.8%) 19 (15.8%) 2 (1.7%)

18 (15.0%) 10(8.3%) I (0.8%) 5 (4.2%) 6(5.0%) 8 (6.7%) 2 (1.7%) I (0.8%) I (0.8%) I (0.8%) 1 (0.8%)

165

Number of companies= 120. The total number of "causes" exceeds 120 because there are sometimes multiple reasons for failure. Double-counting of causes that are cited in both theFT and practitioners' letters is avoided. "Macroeconomic" causes include falls in industry demand, high interest rates and unfavourable exchange rates. "Problems with customers" include failure to win expected orders and bad debts. "Problems with suppliers" include late delivery, defective supplies and deteriorating relations due to late payments. "Problems arising under former chairpersons" are categorised as "exogenous" since they do not reflect the decisions of current chairpersons.

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Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81 71

3.2 Problems that are apparent when chairpersons write their statements

FT news items and practitioners' letters are used to identify 42 companies in which problems are apparent when chairpersons write their final statements. In the remaining 78 companies, problems either become apparent after chairpersons write their state­ments or it is impossible to identify when they become apparent. For the 42 companies, chairpersons' statements are checked to see if they candidly disclose existing problems. Although problems are identified that are apparent when chairpersons write their statements, an important caveat to this analysis is that it is unclear whether chairpersons know about the problems. In other words, it is not possible to distinguish between deception and incompetence.

Chairpersons candidly disclose problems in 22 of the 42 companies. In eight compa­nies, chairpersons fail to mention existing problems and in a further six cases chairper­sons' disclosures contradict the identified problems (these are detailed in Table 3).9 In the remaining six companies, chairpersons briefly disclose problems, but their disclosures are arguably too positive (these are detailed in Table 4). In summary, 20 out of 42 chairpersons do not provide full and candid .disclosure of existing problems.

3.3 Chairpersons' disclosures about past performance and future prospects

This section examines whether the tones of chairpersons' disclosures about future pros­pects are over optimistic relative to what chairpersons might reasonably have expected future performance to be. Actual performance is measured using the growth in market val­ues, L1 V;,• and chairpersons' disclosures about past and future performance are defined as R(L1 V ) and R(L1 V) respectively. When chairpersons disclose good news about future pros-

li-J It

pects R(L1V;,) > 0 and when they disclose bad news R(L1V) < 0. Similarly, chairpersons' expectations are defined as E(L1 V;,_) and E(L1 VJ The null and alternative hypotheses are:

H0

: Chairpersons' prospective disclosures are not more optimistic than their expectations, i.e. R(L1 V) :-:::; E(L1 VJ

HA: Chairpersons' prospective disclosures are more optimistic than their expectations, i.e. R(L1V) >E(L1V).

As shown in Table 1, performance quickly deteriorates as companies approach bank­ruptcy. Therefore, by construction, the sample likely consists of companies whose future

9 For example, Donelan Tyson (DT) was seeking over £6 million in a legal dispute with a major customer while at the same time defending a counter-claim for damages. Although the chairperson mentions DT's claim, his statement (and the financial accounts) do not disclose the existence of a counter-claim. DT lost the dispute and had to pay substantial damages, which contributed significantly to its downfall.

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72 Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81

Table 3 Chairpersons' Statements that Contradict Practitioners' Letters I FT News Items

Company

Charterhall

DunkeldGp.

Egerton Trust

Ferguson (J)

Holdings

Maxwell

Mountleigh Group

Practitioners' Letters I FT

In the first half of 1988, Charterhall acquired Tandem, Corah and Textured Jersey. Trading in these acquisitions deteriorated throughout 1989.

The disruptive effects of integrating the Slix swimwear business (acquired in December 1992) were under-estimated and occurred during the traditionally busiest production period. Orders were cancelled as a result of delivery dates not being met and additional discounts were demanded by customers.

It became apparent in early 1990 that the commerical property sector was declining markedly. The values of acquisitions by the Commercial property division fell 30% in the first three months of 1990.

A fraud was perpetrated by the Chairperson (Peter Clowes) in connection with the acquisition of Barlow Clowes. Ferguson Holdings filed for bankruptcy after it was revealed that investors' funds from the Barlow Clowes companies were used as security for bank borrowings when these sums were due to the liquidators of Barlow Clowes.

Paid too much for the acquisition of Macmillan in 1988, resulting in debts of £1.9bn.

Poor performance of Galerias continued over a number of years following its acquisition in 1987.

