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Financial Reporting Quality

7 important questions on Financial Reporting Quality

Financial reporting quality adheres to two things

- Generally accepted accounting principles (GAAP)
- decision useful in terms of relevance (info is useful in terms of amount) and faithful representation (neutral, complete and free from error.

Quality of reported earnings adhere to two things

- high enough to provide the firm’s investors with an adequate return
- are sustainable in future periods.

A spectrum for assessing financial reporting quality considers both the quality of a irm’s inancial statements and the quality of its earnings. One such spectrum, from highest quality to lowest, is the following: 6 in total

- 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.

Biased accounting choices that can be made within GAAP include conservative and aggressive accounting, explain both:

- 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 artiicially smooth earnings.

Why manipulate financial reports (3 things)?

Opportunity = The system is weak enough, management can manipulate without being stopped. (weak internal controls)

Motivation = pressure to meet or exceed earnings targets, career considerations, increasing their compensation,

Rationalization: Most people who do something they know is wrong tell themselves a story that seems (at least to them) to justify breaking the rules. Whether the story is “I’ll ix it next period” or “I have to do it to get my bonus and pay for my parents’ care,” the resulting behavior is the same.

Mechanisms that help to discipline financial reporting quality (three things)

- regulation = Regulators typically require public companies to provide periodic inancial statements and notes, including management commentary, and obtain independent audits.

- auditing = A clean audit opinion offers reasonable assurance that inancial statements are free from material errors but does not guarantee the absence of error or fraud. The fact that irms select and pay their auditors may limit the effectiveness of auditing to discipline inancial reporting quality.

- Private contracts = Lenders as watchdogs, show me clean numbers and you can lend money

What does IFRS do to tackle: Firms may attempt to inluence 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.

The question on the page originate from the summary of the following study material: