Financial Reporting Quality
Learning Outcomes
• Distinguish between financial reporting quality and quality of reported results (including quality
of earnings, cash flow, and balance sheet items)
• Describe a spectrum for assessing financial reporting quality
• Distinguish between conservative and aggressive accounting
• Describe motivations that might cause management to issue financial reports that are not high
quality
• Describe conditions that are conducive to issuing low-quality, or even fraudulent, financial reports
• Describe mechanisms that discipline financial reporting quality and the potential limitations of
those mechanisms
• Describe presentation choices, that could be used to influence an analyst’s opinion
• Describe accounting methods (choices and estimates) that could be used to manage earnings,
cash flow, and balance sheet items
• Describe accounting warning signs and methods for detecting manipulation of information in
financial reports
Introduction
• What is financial reporting quality?
• It pertains to the quality of information in financial reports, including
disclosures in notes.
• What are the attributes of high quality reporting?
• 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.
Relationship between financial reporting
quality and earnings quality
• Financial reporting quality and results or earnings quality are
interrelated attributes of quality
Quality Spectrum of Financial Reports
Decision-Useful, but Sustainable?
Excerpt from Toyota Motor Corporation’s Consolidated Financial Results for FY2014 First
Quarter Ending 30 June 2013
• Consolidated vehicle unit sales in Japan and overseas decreased by 37 thousand units, or
1.6%, to 2,232 thousand units in FY2014 first quarter (the three months ended June 30,
2013) compared with FY2013 first quarter (the three months ended June 30, 2012).
Vehicle unit sales in Japan decreased by 51 thousand units, or 8.8%, to 526 thousand
units in FY2014 first quarter compared with FY2013 first quarter. Meanwhile, overseas
vehicle unit sales increased by 14 thousand units, or 0.8%, to 1,706 thousand units in
FY2014 first quarter compared with FY2013 first quarter.
• As for the results of operations, net revenues increased by 753.7 billion yen, or 13.7%, to
6,255.3 billion yen in FY2014 first quarter compared with FY2013 first quarter, and
operating income increased by 310.2 billion yen, or 87.9%, to 663.3 billion yen in FY2014
first quarter compared with FY2013 first quarter. The factors contributing to an increase
in operating income were the effects of changes in exchange rates of 260.0 billion yen,
cost reduction efforts of 70.0 billion yen, marketing efforts of 30.0 billion yen and other
factors of 10.2 billion yen. On the other hand, the factors contributing to a decrease in
operating income were the increase in expenses and others of 60.0 billion yen.
Biased Accounting Choices
• What are biased accounting choices?
• Biased choices result in financial reports that do not faithfully represent
the economic substance of what is being reported.
• What is the problem with biased financial reporting?
• The problem with bias in financial reporting, as with other deficiencies in
reporting quality, is that it impedes an investor’s ability to correctly assess a
company’s past performance, to accurately forecast future performance,
and thus to appropriately value the company.
• What do you understand by aggressive financial reporting? What is the
consequence of aggressive or conservative financial reporting?
• What do you mean by earnings smoothing?
• What are different biased choices?
Caselet 1
Non-IFRS Reporting
• Non-IFRS reporting is being followed by many firms at management discretion.
• Non-IFRS reporting of financial metrics includes both financial metrics and
operating metrics
• 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.
• Non-GAAP financial reporting has become increasingly common, presenting
challenges to analysts.
• An important challenge is that non-GAAP financial reporting diminishes
comparability across financial statements. The adjustments that companies make
to create non-GAAP earnings, for example, are generally ad hoc and thus differ
significantly. When evaluating non-GAAP metrics, investors must decide the
extent to which specific adjustments should be incorporated into their analyses
and forecasts.
Caselet 2
Biased Accounting Choices
• Poor reporting quality occurs simultaneously with poor earnings quality, for
example, aggressive accounting choices are made to obscure poor performance.
• Is it possible for poor reporting quality to occur with high-quality earnings?
• What are some common examples of conservatism in accounting standards?
• Research costs: Because the future benefit of research costs is uncertain at the
time the costs are incurred, reporting standards require immediate expensing
instead of capitalization.
• Litigation losses: When it becomes “probable” that a cost will be incurred, IFRS
require expense recognition, even though a legal liability may not be incurred
until a future date.
• Insurance recoverable: 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.
Within Reporting Standards but “Earnings Management”
• The distinction between earnings management and biased choices is
subtle and, primarily, a matter of intent.
• What can be examples of earnings management?
• Because it is difficult to determine intent, we include earnings
management under the biased choices discussion.
Departures from Reporting Standards
• Financial reporting that departs from reporting standards can generally be
considered low quality.
• An example of improper accounting was Enron (accounting issues revealed
in 2001), whose inappropriate use of off-balance-sheet structures and
other complex transactions resulted in vastly understated indebtedness as
well as overstated profits and operating cash flow.
