12.1: Quality of Financial Reports

Question 1

The conceptual framework for assessing the quality of a company’s reports entails answering two questions:

Answer 1

Are the underlying financial reports GAAP compliant and decision-useful?
Are the earnings of high quality?

Question 2

Financial Reports Quality (High to Low)

Answer 2

Question 3

Potential problems that affect the quality of financial reports may arise from:

Answer 3

Measurement and timing issues and/or
Classification issues.

Question 4

Measurement and Timing Issues

Answer 4

For example, aggressive revenue recognition practices increase reported revenues, profits, equity, and assets.

Question 5

Classification Issues

Answer 5

classification of expenses as operating vs. non-operating in the income statement

Question 6

Mergers and acquisitions often provide opportunities and motivations to manage financial results.

Answer 6

For example, companies with declining operating cash flow may be motivated to acquire other cash-generating entities to increase cash flow from operations.

Stock acquisitions provide an incentive for the acquiring company management to pursue aggressive accounting so as to inflate their stock price prior to acquisition.