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Impact of Bad news on Company Share Prices

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Published: Wed, 26 Jul 2017

Tesco mini-case study

Back in in the early 21st century, the accounting scandals of Enron (2001) and WorldCom (2002) brought a massive shock to the financial market, causing investors and shareholders to lose millions due to fraudulent reporting of the company’s financial data. This brought up major concerns on how managerial personal incentives or strategic delay of negative news announcement will create information asymmetry between the management and the shareholders, thus creating the potential for accounting frauds occurring. The spotlight was put onto governments of major financial markets on they are going to respond appropriately and quickly towards these historical scandals.

The British government acted by demanding the creation of new auditory units and an independent ethical standards board within the Financial Reporting Council (FRC), an independent financial regulatory board; The United States reacted by enacting the Sarbanes-Oxley Act of 2002 (SOX) bill, which aims to protect shareholders from fraudulent representation in corporate financial statements and attempts to strengthen corporate oversight and improve corporate control.

Nonetheless, these precautions will not fully prevent fraudulent financial reporting from arising, from small businesses to international names. Amongst the post-financial crisis of 2008, Tesco PLC a well-known multinational grocery and merchandise retailer was struck with a major case of fraudulency in late-2014. They admitted on September 22 that its first-half profits were overstated by an estimated £250m. This overstatement caused major speculation on the management within Tesco and put to question the internal controls of the firm. Deloitte was called in place of their usual auditors, amongst them PricewaterhouseCoopers, to undertake a comprehensive review of their accounts.

It was found that the overstatement was due to accelerated recognition of commercial income and the delayed accrual of costs. Tesco, already having come under threat from German discounters Aldi and Lidl and existing rival competition from other major grocery retailers like J Sainsbury and Waitrose, had suspended four senior managers and lost significant shareholder confidence.

A study conducted by Cox and Weirich (2010) came into conclusion that within the cases of financial fraudulency, majority of it were by overstatement of company revenue. Thus, we may expect that stock prices will reaction differently to good and bad news. This will signify that managers likely be more vary of bad news being disclosed than good news, withholding bad news until the appropriate time to disclose them while quickly report good news to the shareholders or the public. Managers wanting to withhold bad news can be related to the agency problem as the firm’s performance might not be up to shareholders’ expectations. As managers are the main legitimate source of confidential information regarding the firm’s performance to the investment community, they have the power to decide the “appropriate” information being disclosed or withheld. This asymmetry of information between managers and shareholders can be reduced by managerial commitment towards immediate disclosure of private information, albeit good or bad; however, run the risk of revealing too much information to rivals.

Based on previous findings of Kothari, Shu and Wysocki (2009), it is indicated that, on average, good news tends to be leaked out into the market while bad news is withheld until an appropriate time or when it is inevitable that the bad news must be released. Also, that the magnitude of market reaction towards bad news disclosure exceeds those of good. In Cox and Weirich (2002), it is evident that the stock market will eventually correct itself of any overreaction, suggesting that the markets, over a long term, are efficient having incorporated any publicly available information.

The amount of change or the magnitude of market reaction towards the news can be measured in different ways depending on the nature of the announcement. There are a few things we need to consider when measuring the change in stock prices. Firstly, the implications of withholding bad news, as bad news tends to affect stock prices more negatively than good news positively, this implies that managers would want to accumulate and withhold bad news until a certain level or time. As when it is disclosed, the public would be expected to react much larger towards the bad news. Secondly, the effect of incentives on managers’ disclosure behaviour. Due to the aftermath of Enron (2001) and WorldCom (2002), many laws and rules have been implemented to put off managers from withholding any news, demanding more transparent financial documents and promote managerial integrity. Thus, managers will face risks like, litigation, career concerns, etc., that will highly put them off from withholding information. However, some managers may justify that withholding information may benefit the firm in the short term, delay costs that may affect the firm and hope that future good prospects may soften the impact of the bad news. This is usually the mentality that leads to managers wanting to manipulate figures and delay information disclosure.

Whenever a piece of new information is announced publicly by a firm, be it good or bad news. There will be an affect shown by it in the form of share price changes. Theoretically, good news will have a positive effect on the share price, and bad news having a negative effect. There are several methods on measuring the changes of stock price of the firm after news is disclosed. Using the dividend-change model, it shows the effects of information being disclosed. A dividend change is defined by the percentage difference in dividend, Div(t) – Div(t-1) / Div(t-1). Taking the dividend of time t minus the dividend of time t-1, over the dividend of time t-1.

