Financial Reporting Quality

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2024 Curriculum CFA Program Level I Financial Reporting and Analysis

Two ways to enjoy this Refresher Reading

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Introduction

Ideally, analysts would always have access to financial reports that are based on sound financial reporting standards, such as those from the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB), and are free from manipulation. But, in practice, the quality of financial reports can vary greatly. High-quality financial reporting provides information that is useful to analysts in assessing a company’s performance and prospects. Low-quality financial reporting contains inaccurate, misleading, or incomplete information.

Extreme lapses in financial reporting quality have given rise to high-profile scandals that resulted not only in investor losses but also in reduced confidence in the financial system. Financial statement users who were able to accurately assess financial reporting quality were better positioned to avoid losses. These lapses illustrate the challenges analysts face as well as the potential costs of failing to recognize practices that result in misleading or inaccurate financial reports. Examples of misreporting can provide an analyst with insight into various signals that may indicate poor-quality financial reports.

This reading addresses financial reporting quality, which pertains to the quality of information in financial reports, including disclosures in notes. High-quality reporting provides decision-useful information, which is relevant and faithfully represents the economic reality of the company’s activities during the reporting period as well as the company’s financial condition at the end of the period. A separate but interrelated attribute of quality is quality of reported results or earnings quality, which pertains to the earnings and cash generated by the company’s actual economic activities and the resulting financial condition. The term “earnings quality” is commonly used in practice and will be used broadly to encompass the quality of earnings, cash flow, and/or balance sheet items. High-quality earnings result from activities that a company will likely be able to sustain in the future and provide a sufficient return on the company’s investment. The concepts of earnings quality and financial reporting quality are interrelated because a correct assessment of earnings quality is possible only when there is some basic level of financial reporting quality. Beyond this basic level, as the quality of reporting increases, the ability of financial statement users to correctly assess earnings quality and to develop expectations for future performance arguably also increases.

Section 2 provides a conceptual overview of reporting quality. Section 3 discusses motivations that might cause, and conditions that might enable, management to issue financial reports that are not high quality and mechanisms that aim to provide discipline to financial reporting quality. Section 4 describes choices made by management that can affect financial reporting quality—presentation choices, accounting methods, and estimates—as well as warning signs of poor-quality financial reporting.

Learning Outcomes

The member should be able to:

1. distinguish between financial reporting quality and quality of reported results (including quality of earnings, cash flow, and balance sheet items);
2. describe a spectrum for assessing financial reporting quality;
3. distinguish between conservative and aggressive accounting;
4. describe motivations that might cause management to issue financial reports that are not high quality;
5. describe conditions that are conducive to issuing low-quality, or even fraudulent, financial reports;
6. describe mechanisms that discipline financial reporting quality and the potential limitations of those mechanisms;
7. describe presentation choices, including non-GAAP measures, that could be used to influence an analyst’s opinion;
8. describe accounting methods (choices and estimates) that could be used to manage earnings, cash flow, and balance sheet items;
9. describe accounting warning signs and methods for detecting manipulation of information in financial reports.

Summary

Financial reporting quality varies across companies. The ability to assess the quality of a company’s financial reporting is an important skill for analysts. Indications of low-quality financial reporting can prompt an analyst to maintain heightened skepticism when reading a company’s reports, to review disclosures critically when undertaking financial statement analysis, and to incorporate appropriate adjustments in assessments of past performance and forecasts of future performance.

• Financial reporting quality can be thought of as spanning a continuum from the highest (containing information that is relevant, correct, complete, and unbiased) to the lowest (containing information that is not just biased or incomplete but possibly pure fabrication).
• Reporting quality, the focus of this reading, pertains to the information disclosed. High-quality reporting represents the economic reality of the company’s activities during the reporting period and the company’s financial condition at the end of the period.
• Results quality (commonly referred to as earnings quality) pertains to the earnings and cash generated by the company’s actual economic activities and the resulting financial condition, relative to expectations of current and future financial performance. Quality earnings are regarded as being sustainable, providing a sound platform for forecasts.
• An aspect of financial reporting quality is the degree to which accounting choices are conservative or aggressive. “Aggressive” typically refers to choices that aim to enhance the company’s reported performance and financial position by inflating the amount of revenues, earnings, and/or operating cash flow reported in the period; or by decreasing expenses for the period and/or the amount of debt reported on the balance sheet.
• Conservatism in financial reports can result from either (1) accounting standards that specifically require a conservative treatment of a transaction or an event or (2) judgments made by managers when applying accounting standards that result in conservative results.
• Managers may be motivated to issue less-than-high-quality financial reports in order to mask poor performance, to boost the stock price, to increase personal compensation, and/or to avoid violation of debt covenants.
• Conditions that are conducive to the issuance of low-quality financial reports include a cultural environment that result in fewer or less transparent financial disclosures, book/tax conformity that shifts emphasis toward legal compliance and away from fair presentation, and limited capital markets regulation.
• Mechanisms that discipline financial reporting quality include the free market and incentives for companies to minimize cost of capital, auditors, contract provisions specifically tailored to penalize misreporting, and enforcement by regulatory entities.
• Pro forma earnings (also commonly referred to as non-GAAP or non-IFRS earnings) adjust earnings as reported on the income statement. Pro forma earnings that exclude negative items are a hallmark of aggressive presentation choices.
• Companies are required to make additional disclosures when presenting any non-GAAP or non-IFRS metric.
• Managers’ considerable flexibility in choosing their companies’ accounting policies and in formulating estimates provides opportunities for aggressive accounting.
• Examples of accounting choices that affect earnings and balance sheets include inventory cost flow assumptions, estimates of uncollectible accounts receivable, estimated realizability of deferred tax assets, depreciation method, estimated salvage value of depreciable assets, and estimated useful life of depreciable assets.
• Cash from operations is a metric of interest to investors that can be enhanced by operating choices, such as stretching accounts payable, and potentially by classification choices.