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DISCLOSURE OF ADVERTISING EXPENDITURES IN ANNUAL REPORTS♣♣♣♣

Syed Zulfiqar Ali Shah

January 15, 2001

Abstract

Given the increasing emphasis and huge spending on advertising by majority of large firms, it seems surprising that there is a relative lack of accounting data on advertising to support it. In this paper we provide a discussion based on an examination of annual reports of around one hundred non-financial UK firms that appear to have spent money on advertising. In so doing, we attempt to address the issue of voluntary disclosures of advertising expenditures by UK firms in their annual accounts and highlight the need for disclosure of quantitative data on advertising expenditure in financial statements. While establishing the reasons why firms choose to disclose or decide not to disclose advertising expenditures in financial statements is beyond the scope of the present study, we do provide some of the possible reasons why a firm might choose to adopt one or the other alternative. We conclude with the suggestion that, in the interest of investors in general, it would be more appropriate for the relevant accounting institutions responsible for devising accounting standards and policies to start addressing more seriously the issues related to the disclosure (and accounting treatment) of advertising expenditures in the accounting records. Corresponding Author Syed Zulfiqar Ali Shah, Lecturer in Accounting and Finance, School of Business and Economics, University of Exeter, Streatham Court, Rennes Drive, Exeter, EX4 4PU. Tel : +44 01392 263216 E.mail: sza_shah@exeter.ac.uk ♣ This is a first draft. Please do not quote without permission.

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1.1 Introduction Keeping in view the fact that advertising has become increasingly important factor in the UK economy1 that is generating an intangible asset for some, if not all, of the sectors of the economy, one would expect that information on advertising spending might affect investors’ expectations regarding the future profitability of the firm.2 As a consequence, a relevant question to ask is whether there is any need for an accounting policy for advertising expenditures to address issues of advertising recognition and disclosure in the financial statements? But, before discussing such issues, it is interesting to see how far UK firms voluntarily disclose any information regarding advertising expenditures in the financial statements.3 An analysis of 170 annual reports of a sample of 100 non-financial UK firms reveals that very few firms voluntarily disclose quantitative figures of their spending on advertising. This is in contrast to the practice in the USA, where a relatively large number of firms disclose quantitative figures of their spending on advertising in the annual reports. Whether this lack of initiative on the part of UK firms is due to the insignificant amount of money spent on advertising or because of fear of competitive spending by rival firms is not at issue here. The main purpose of the paper is to investigate how far UK firms report the amount they spend on advertising in the annual reports. To explore and establish the reasons why a firm chooses to disclose or decides not to disclose advertising expenditures in financial statements is beyond the scope of the present study. While emphasizing the importance of disclosures in financial statements, we will, however, present at least some of the possible reasons why a firm might choose to adopt one or the other alternative. 1.2 Disclosures by Firms in Financial Statements One of the issues in the accounting and financial economics literature that attracts a growing interest is the choice and extent of disclosures by firms in their financial statements. This interest broadly stems from debates on the value relevance of financial statement information and other related aspects of whether the increasing requirements for more disclosure at a more disaggregated level are of any benefit to potential users of the information. The existing literature on disclosures (voluntary and/or compulsory) has either focused on theoretical issues related to the content and timing of various disclosures (e.g., Ohlson and Buckman 1981, Verrecchia 1983, amongst others) or taken the path of providing empirical evidence (e.g., Cooke 1989, 1992, Beaver et al. 1989, etc.). As contrasted with 1 Advertising Statistics Yearbook 1998, for instance, reveals that total advertising

expenditures in the UK in 1997 amounted to £13.14 billion – i.e., 1.94% of total GDP and 2.60% of total consumer expenditures.

2 See, for example, Peles (1970), Hirschey and Weygandt (1985), Shah and Stark (2000); amongst others.

3 Firms in the UK have a discretion as to whether or not to disclose spending on advertising.

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studies relying on the development of theoretical models, the majority of the empirical research on disclosure has mostly been exploratory in nature investigating the influence of disclosures of one or more items of interest. The scope of compulsory disclosure requirements encompasses issues such as measurement principles and the level of aggregation of various accounting items. The regulatory framework for companies in the UK is largely governed by the Companies Act of 1985 (amended by the Companies Act 1989), supplemented by the requirements of other institutions such as the Accounting Standards Board (ASB), and the London Stock Exchange etc. Voluntary disclosures, on the other hand, are largely at the discretion of the management of the firm and involve aspects such as providing more detailed and disaggregated information, forecast information, qualitative aspects of the firm etc.4 According to Verrecchia’s (1990, p.246) theory of discretionary disclosure, a manager’s decision to voluntarily disclose information is influenced by how external parties without access to the information (e.g., competitors, shareholders etc.) interpret its absence in the event that it is withheld. In the absence of disclosure costs, managers are always forced to disclose information. If, on the other hand, there do exist some disclosure-related costs (perhaps because the information is proprietary in nature), then a threshold level of disclosure exists whereby a manager only discloses information above the threshold and withholds it otherwise. The nature of proprietary costs determines the threshold. There is a large literature on voluntary disclosure available that provides empirical evidence on various factors (e.g., firm size, financial leverage, stock market listing, proportion of assets in place, earnings volatility, etc.) that might have an influence on various disclosure decisions (e.g., earnings forecast,5 interim earnings disclosure,6 current cost financial statements,7 etc.). Firth (1979), for instance, examines whether the level of disclosure in corporate annual reports is associated with the size of the firm, whether it has a stock market listing, and who its auditors are. The results provide some evidence that both firm size and the stock market listing variables are related to disclosure, but the auditor factor has no impact at all.8

4 See Meek and Gray (1989) for a discussion of required and voluntary disclosures and an analysis of various voluntary disclosures. As a result of their survey of voluntary disclosures they conclude that continental European companies must disclose more than the minimum requirements of London Stock Exchange if they are to compete in international capital markets. 5 For example, see Pownall and Waymire (1989), Lev and Penman (1990), Frankel et al.

(1995), amongst others. 6 See, for example, Bradbury (1992). 7 See Wong (1988). 8 Chow and Wong-Boren (1987) also provide some evidence that seems to suggest that the

extent of voluntary disclosure increases with firm size.