• Another notorious example of improper accounting was WorldCom
(accounting issues discovered in 2002), a company that by improperly
capitalizing certain expenditures dramatically understated its expenses and
thus overstated its profits.
• Both of these companies subsequently filed for bankruptcy.
Conditions Conducive to Issuing Low-Quality
Financial Reports
• Opportunity
• poor internal controls or an ineffective board of directors
• external conditions, such as accounting standards that provide scope for divergent
choices
• minimal consequences for an inappropriate choice.
• Motivation
• management compensation
• Career concerns
• equity market effects (for example, building credibility with market participants and
positively affecting stock price)
• trade effects (for example, enhancing reputation with customers and suppliers).
• Rationalization e.g., Enron
Enron
• Former Enron CFO Andrew Fastow, speaking at the 2013 Association
of Certified Fraud Examiners Annual Fraud Conference, indicated that
he knew at the time he was doing something wrong but followed
procedure to justify his decision (Pavlo, 2013). He made sure to get
management and board approval, as well as legal and accounting
opinions, and to include appropriate disclosures. The incentive and
corporate culture was to create earnings rather than focus on long-
term value. Clearly, as reflected in his prison sentence, he did
something that was not only wrong but illegal.
Mechanisms to Discipline Financial Reporting
Quality
• Registration requirements
• Disclosure requirements
• Auditing requirements
• Management commentaries
• Regulatory review of filings
• Enforcement mechanisms
How to increase performance in current
period?
• A manager that wants to increase performance and financial position in the
reporting period could:
• Recognize revenue prematurely;
• Defer expenses to later periods;
• Use non-recurring transactions to increase profits;
• Measure and report assets at higher values; and/or
• Measure and report liabilities at lower values.
• A manager that wants to increase performance and financial position in a
later period could:
• Defer current income to a later period (save income for a “rainy day”); and/or
• Recognize future expenses in a current period, setting the table for improving future
performance.
Accounting methods (choices and estimates) that
could be used to manage earnings, cash flow, and
balance sheet items
• Recognition of sales
• Choice of inventory method
• Depreciation method
• Capitalization practices e.g., Worldcom
• Goodwill reporting
• Relationship between cash flow and net income (Time series analysis)
Case of WorldCom Inc.,
• WorldCom Inc., a telecom concern that grew rapidly in the late 1990s.
Much of WorldCom’s financial reporting was eventually found to be
fraudulent. An important part of the misreporting centered on its
treatment of what is known in the telecom industry as “line costs”. These
are the costs of carrying a voice call or data transmission from its starting
point to its ending point, and they represented WorldCom’s largest
expense. WorldCom’s chief financial officer decided to capitalize such costs
instead of treating them as an operating expense. As a consequence, from
the second quarter of 1999 through the first quarter of 2002, WorldCom
increased its operating income by $7 billion. In three of the five quarters in
which the improper line cost capitalization took place, WorldCom would
have recognized pre-tax losses instead of profits
How choices affect the cash flow statement?
• Why cashflow statement is scrutinized by the investors?
• In practice, companies rarely use the direct method.
• They use the indirect method, which shows a reconciliation of net
income to cash provided by operations. The reconciliation shows the
non-cash items affecting net income along with changes in working
capital accounts affecting cash from operations
Example
Cash Flows from Operating Activities ($ millions) 2018
Net income $3,000
Adjustments to reconcile net income to net cash provided
by operating activities:
Provision for doubtful receivables 10
Provision for depreciation and amortization 1,000
Goodwill impairment charges 35
Share-based compensation expense 100
Provision for deferred income taxes 200
Changes in assets and liabilities:
Trade, notes and financing receivables related to sales (2,000)
Inventories (1,500)
Accounts payable 1,200
Accrued income taxes payable/receivable (80)
Retirement benefits 90
Other (250)
Net cash provided by operating activities $1,805
Areas where choices and estimates affect
financial reporting
• Revenue recognition
• How is revenue recognized: upon shipment or upon delivery of
goods?
• Is the company engaging in “channel stuffing”—the practice of
overloading a distribution channel with more product than it is
normally capable of selling?
• Is there unusual activity in the allowance for sales returns relative to
past history?
• Does the company use rebates as part of its marketing approach?
Areas where choices and estimates affect
financial reporting
• Long-lived assets: Depreciation policies
• Do the estimated life spans of the associated assets make sense, or
are they unusually low compared with others in the same industry?
• Have there been changes in depreciable lives that have a positive
effect on current earnings?
• Allowance for doubtful accounts/loan loss reserves
• Are additions to such allowances lower or higher than in the past?
• Does the collection experience justify any difference from historical
provisioning?
Other Warning signs
• Depreciation methods and useful lives
• Fourth-quarter surprises
• Presence of related-party transactions
• Classification of expenses as “non-recurring”
• Non-operating income or one-time sales included in revenue
• Gross/operating margins out of line with competitors or industry
• Management has adopted a minimalist approach to disclosure
• Management has a merger and acquisition orientation
