Class 2- Assessing the role of

the capital market players in

the game of numbers

AC 420 Financial Reporting in Capital Market

• GlaxoSmithKline plc (GSK) a British multinational
pharmaceutical, biologics, vaccines and consumer
healthcare company headquartered in London, United
Kingdom. It is the world's fourth-largest pharmaceutical
company measured by 2009 prescription drug sales.

• AstraZeneca plc (AZN) is a British-Swedish multinational

pharmaceutical and biologics company headquartered in
London, United Kingdom. It is the world's fifth-largest
pharmaceutical company measured by 2009 prescription
drug sales.
 Question a Slide 1
a. Comment on the frequency of meeting analyst expectation (consensus
forecast) in the pre- and post-Sarbanes Oxley (SOX) period

What is SOX?
SOX stands for the Sarbanes–Oxley Act of 2002, is a United States federal
law that set new or enhanced standards for all U.S. public company boards,
management and public accounting firms.

As a result of SOX:
1. corporations have improved their internal controls and that financial statements are
perceived to be more reliable.
2. There is more accuracy of analyst earning forecast.
3. SOX 404 led to conservative reported earnings, penalties for fraudulent financial
activity are much more severe.
4. SOX increased the independence of the outside auditors who review the accuracy of
corporate financial statements, and increased the oversight role of boards of directors

• Pre-SOX period: before 2002

• Post-SOX period: after 2002
I
 Frequency of meeting analyst expectation (consensus Question a Slide 2
forecast) in the pre- and post-Sarbanes Oxley (SOX) period
Source: I/B/E/S Institutional Brokers' Estimate System
Last Analyst Last Analyst
Year end Company Name forecast consensus forecast Actual EPS SURP MBE (indicator)
Dec-99 ASTRAZENECA PLC 1.56 1.53 1.59 0.06 1
Dec-00 ASTRAZENECA PLC 1.63 1.71 1.44 -0.27 0
Dec-01 ASTRAZENECA PLC 1.75 1.75 3.05 1.30 1
Dec-02 ASTRAZENECA PLC 1.78 1.81 1.84 0.03 1
Dec-03 ASTRAZENECA PLC 1.77 1.80 1.78 -0.02 0
Dec-04 ASTRAZENECA PLC 2.10 2.11 2.11 0.00 1

Dec-05 ASTRAZENECA PLC 2.91 2.88 2.91 0.03 1

Dec-06 ASTRAZENECA PLC 3.87 3.87 3.85 -0.02 0
Dec-07 ASTRAZENECA PLC 4.44 4.04 4.38 0.34 1
Dec-08 ASTRAZENECA PLC 4.95 4.81 5.10 0.29 1
Dec-09 ASTRAZENECA PLC 5.54 6.44 6.32 -0.12 0
Dec-10 ASTRAZENECA PLC 6.70 6.62 6.71 0.09 1
Dec-11 ASTRAZENECA PLC 7.31 7.26 7.28 0.02 1

Dec-99 GLAXOSMITHKLINE PLC 1.74 1.77 1.72 -0.05 0

Dec-00 GLAXOSMITHKLINE PLC 1.85 1.98 1.85 -0.13 0
Dec-01 GLAXOSMITHKLINE PLC 2.10 2.14 2.09 -0.05 0
Dec-02 GLAXOSMITHKLINE PLC 2.29 2.40 2.35 -0.05 0
Dec-03 GLAXOSMITHKLINE PLC 2.77 2.83 2.67 -0.16 0
Dec-04 GLAXOSMITHKLINE PLC 2.86 2.79 2.88 0.09 1
Dec-05 GLAXOSMITHKLINE PLC 2.96 2.86 3.00 0.14 1
Dec-06 GLAXOSMITHKLINE PLC 3.72 3.57 3.48 -0.09 0
Dec-07 GLAXOSMITHKLINE PLC 3.84 3.87 3.97 0.10 1
Dec-08 GLAXOSMITHKLINE PLC 2.84 3.62 3.26 -0.36 0
Dec-09 GLAXOSMITHKLINE PLC 3.67 3.86 3.39 -0.47 0
Dec-10 GLAXOSMITHKLINE PLC 2.62 2.84 0.99 -1.85 0
Dec-11 GLAXOSMITHKLINE PLC 3.12 3.12 3.31 0.19 1