Chairpersons' Statements (Date)

"Despite being loss making at the time of acqui­sition, Corah recorded a very satisfactory performance. With the acquisition ofTextured Jer­sey Pic, Corah's turnover for the current financial year should increase to £90m and yield the bene­fits which are inherent in Charterhall 's industry rationalisation philosophy" ( 12 September 1989).

"Both the Shirt and Swimwear Divisions are strong, significant and growing businesses in their respective market sectors ... The acquisition of Slix has been successfully completed and its man­ufacturing operations are now integrated into the Group's factory in north west London. After tak­ing into account marketing, distribution and related costs specific to Slix, the directors remain confident that Slix will make a considerable net contribution to the Division ... the Swim wear Division has substantial cost advantages and is well placed to withstand competitive pressures" (24 February 1993 ).

"The switch of emphasis from housebuilding to commercial property in 1988 proved opportune ... the main profit thrust for 1989 came from com­mercial property ... In the commercial field we have a secure portfolio of properties at low book values and a development programme which can be timed to meet prevailing market conditions. Negotiations are in hand for the sale of various properties which will generate substantial prof­its in 1990" ( 13 February 1990).

"With the acquisition of Barlow Clowes ... it is appropriate that gilt broking and asset manage­ment become our core business activities ... The results to 31st March 1987 are prior to the acqui­sition of the Barlow Clowes Group of Companies and hence do not include any contribution from those Companies. The wisdom of this acquisition is, however, now becoming apparent as there has been a substantial contribution to profits from this source in the current year" ( 12 August 1987).

"The strategy of becoming a global pure publish­ing company by acquiring North American publishing assets [Macmillan] and disposing of printing and other peripheral businesses has proven correct" (4 July 1991).

"Galerias continues to trade well, building on the foundations laid since its acquisition in 1987" (8 August 1991 ).

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Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63~81 73

Table4 Chairpersons' Statements that are More Positive than Practitioners' Letters I FT News Items

Company Practitioners' Letters I FT

Babcock High costs arising from integrating Prebon the newly-acquired money broking

businesses.

British Island Late delivery of new aircraft in Airways 1988 and the improved turnover

resulting from the new aircraft did not cover the new aircraft's financing and introductory costs.

Clearmark Group

Ferrari Hdg.

Grovewood Securities

Spice

Unsuccessful acquisition of Celebrity Group on I February 1990 which was run down for disposal during 1991.

Financial difficulties arose primarily as result of the acquisitions of UCL Group in August 1989 and Telecomputing in December 1989.

The £50m acquisition of Priest Marians in November 1990 brought severe cashflow problems and losses by the half-year ending 3013191.

In 1988, Spice decided to source its sales from a National Distribution Centre (NDC). This absorbed a significant amount of working capital and was closed in 1989 as a "wholly unprofitable" enterprise.

Chairpersons' Statements (Date)

"Although the one-off charges [arising from the ac­quired money broking businesses] converted the result into a loss, it is the trading profits of the two core busi­nesses [money broking and "big ticket" leasing]- which were substantially improved - which will determine the future of the group" (27 February 1991 ).

"New aircraft were successfully introduced and inte­grated into our operation" (25 April 1989).

"The appointment of a receiver to the previous owner of the businesses shortly after completion caused con­siderable disruption to the integration of the [Celebrity Group] businesses within your Group ... In view of the considerable potential identified by your board in sports promotion activities ... these businesses are expected to make a significant contribution to profitability in the second half of the current year" (25 May 1990).

"I am pleased to tell you that all of the recent acquisi-tions ... have now been fully integrated within the Group ... The task of integrating acquisitions is a dif-ficult and complex process in which clear and communicable objectives must be defined. We under­stand this process and I believe that in this lies our strength. There has been the need for significant re­organisation and re-structuring at the acquired companies" (12April 1990).

"The principal asset of Priest Marians is the Langham Estate, which is a highly reversionary investment prop­erty portfolio with considerable profit potential over the next three to four years ... Despite the extremely testing conditions in the banking and property mar­ket, plans are well advanced for the refinancing of certain short and medium term borrowings of Priest Marians inherited on its acquisition. Completion of the refinancing will provide the appropriate long term debt finance to enable the company to enhance the Langham estate's capital value and increase its rental income over the next few years" (22 March 1991 ).

"Too much attention was [initially] focused on imple­mentation of the NDC with the result that we lost market share to our competitors ... As the systems at NDC are modified and refined, managers' time spent on stock replenishment and other administrative func­tions will reduce allowing a more concentrated effort on sales and customer service ... the long-term ben­efits [of the NDC] should come through in the second half and thereafter" (24 January 1989).

