Quality of Financial Reports

Financial Report Quality

The quality of financial reports can be viewed along two highly related dimensions: earnings quality and reporting quality. Reporting quality is an assessment of the information disclosed in the financial reports. High quality reporting provides decision useful information; information that is accurate as well as relevant.

Low quality reporting impedes assessment while high quality reporting enables it.

The term high - quality earnings refers to a high level of earnings (i.e., meets the required return on investment) as well as sustainability of earnings. Good economic performance and sustainable earnings are considered higher quality. Conversely, low quality earnings arise either due to genuinely bad performance or due to misrepresentation of economic performance.

Earnings quality is also referred to as results quality. High quality earnings increase the value of a company more than low quality earnings.

One cannot have both low quality reporting and high quality earnings; high quality earnings assume high quality reporting. However, one could have a situation in which the company has high quality reporting but low quality earnings. For example, a strike during the reporting period may have resulted in LIFO liquidation and, hence, given a one off boost (i.e., earnings have low persistence) to reported earnings.

However, the underlying reporting was accurate and decision useful.

The conceptual framework for assessing the quality of a company’s reports entails answering two questions:

1. Are the underlying financial reports GAAP compliant and decision useful?

2. Are the earnings of high quality?

For this discussion, GAAP is used in a generic sense and refers to either U.S. GAAP or IFRS.

Based on the answer to the previous two questions, the overall quality of financial reports can be classified along a continuum of high to low quality as shown in Figure 11.1.

Figure 11.1: Financial Reports Quality (High to Low)

1. GAAP compliant and decision useful, high quality earnings.
2. GAAP compliant and decision useful, low quality earnings.
3. GAAP compliant but not decision useful (biased choices).
4. Noncompliant accounting.
5. Fraudulent accounting.

Biased accounting provides information that hinders an analyst’s ability to generate accurate forecasts of the future performance of the company. Biased accounting can be aggressive (recognizing future revenues/earnings in the current period) or conservative (postponing current earnings to the future). A related bias is ‘earnings management’ (e.g., earnings smoothing).

Potential problems that affect the quality of financial reports may arise from:

Measurement and timing issues, and/or

Classification issues

Measurement and Timing Issues

Errors in measurement and/or timing typically affect multiple financial statement elements. For example, aggressive revenue recognition practices increase reported revenues, profits, equity, and assets. Similarly, omission or postponement of expense recognition would increase profits, equity, and assets.

Conversely, conservative revenue recognition practices reduce reported revenues, profits, equity, and assets.

Classification Issues

Classification issues refer to how an individual financial statement element is categorized within a particular financial statement (e.g., classification of expenses as operating vs. non operating in the income statement). While timing/measurement issues affect multiple financial statement elements, classification issues typically affect one element. Figure 11.2 provides some examples of classification issues and the effects of misclassification.

Figure 11.2: Examples of Misclassification

Biased Accounting

Biased accounting choices seek to further a specific agenda, to sell a story. Some examples of biased accounting choices and their related warning signs are shown next.

Mechanisms to misstate profitability:

Aggressive revenue recognition, including channel stuffing (aggressively selling products to distributors on generous terms such as lax return policies), bill and hold sales (where economic title to goods may not truly pass to customers), and outright fake sales. Lessor use of finance lease classification.

Classifying non operating revenue/income as operating, and operating expenses as non operating. Channeling gains through net income and losses through OCI.

Warnings signs of misstated profitability:

Revenue growth higher than peers’. Receivables growth higher than revenue growth.

High rate of customer returns. High proportion of revenue is received in final quarter.

Unexplained boost to operating margin. Operating cash flow lower than operating income. Inconsistency in operating versus non operating classification over time.

Aggressive accounting assumptions (e.g., high estimated useful lives). Executive compensation largely tied to financial results.

Mechanisms to misstate assets/liabilities:

Choosing inappropriate models and/or model inputs and thus affecting estimated values of financial statement elements (e.g., estimated useful lives for long lived assets). Reclassification from current to non current.

Over or understating allowances and reserves. Understating identifiable assets (and overstating goodwill) in acquisition method accounting for business combinations.

Warnings signs of misstated assets/liabilities:

Inconsistency in model inputs for valuation of assets versus valuation of liabilities. Typical current assets (e.g., inventory, receivables) being classified as non current.

Allowances and reserves differ from those of peers and fluctuate over time. High goodwill relative to total assets. Use of special purpose entities.

Large fluctuations in deferred tax assets/liabilities. Large off balance sheet liabilities.

Mechanisms to overstate operating cash flows:

Managing activities to affect cash flow from operations (e.g., stretching payables). Misclassifying investing cash flow as cash flow from operations.

Warnings signs of overstated operating cash flows:

Increase in payables combined with decreases in inventory and receivables. Capitalized expenditures (which flow through investing activities).

Increases in bank overdraft.

Business Combinations, Acquisition Method Accounting

Mergers and acquisitions often provide opportunities and motivations to manage financial results. For example, companies with declining operating cash flow may be motivated to acquire other cash generating entities to increase cash flow from operations. Cash acquisitions are reflected in cash flow from investing activities.

If acquisitions are paid for using stock, such a payment would bypass the cash flow statement altogether.

Stock acquisitions provide an incentive for the acquiring company management to pursue aggressive accounting so as to inflate their stock price prior to acquisition. Similarly, target company managers may also be motivated to inflate their firm’s stock price to fetch an attractive price at acquisition.

In some cases, misreporting is actually the impetus for acquisitions: acquiring company managers may pursue acquisitions to hide pre acquisition accounting irregularities. Such companies may acquire targets with dissimilar operations or with less publicly available information to reduce the comparability and consistency of their own financial statements.

At the time of acquisition, acquiring company must allocate the purchase price to fair value of identifiable net assets of the subsidiary and the balance to goodwill. Acquiring companies often underestimate the value of identifiable net assets, thereby overestimating goodwill on acquisition. Fair value adjustments for identifiable assets typically result in excess depreciation which reduces profits for future reporting periods.

Since goodwill is not amortized, the effect of overestimating goodwill (and underestimating the value of identifiable assets) is to increase future reported profits. Such inflated goodwill will eventually have to be written down as part of impairment testing but such losses can be timed. In addition, impairment losses can be downplayed as a one off, non recurring event.

GAAP Accounting but not Economic Reality

Sometimes, an accounting treatment may conform to reporting standards but, nonetheless, result in financial reporting that does not faithfully represent economic reality. For example, prior to mandatory consolidation requirements for variable interest entities under U.S. GAAP, Enron was able to avoid consolidation of various special purpose entities on technical grounds, thereby keeping large losses and liabilities off balance sheet.

Restructuring provisions and impairment losses provide opportunities to time the recognition of losses (i.e., earnings management). Typically, recognition of impairment or restructuring losses in a period reflects overstatement of income in prior periods. Conversely, impairment or restructuring provisions may be strategically timed to shift future expenses into the current period.

For example, impairment losses on long lived assets recognized in the current period will reduce future depreciation expense. Similarly, restructuring provisions allow managers to effectively set aside profits in the current period to be used in the future. Provisions are non cash expenses charged in the current period; future expenses from such provisions bypass the income statement.

In such cases, losses recognized in the current period will boost income in the future when reversed.