SUPR is the amount we get from the difference between Actual EPS and the Analyst consensus forecast.
If the earnings surprise is zero or positive, then the actual EPS is larger then analyst consensus forecast, which means the EPS meets analyst expectation.
Frequency of meeting analyst expectation (consensus forecast)
in the pre- and post-Sarbanes Oxley (SOX) period Question a Slide 3
Astrazeneca Plc ( AZN) Source: Earning Surprise from 1999-2011

1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
ASTRAZENECA PLC

ASTRAZENECA PLC
ASTRAZENECA PLC

ASTRAZENECA PLC

ASTRAZENECA PLC

ASTRAZENECA PLC

ASTRAZENECA PLC

ASTRAZENECA PLC

ASTRAZENECA PLC

ASTRAZENECA PLC

ASTRAZENECA PLC

ASTRAZENECA PLC

ASTRAZENECA PLC
-0.20
-0.40
Source: I/B/E/S
Institutional
Brokers'…

Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11

• Earnings surprises are more volatile between 1999-2001 than 2002-11.

• From the data, we can see there is no much change in the frequency of meeting
analyst expectations in the pre and post SOX period. Since 7 out of 10 years’
earnings surprises are positive, compared with 2 out of 3 years in the pre-SOX
periods.
• the frequency of just meeting/beating analyst earnings expectations gradually
diminished in the Post-SOX period. (may results from decline in the prevalence of
expectations management )
Frequency of meeting analyst expectation (consensus forecast)
in the pre- and post-Sarbanes Oxley (SOX) period Question a Slide 4

Earning Surprise for GSK from 1999-2011

0.50

0.00
Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

-0.50

-1.00
SURP

-1.50

-2.00

It is more frequently of meeting or beating analyst expectation in the post SOX period. Four
out of 10 years have the firm beat the analyst expectation compared with the pre-SOX
period. The earnings surprises are more volatile in the post-SOX period (negative).

In general, from the data of these two companies in the pre and post SOX period, we can
hardly get any conclusion whether there is more or less frequently the company’s EPS meet
analyst expectation in the post-SOX period. Since the sample size for the pre-SOX period is
too small.
 Question b Slide 1

b. Evidence of earnings management?

Two types of earnings management

• A) Accrual earnings management

• B) Real earnings management

This type of earnings management is very
difficult to identify
 Question b Slide 2

Evidence of earnings management? (Cont.)

Accrual earnings management*
Income Smoothing – Creating reserves (allowances, provisions)
and use them in bad years.

Big Bath behavior – Cleaning house in particularly bad periods

(impairments and write-offs) and future periods look better.

Accounting Changes – Changing estimates, methods. For

example, depreciation, capitalization rules, inventory.

Classification of good news/bad news – Recognize good news

above the line and bad news below the line (discontinued
operations).

*based on the lecture slides of AC420 (first module)

 Question b Slide 3

Evidence of earnings management? (Cont.)

GlaxoSmithKline PLC

In GBP in Millions 31.12.2008 31.12.2009 31.12.2010 31.12.2011

AR Bad Debt and Provisions 129 116 150 152

Net Accounts Receivables and Other 6,265 6,492 5,793 5,576

Gross Trade and Other Receivables 6,394 6,608 5,943 5,728

% Bad Debt /Trade and Other

Receivables 2.02% 1.76% 2.52% 2.65%
 Question b Slide 4

Evidence of earnings management? (Cont.)

GlaxoSmithKline PLC

In GBP in Millions 31.12.2008 31.12.2009 31.12.2010 31.12.2011

Other Provisions (ST) 1,454 2,256 4,380 3,135

Other Provisions (LT) 1,645 985 904 499

Total Provisions: 3,099 3,241 5,284 3,634

Incl. provision for litigation 2.8 bil. in 2011 (4.0 bil. In 2010)
 Question b Slide 5

Evidence of earnings management? (Cont.)

GlaxoSmithKline PLC

GSK PLC Other Provisions

12,000

10,000

8,000

Total Provisions:
6,000
Other Provisions (LT)
Other Provisions (ST)
4,000

2,000

0
31.12.2008 31.12.2009 31.12.2010 31.12.2011
 Question b Slide 6

Evidence of earnings management? (Cont.)

AstraZeneca PLC

in USD millions 31.12.2008 31.12.2009 31.12.2010 31.12.2011

NET Trade and other receivables 7,261 7,709 7,847 8,754

Bad Debt and Allowances 99 81 81 66

Gross Trade and other receivables 7,360 7,790 7,928 8,820

% Bad Debt /Trade and Other

Receivables 1.35% 1.04% 1.02% 0.75%
 Question b Slide 7

Evidence of earnings management? (Cont.)