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74 Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81

performance is worse than the chairpersons expect(~ V;, < E(~ V)). It would therefore be invalid to test H

0 by comparing ex-post performance with chairpersons' prospective

disclosures. 10 Rather, two assumptions (AI and A2) are used to define upper bounds for chairpersons' expectations about future performance.

AI: Chairpersons do not generally make overly unfavourable disclosures about past per­formance, i.e. R(~ V .) ;;:::: E(~ V ).

Jt-j lt-J

A2: Chairpersons do not generally expect performance to be better in the future than in the past, i.e. E(~ V) :-:; E(~ V;,_i).

It is important to note that AI and A2 allow ex-post performance to be worse than chairpersons generally expect (~ V;, < E(~ V) ). Here A 1 assumes that chairpersons do not deliberately exaggerate poor past performance and A2 assumes that chairpersons do not form irrationally optimistic expectations about future performance. A 1 and A2 imply that chairpersons' disclosures about past performance can be used as upper bounds for their expectations about future performance, (R(~ V .) ;;:::: E(~ V )). Therefore, the null and alter-

lt-J It

native hypotheses can be written as:

H0 : R(~ V) :-:; E(~ V) :-:; R(~ V;,_) HA: R(~V)>E(~V):-s;R(~V;,_)·

Under H0

, chairpersons' prospective disclosures are not more optimistic than their disclosures about past performance (R(~ V) :-:; R(~ V )). Under HA, chairpersons' pro-

It it-J

spective disclosures may be more or less optimistic than their disclosures about past per-formance. Under AI and A2, the methodology is biased against finding that chairpersons make over-optimistic prospective disclosures for two reasons. Firstly, chairpersons may make overly favourable disclosures about past performance (R(~ Vi,-j) > E(~ V;,_), see A 1 ). Secondly, chairpersons may expect future performance to be worse than past performance (E(~ V) < E(~ V;,_), see A2).

Similar to Frost ( 1997), the tones of chairpersons' disclosures are subjectively clas­sified as "strongly favourable"(= 1), "weakly favourable"(= 2), "neutral"(= 3), "weakly unfavourable"(= 4) or "strongly unfavourable"(= 5). Panel A of Table 5 reports disclo­sure tones for past performance and future prospects. Under H

0, observations are

distributed on or below the leading diagonal. Panel A shows that only five observations lie below the diagonal, 43 lie on the diagonal while 72 lie above the diagonal. Therefore, chairpersons' statements tend to be more optimistic about future performance than past

10 In contrast to this study, Frost (1997) compares disclosures with ex-post outcomes. Her finding that prospective disclosures are more optimistic than ex-post outcomes may therefore reflect sampling bias rather than biased reporting.

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Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81 75

performance. 11 Panel B shows that the difference in tones for past and prospective dis­closures is statistically significant. Therefore, the null hypothesis that chairpersons do not make over-optimistic prospective disclosures is rejected.

Table 5 Chairpersons' Disclosure Tones about Past Performance (PAST;_,) and Future Prospects (FUTURE;_,)

Pane/A

PAST;_2

(l) (2) (3) (4) (5) Totals (l) 15 2 2 2 22

(2) 4 13 12 12 7 48

FUTURE;_2 (3) 0 6 14 12 33

(4) 0 0 0 5 8 13

(5) 0 0 0 0 4 4

Totals 19 16 20 33 32 120

Panel B: (Totals from Panel A)

(I) (2) (3) (4) (5) Total PAST;_2 19 16 20 33 32 120

FUTURE;_2 22 48 33 13 4 120

X2 = 24.94**

Notes: ** Significant at the I% level. PAST;_, =Tone of chairpersons' disclosures about past performance. FUTURE;_2 =Tone of chairpersons· disclosures about future prospects. (I) =Strongly favourable. (2) =Weakly favourable. (3) =Neutral. (4) =Weakly unfavourable. (5) = Strongly unfavourable.

