3.11 Financial reporting quality Flashcards
Financial reporting quality is high if?
a company’s financial reports provide investors with decision-useful information that accurately represents its underlying economics.
Earnings quality is high if?
a company’s operations are likely to generate the returns that investors require on a sustainable basis.
The spectrum of financial reporting quality (from best to worst) is summarized below:
- GAAP, Decision-Useful, Sustainable, and Adequate Returns
- GAAP, Decision-Useful, but Sustainable?
- Biased Accounting Choices
- Within GAAP, but “Earnings Management”
- Departures from GAAP
Three conditions usually accompany the issuance of low-quality financial reports:
Opportunity created by internal or external factors (e.g., poor internal controls, insufficient regulatory oversight).
Motivation rooted in performance expectations or personal circumstances.
Rationalization of decisions that the individual knows, on some level, to be wrong.
The following IOSCO features of regulation directly impact financial reporting quality:
Registration requirements: Required documentation includes relevant information about the issuer’s prospects and risk exposures.
Disclosure requirements: Periodic reports are usually required. Standards are often set by self-regulatory bodies (e.g., IASB, FASB) and enforced by regulators.
Auditing requirements: Opinions must state that financial statements conform to relevant standards. Some regulators also require opinions on internal controls.
Management commentaries: These may include a “fair review” of an issuer’s business and a description of its risk exposures.
Responsibility statements: Individuals who attest to the correctness of corporate statements may be held personally responsible for inaccuracies.
Enforcement mechanisms: Regulators can enforce compliance through fines, suspensions, or even criminal prosecutions.
There are several limitations of audit opinions:
Companies may make deliberate efforts to deceive their auditors.
Audits are based on samples, not an exhaustive review of all relevant information.
Unlike the public’s expectation, an audit is not intended to detect fraud, only to provide some assurance of fair presentation.
Auditors are paid directly by the company being audited, which can create an incentive for leniency.
in the cash flow statement, where should analysts try to catch potential manipulation?
Analysts should study changes in the operating cash flow section to catch manipulation.
–> Their suspicion should be aroused if net income is consistently greater than cash flow
–> Management knows that operating cash flow is scrutinized, so they sometimes try to classify outgoing cash flow to the investing and financing categories.
Warning Signs
Revenue
A company’s revenue growth rate should be compared in the context of its peer group.
A notable increase in accounts receivable as a share of revenue may be an indication of deteriorating revenue quality.
A decreasing asset turnover ratio suggests that assets are being used less productively.
Warning Signs
Inventory Signals
Rapid inventory growth and a lower inventory turnover ratio may be signs of obsolescence problems.
Warning Signs
Capitalization policies and deferred costs
Improper capitalization leads to overstated earnings.
A company’s policies should be compared to those of its peers.
Warning Signs
Relationship between cash flow and net income
Companies need cash to continue operating and, over the long run, net income must be consistent with operating cash flows.
Rising net income during a period of lower operating cash flows may be an indication of accounting irregularities.
Warning Signs
Other areas that should be analyzed include:
Fourth-quarter surprises that cannot be attributed to seasonality
Related-party transactions
Treating one-time sales and non-operating items as revenue
Classifying expenses as non-recurring
Minimal management disclosures
Use of non-GAAP measures
A high-quality financial report may reflect:
A
earnings smoothing.
B
low earnings quality.
C
understatement of asset impairment.
B
low earnings quality.
High-quality financial reports offer useful information, meaning information that is relevant and faithfully represents actual performance. Although low earnings quality may not be desirable, if the reported earnings are representative of actual performance, they are consistent with high-quality financial reporting. Highest-quality financial reports reflect both high financial reporting quality and high earnings quality.
A company is experiencing a period of strong financial performance. In order to increase the likelihood of exceeding analysts’ earnings forecasts in the next reporting period, the company would most likely undertake accounting choices for the period under review that:
A
inflate reported revenue.
B
delay expense recognition.
C
accelerate expense recognition.
C
accelerate expense recognition.
In a period of strong financial performance, managers may pursue accounting choices that increase the probability of exceeding earnings forecasts for the next period. By accelerating expense recognition or delaying revenue recognition, managers may inflate earnings in the next period and increase the likelihood of exceeding targets.
Which of the following conditions best explains why a company’s manager would obtain legal, accounting, and board level approval prior to issuing low-quality financial reports?
A
Motivation
B
Opportunity
C
Rationalization
C
Rationalization
Typically, conditions of opportunity, motivation, and rationalization exist when individuals issue low-quality financial reports. Rationalization occurs when an individual is concerned about a choice and needs to be able to justify it to herself or himself. If the manager is concerned about a choice in a financial report, she or he may ask for other opinions to convince herself or himself that it is okay.
