Evaluating Quality of Financial Reports

2024 Curriculum CFA Program Level II Financial Reporting and Analysis

Refresher reading access

Access the Full Reading in the Learning Ecosystem Download the full reading (PDF)

Introduction

The ability to assess the quality of reported financial information can be a valuable skill. An analyst or investor who can recognize high-quality financial reporting can have greater confidence in analysis based on those financial reports and the resulting investment decisions. Similarly, an analyst or investor who can recognize poor financial reporting quality early—before deficiencies become widely known—is more likely to make profitable investment decisions or to reduce or even avoid losses.

An example of early recognition of an ultimate financial disaster is James Chanos’s short position in Enron in November 2000 —more than a year before Enron filed for bankruptcy protection (in December 2001). Despite Enron’s high profile and reputation, Chanos had a negative view of Enron based on both quantitative and qualitative factors. Chanos noted that Enron’s return on capital was both lower than comparable companies’ return on capital and lower than the company’s own cost of capital. Qualitative factors contributing to Chanos’s view included the company’s aggressive revenue recognition policy, its complex and difficult-to-understand disclosures on related-party transactions, and one-time earnings-boosting gains. Later events that substantiated Chanos’s perspective included sales of the company’s stock by insiders and the resignation of senior executives.

Another example of early recognition of eventual financial troubles is June 2001 reports by analyst Enitan Adebonojo. These reports highlighted questionable accounting by Royal Ahold, a European food retailer. The questionable accounting included “claiming profits of acquired firms as ‘organic growth,’ booking capital gains from sale-and-leaseback deals as profit, and keeping billions in debt off its balance sheet.” In 2003, Royal Ahold announced that it had significantly overstated its profits in the prior two years. The CEO and CFO resigned, various regulators announced investigations, and Royal Ahold’s market value dropped significantly.

This reading focuses on reporting quality and the interrelated attribute of results quality. Reporting quality pertains to the information disclosed in financial reports. High-quality reporting provides decision-useful information—information that is relevant and faithfully represents the economic reality of the company’s activities during the reporting period and the company’s financial condition at the end of the period. A separate, but interrelated, attribute of quality is results or earnings quality, which pertains to the earnings and cash generated by the company’s actual economic activities and the resulting financial condition relative to expectations of current and future financial performance. Note that the term “earnings quality” is more commonly used in practice than “results quality,” so throughout this reading, earnings quality is used broadly to encompass the quality of earnings, cash flow, and/or balance sheet items.

High-quality earnings reflect an adequate level of return on investment and are derived from activities that a company will likely be able to sustain in the future. Thus, high-quality earnings increase the value of a company more than low-quality earnings. When reported earnings are described as being high quality, it means that the company’s underlying economic performance was good (i.e., value enhancing), and it also implies that the company had high reporting quality (i.e., that the information that the company calculated and disclosed was a good reflection of the economic reality).

Earnings can be termed “low quality” either because the reported information properly represents genuinely bad performance or because the reported information misrepresents economic reality. In theory, a company could have low-quality earnings while simultaneously having high reporting quality. Consider a company with low-quality earnings—for example, one whose only source of earnings in a period is a one-off settlement of a lawsuit without which the company would have reported huge losses. The company could nonetheless have high reporting quality if it calculated its results properly and provided decision-useful information. Although it is theoretically possible that a company could have low-quality earnings while simultaneously having high reporting quality, experiencing poor financial performance can motivate the company’s management to misreport.

This reading begins in Section 2 with a description of a conceptual framework for and potential problems with financial reporting quality. This is followed in Section 3 with a discussion of how to evaluate financial reporting quality. Sections 4, 5, and 6 focus on the quality of reported earnings, cash flows, and balance sheets, respectively. Section 7 covers sources of information about risk. A summary and practice problems in the CFA Institute item set format complete the reading.