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Trueman (1986) attempts to provide a theoretical explanation for why a manager would be motivated to voluntarily disclose an earnings forecast, given the fact that actual earnings must be reported by the end of a financial period anyway. Trueman cites various alternative explanations that have been suggested for such managerial behaviour. Diamond (1985), for instance, hypothesizes that forecasts would be released in order to eliminate the need for investors to collect their own costly information about the firm’s future prospects. Ajinkya and Gift (1984) and Lees (1981) provide an explanation that suggest that managers release earnings forecasts in order to correct any ‘unrealistic’ estimates in the market place concerning the firm’s earnings. Similarly, Verrecchia (1983) demonstrates that a manager who seeks to maximize firm value and who is in possession of private information will have an incentive to disclose it if it conveys good news in order to receive a higher firm valuation from investors. Knowing this behaviour, investors will interpret the absence of a disclosure as meaning that the manager possesses bad news and will bid down the price of the firm in that case. As a consequence managers will be motivated to voluntarily disclose their information in equilibrium, assuming there are no costs of disclosure. According to Trueman (1986), the market value of the manager’s firm is a function of investor’s perceptions of his ability to anticipate future changes in the firm’s economic environment and adjust the firm’s production plan accordingly. As contrasted with earlier explanations, Trueman (1986) indicates that the manager’s motivation to release his earnings forecast stems not from his desire to inform investors about his revised expectation for the period’s earnings but rather from his desire to inform them that he has received new information about the period’s earnings. This means that the manager will be just as willing to release bad news as he is to release good news. Using a treatment sample (firms voluntarily disclosing current cost financial statements) of 15 firms, Wong (1988) investigates whether tax and political cost variables influence New Zealand listed companies’ decisions to voluntarily disclose current cost financial statements. Wong concludes that the results are consistent with the view that companies subject to wealth transfer by way of taxes and government regulation attempt to affect the probability of such transfers via an accounting choice: the voluntary disclosure of supplementary current cost financial statements. Skinner (1994) provides evidence on corporate voluntary disclosure practices by examining earnings-related disclosures made by a sample of 93 firms during 1981-90. His results confirm previous findings and suggest that managers voluntarily disclose earnings information. Frost and Pownall (1994) provide some interesting contrasts between US and UK firms’ disclosure practices. Frost and Pownall analyse periodic disclosures of 107 firms from 13 domiciles with equity securities traded on US and/or UK exchanges during 1989. They provide evidence that

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seems to indicate that both mandatory and voluntary accounting disclosures are substantially more frequent in the US than in the UK. According to Frost and Pownall (1994, p.76), this ‘... variation reflects both differences in disclosure rules and significant differences in the frequency and timing of voluntary disclosures in the two jurisdictions. In particular, our sample firms made voluntary disclosures more frequently in the United States than in the United Kingdom, regardless of domicile....’ Frost and Pownall also compare cross-listed UK firm’s US disclosures with their UK disclosures. They report that these firms disclose more than twice as frequently in the US as in the UK. Frost and Pownall (1994, p.89) comment that it ‘... is difficult to imagine any reason other than investor demand for information that would cause U.K. firms’ U.S. investor relations agents to disclose more frequently than their U.K. investor relation agents. However, we are unable to measure investor demand for public disclosure so this comparison should be interpreted carefully.’ Kasznik (1999) investigates whether managers who issue voluntary annual earnings forecasts manage reported earnings toward their forecasts, fearing legal actions by investors and loss of reputation for accuracy. Kasznik provides evidence that managers manage reported earnings towards their forecasts. Similarly, Noe (1999) provides evidence on voluntary disclosures and insider transactions. The overall findings in Noe suggest that managers capitalize on private information when making insider transactions but do so in subtle ways. Muller (1999) investigates UK firms’ contracting cost incentives for voluntary recognition of estimates of acquired brands during the period 1988-96. Results in the study indicate that UK firms capitalized acquired brands to reduce the cost of seeking London Stock Exchange mandated shareholder approval for future acquisitions and disposals. Disclosure of information in the financial statements serves a broad range of purposes. On the demand side of financial information, we can identify a number of different segments of the society (e.g., owners, managers, employees, creditors, investors, suppliers, government and regulatory agencies etc.) that are interested in the financial statement information. Each of these various groups of society has different and diverse needs for financial information which can result in conflicting views and attitudes regarding the financial statements. The demand for financial information by these various groups is largely derived from its role in either facilitating decision-making or in contributing to monitoring the activities and performance of the parties concerned (e.g., the management of a firm). On the supply side of financial information, firms are continuously faced with the dilemma whether to disclose various sets of information. The choice of whether to disclose or otherwise withhold certain information largely depends on a number of factors both internal and exogenous to the firm. Most of the theoretical work on financial communication utilizes the methods of game theory and information

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economics.9 These methods typically make use of models of economic behaviour in a variety of situations involving asymmetric information and a conflict of interests among the parties involved. Since a number of factors affect the choice of firms’ financial communication policies, some of which are largely unknown, it becomes rather difficult to address all the issues in a single study. Perhaps that is one of the reasons that the relevant literature addresses only one or a few of such factors at a time while attempting to explain information economics (Walker 1997). Over the past few decades, there has been a substantial increase in the disclosure requirements of firms’ financial reporting. Although there are other sources of financial information available (e.g., corporate press releases, newspapers etc.), financial statements are regarded as comparatively better sources of such information mainly due to their reliability.10 Other advantages of financial statements as a source of financial information include the provision of more relevant and timely information at a relatively low cost.11 A number of studies indicate that accounting numbers in the financial statements provide useful information to potential users. Chang et al. (1983), for instance, conduct a survey of individual investors, institutional investors, and financial analysts in three countries (UK, US, and New Zealand). The average ranking score on a five-point scale ranging from most important to least important indicates that corporate annual reports are the source with the most consistently high ranking of importance. The rankings of ten items included in annual reports indicate the income statement as the item with the highest ranking of importance. Similarly, in response to some recent proposals to reduce the quantity of detailed accounting data disclosures in the financial statements, Wild (1992) provides empirical evidence on the informativeness of accounting number (and their various components) disclosures. Wild (1992, p.150) concludes that the ‘... evidence in my paper should alert accounting regulatory agencies to seriously question, if not resist, any across-the-board reduction in firms’ financial reporting disclosure requirements.’ Grinyer et al. (1994) investigate the impact of financial reporting on revenue investments (e.g., advertising and research and development etc.). Grinyer et al. provide empirical evidence from a survey of finance directors of the top 1000 UK industrial companies. They state (p.130) that ‘...on balance, the responses observed are consistent with the validity of the earlier arguments that many

9 As an example, see for instance, Darrough and Stoughton (1990). 10 The presence of audit requirements, or the presence of other mechanisms (e.g., internal

control systems in the firm, reputation of the firm, management etc.) ensure more reliability.

