Book 3_FinAn_READING-38_FINANCIAL-REPORTING-QUALITY Flashcards
High-quality financial reporting
adheres to generally accepted accounting principles (GAAP) and is decision useful in terms of relevance and faithful representation.
High-quality earnings
high enough to provide the firm’s investors with an adequate return and are sustainable in future periods.
Biased accounting choices
include conservative and aggressive accounting
Conservative accounting choices
decrease the company’s reported earnings and financial position for the current period.
Aggressive accounting choices
increase reported earnings or improve the financial position for the current period.
the quality levels of financial reports, from best to worst
- compliant and decision useful; earnings are sustainable and adequate.
- compliant and decision useful, but earnings quality is low
- compliant but earnings quality is low and reporting choices and estimates are biased.
- compliant, but the amount of earnings is actively managed.
- not compliant, although the numbers presented are based on the company’s actual economic activities.
- not compliant and includes numbers that are essentially fictitious or fraudulent.
Motivations for firm managers to issue low-quality financial reports
- Pressure to meet or exceed earnings targets,
- career considerations,
- increasing their compensation,
- improving perceptions of the firm among customers and suppliers,
- or meeting the terms of debt covenants.
Conditions that are often present when managers issue low-quality financial reports
- motivations, opportunities, and rationalizations
Oppotunities - Weak internal controls,
- inadequate oversight by the board of directors,
- and wide ranges of acceptable accounting treatments
Mechanisms that help to discipline financial reporting quality
regulation, auditing, and private contracts
Regulators typically require public companies to provide
periodic financial statements and notes, including:
- management commentary, and obtain independent audits.
A clean audit opinion
offers reasonable assurance that financial statements are free from material errors but does not guarantee the absence of error or fraud.
Firms may attempt to influence analysts’ valuations by
- presenting non-GAAP measures, such as earnings that exclude certain nonrecurring items
- IFRS requires firms to define and explain the relevance of any non-GAAP measures and reconcile them to the most comparable IFRS measure.
- Similar requirements apply to U.S.public firms.
Accounting choices and estimates that can be used to manage earnings include:
- Revenue recognition choices
- Estimates of reserves for uncollectible accounts or warranty expenses.
- Valuation allowances on deferred tax assets.
- Depreciation methods, estimates of useful lives and salvage values, and recognition of impairments.
- Inventory cost flow methods.
- Capitalization of expenses.
- Related-party transactions
Accounting warning signs that indicate a need for closer analysis may include:
- Revenue growth out of line with comparable firms, changes in revenue recognition methods, or lack of transparency about revenue recognition.
- Decreases over time in turnover ratios (receivables, inventory, total asset).
- Bill-and-hold, barter, or related-party transactions.
- Net income not supported by operating cash flows.
- Capitalization decisions, depreciation methods, useful lives, salvage values out of line with comparable firms.
- Fourth-quarter earnings patterns not caused by seasonality.
- Frequent appearance of nonrecurring items.
- Emphasis on non-GAAP measures, minimal information and disclosure in financial reports.
IFRS require a firm that presents a nonstandard financial measure
- reconcile that measure to an IFRS measure
- and explain why the firm believes the nonstandard measure is relevant to users of the financial statements