AstraZeneca PLC

in USD millions 31.12.2008 31.12.2009 31.12.2010 31.12.2011

Provisions Short Term 600 1,209 1,095 1,388

Provisions Long Term 542 477 843 474

Total Provisions 1,142 1,686 1,938 1,862

 Question b Slide 8

Evidence of earnings management? (Cont.)

AstraZeneca PLC

Astrazeneca PLC Provisions

4500
4000
3500
3000
Axis Title

2500 Total Provisions

2000 Provisions Long Term
1500 Provisions Short Term
1000
500
0
31.12.2008 31.12.2009 31.12.2010 31.12.2011
 Question b Slide 9

Evidence of earnings management? (Cont.)

• Based on analysis of 2 line items (AR allowances
and provisions) we can speculate that
GlaxoSmithKline PLC is more actively involved in
accrual earnings management than AstraZeneca
PLC.
 Question b Slide 10

Were the analysts guided?

Astrazeneca PLC
8
7.5
7.32 7.26 7.28
7
6.5
6
5.5
5
Axis Title

4.5
4
3.5 Astrazeneca analysts forecast
3.31
3 3.15 3.12 Glaxosmithkline PLC
2.5
2
1.5
1
0.5
0
 Question b Slide 11

Were the analysts guided? (cont.)

Analysts Revisions
0.4

0.3

0.2

0.1

0 Astrazeneca PLC Analysts Revisions

Glaxosmithkline PLC Analysts Revisions
-0.1

-0.2

-0.3

-0.4

-0.5
 Question b Slide 12

Were the analysts guided? (cont.)

• For both companies we observe some suspicious
expectation paths.

• But is AstraZeneca more actively involved in

analysts guidance?
 Question c Slide 1
Market response vs company earnings

• Define market response:

→ typically, difference between the day prior to
earnings announcement and the day after the
earnings announcement
→ in practice, earnings are announced after stock
exchange closes, so the earnings information is
quickly built-up in the stock price next day
→ best expressed in %
→ in the Financial Data.xls from Moodle: CAR(-
1,1)

• Define analyst earnings forecast:

→ it is important to compare analyst forecast of
earnings (EPS) vs. actual EPS
→ we use Last Analyst consensus forecast and
Actual EPS - the difference is SURP
→ SURP measures how much has the company
beat/missed consensus analyst estimates (in %)
 Question c Slide 2
Market response vs company earnings
AstraZeneca Plc
AstraZeneca PLC

Last Analyst Market Difference in

Consensus Actual SURP - response - CAR magnitude abs(SURP-
Date Forecast EPS absolute GBP SURP in % of AF (-1,1) CAR)
Dec-99 1.53 1.59 0.06 3.92% -1.02% 4.94%
Dec-00 1.71 1.44 -0.27 -15.79% -1.81% 13.98%
Dec-01 1.75 3.05 1.30 74.29% 7.62% 66.66%
Dec-02 1.81 1.84 0.03 1.66% 11.53% 9.87%
Dec-03 1.80 1.78 -0.02 -1.11% 1.13% 2.24%
Dec-04 2.11 2.11 0.00 0.00% 3.82% 3.82%
Dec-05 2.88 2.91 0.03 1.04% -2.68% 3.72%
Dec-06 3.87 3.85 -0.02 -0.52% 2.88% 3.40%
Dec-07 4.04 4.38 0.34 8.42% -6.99% 15.40%
Dec-08 4.81 5.10 0.29 6.03% -2.52% 8.55%
Dec-09 6.44 6.32 -0.12 -1.86% -6.10% 4.24%
Dec-10 6.62 6.71 0.09 1.36% 0.74% 0.61%
Dec-11 7.26 7.28 0.02 0.28% 0.54% 0.26%
Correlation coefficient (SURP-
CAR): 0.382

What can we imply?