11 As contrasted with financial statements, which are normally provided free of charge, other sources of financial information (e.g., commercial data sources) might involve charges for access to information.

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managers are likely to believe that short-term reported accounting profits are important...’ The findings in Grinyer et al. (1994) also suggest that advertising expenditures could be varied more easily than other revenue expenditures which often resulted in longer term commitments. One of the reasons for this could be the absence of any compulsory requirements to disclose spending on advertising in the financial statements. Given the fact that the managers perceive the market to be myopic, it might be relatively easier for them to cut back spending on advertising than on RD, for instance, which they must report in the financial statements, especially when earnings are under pressure. Gray et al. (1990) examine the cost-benefit perceptions of financial executives from 195 UK and 220 US multinationals regarding voluntary information disclosure in a comparative UK/US study of multinational disclosure behavior. According to Gray et al. (1990), voluntary disclosures will be constrained by both direct costs, such as data collection, processing, production, and auditing, and indirect costs such as the danger of providing useful information to both existing and potential competitors. The results indicate that, on average, the respondents tend to perceive most voluntary/discretionary disclosure items as giving rise to a net cost. An interesting finding regarding the disclosure of advertising cost also emerges from the study. According to Gray et al. (1990, p.604), ‘... U.K. financial executives are significantly worried about the net costs of providing information on the amount of advertising expenditure...’ 1.3 Some Possible Reasons for Potential Lack of Advertising Expenditures

Disclosure in the Financial Statements There could be a number of reasons for firms to choose not to report advertising expenditures in their annual accounts. Some of the possible reasons are briefly discussed below. 1.3.1 Is Materiality an Issue Here? Among one of the reasons for a firm not to report any figure on its spending on advertising could be that the amount spent on advertising is not material enough to be reported in its financial statements. The Accounting Standard Board’s draft ‘Statement of Principles for Financial Reporting’ defines and explains the concept of materiality as follows: ‘2.6 Materiality is a threshold quality. It provides a cut-off point rather than being a primary qualitative characteristic that information must have if it is to be useful, and it needs to be considered before the other qualities of that information. If any information is not material, it does not need to be considered further. 2.7 Information is material if it could influence users’ decisions taken on the basis of the financial statements. If that information is misstated or if certain information

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is omitted the materiality of the misstatement or omission depends on the size and nature of the item in question judged in the particular circumstances of the case. Aspects of the nature of the item that affect a judgement about its materiality include the events and transactions giving rise to it and the particular financial statement headings and disclosures that are affected. Circumstances that are considered include other elements of the financial statements taken as a whole and other information available to users that would affect their evaluation of the financial statements: this involves, for example, a consideration of the implications of the item for the evaluation of trends. Where there are two or more similar items, the materiality of the aggregate as well as the individual items needs to be considered.’ (ICAEW 1998). If materiality of advertising expenditure is an issue, then one should bear in mind that the term ‘materiality’ is a relative term and, hence, its meaning largely depends on the judgement of the person related to making or affected by such a judgement. For instance, the producer of accounting information (e.g., management) might make this judgement whether an item is material enough to affect the decision-making of a person who might use that information. Alternatively, according to the information-user approach, it should be the financial information users who would make a judgement about the materiality of information. Irrespective of whether an item is material or otherwise, the more important question to ask is whether the disclosure of information provides any utility to the users of such information? A firm might choose not to disclose an item of information because (in its view) users are not interested in that kind of information. But again, this argument might not be valid as regards to the disclosure of advertising expenditures. Information on advertising expenditures is relevant and useful to various decision-makers. It is a normal practise to compare for instance, advertising and the resultant sales for various periods. Management of firms uses these analyses to plan their advertising budgets for the future. Similarly, financial analysts might be interested in knowing how much money a firm spends on its advertising in order to assess the firm’s strategies and competitive strengths and weaknesses. Information about a firm’s investment in advertising might indicate growth prospects and future profitability for the firm, hence helping investors to form expectations regarding the size and variability of future cash flows. Similarly, information on advertising expenditure might facilitate the monitoring of management. According to Ross (1983) individuals have differing views as to how to amalgamate the data into an assessment of the worth of an investment. Accounting data serves this purpose by providing all the necessary information to satisfy the variety of differing opinions. Similarly, the Council of the Institute of Chartered Accountants in England and Wales indicates in a statement issued for the guidance of its members that while ‘… the qualification of materiality is fundamental and unavoidable, materiality can