11 For example, the chairperson of Sound Diffusion writes concerning past performance, 'There are two special factors which have had a major adverse influence on the 1987 audited results. In the first place the company had allowed its costs to escalate to a level which was significantly higher than was justified by the volume of business transacted in the year. The second factor has been our decision that for 1987 and the future. profit will be recognised only in respect of business completed in all respects and so acknowledged in writing by the customer." With respect to future prospects he writes, "The current year has got off to a bright start. The sales order book is currently at a higher level than ever before whilst the value, in terms of annual rent, of products installed in customers' premises is greater than at the equivalent stage of any of the preceding five years. For 1988 as a whole we are budgeting for a record level of completed installations and these early indications encourage us to believe that our confidence is well founded. At the same time we have, as I have indicated, taken steps to cut back expenses ... Our plans are for strong growth in 1988." The predicted strong growth did not materialise. Sound Diffusion's market value fell throughout 1988 and trading was suspended at £31 million. Sound Diffusion filed for bankruptcy on the 6 December 1988 with an estimated recovery rate of only 10%.

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76 Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81

3.4 Chairpersons' disclosures and compensation

While the previous sections find evidence consistent with the cover up hypothesis, this section discusses chairpersons' incentives to hide bad news. Chairpersons in stressed com­panies may wish to hide poor performance in order to avoid bankruptcy, loss of office or lower compensation. The sample consists only of soon-to-be-bankrupt companies because FT news items and practitioners' letters are required to evaluate the candour of chairper­sons' statements. This means that chairpersons in this sample do not successfully avoid bankruptcy or loss of office by withholding bad news. Instead this section investigates the relation between chairpersons' disclosures and compensation.

During Annual General Meetings, shareholder approval is sought for directors' com­pensation and chairpersons' statements are read out. In such circumstances, it can be diffi­cult for chairpersons to justify similar or higher compensation if, at the same time, their statements disclose poor performance. So chairpersons may cover up poor performance in their statements in order to avoid falls in compensation.

Data on chairpersons' compensation are available from annual reports for 109 of the 120 companies. 12 Although companies exhibit poor performance, chairpersons' compen­sation generally increases between penultimate and final year-ends. Mean (median) com­pensation rises from £88,662 to £115,349 (£67,000 to £77,000). Compensation rises in 70 companies, remains unchanged in seven companies and falls in 32 companies. The de­pendent variable in the following analysis is the growth in chairpersons' compensation (tlCOMP;_

2) between penultimate and final year-ends.

The disclosure variables are the number of exogenous (EXOG;_) and endogenous (ENDOG;_

2) factors cited by chairpersons and the tones of chairpersons' disclosures about

past performance (PAST;_2

) and future prospects (FUTURE;_2). It is hypothesised that the

growth in chairpersons' compensation is negatively related to bad news disclosures. Since chairpersons' disclosures and compensation may be correlated with corporate

performance, the growth in market values (tl V;_2

) and the growth in operating profits (tlP;_

2) are included as control variables. Table 1 reveals significant differences between

the means and medians for the market (tl V;_2

) and profitability (LlP;_2

) variables. These performance variables and the compensation variable (tlCOMP;_

2) are highly skewed and

contain outlying observations, which can lead to spurious results if ignored. These prob­lems cannot be resolved by performing log or square root transformations because of negative value observations. Moreover, Kane and Meade (1998) show that rank transfor­mations generally perform better than log or square root transformations in resolving outlier and skewness problems.U Following Kane and Meade (1998), the untransformed obser­vations are replaced with their corresponding ranks (in ascending order) and each ranked

11 Companies do not disclose compensation between final year-ends and bankruptcy.

L' Kane and Meade (1998) find rank transformations contain information that is obfuscated by untransformed variables or alternative transformations. Moreover, simulation studies indicate little loss of efficiency when rank transformations are applied to normally distributed variables (Conover and !man ( 1980), !man and Conover ( 1979)). Rank transformations have previously been used in event studies (e.g. Cheng et al., 1992) and accounting disclosure studies (Lang and Lundholm (1996), Wallace et al., (1994),Wallace and Naser (1995)).

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Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81 77

observation is divided by n+ 1 (where n = 1 09). This transformation means that the ranked variables (RK(L1COMP;_), RK(Ll V;_~), RK(LlP;_~)) are uniformly distributed between zero and one.

Table 6 reports a correlation matrix for chairpersons' compensation growth (RK(L1COMP;_)), chairpersons' disclosures (EXOG;_2, ENDOG;_~, PAST;_~, FUTURE;_) and corporate performance (RK(Ll V;_

2), RK(LlP;_)). The results show that chairpersons receive

significantly lower compensation when they cite endogenous causes of stress and when their disclosure tones are unfavourable. The insignificant correlation between RK(L1COMP;_~) and EXOGi-~ indicates that chairpersons do not generally receive lower compensation when

Table 6 Correlation Matrix for Chairpersons' Compensation (RK(.1.COMP,_2)), Chairpersons' Disclosures (ENDOG,_,, EXOG,_

2, PAST,_

2, FUTURE,_,), and Market and Accounting Performance (RK(.1. V,_,),

RK(M,_,))

ENDOG,_,

RK(.1.COMP;_,) -0.315**

ENDOG;_, 1.000

EXOG,_,

PAST;_,

FUTURE,_,

RK(L'>V,_,)

Notes: Observations = I 09. ** Significant at the I% level. * Significant at the 5% level.