Management earnings forecasts can also affect the changes in stock prices. This is the management’s way of announcing that they predict the firm’s performance to be either better or worse than current. Analysts and media outlets will pick up on these announcements and product reports based on it and will likewise affect the way the public will foresee the performance of the firm. We can calculate this from taking [Management Forecast – Analyst Forecast]/[Analyst Forecast]. We can see the similarity to the dividend model but in contrast this uses future predicted values as oppose to past values.

Since 2012 Tesco has been having low profits ever since its first profit warning in 20 years. Based on the dividend-change model, it can be estimated that future dividends will not hold high returns. This is partly due to the sudden shock of the misstatement shaking investor confidence, suspension of several executive managers and change of CEO. All these factors contributing can be predicted that in the short term, Tesco’s stock prices will fall further until stability is achieved. Based on the management earnings forecast model, it is very clear that Tesco’s management was not confident in their future performances. Announcements made by Phil Clarke in June 2014 saying he has never seen such poor trading in all his time at Tesco signalled to the public that the firm is going through a crisis they can no longer hide and that investors should be prepared to make losses. It can also be said that the announcements are made to avoid any further litigation costs that come from delaying disclosure of critical information. Statistics also show that ever since major discounters have entered the market, Tesco, amongst the big 4 grocery retailers, has struggled to keep up their profits amidst all the competition.

What happened post announcement of the misstatement was quite similar to what was estimated. The announcement by Tesco of overstating their profits by £250m wasn’t the beginning of their sorrows. It came amongst a streak of terrible performance over the previous years that lead up to a major disaster. Prior incidents that clouded public confidence Tesco begun in January 2012 where they had their first profit warning in 20 years causing a £5bn reduction in market cap. This had a lasting long term effect as Tesco’s stock prices fell from over 400 to the low 300s. As the market progressed, Tesco was struck with another blow as their full year pre-tax profits were reduced by half having a £1bn penalty for backing out from the US venture Fresh & Easy along with UK property market having writedowns. In April 2014, Tesco reported a second consecutive year of falling profits, falling 6.9% to £3.05bn. This was followed by the long-serving finance director Laurie McIlwee announcing his resignation from the firm. Few months later, the acting chief executive, Phil Clarke, said he has never seen such poor trading performance in his 40 years with the firm. He stepped down a month later. Many investors were highly shocked by the news, saying that this is the sort of thing that would occur in the small end of the market, not in the FTSE100. Even shareholders demanded repayment from suspended manager Mr Clarke and then finance director Laurie McIlwee. It was later found that Tesco’s overstatement was larger than initially announced, finalising at £263m in profits. The source of the profits can be related back prior six months, attributing to their practices and told investors that changes will be made over the new managerial changes implemented. Sir Richard Broadbent stood down as chairman, insisting that he chose to leave because it was the appropriate action needed to be taken to demonstrate accountability.

With the change of management and the suspension of previous executives that showed to have neglected internal controls, Tesco recovered slightly in December 2014. However, this shows the pressure of being a publicly traded company going through tough competition and managers fixed on producing short term performance. Increasing demand in performance put pressure on delaying bad news and overstating future profits in order to produce short term boost to stock prices backfired badly. This seems have put Tesco in a terrible spot as they seek to recover back to their glory days.

References:

Barrett, C., Felsted, A. and Sharman, A. (2014). Tesco reveals it overstated first-half results by £250m. [online] Ft.com. Available at: https://www.ft.com/content/67fb8db4-421e-11e4-9818-00144feabdc0 [Accessed 4 Mar. 2017].

Cox, R. and Weirich, T. (2002). The stock market reaction to fraudulent financial reporting. Managerial Auditing Journal, 17(7), pp.374-382.

Felsted, A., Oakley, D. and Agnew, H. (2014). Tesco in turmoil after profits overstatement. [online] Ft.com. Available at: https://www.ft.com/content/5823a7cc-4279-11e4-9818-00144feabdc0#axzz3F6B0pXLq [Accessed 4 Mar. 2017].

KOTHARI, S., SHU, S. and WYSOCKI, P. (2009). Do Managers Withhold Bad News?. Journal of Accounting Research, 47(1), pp.241-276.

Miller, A. (2015). Tesco scandal | Student Accountant | Students | ACCA Global. [online] Accaglobal.com. Available at: http://www.accaglobal.com/ubcs/en/student/sa/features/tesco-scandal.html [Accessed 8 Mar. 2017].

Ruddick, G. (2014). Tesco crisis: everything you need to know. [online] Telegraph.co.uk. Available at: http://www.telegraph.co.uk/finance/newsbysector/epic/tsco/11181686/Tesco-crisis-what-you-need-to-know.html [Accessed 6 Mar. 2017].

Adibi, D., Aziz, J. and Nur, G., Do markets react to fraudulent financial reporting: study of Tesco’s overestimation of revenue.


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