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never be judged purely on the basis of absolute size ... in some cases the nature and circumstances of an item can be of such importance to users that a size threshold is of little practical significance in determining materiality. This is particularly likely where the quality of management stewardship or corporate governance are at issue’ (ICAEW, 1998). These and other similar arguments support the usefulness of advertising disclosure in corporate annual reports. Based on the above description and explanation of ‘materiality’ one might argue that if advertising expenditure appears to be valued by the market positively, then it would mean that spending on advertising is actually ‘material’ and of ‘significant’ nature to warrant disclosure in the financial statements. Shah and Stark (2000) indicate that advertising has a positive and significantly large influence on the market values of firms. For instance, estimation results of their pooled sample for the years 1990-98 indicate that, on the average, a one unit change in advertising expenditure results in a change of around 8 units in the market value of the firm. Similarly, their regression results for the large firms pooled sample indicate a coefficient of nearly 12, which again points to a significantly positive influence of advertising on the market values of firms. Judging from these results alone, by virtue of its nature and influence on market value, advertising expenditure appears to be a material item for a majority of firms spending on advertising. Firms are, therefore, expected to disclose their advertising expenditure in the financial statements. During our empirical analysis of financial statements of the sample firms, we came across instances that put the materiality of advertising as a deciding factor for disclosure choice into doubt. Cadbury Schweppes, for instance, refers its various advertising campaigns but gives no separate figures for advertising in the annual reports for the years 1994, 1995, 1996, and 1997. In its annual report for 1998, however, it provides comparative advertising figures of £317m, £345m, and £354m for the years 1996, 1997 and 1998 respectively (Notes to the Accounts, p.99). An analysis of the advertising expenditures for Cadbury Schweppes (Table 1.1) reveals that advertising spending by the firm, expressed as a percentage of sales is 6.2%, 8.2%, and 8.6% in the years 1996, 1997 and 1998, respectively. Similarly, advertising figures as a percentage of profits are at 93.2%, 49.9%, and 99.7% for those years. Advertising expenditures as a percentage of book value are 26.4%, 27.8%, and 33.2%, respectively. These figures indicate that Cadbury Schweppes is spending large sums of money on advertising and the proportion of spending is quite significant in all the three years analysed. Similar observations apply to the advertising expenditures of SmithKline and Beecham as evidenced by the comparative advertising figures for the years 1994-96 in its 1996 annual report (Table 1.2). The annual reports for 1994 and 1995, however, do not give any advertising figures.

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Table 1.1

Comparative Analysis: Cadbury Schweppes 1996 1997 1998 Advertising 317 345 354 Sales 5115 4220 4106 Book Value 1191 1675 1847 Market Value 5397 9522 8294 Comparative Analyses Advertising/Sales% 6.2 8.2 8.6 Advertising/Bv% 26.6 20.6 19.2 Advertising/Mv% 5.9 3.6 4.3

Table 1.2

Comparative Analysis: SmithKline Beecham 1994 1995 1996 Advertising 191 291 344 Sales 6492 7011 7925 Book Value 549 1202 1369 Market Value 7903 19023 31740 Comparative Analyses Advertising/Sales% 2.9 4.2 4.3 Advertising/Bv% 34.8 24.2 25.1 Advertising/Mv% 2.4 1.5 1.1

1.3.2 Fear of a Negative Response Another possible reason for a lack of inclination to report quantitative figures for advertising in financial statements could be the management’s fear of a negative response from investors, especially if profits are under pressure.12 Baber et al. (1991), for instance, report that the relative RD (another discretionary item similar to that of advertising) spending is significantly less when spending jeopardizes the ability to report positive profits. 12 The empirical evidence (e.g., Hirschey 1982, Chauvin and Hirschey 1993), on the other

hand, suggests that advertising has a positive relation with the market value of the firm.

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Similarly, according to Erickson and Jacobson (1992), the failure to commit to expenditures which may hurt current-term earnings but are necessary for long-term competitive success is often blamed on the myopic orientation of stock market participants and the pressures they place on managers. Erickson and Jacobson (1992, p.1265) indicate that managers ‘… are posited to adopt a current year/current quarter style of management in response to the incentives in the stock market. As advertising and R&D often adversely affect current period earnings, this can explain firms’ reluctance to make these expenditures.’ Kasznik (1999) indicates that managers who overestimate earnings might postpone expenditures to increase reported earnings and meet their forecasts. Kasznik also indicates that firms with earnings below management forecasts have smaller levels of abnormal research and development and advertising than firms with earnings above the forecasts. Reed (1998) provides some empirical evidence that investment in advertising, RD, and capital expenditures are positively associated with having above target earnings, consistent with downward smoothing through greater increases in these expenditures. She also reports that changes in capital expenditures and advertising are negatively associated with having earnings below target earnings, consistent with upward smoothing through smaller increases or greater decreases in capital and advertising expenditures. The dominant practice of not reporting spending on advertising in the UK (as our analysis would suggest later on in the chapter) might partly be encouraged by the absence of any regulation for reporting advertising expenditure in the corporate financial statements. Another reason why firms might not want to disclose quantitative advertising data could be the fear that it might lead to potential increases in political costs. According to Gray et al. (1990), for instance, there could be a potential increase in political costs (e.g., faced by multinationals) if disclosures reveal, for example, situations of monopolistic advantage or social inequalities. Whatever the reason for this lack of quantitative advertising data disclosure, its implications might be counter-productive to the very purpose of reporting a fair and accurate financial position of a firm’s operations. 1.3.3 Competition Wagenhofer (1990) provides an interesting scenario involving three players: a firm, an opponent, and a group of (unanimous) investors referred to as the (financial) market. Wagenhofer analyses disclosure strategies of a firm endowed with private information13 which is valuable to both the financial market and an opponent. The market revises the price of the firm contingent on the disclosure

13 According to Feltham and Xie (1992), for instance, managers frequently acquire

information about their firm’s future profitability as part of the management process. To the extent that this information is not known by others, it is referred to as private management information.

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decision observed. The opponent decides to take a beneficial action only if the information is favorable. This action imposes proprietary costs on the disclosing firm. If the firm does not disclose, it can still incur proprietary costs, since the opponent might take an adverse action based on the information conveyed by nondisclosure. Conversely, disclosure can result in no proprietary costs if the information disclosed deters the opponent from taking an adverse action. Wagenhofer demonstrates that there is always a full-disclosure equilibrium. He believes that there can exist partial-disclosure equilibria with two nondisclosure intervals. One interval includes very unfavorable information, which mainly stems from concerns about the market reaction. The other interval includes information upon which the opponent would want to take the adverse action, but does not if the information is withheld. According to Wagenhofer (1990, p.341), ‘...the comparative statistics show some counter-intuitive results, e.g., higher proprietary costs or higher risk of an adverse action can make disclosure of favorable information more or less likely.’ Competitive response by third parties (e.g., competitor, potential new entrants, etc.) could be yet another reason for not disclosing advertising expenditures in annual reports. According to this argument firms might not want to disclose their spending on advertising due to the strategic nature of such spending. Firms might fear competitive responses that would nullify their own efforts of penetrating the market through advertising. This argument is often used for both RD and advertising expenditures, both of which are considered as alternative means of product differentiation. While the argument might appear to be true in the case of RD expenditure disclosures, its application to advertising expenditure is debatable. Spending on RD by firms might not be known to the public and third parties until the firm decides to reveal it to the market (either by announcing their spending in the financial press or through other ways of communication with the market). Advertising, on the other hand, cannot be kept ‘secret’ in the strict sense for too long, mainly due to its visible nature. Firms must make use of various media of communication in order to convey their advertising messages across. This compulsion in itself reduces the probability of keeping the extent of the advertising expenditures ‘secret’. To assign a monetary value to advertising spending in their disclosure could benefit the potential investor more than a competitor. While an individual investor might find it difficult to estimate a monetary value for the advertising expenditure of a firm, it might be relatively easier for a competitor to do so (assuming a competitor would have more resources and inclination to estimate a monetary figure as compared to an individual investor). Moreover, a competitor would normally utilize its resources in trying to estimate a value for the