EXOG,_, PAST,_,

-0.158 -0.316**

0.218* 0.379**

1.000 0.461 ** 1.000

COMP,_, =Chairpersons' compensation at final year-end.

FUTURE,_,

-0.254**

0.271 **

0.278**

0.664**

1.000

COMP,_3

=Chairpersons' compensation at penultimate year-end. L'>COMP;_, = (COMP;_,- COMP;_

3) I COMP,_,.

RK(L'>COMP;_,) = Rank-transformation of L'>COMP,_,. ENDOG,_, =Number of endogenous causes of stress cited by chairpersons. EXOG,_, = Number of exogenous causes of stress cited by chairpersons.

RK(.1.V,_2)

0.174

-0.278**

-0.261 **

-0.629**

-0.454**

1.000

See Table 2 for information on endogenous and exogenous causes of stress.

PAST;_, FUTURE;_,

= Tone of chairpersons' disclosures about past performance. = Tone of chairpersons· disclosures about future prospects.

RK(M,_,)

0.095

-0.235**

-0.253**

-0.483**

-0.201 *

0.462**

(Strongly favourable= (I); Weakly favourable= (2); Neutral= (3): Weakly unfavourable= (4); Strongly unfavourable= (5)).

RK(L'>V,_2)

L'>V;_,

vi-3

vi-2

RK(L'>P,_,l L'>P,_,

pi-3

pl-2

=Rank-transformation of L'> V,_,. = cv;_,- v,_) 1 v,_,. =Market value of equity at the penultimate year-end (£million). =Market value of equity at the final year-end (£million). = Rank-transformation of L'>P,_,.

= (P;_,- P;_) IV,_,. =Operating profits at the penultimate year-end (£ million). =Operating profits at the final year-end(£ million).

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78 Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81

poor performance is blamed on exogenous factors. Although compensation is positively correlated with market (RK(L1 V;_)) and accounting (RK(L1P;_

2)) performance, the associa­

tion is statistically insignificant. The correlations involving EXOG;_2, ENDOG ;_

2, PAST;_

2 and FUTURE;_

2 are all posi­

tive and statistically significant. This means that chairpersons who cite endogenous fac­tors are more likely to cite exogenous factors and their disclosure tones are less favourable. To some extent therefore, the disclosure variables reflect similar effects although multi­collinearity is not a problem (the largest correlation co-efficient is 0.664 ). The correlations between the disclosure variables (EXOG ;_

2, ENDOG ;_

2, PAST;_

2, FUTURE;_

2) and per­

formance (RK(L1 V;_2), RK(L1P;_

2)) are significantly negative. Not surprisingly, chairper­

sons are more likely to disclose bad news when past performance is poor. The significant positive correlation between RK(L1 V;_

2) and RK(L1P;_

2) shows a close relation between market

and accounting performance. Table 7 reports the association between compensation growth and chairpersons' dis­

closures after controlling for market and accounting performance. Columns (I) and (4) show that chairpersons receive significantly lower compensation when they disclose en­dogenous causes of poor performance, but not when they disclose exogenous factors. This is consistent with chairpersons blaming poor performance on exogenous rather than en­dogenous factors in order to avoid falls in compensation. Columns (2)-( 4) show that com­pensation is negatively associated with chairpersons' disclosure tones. This is consistent with chairpersons putting positive spins on their statements in order to avoid falls in com­pensation. As in Table 6, compensation growth is insignificantly associated with market and accounting performance. 14

3.5 Chairpersons' disclosures and corporate governance

Finally, this paper examines whether corporate governance variables help explain the candor of chairpersons' statements. Candor is measured using three disclosure vari­ables: chairpersons' citations of endogenous and exogenous causes of poor performance (ENDOG;_

2 and EXOG;_

2); disclosure of problems that exist when chairpersons write

their statements (Tables 3 and 4); and, chairpersons' disclosure tones (PAST;_2

and FUTURE;_J Corporate governance is measured using three variables: a dummy for auditor size indicating whether the audit firm belongs to the Big Five (Six); a dummy indicating whether the chairperson is a non-executive director; and, a dummy indicating whether the chairperson is also the CEO.

