Financial Reporting Quality Flashcards
Describe the conceptual overview of Earnings Quality and Reporting Quality.
High reporting quality enables good assessment.
High earnings quality increases company value.
What is aggressive accounting?
Inflating the reported performance of the company, this may lead to reductions in performance later on.
What is conservative accounting?
Deflating the reported performance of the company, this may lead to increases in performance later on.
What is earnings smoothing?
Earnings smoothing can result from conservative choices to understate earnings in periods when a company’s operations are performing well, building up (often hidden) reserves that allow aggressive choices in periods when its operations are struggling.
What are hidden revenues?
Management had already exceeded targets before the end of the period and thus made conservative accounting choices that would delay reporting profits until the following period (so-called hidden reserves).
Unbiased reporting is optimal!
What is non-GAAP reporting?
Reporting of financial metrics not in compliance with generally accepted accounting principles, such as US GAAP and IFRS
A common non-GAAP financial metric is “non-GAAP earnings,” which are created by companies “that adjust standards-compliant earnings to exclude items required by accounting standards or to include items not permitted by accounting standards” (Ciesielski and Henry, 2017). In contrast, non-GAAP operating metrics do not relate directly to the financial statements and include metrics that are typically industry-driven, such as subscriber numbers, active users, and occupancy rates.
Financial reporting that departs from GAAP generally can be considered low-quality. In such situations, earnings quality is likely difficult or impossible to assess.
Name three big examples of low-quality financial reporting that had major consequences.
Enron, WorldCom and New Century Financial
Unbiased financial reporting is ideal. But some investors may prefer or be perceived to prefer conservative rather than aggressive accounting choices, because a positive surprise is acceptable. In contrast, management may make, or be perceived to make, aggressive accounting choices because they increase the company’s reported performance and financial position.
Conservative accounting does usually not create sustainability issues.
Verification drives the degree of conservatism. For recognition of revenues, a higher degree of verification would be required than for expenses.
Name three accounting examples of conservatism in the GAAP accounting standards.
- Research costs - always expensed because future benefits are unknown.
- Litigation losses - when it becomes “probable” that a cost will be incurred, both US GAAP and IFRS require expense recognition, even though a legal liability may not be incurred until a future date.
- Insurance recoverables - generally, a company that receives payment on an insurance claim may not recognize a receivable until the insurance company acknowledges the validity of the claimed amount.
What are four potential benefits of conservatism?
- Given asymmetrical information, conservatism may protect the contracting parties with less information and greater risk. This protection is necessary because the contracting party may be at a disadvantage.
- Conservatism reduces the possibility of litigation and, by extension, litigation costs. Rarely, if ever, is a company sued because it understated good news or overstated bad news.
- Conservative rules may protect the interests of regulators and politicians by reducing the possibility that fault will be found with them if companies overstate earnings or assets.
- In many tax jurisdictions, financial and tax reporting rules are linked. For example, in Germany and Japan, only deductions taken against reported income can be deducted against taxable income. Hence, companies can reduce the present value of their tax payments by electing conservative accounting policies for certain types of events.
What is a big bath restructuring charge?
Both US GAAP and IFRS provide for accrual of future costs associated with restructurings, and these costs are often associated with and presented along with asset impairments. But in some instances, companies use the accounting provisions to estimate “big” losses in the period under review so that performance in future periods will appear better.
Managers may be motivated to issue financial reports that are not high quality to mask poor performance, such as a loss of market share or lower profitability than competitors.
Even when there is no need to mask poor performance, managers frequently have incentives to meet or beat market expectations as reflected in analysts’ forecasts (especially for earnings) or management’s own forecasts. Exceeding forecasts may increase the stock price, if only temporarily. Additionally, exceeding forecasts can increase management compensation that is linked to increases in stock price or to reported earnings.
Give three conditions for low-quality reporting. (Fraud triangle)
Pressure / motivation - reasons such as meeting analysts’ forecasts or getting a bonus
Opportunity - can be the result of poor internal controls
Rationalization - justification
What are four mechanisms to discipline financial reporting?
Markets
Market regulatory authorities
Auditors
Private contracts
How do markets discipline financial reporting?
Markets may discipline poor financial reporting quality. Companies and nations compete for capital, and the cost of capital is a function of perceived risk—including the risk that a company’s financial statements will skew investors’ expectations. Thus, in the absence of other conflicting economic incentives, a company seeking to minimize its long-term cost of capital should aim to provide high-quality financial reports.
How do market regulatory authorities discipline financial reporting?
National regulations and the regulators that establish and enforce rules can play a significant role in financial reporting quality. Many of the world’s securities regulators are members of the International Organization of Securities Commissions (IOSCO). IOSCO is recognized as the “global standard setter for the securities sector,” although it does not actually set standards but rather establishes objectives and principles to guide securities and capital market regulation.They use rules such as:
- Registration requirements
- Disclosure requirements
- Auditing requirements
- Management commentaries
- Responsibility statements
- Regulatory review of filings
- Enforcement mechanisms
How do auditors discipline financial reporting?
Regulatory authorities typically require that publicly traded companies’ financial statements be audited by an independent auditor. Private companies also obtain audit opinions for their financial statements, either voluntarily or because audit reports are required by an outside party, such as providers of debt or equity capital. Audit opinions provide financial statement users with some assurance that the information complies with the relevant set of accounting standards and presents the company’s information fairly.
How do private contracts discipline financial reporting?
Aspects of private contracts, such as loan agreements or investment contracts, can also serve as mechanisms to discipline poor financial reporting quality. Many parties that have a contractual arrangement with a company have an incentive to monitor that company’s performance and to ensure that the company’s financial reports are high quality.