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advertising by a firm, while leaving the potential investor at a disadvantage who could not do so due to lack of resources.14 1.3.4 Credibility of Disclosure Among other reasons for not disclosing information is the ‘credibility’ of information. It is often believed that firms avoid disclosure of information that has ‘low’ credibility mainly due to fear of litigation. Since spending on advertising is normally made according to a particular budget and obviously (like any other spending) the firm makes a record of spending on advertising, credibility of advertising data as disclosed by the firm itself cannot be an issue for not disclosing it. Having outlined some of the possible reasons why firms might choose not to disclose certain information, we now turn to our empirical investigation of how far UK firms voluntarily disclose quantitative figures for advertising expenditures in their financial statements. The following analysis reveals that majority of the UK firms choose not to recognize quantitative figure for advertising expenditures in their financial statements. Whether this choice is driven by any of the reasons outlined above or some other reason could not be established, however, by our investigation. 1.4 Do UK Firms Disclose Spending on Advertising in Annual Reports? In order to investigate how far UK firms report advertising expenditures voluntarily in their annual reports, potential sources of advertising data (if any), reported by UK listed firms are searched. One kind of source for such data is the use of various databases available (e.g., Datastream, LSPD, Extel etc.) which provide a variety of accounting and market data. After a thorough search, however, no advertising data are found through Datastream, one of the main sources of financial market and accounting data in the UK. The annual cross sectional results reported in Shah and Stark (2000) indicate that advertising expenditures appear to be treated as investments in intangible assets by the market. Shah and Stark also indicate that some of the firms in their sample do actually spend considerable amounts of money on advertising. As a consequence, one might expect these firms to disclose their spending on advertising in their respective annual reports. Similarly, another source of firms spending on advertising is the Top Advertiser’s list published in the Advertising Statistics Yearbook.15

14 Although one might argue that there are intermediaries (e.g., security analysts) who could

assist in undertaking the analysis for individual investors, the fact remains that even intermediaries rely heavily on information disclosed in the financial statements.

15 A publication of NTC Publications Ltd., produced and published for The Advertising Association.

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Based on the analysis of firms in the cross-sections 1990-98 (as used in Shah and Stark, 2000) and the Top Advertiser’s list given in the Advertising Statistics Yearbook (1997, 1998), a number of firms are identified as having spent considerable amounts on advertising.16 On identifying these firms, 170 annual reports for a sample of 100 non-financial UK firms are investigated, including most of the firms reported in the Top Advertisers’ list. The sample consists of firms from various industries (Table 1.3).

Table 1.3

Distribution of the Sample of Firms Studied for Advertising Disclosures by Industry

Breweries, Pubs, Restaurant 8 Food Processors 8 Distillers + Vintners 6 Engineering, General 6 Food + Drug Retailers 6 House Building 5 Retailers, Soft Goods 5 Medical Equipment + Supplies 4 Retail, Hardlines 4 Retailers, Multi Dept 4 Hotels 3 Publishing & Printing 3 Vehicle Distribution 3 Aerospace 2 Airline + Airports 2 Broadcasting 2 Cable & Satellite 2 Clothing + Footwear 2 Electricity 2 Leisure Facilities 2 Other Construction 2 Pharmaceuticals 2 Telecom Fixed Line 2 Water 2 Others 13 Total

100

16 Firms such as, BT, Unilever, Kingfisher etc.

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Since advertising is currently treated as a single period expense, it seems logical to report advertising expenditures as part of the income statement. But at the same time the absence of any compulsory disclosure requirements (especially, in the UK) gives firms a choice either to report it, or otherwise, not disclose such expenditures in their financial statements. Given the increasingly important role being played by advertising in generating demand for the firms’ products and services and contributing to the revenues of the firm, it might be expected that any material amount spent on advertising would be reported in the financial statements. It is surprising, however, that few of the firms reported to have spent large sums of money on advertising (e.g., in ACNielsen MEAL quarterly summary of advertising expenditures), and which are included in the Top 50 Advertisers’ list, report advertising expense separately in their annual reports. For instance, BT is rated as the topmost advertiser, with a total advertising spend of £130.9m in the year 1997 (Advertising Statistics Yearbook 1998). When the annual report is examined, however, it mentions the various radio and TV advertising campaigns the company launched during the period but never mentions any solid figure for advertising expenditures. Similarly, Safeway, Asda, etc., also appear in the Top 50 Advertisers’ list, given in the Advertising Statistics Yearbook 1998. Advertising expenditure is, however, not reported as a separate item, nor is any note to this effect made in the financial statements. Out of the total sample of one hundred firms, fifty-eight firms appear to have invested money in advertising as each refers to various advertised brands and advertising campaigns in their annual reports (Table 1.4).

Table 1.4

Advertising Disclosures in the Annual Report

Advertising Figure Reported Separately 7

Combined Advertising And Promotion/ Marketing Figure Reported

5

Combined Figure For Advertising And Other Operating Expenses

4

Advertising Mentioned Without Giving Any Figure

42

Total

58

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However, only seven firms have given separate figures for advertising expenditures (e.g., Bass Plc, Reuters Plc etc.), while another five of the firms provide a combined figure for both advertising and promotion/marketing (e.g., Grand Metropolitan) (see Tables 1.5 - 1.8).

