LM11 Financial Reporting Quality

Part 1

1. Introduction & Conceptual Overview

There are two main interrelated concepts that will be discussed in detail in this reading: financial reporting quality and earnings quality.

Financial reporting quality:  High-quality financial reporting provides information that is useful to analysts in assessing a company’s performance and prospects. They contain information that is relevant, complete, neutral, and free from error.

High-quality reporting helps in making the right decision as it depicts the true economic reality of a company for the reporting period. Low-quality financial reporting contains inaccurate, misleading, or incomplete information.

Earnings quality: 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. If the return on investment is greater than the cost of funds, then it indicates high earnings quality.

Sustainability is the key here. For example, assume a company uses accrual-based earnings in a quarter. It has high accounts receivable and as a result reports high earnings, which is not sustainable in the following quarters. This implies earnings quality is low.

2 – 4. Quality Spectrum of Financial Reports

Combining the two aspects – financial reporting quality and earnings quality, we get a spectrum spanning from highest to lowest. Let us now look at the characteristics of reporting/earnings quality as we move down along the spectrum as shown in the exhibit below.

1. Reporting is GAAP compliant and decision useful. The earnings are also sustainable and adequate.
2. Reporting is GAAP compliant and decision useful. However, earnings quality is low, i.e., the earnings are not sustainable or adequate.
3. Reporting is GAAP compliant, but the reporting choices and estimates used while preparing the reports are biased.
4. Reporting is GAAP compliant, but the amount of earnings is actively managed. The intent is to increase/decrease/smooth reported earnings.
5. Reporting is not GAAP compliant, although the reports are based on the company’s actual economic activities.
6. Reporting is not GAAP compliant and the reports contain numbers that are fictitious.

Non-GAAP reporting of financial metrics which is not in compliance with generally accepted accounting principles such as US GAAP and IFRS includes both financial metrics and operating metrics. Non-GAAP earnings are sometimes referred to as underlying earnings, adjusted earnings, recurring earnings, or core earnings.

5. Differentiate between Conservative and Aggressive Accounting

The choice of accounting methods used can distort the economic reality. Unbiased financial reporting is the ideal, but investors may prefer conservative accounting choices as a positive surprise is acceptable. Whereas the management may prefer aggressive accounting choices.

Aggressive accounting: It refers to biased accounting choices that aim to improve the reported earnings or financial position in the period under review.

Conservative accounting: It refers to biased accounting choices that aim to decrease the reported earnings or financial position in the reporting period.

Some managers use aggressive accounting when earnings are below targets and conservative accounting when earnings are above targets, to artificially smooth earnings.

When a company makes conservative choices, it implies that:

• revenue is recognized only when earned and when collections are reasonably certain.
• expenses/losses are recognized when probable.
• earnings will be understated in the current period.

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