• Relatively weak positive correlation between actual EPS surprise and
market response
• What is difference in magnitude ? => absolute value of difference: SURP
minus CAR
• Abnormal results mostly in pre-Enron years and Financial crisis years,
implying investor skepticism
 Question c Slide 3
Market response vs company earnings
GlaxoSmithKline Plc
GlaxoSmithKline PLC
Last Analyst Market
Consensus Actual SURP - response - CAR Difference in magnitude
Forecast EPS absolute GBP SURP in % of AF (-1,1) abs(SURP-CAR)
Dec-99 1.77 1.72 -0.05 -2.82% -4.30% 1.48%
Dec-00 1.98 1.85 -0.13 -6.57% -3.30% -3.26%
Dec-01 2.14 2.09 -0.05 -2.34% 0.76% -3.10%
Dec-02 2.40 2.35 -0.05 -2.08% 0.35% -2.43%
Dec-03 2.83 2.67 -0.16 -5.65% -1.99% -3.66%
Dec-04 2.79 2.88 0.09 3.23% 2.68% 0.54%
Dec-05 2.86 3.00 0.14 4.90% 2.93% 1.97%
Dec-06 3.57 3.48 -0.09 -2.52% 1.89% -4.41%
Dec-07 3.87 3.97 0.10 2.58% -7.50% 10.08%
Dec-08 3.62 3.26 -0.36 -9.94% 0.25% -10.19%
Dec-09 3.86 3.39 -0.47 -12.18% -1.24% -10.94%
Dec-10 2.84 0.99 -1.85 -65.14% 1.22% -66.36%
Dec-11 3.12 3.31 0.19 6.09% -1.40% 7.49%
Correlation coefficient (SURP-
CAR): -0.156
What can we imply?
• Slightly negative correlation between actual EPS surprise and stock market
response => implies stock market is skeptical to GSK earnings quality
• Difference in magnitude = absolute value of difference: SURP and CAR
• Abnormal results most of the decade => analysts were probably not guided,
contrary to AZN which has “smoother” SURP
 Question c Slide 4
Market response for 2011
Both companies
SURP/AF=> how
analysts differed
Analyst Actual from actual EPS
consensus Earnings EPS-AF = throughout the
Company Year End Date of consensus forecast Announcement date Actual EPS SURP year
ASTRAZENECA PLC 30/12/2011 16/02/2011 6.68 05/02/2012 0.60 8.98%
ASTRAZENECA PLC 30/12/2011 16/03/2011 6.68 05/02/2012 0.60 8.98%
ASTRAZENECA PLC 30/12/2011 13/04/2011 6.94 05/02/2012 0.34 4.90%
ASTRAZENECA PLC 30/12/2011 18/05/2011 7.22 05/02/2012 0.06 0.83%
ASTRAZENECA PLC 30/12/2011 15/06/2011 7.17 05/02/2012 0.11 1.53%
ASTRAZENECA PLC 30/12/2011 13/07/2011 7.15 05/02/2012 0.13 1.82%
ASTRAZENECA PLC 30/12/2011 17/08/2011 7.06 05/02/2012 0.22 3.12%
ASTRAZENECA PLC 30/12/2011 14/09/2011 7.25 05/02/2012 0.03 0.41%
ASTRAZENECA PLC 30/12/2011 19/10/2011 7.31 05/02/2012 -0.03 -0.41%
ASTRAZENECA PLC 30/12/2011 16/11/2011 7.32 05/02/2012 -0.04 -0.55%
ASTRAZENECA PLC 30/12/2011 14/12/2011 7.32 05/02/2012 -0.04 -0.55%
ASTRAZENECA PLC 30/12/2011 18/01/2012 7.26 05/02/2012 7.28 0.02 0.28%

GLAXOSMITHKLINE
PLC 30/12/2011 16/02/2011 3.8 06/02/2012 -0.49 -12.89%
GLAXOSMITHKLINE
PLC 30/12/2011 16/03/2011 3.73 06/02/2012 -0.42 -11.26%
GLAXOSMITHKLINE
PLC 30/12/2011 13/04/2011 3.73 06/02/2012 -0.42 -11.26%
GLAXOSMITHKLINE
PLC 30/12/2011 18/05/2011 3.72 06/02/2012 -0.41 -11.02%
GLAXOSMITHKLINE
PLC 30/12/2011 15/06/2011 3.69 06/02/2012 -0.38 -10.30%
GLAXOSMITHKLINE
PLC 30/12/2011 13/07/2011 3.69 06/02/2012 -0.38 -10.30%
GLAXOSMITHKLINE
 Question c Slide 5
Market response for 2011
Both companies => Implications

• What can we imply?