Table 1.5

Quantitative Figure for Advertising Expenditures Reported in Annual Reports

Name Amount (£) Place in the Annual Report Bass Plc 50 m (1993)

37 m (1994) Notes to the Accounts

Cadbury Schweppes

317 m (1996) 345 m (1997) 354 m (1998)

Notes to the Accounts

Matthew Clark

Rising from 2-8 m in 1997

Review Section

Reuters Plc

16m (1995) 21 m (1996) 17m (1997)

Notes to the Accounts

Signet Group Plc

34.9 m (1995) 30.8 m (1996) 33.0 m (1997)

Notes to the Accounts (Annual Report on Form F-20)

Smithkline and Beecham

191 m (1994) 291 m (1995) 344 m (1996)

Note to the Accounts

Telewest Communication

24.8 m (1996) 25.9 m (1997) 20.5 m (1998)

Separate Section Under US GAAP Gives the Figures

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Table 1.6

Combined Advertising and Promotion/Marketing Expenditure Figure Reported in Annual Reports

Name Amount Place in the Annual Report

British Sky B.cast

36.9 m (1994) 58.6 m (1995)

Review Section

Grand Metropolitan

879 m (1993) 901 m (1994) 1073 m(1995)

Notes to the Accounts

The Savoy Hotel Plc

1.89 m (1996)

Notes to the Accounts

Vodafone Group

26 m (1997)

Review Section

Unilever

3786 m(1996) 3628 m(1997)

Notes to the Accounts

Table 1.7

Combined Advertising and Other Operating Expenditure Figure Reported in Annual Reports

Name Advertising Mentioned

Allied Domecq

Review Section

Fuller Smith

MD’s Review

Kwik-Fit

Accounting Policies Section

Scholl

Accounting Policies Section

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Table 1.8

Industry Distribution of Firms Mentioning Advertising Expenditure in Their Annual Reports

Breweries, Pubs, Restaurant 8 Food Processors 7 Distillers + Vintners 6 Food + Drug Retailers 5 Medical Equipment + Supplies 4 Retail, Hardlines 3 Hotels 3 Pharmaceuticals 2 Retailers, Multi Dept 2 Retailers, Soft Goods 2 Telecom Fixed Line 2 Others 14 Total 58

Interestingly, among firms reporting advertising figures, ‘Telewest Communications’ for instance, do not give advertising figures under UK GAAP, but report comparative figures for advertising under a separate US GAAP section of the annual report. Similarly, another firm ‘Signet Group’ presented its annual report on Form F-20. Body Shop International gives a figure of 1.3m pounds for an advertising trial in its review section (Annual Report 1996, p.21). In most of the cases, however, firms have mentioned various advertising campaigns and their role in boosting sales, reinforcing brand awareness, establishing their brand leadership positions, and expanding market share etc., but very few have reported any figures for their total spend on advertising. Twenty-three of the firms in the sample mention advertising, and its role is highlighted in the ‘review of operations’ section of the financial statements by the respective officials, but fail to provide any accounting figure for the advertising expenditure (Table 1.9).

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Table 1.9

Firms Mentioning Advertising Expenditure in Their Annual Reports Without Giving Any Figure

Name Advertising Mentioned In Section Asda Group Review Section Boddingtons Group Operating Review British Airways Operating/Financial Review British Gas Review Section British Steel Review Section British Telecom Review Section Budgens Chairman’s Statement Bulmer HP Review Section Dairy Crest Review Section Dixons Operating Review Friendly Hotels Review Section George Wimpey Review Section Glaxo Wellcome Financial Review Glenmorangie Chairman’s Statement Goldsmiths Group Chairman’s Review Granada Group Review Section Greene King Review Section Highland Distl. CEO’s Report Hillsdown Review Section Iceland Review Section Kingfisher Operational Review Kwik Save Operating/Financial Review Ladbroke Group Review Section Laura Ashley Chairman’s Statement London Int’l Gp. Review Section Marston Thompson Review Section Matthew Clark Chief Executive’s Statement Merrydown Review Section Pentland Group Operating Review Reckitt & Colman Category Review Safeway Operating Review Scottish & Newcastle Review Section Seton Hlt Care Review Section Silentlight Hldg. Chief Executive’s Review Smith & Nephew Review Section Storehouse MD’s Review The Boddington Plc Operating Review The Greenall’s Group Review Section

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Table 1.9 continued Advertising Mentioned Name In Section The Rank Group Operating/Financial Review Time Products Chairman’s Review Unigate Review Section Whitbread Plc Operating/Financial Review

Following is a summary of various instances where the role of advertising is highlighted in the financial statements of the sample firms analysed. 1.4.1 Advertising’s Role as Information Citing a press advertisement, British Gas, on page 3 of the annual review section of its 1997 annual report, indicates a ‘... press advertisement from the Transco advertising campaign designed to inform consumers of the role Transco plays in the competitive market...’ Safeway reports (1997 Annual Report, p.13) that ‘...our national TV campaign ... continues to communicate our core brand values of family friendliness and service ... during the year, this campaign achieved nearly 60% levels of popular recall - the highest ever for an advertising campaign in our sector...’ Dixons also indicates (Annual report 1998/99, p.18) that ‘...Currys continues to showcase the widest range of electrical products, as featured in our recent ‘Currys-the choice for you’ advertising...’ Storehouse, another prominent firm in the retail business indicates its reliance on advertising to convey its message to the market. In the review section of the Annual Report for 1996 (pp.10-11) it emphasizes the value of its TV advertising by mentioning that for ‘… the second year running, Bhs used TV advertising to convey the fashionability, quality and value of Bhs merchandise as well as a sense of fun and excitement…’ However, the financial statements for the same year do not give any separate figure for advertising expenditure, nor are any details given in the notes to the financial statements. Similarly, Bass Plc, on page 21 of the annual review section of its 1996 annual report, states that ‘... our £5m summer television advertising programme for the Robinson’s Fruit and Barley’s range featured five exciting ways of mixing our newly introduced flavours...’ 1.4.2 Advertising’s Role in Increasing Sales Highlighting the growth in its sales as a result of its direct-to-consumer advertising, Glaxo Wellcome (Annual report 1998, p.22) reports that ‘...Flixtonase growth came primarily from the USA where sales were driven by direct-to-consumer advertising campaigns...’ Budgens, in its 1997 annual report (Chairman’s statement section, p.3) indicates advertising’s role in boosting sales by stating that towards ‘... the end of April 1997 Budgens launched its 125th Anniversary campaign. It has been extensively advertised in the national press and