Learning Outcomes

The member should be able to:

demonstrate the use of a conceptual framework for assessing the quality of a company’s financial reports;
explain potential problems that affect the quality of financial reports;
describe how to evaluate the quality of a company’s financial reports;
evaluate the quality of a company’s financial reports;
describe the concept of sustainable (persistent) earnings;
describe indicators of earnings quality;
explain mean reversion in earnings and how the accruals component of earnings affects the speed of mean reversion;
evaluate the earnings quality of a company;
describe indicators of cash flow quality;
evaluate the cash flow quality of a company;
describe indicators of balance sheet quality;
evaluate the balance sheet quality of a company;
describe sources of information about risk.

Conclusion

Assessing the quality of financial reports—both reporting quality and results quality—is an important analytical skill.

The quality of financial reporting can be thought of as spanning a continuum from the highest quality to the lowest.
Potential problems that affect the quality of financial reporting broadly include revenue and expense recognition on the income statement; classification on the statement of cash flows; and the recognition, classification, and measurement of assets and liabilities on the balance sheet.
Typical steps involved in evaluating financial reporting quality include an understanding of the company’s business and industry in which the company is operating; comparison of the financial statements in the current period and the previous period to identify any significant differences in line items; an evaluation of the company’s accounting policies, especially any unusual revenue and expense recognition compared with those of other companies in the same industry; financial ratio analysis; examination of the statement of cash flows with particular focus on differences between net income and operating cash flows; perusal of risk disclosures; and review of management compensation and insider transactions.
High-quality earnings increase the value of the company more than low-quality earnings, and the term “high-quality earnings” assumes that reporting quality is high.
Low-quality earnings are insufficient to cover the company’s cost of capital and/or are derived from non-recurring, one-off activities. In addition, the term “low-quality earnings” can be used when the reported information does not provide a useful indication of the company’s performance.
Various alternatives have been used as indicators of earnings quality: recurring earnings, earnings persistence and related measures of accruals, beating benchmarks, and after-the-fact confirmations of poor-quality earnings, such as enforcement actions and restatements.
Earnings that have a significant accrual component are less persistent and thus may revert to the mean more quickly.
A company that consistently reports earnings that exactly meet or only narrowly beat benchmarks can raise questions about its earnings quality.
Cases of accounting malfeasance have commonly involved issues with revenue recognition, such as premature recognition of revenues or the recognition of fraudulent revenues.
Cases of accounting malfeasance have involved misrepresentation of expenditures as assets rather than as expenses or misrepresentation of the timing or amount of expenses.
Bankruptcy prediction models, used in assessing financial results quality, quantify the likelihood that a company will default on its debt and/or declare bankruptcy.
Similar to the term “earnings quality,” when reported cash flows are described as being high quality, it means that the company’s underlying economic performance was satisfactory in terms of increasing the value of the firm, and it also implies that the company had high reporting quality (i.e., that the information calculated and disclosed by the company was a good reflection of economic reality). Cash flow can be described as “low quality” either because the reported information properly represents genuinely bad economic performance or because the reported information misrepresents economic reality.
For the balance sheet, high financial reporting quality is indicated by completeness, unbiased measurement, and clear presentation.
A balance sheet with significant amounts of off-balance-sheet debt would lack the completeness aspect of financial reporting quality.
Unbiased measurement is a particularly important aspect of financial reporting quality for assets and liabilities for which valuation is subjective.
A company’s financial statements can provide useful indicators of financial or operating risk.
The management commentary (also referred to as the management discussion and analysis, or MD&A) can give users of the financial statements information that is helpful in assessing the company’s risk exposures and approaches to managing risk.
Required disclosures regarding, for example, changes in senior management or inability to make a timely filing of required financial reports can be a warning sign of problems with financial reporting quality.
The financial press can be a useful source of information about risk when, for example, a financial reporter uncovers financial reporting issues that had not previously been recognized. An analyst should undertake additional investigation of any issue identified.

2.75 PL Credit

If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.