AZN
• AZN AFs were mostly close to actual EPS – this implies analyst guidance by
AZN
• CAR(-1,1) only .54% in 2011, compared to SURP of .28% therefore market
reacted perfectly accordingly
• over the year 2011, market was strongly and correctly updated on EPS by
analysts; AF predictions were relatively correct
• as a result of achieving predictions, market (CAR) did not move dramatically,
instead showed “smooth, mild behavior”

GSK
• during the year, AFs were lower on average by -10.6% than actual EPS, up till
10/2011
• during Q4 2011, analysts dramatically downgraded their forecasts so in the
end they differed by ca. +5% to actual EPS (previously, they differed by ca.
-10% ) => this is due to “impairment” as GSK pleaded guilty in $3 bln. health
care fraud
• CAR equals to -1.40%, suggesting that market thinks: earnings are of lower
quality
• GSK shows larger differences in AF against actual EPS than AZN
• GSK market response is contrarian to EPS (negative correlation is the
evidence)
 Question c Slide 6
Conclusion
What can we conclude?
• Both companies burdened with heavy scandals throughout recent decade
• GSK had more controversies (product, fines, backdated taxes and interest,
monopolistic behavior, tax disputes with IRS, bribes in Iraq…) than AZN
• Just look at the controversies section at Wikipedia…GSK doing worse AZN
• GSK scandals imply that GSK is more likely to massage earnings?
• But AZN has smoother surprises over time than GSK… => implying analyst
guidance?
• Wall Street game: Guide down and then beat, then stay conservative in
guidance and keep beating
• Bottom line: stock market is manipulated by large MMs. Hedge funds, and large
investment banks have grown massive: they all have monumental power to short
the stocks, cover their positions, and then re-purchase at lower prices
• No matter how bullish a story, you need new buyers of the stock each and every
day to fuel growth of the stock price over time, or it will go down
 Question d Slide 1

1d)Assess the analysts’ response to the

earnings game and comment on how
it differs from the markets response.
 Question d Slide 3

• For Astrazeneca Plc we can see that from 1999-2011

most all of the analysts' forecasts were positive
forecast errors which means that the difference
between the Actual EPS and AF1 beg is > 0
indicating that the actual EPS was higher than the
analysts' mean forecast at the start of the year.
 Question d Slide 4

• For GlaxosmithKline Plc we can see that most of the

Analyst's forecasts were negative forecast errors
indicating that Actual EPS - AF1 beg<0 . There were
some positive forecast errors for some years.
 Question d Slide 5

• The expectation path shows the Analysts’ response

to the earnings game.

• The expectation path that ends with ’no change'

and 'up' respectively corresponds to the meeting or
beating analysts' forecasts.
 Question d Slide 6

• Comparing the market response (CAR) with the

AF1rev we can conclude that for both the
companies the market response to the earnings
game does not correspond with the Analysts’
response.
 AstraZeneca PLC Question e Slide 1

Shareholder 2 Feb 2012 27 Jan 2011 28 Jan 2010

(%) (%) (%)
BlackRock, Inc 7.87 7.18 6.94
Invesco Limited 5.67 5.18 5.01
Axa SA 4.44 4.06 3.92
Investor AB 4.02 3.67 3.55
Legal & General 4.50 4.10 4.64
Investment Management
Limited
Free float 73.5 75.81 75.94
• The % of ordinary shares held by the major shareholders have been
increasing since year 2010.
Focus on long run profits
• Institutional investors consists of Hedge funds (Blackrock), Insurance
(AXA), Pensions (L&G).
Pensions and Insurance institutions focus on long run performance of the
company.
•With the large separation of shareholders, it is unlikely for a single
institutional Shareholder to have an indirect affect on earning
management. However this does not show that Astra has not been involve
in forecast guidance.
 GlaxoSmithKline Plc
Shareholders % (2012)
Blackrock 5.26
Legal & General Group plc 3.72
Free float 90.64

• Institutional invertors consists of Blackrock (Hedge fund) and L&G

(Insurance)
Pressure can be exerted by Blackrock and L&G to manipulate earnings
since they are the only major institutional investors. (consistent with
markets’ skepticism)
• In November 2011, 3 billion as settlement against the fraud case was
announced.
 According to the slides above, earning surprise became positive during
November. (markets’ scepticism have fallen)
With lower degree of uncertainty the percentage of market response
has fallen.
Therefore, there is unlikely any sign of forecast guidance seen in
GLX