Reading 26: Financial Reporting Quality Flashcards
Compare and contrast financial reporting quality of reported results (including quality of earnings, cash flow, and balance sheet items).
Financial reporting quality refers to the characteristics of a firm’s financial statements. High-quality financial reporting adheres to generally accepted accounting principles (GAAP) and is decision useful in terms of relevance and faithful representation.
Quality of reported results refers to the level and sustainability of a firm’s earnings, cash flows, and balance sheet items. High-quality earnings are high enough to provide the firm’s investors with an adequate return and are sustainable in future periods.
Describe a spectrum for assesing financial reporting quality.
A spectrum for assessing financial reporting quality considers both the quality of a firm’s financial statements and the quality of its earnings. One such spectrum, from highest quality to lowest, is the following:
* Reporting is compliant with GAAP and decision useful; earnings are sustainable and adequate.
* Reporting is compliant and decision useful, but earnings quality is low.
* Reporting is compliant, but earnings quality is low and reporting choices and estimates are biased.
* Reporting is compliant, but earnings are actively managed.
* Reporting is not compliant, but the numbers presented are based on the company’s actual economic activities.
* Reporting is not compliant and includes numbers that are fictitious or fraudulent.
Explain the difference between conservative and aggressive accounting.
Biased accounting choices that can be made within GAAP include conservative and aggressive accounting. Conservative accounting choices tend to decrease the company’s reported earnings and financial position for the current period. Aggressive accounting choices tend to increase reported earnings or improve the financial position for the current period.
Some managers employ conservative bias during periods when earnings are above target and aggressive bias during poor periods of below-target earnings to artificially smooth earnings.
Describe motivations that might cause management to issue financial reports that are not high quality.
Motivations for firm managers to issue low-quality financial reports may include 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.
Describe conditions that are conducive to issuing low-quality, or even fraudulent, financial reports.
Conditions that are often present when managers issue low-quality financial reports include motivations, opportunities, and rationalizations. Weak internal controls, inadequate oversight by the board of directors, and wide ranges of acceptable accounting treatments are among the factors that may provide opportunities for low-quality reporting.
Describe mechanisms that discipline financial reporting quality and the potential limitations of those mechanisms.
Mechanisms that help to discipline financial reporting quality include 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. The fact that firms select and pay their auditors may limit the effectiveness of auditing to discipline financial reporting quality.
Describe presentation choices, including non-GAAP measures, that could be used to influence an analyst’s opinion.
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.
Describe accounting methods (choices and estimates) that could manage earnings, cash flow, and balance sheet items.
Accounting choices and estimates that can be used to manage earnings include:
* Revenue recognition choices such as shipping terms (FOB shipping point versus FOB destination), accelerating shipments (channel stuffing), and bill-and-hold transactions.
* 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.
Describe accounting warning signs and methods for detecting manipulation of information in financial reports.
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.