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on regional television ... the campaign has been successful, generating an up-lift in sales...’ Referring to one of its brands, The Boddington Group Plc (Annual report 1994, p.6) reports that the ‘... Henrys Table brand was supported by television advertising, on Granada ... which increased both awareness and sales revenue...’ Kingfisher (Annual report 1997, p.22) reports that ‘... Superdrug carried out its first TV advertising in the run-up to Christmas which had a positive effect on transaction numbers and sales ...’ Similarly, indicating advertising’s role in affecting sales, Iceland reports in its 1996 annual report (Review section, p.4) that ‘...we have adopted a new style of press and TV advertising which has achieved high level of consumer recall and has undoubtedly contributed to improving like for like performance. Our high profile Christmas advertising campaign, in particular, elicited a strong response ...’ 1.4.3 Advertising’s Role in Expanding Market Share and Maintaining

Leadership Position Reckitt & Colman in its Annual Report for the year 1998 (p.21) indicates its reliance on advertising by mentioning about one of its brands that, ‘...a global TV commercial has driven market share and consolidated the brand’s number one position...’ Indicating advertising’ s role in helping reposition one of its brands, Hillsdown (Annual report 1998, p.14) reports that following ‘... a highly successful advertising campaign, Typhoo was repositioned and increased brand share yet again, with volume sales up an encouraging 12%...’ The Chairman of Glenmorangie Plc in his statement (Annual Report 1996, p.9) refers to the extensive TV and poster advertising and highlights its effectiveness, ‘…Christmas television advertising in the Scottish region helped to maintain Glenmorangie’s leadership position as Scotland’s favourite malt…’ 1.4.4 Advertising’s Role in Creating Brand Awareness and Boosting Brand

Image British Steel, in its Review of the year section for the year 1997 (p.8), indicates that advertising expenditure had boosted its brand by the following remark ‘… an advertising campaign, under the banner ‘British Steel-World Beater’ began in 1996 and is scheduled to run through 1997. The aim is to associate British Steel in the minds of key opinion formers with the large, prestigious, international projects for which the company’s products are frequently used…’ Similarly, Signet Group (Annual report 1998, p.4) also points to the use of advertising in supporting its ‘Kay Stores’, ‘... Kay stores were supported by national TV advertising...’ The Rank Group in its Review section (Annual Report 1998, p.5) highlights the role of advertising in creating awareness for one of its brands by stating that ‘...we were the first bingo operator to invest in TV advertising and in areas where our campaign has run we have achieved brand awareness levels of 96%...’ Reckitt & Colman (Annual report 1997, p.21) reports that ‘...savings in overhead were

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reinvested in brand support, with investment in media campaigns growing by one-third over 1996...’ To cite another such example, Greene King (Annual Report 1998-99, p.19), in its Chief Executive’s Review section, talk about the value of its various advertising efforts in the following terms: ‘...both Greene King IPA and Abbot received major advertising investment as well as consistent below-the-line support: IPA was advertised on both Anglia and Sky television, as well as benefiting from a national newspaper campaign, while Abbot was given lengthy national press advertising...’ It goes on to say (Annual Report 1998-99, p.21) that ‘...we also intend to sustain heavy television, press, radio and tube card advertising campaigns in our existing areas to continue the progress already being made...’ Granada Group (Annual report 1998, p.9) emphasizes advertising’s role in building brand awareness by pointing that a ‘... new advertising campaign featuring TV star Jeremy Clarkson has succeeded in building brand awareness in the run up to the launch of digital television...’ Similarly, the Chief Executive of Highland Distilleries, in his statement (Annual report 1996, p.9), talks about their advertising campaign in that ‘...the new advertising campaign introduced ... has been very well received and has substantially increased awareness of the brand...’ Among other benefits of advertising mentioned include reducing the decline in sales, improving relations with stockists, increasing reach, and greater customer recall etc. Unigate (Annual report 1997, p.22), for instance, indicates how, among other measures, it also resorted to an extensive television advertising campaign to reduce the rate of decline in sales. Similarly, Time Products (Annual report 1998, p.4) reports that an advertising campaign, together with other marketing initiatives, has strengthened relationships with its stockists 1.5 What Do We Find ? On the whole, it has been observed that firms have generally mentioned their advertising spending and its role in either the operating review section, or in the notes to the income statement, but very few have given any figure for advertising expenditures. This contrasts with what is normal practice in the US. A relatively larger number of firms in the US disclose the amount of money spent on advertising in their annual reports. This is evident from an analysis of advertising figures for a relatively larger number of US firms reported by Compustat.17 Top US firms like Coca-Cola, General Motors, Chrysler, amongst others, generally appear to have reported an accounting figure for advertising expenditures in their annual reports. The American Institute of Certified Public Accountants (AICPA) in 1993 standardized the financial accounting treatment of advertising by issuing Statement of Position 93-7. SOP 93-7 requires that advertising costs be expensed as they are 17 An American Database of financial and market information.

