Financial Reporting Quality

Financial reporting quality varies across companies. The ability to assess the quality of a company’s financial reporting is an important skill for analysts. Indications of low-quality financial reporting can prompt an analyst to maintain heightened skepticism when reading a company’s reports, to review disclosures critically when undertaking f inancial statement analysis, and to incorporate appropriate adjustments in assessments of past performance and forecasts of future performance.

• Financial reporting quality can be thought of as spanning a continuum. Reporting of the highest quality contains information that is relevant, correct, complete, and unbiased, whereas the lowest quality reporting contains information that is not just biased or incomplete but possibly pure fabrication.
• Reporting quality, the focus of this module, pertains to the quality of the information disclosed. High-quality reporting 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.
• Results quality (commonly referred to as earnings quality) 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. Quality earnings can be regarded as more sustainable, providing a sound platform for forecasts.
• An aspect of financial reporting quality is the degree to which accounting choices are conservative or aggressive. “Aggressive” typically refers to choices that aim to enhance the company’s reported performance and financial position by inflating the amount of revenues, earnings, and/or operating cash flow reported in the period; or by decreasing expenses for the period and/or the amount of debt reported on the balance sheet.
• Conservatism in financial reports can result from either (1) accounting standards that specifically require a conservative treatment of a transaction or an event or (2) judgments made by managers when applying accounting standards that result in conservative results.
• Managers may be motivated to issue less-than-high-quality financial reports to mask poor performance, boost the company’s stock price, to increase personal compensation, and/or to avoid violation of debt covenants.
• Conditions that are conducive to the issuance of low-quality financial reports include a cultural environment that result in fewer or less transparent financial disclosures, book/tax conformity that shifts emphasis toward legal compliance and away from fair presentation, and limited capital markets regulation.
• Mechanisms that discipline financial reporting quality include open capital markets and incentives for companies to minimize cost of capital, independent auditors, contract provisions specifically tailored to penalize misreporting, and enforcement by regulatory entities.
• Pro forma earnings (also commonly referred to as non-GAAP or non-IFRS earnings) adjust earnings as reported on the income statement. Pro forma earnings that exclude negative items are a hallmark of aggressive presentation choices.
• Companies are required to make additional disclosures when presenting any non-GAAP or non-IFRS metric.
• Managers’ considerable flexibility in choosing their companies’ accounting policies and in formulating estimates provides opportunities for aggressive accounting.
• Examples of accounting choices that affect earnings and balance sheets include inventory cost flow assumptions, estimates of uncollectible accounts receivable, estimated realizability of deferred tax assets, depreciation method, estimated salvage value of depreciable assets, and estimated useful life of depreciable assets.
• Cash flow from operations is an important metric for investors that can be enhanced by management’s operating choices, such as stretching accounts payable, and potentially by classification choices.