Earnings Management in English NHS Hospital Trusts

English NHS Trusts have a statutory duty to achieve financial breakeven basedon reported income. Failure to do so can lead to the dismissal of the Trust CEO.Therefore, strong incentives exist for the use of discretionary accruals to ensurefinancial breakeven is achieved. From a regulatory and control perspective,discretionary accruals1 can be used to disguise poor financial performance whichcould delay the implementation of remedial action. Furthermore, continuingpoor financial performance can only be disguised through the use of everincreasing discretionary accruals which, when they are ultimately reversed, canlead to an apparently sudden, significant and unanticipated deterioration infinancial performance.The statutory requirement to breakeven is based on reporting zero currentcost-based residual income, after charging a cost for capital invested, in annualfinancial statements.2 In this paper we review the financial reporting incentivesassociated with the requirement to breakeven and contribute to the limitedliterature on earnings management in not-for-profit hospitals (Leone and VanHorn, 2005; and Bouwens, Hollander and Schaepkens, 2006). We do this byinvestigating managerial discretion over accruals in English NHS hospitalTrusts in the eight year period 1998 to 2004. Panel data estimation techniquesare applied and for the first time in the literature we identify a direct linkbetween discretionary accruals and the achievement of financial breakeven thatis robust to recent challenges to earnings management explanations based ondistributional and aggregate accruals methodologies (Dechow, Richardson andTuna, 2003; Durtschi and Easton, 2005; and Wysocki, 2005). The magnitudeof discretionary accruals identified is sufficiently large to significantly impair financial management in English NHS hospital Trusts and this may offer apartial explanation for the recent deterioration in their financial position.