Auditors may be unwilling to sign off accounts when chairpersons' statements lack candor. If large auditors have more valuable reputations than small auditors, they may put more pressure on chairpersons to disclose bad news (DeAngelo, 1981 ). According to this argument, there should be a positive relation between auditor size and chairpersons' bad news disclosures. The Cadbury Report (1992) recommends splitting up the CEO and

'"This is consistent with other UK studies that find executive compensation is very weakly correlated with market and accounting performance (e.g. Gregg et al.. 1993).

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Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81 79

Table 7 Model Explaining the Growth in Chairpersons' Compensation (RK(aCOMP,_

2))

Disclosure variables

EN DOG,_,

EXOG,_2

PAST,_,

FUTURE,_,

TONE,_,

Control variables

RK(aV,_2

)

RK(aP,_2

)

CONSTANT

Notes: Observations = 109. ** Significant at the I% level. * Significant at the 5% level.

(1)

-D.098 (-3.344)**

-0.037 (-0.857)

0.092 (0.910)

-0.027 (-0.247)

0.542 (6.791)**

The dependent variable is RK(Ll.COMP,_,).

(2)

-0.073 (-3.053)**

-0.029 (-0.239)

-D.052 (-0.476)

0.780 (5.511)**

COMP,_2

=Chairpersons' compensation at the final year-end.

(3)

-0.064 (-2.342)*

0.059 (0.526)

0.026 (0.238)

0.608 (5.769)**

COMP,_3

=Chairpersons' compensation at the penultimate year-end. Ll.COMP,_, = (COMP,_,- COMP,_3) I COMP,_3•

RK(Ll.COMP,_2

) =Rank-transformation of Ll.COMP,_2•

ENDOG,_, =Number of endogenous causes of stress cited by chairpersons. EXOG,_, = Number of exogenous causes of stress cited by chairpersons. PAST,_

2 = Tone of chairpersons' disclosures about past performance.

FUTURE,_, = Tone of chairpersons' disclosures about future prospects.

(4)

-{).084 (-2.896)**

-{).001 (-0.006)

-D.069 (-2.343)*

-0.036 (-{).304)

-D.040 (-0.377)

0.775 (5.922)**

Strongly favourable= (I); Weakly favourable= (2); Neutral= (3); Weakly unfavourable=

TONE,_, RK(aV,_,) av,_, vi-J

vi-2

RK(Ll.P,_2)

Ll.P,_,

pi-J

pi-2

(4); Strongly unfavourable= (5)). = (PAST,_,+ FUTURE,_,) I 2. =Rank-transformation of aV,_

2.

= cv,_,- v,_,l 1 v,_,. =Market value of equity at the penultimate year-end(£ million). =Market value of equity at the final year-end(£ million). = Rank-transformation of Ll.P,_,. = (P,_, - P,_) IV,_,. =Operating profits at the penultimate year-end(£ million). =Operating profits at the final year-end(£ million).

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80 Clive Lennox I Asia-Pacific Journal of Accounting & Economics 8 (2001) 63-81

chairperson roles and advocates the appointment of non-executive directors. According to these arguments, chairpersons should be more willing to disclose bad news when they are not CEOs and when they are non-executives. In unreported results, none of these corpo­rate governance variables are significantly associated with chairpersons' disclosuresY Therefore, it appears that these traditional corporate governance mechanisms may not be effective in encouraging candid disclosure of bad news.

4. Conclusion

This paper finds evidence that is consistent with chairpersons in failing UK companies covering up poor performance. Firstly, chairpersons are excessively willing to blame poor performance on exogenous factors rather than managerial decisions. Secondly, 20 out of 42 chairpersons do not candidly disclose problems that exist when they write their state­ments. Thirdly, prospective disclosures are more optimistic than disclosures about past performance despite significantly worse performance after chairpersons' statements.

The evidence is also consistent with chairpersons receiving higher compensation as a result of covering up poor performance. Chairpersons receive significantly lower compen­sation when they disclose endogenous causes of poor performance, but not when they disclose exogenous causes. Chairpersons also receive significantly lower compensation when the tones of their statements are negative.

An important caveat to the paper is that chairpersons' beliefs are not directly observ­able and so it is impossible to prove beyond doubt that chairpersons knowingly make misleading statements. In particular, chairpersons may be unaware of problems that exist when they write their statements and they may have irrationally optimistic expectations about future prospects.

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