Financial Reporting Quality Concepts | CFA Level I FSA

Now that we have a better understanding of financial reporting and analysis, let’s dive deeper into evaluating the quality of financial reporting.

Financial Reporting Quality Concepts

High-quality financial reports should not only adhere to generally accepted accounting principles (GAAP) but also provide decision-useful information. Such information should be relevant, meaning it is useful to the users of financial statements for making investment or credit decisions. Additionally, the information should faithfully represent the economic reality of the company’s activities, meaning it is complete, neutral, and without errors.

Earnings quality refers to the quality of earnings, cash flow, and balance sheet items. High-quality earnings result from sustainable activities and provide a sufficient return on the company’s investment. For instance, an increase in earnings due to increased efficiency or growing market share is considered sustainable. On the other hand, one-off sales of assets or investment gains leading to increased profits are likely unsustainable and considered low-quality earnings.

The continuum of financial report quality ranges from the highest quality reports to the lowest. At the top, the highest quality reports are GAAP-compliant, provide decision-useful information, and have high-quality earnings. Lower-quality reports may be GAAP-compliant but have biased accounting choices or earnings management. The lowest-quality reports are non-compliant with GAAP and may contain fraudulent information.

Low-Quality Reporting Context

Three factors typically exist in cases where management provides low-quality financial reporting: motivation, opportunity, and rationalization.

Motivations can be in the form of rewards (career motivation, bonuses tied to stock price, enhancing company reputation) or avoiding negative consequences (violating debt covenants). For example, managers may be motivated to report earnings that exceed expectations to improve their reputation or earn larger bonuses. Alternatively, highly leveraged and unprofitable companies may be motivated to avoid violating debt covenants by manipulating their financial reports.

Opportunities for misreporting arise when a company has weak internal controls, inadequate board supervision, or when accounting standards have loopholes or inadequate penalties. In such cases, management can exploit these opportunities to misreport financial information without immediate consequences.

Rationalization depends on the management’s circumstances and personal principles. Most people who break the rules tell themselves a story to justify their actions, even if there are hardly any valid justifications for misreporting.

Disciplinary Measures

Disciplinary measures include enforcement actions by regulators (fines, suspension of participation, public disclosure, or criminal prosecution) and private contracts with lenders specifying financial measures. Regulatory bodies like the SEC, European Securities and Markets Authority, and IOSCO work to ensure financial reporting quality across countries and markets.

Securities regulations typically require:

• Registration process for new publicly traded securities
• Disclosure and reporting requirements, including periodic financial statements and accompanying notes
• Independent audits of financial reports
• Management’s statement of financial condition
• Signed statement by the person responsible for preparing the financial reports
• Review process for newly registered securities and periodic reviews after registration

Private contracts, such as those with lenders, also play a role in ensuring high-quality financial reports. Loan covenants often specify how financial measures will be calculated, giving the counterparties an incentive to monitor the firm’s financial reporting closely.

Conclusion

In conclusion, understanding financial reporting quality is crucial for analysts to make informed decisions. By recognizing the motivations, opportunities, and rationalizations behind low-quality reporting, analysts can better identify potential red flags and assess the overall quality of a company’s financial reports.

That wraps up our lesson on Financial Reporting Quality Concepts. In our next lesson, we’ll discuss the accounting methods and estimates that can be used to manipulate earnings and the warning signs that analysts should be aware of.