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incurred or when the advertising first occurs.18 SOP 93-7, however, allows a firm to capitalize ‘direct response advertising costs’, provided it demonstrates from its past experience that future net revenues from customers obtained through the advertising will exceed the amount of capitalized costs. In a recent letter to the American Institute of Certified Public Accountants (AICPA),19 L.E.Turner, of the Securities Exchange Commission, explains the provisions of the SOP 93-7 in the following words, ‘... SOP No. 93-7 requires that companies disclose the accounting policy for reporting advertising costs, indicating whether such costs are expensed as incurred or the first time the advertising takes place. The notes to the financial statements also should disclose the accounting policy for direct-response advertising, if any, a description of the direct-response advertising reported as assets, the amount of advertising reported as assets in each balance sheet presented, and the amortization period. Disclosure of the total amount charged to advertising expense for each income statement presented and separate disclosure of any amounts representing a write-down to net realizable value should also are required....’20 (also, see Accounting Standards Executive Committee Statement of Position, SOP 93-7: Reporting on Advertising Costs). Establishing whether advertising expenditures reported by the US firms constitute the portion of advertising expenditure capitalized earlier and subsequently amortized and charged to advertising expenditure of the period (as required by SOP 93-7) or represent the disclosure of advertising expenditures charged as incurred is beyond the scope of the present analysis, however. Similarly, although apparently it seems that most US firms tend to disclose their advertising figures in contrast with UK firms, it is not clear, however, if this represents the majority of the US firms who actually spent money on advertising. There might be cases where firms had spent money on advertising but chose not to disclose it or include it under a more general marketing category, rather than recognizing it separately in their financial statements. Grabowski (1976, n.15, p.71), for instance, observes that a majority of US firms do not explicitly report advertising expenditures but, instead, aggregate them into more general administrative and selling costs categories. 1.6 What is Needed? Accounting figures convey useful financial information to various segments of society (e.g., creditors, investors, security analysts, customers, management, owners, and the general public etc.). Since accounting numbers serve a variety of 18 SOP 93-7 is effective for fiscal years ending after June 15, 1994. 19 The letter is intended to provide information and useful guidance to the members of the

profession in assisting them with the preparation and audit of financial statements included in filings with the United States Securities and Exchange Commission (SEC).

20 SEC’s Office of the Chief Accountant: Letter: 2000 Audit Risk Alert to the American Institute of Certified Public Accountants, dated October 13, 2000, p.3 (www.sec.gov/offices/account/audrsk2k.htm).

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segments of society, they must convey relevant details in a more explicit and meaningful manner for the benefit of all. Advertising today plays a vital role in stimulating demand and contributing to revenues, and firms do realize this fact and invest huge amounts of money in advertising campaigns. It is rather surprising then to find that only a few firms take the initiative of voluntarily disclosing advertising expenditures in their financial statements. It is about time for the various institutions responsible for devising accounting principles and regulations (especially in the UK) to take a positive step in this regard and make disclosure of advertising expenditures compulsory in the financial statements. It will serve at least two important purposes.21 First, it will make financial statements more representative of the firms’ financial position and the information conveyed to investors will be more realistic. Second, it will put a pressure on management to devise more economical and neatly outlined advertising budgets, as the amount allocated and spent on advertising has to be reported and accounted for in corporate financial statements. Ross (1983, p.380), for instance, comments that ‘...we report the accounting data as a check, a way of monitoring performance and veracity...’ Similarly, Grinyer et al. (1994, p.124) also share the same views by commenting that ‘...the use of accounting for control of subordinates suggests that financial reports may be of value in the control of top management by external owners...’ Grinyer et al. also believe that shareholders can only hold managers accountable for outcomes of which the shareholders are aware. According to their view, as some of the financial aspects of such outcomes are reported in the financial statements, the contents of the published accounting reports assume potential importance for the motivation and control of managers. Finally, one criticism against advertising is that it is excessive (see, for example, Kaldor 1950). Compulsory disclosure of advertising could in some respect also put an indirect check on overspending on advertising. Firms would be more likely inclined to report efficiency of their advertising spending rather than just the scale of advertising. As regards the fears that compulsory disclosure requirement might discourage small firms from spending on advertising, it is suggested that selected reductions in accounting disclosure requirements for particular industries and firms of certain sizes might not be an unreasonable proposition.22

21 There could be a number of other benefits though. For instance, comprehensive guidelines

on advertising costs could put an end to the currently diverse practice of dealing with advertising costs. It could provide clearer guidance to most of the entities. Clearer guidance can not only help auditors in assessing financial statements, but also facilitate the users of financial statements in terms of increased comparability among different entities.

22 For example, one can find examples of this practice in the case of SFAS No.33 (FASB, 1979), SSAP13 (See, para.20) etc.

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1.7 A Final Comment Another important observation worth mentioning is that the majority of firms mentioning advertising in their annual reports are firms from Breweries, Pubs, Restaurants, Food Processors, and Retail industries. On the other hand, firms in the Engineering General, House Building, and Aerospace industries normally have not mentioned advertising. This might indicate that firms in certain industries do use and rely on advertising as a marketing tool as contrasted with firms in other industries that might be using some other forms of marketing.23 This observation also conforms to some earlier empirical evidence that suggests that advertising effectiveness might vary across firms from different industries. Abdel-Khalik (1975, p.667), for instance, concludes that there ‘... is strong evidence that the duration of the effectiveness of advertising and of promotional effort vary considerably between firms in different industries...’ A final comment that concerns another related issue regarding advertising expenditures is the need for accounting policy guidelines for treating advertising expenditures in accounting records. Although the current treatment of advertising is normally to treat it as an expense when incurred, there has been growing empirical evidence (e.g., Peles 1970, Abdel-Khalik 1975, Chauvin and Hirschey 1994 etc.) that indicates that advertising might be creating an intangible asset, at least in some industries. The choice of treating advertising as an expense or as an intangible asset has implications for the income statement, other financial measures (e.g., earnings per share), and possibly the balance sheet. There is need for an effort towards addressing such policy issues as to whether firms in different industries should be allowed to treat advertising differently or not? Whether the expensing only rule is appropriate for all kinds of industries? Perhaps it may not seem unreasonable to devise guidelines like those adopted for the treatment of research and development expenditures (e.g., SSAP 13, IAS9 - recently superseded by IAS38 etc.). It would allow firms to apply these policy guidelines in dealing with the question of whether to treat advertising as an expense or capitalize and amortize it over a period of time. 24

23 This evidence is quite in conformity with the empirical findings in Shah and Stark (2000).

Also, see, for example, Peles (1971), Abdel Khalik (1975), Chauvin and Hirschey (1993), etc.

24 Nonetheless, it is important to note that in the UK context, changes in the accounting regulations and/or treatment of advertising expenditures do not necessarily have a bearing on tax laws that are governed quite separately to accounting regulations.

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