CHAPTER 11
Financial Reporting Quality

Learning Outcomes

After completing this chapter, you will be able to do the following:

• 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 determine financial reporting quality and the potential limitations of those mechanisms;
• describe presentation choices, including non-GAAP measures, 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.

Summary Overview

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 chapter, 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.

Problems

1. In contrast to earnings quality, financial reporting quality most likely pertains to:
   1. sustainable earnings.
   2. relevant information.
   3. adequate return on investment.
2. The information provided by a low-quality financial report will most likely:
   1. decrease company value.
   2. indicate earnings are not sustainable.
   3. impede the assessment of earnings quality.
3. To properly assess a company’s past performance, an analyst requires:
   1. high earnings quality.
   2. high financial reporting quality.
   3. both high earnings quality and high financial reporting quality.
4. Low quality earnings most likely reflect:
   1. low-quality financial reporting.
   2. company activities which are unsustainable.
   3. information that does not faithfully represent company activities.
5. Earnings that result from non-recurring activities most likely indicate:
   1. lower-quality earnings.
   2. biased accounting choices.
   3. lower-quality financial reporting.
6. Which attribute of financial reports would most likely be evaluated as optimal in the financial reporting spectrum?
   1. Conservative accounting choices
   2. Sustainable and adequate returns
   3. Emphasized pro forma earnings measures
7. Financial reports of the lowest level of quality reflect:
   1. fictitious events.
   2. biased accounting choices.
   3. accounting that is non-compliant with GAAP.
8. When earnings are increased by deferring research and development (R&D) investments until the next reporting period, this choice is considered:
   1. non-compliant accounting.
   2. earnings management as a result of a real action.
   3. earnings management as a result of an accounting choice.
9. A high-quality financial report may reflect:
   1. earnings smoothing.
   2. low earnings quality.
   3. understatement of asset impairment.
10. If a particular accounting choice is considered aggressive in nature, then the financial performance for the reporting period would most likely:
    1. be neutral.
    2. exhibit an upward bias.
    3. exhibit a downward bias.
11. Which of the following is most likely to reflect conservative accounting choices?
    1. Decreased reported earnings in later periods
    2. Increased reported earnings in the period under review
    3. Increased debt reported on the balance sheet at the end of the current period
12. Which of the following is most likely to be considered a potential benefit of accounting conservatism?
    1. A reduction in litigation costs
    2. Less biased financial reporting
    3. An increase in current period reported performance
13. Which of the following statements most likely describes a situation that would motivate a manager to issue low-quality financial reports?
    1. The manager’s compensation is tied to stock price performance.
    2. The manager has increased the market share of products significantly.
    3. The manager has brought the company’s profitability to a level higher than competitors.
14. Which of the following concerns would most likely motivate a manager to make conservative accounting choices?
    1. Attention to future career opportunities
    2. Expected weakening in the business environment
    3. Debt covenant violation risk in the current period
15. Which of the following conditions best explains why a company’s manager would obtain legal, accounting, and board level approval prior to issuing low-quality financial reports?
    1. Motivation
    2. Opportunity
    3. Rationalization
16. A company is experiencing a period of strong financial performance. In order to increase the likelihood of exceeding analysts’ earnings forecasts in the next reporting period, the company would most likely undertake accounting choices for the period under review that:
    1. inflate reported revenue.
    2. delay expense recognition.
    3. accelerate expense recognition.
17. Which of the following situations represents a motivation, rather than an opportunity, to issue low-quality financial reports?
    1. Poor internal controls
    2. Search for a personal bonus
    3. Inattentive board of directors
18. Which of the following situations will most likely motivate managers to inflate reported earnings?
    1. Possibility of bond covenant violation
    2. Earnings in excess of analysts’ forecasts
    3. Earnings that are greater than the previous year
19. Which of the following best describes an opportunity for management to issue low-quality financial reports?
    1. Ineffective board of directors
    2. Pressure to achieve some performance level
    3. Corporate concerns about financing in the future
20. An audit opinion of a company’s financial reports is most likely intended to:
    1. detect fraud.
    2. reveal misstatements.
    3. assure that financial information is presented fairly.
21. If a company uses a non-GAAP financial measure in an SEC filing, then the company must:
    1. give more prominence to the non-GAAP measure if it is used in earnings releases.
    2. provide a reconciliation of the non-GAAP measure and equivalent GAAP measure.
    3. exclude charges requiring cash settlement from any non-GAAP liquidity measures.
22. A company wishing to increase earnings in the reporting period may choose to:
    1. decrease the useful life of depreciable assets.
    2. lower estimates of uncollectible accounts receivables.
    3. classify a purchase as an expense rather than a capital expenditure.
23. Bias in revenue recognition would least likely be suspected if:
    1. the firm engages in barter transactions.
    2. reported revenue is higher than the previous quarter.
    3. revenue is recognized before goods are shipped to customers.
24. Which technique most likely increases the cash flow provided by operations?
    1. Stretching the accounts payable credit period
    2. Applying all non-cash discount amortization against interest capitalized
    3. Shifting classification of interest paid from financing to operating cash flows
25. Which of the following is an indication that a company may be recognizing revenue prematurely? Relative to its competitors, the company’s:
    1. asset turnover is decreasing.
    2. receivables turnover is increasing.
    3. days sales outstanding is increasing.
26. Which of the following would most likely signal that a company may be using aggressive accrual accounting policies to shift current expenses to later periods? Over the last five-year period, the ratio of cash flow to net income has:
    1. increased each year.
    2. decreased each year.
    3. fluctuated from year to year.
27. An analyst reviewing a firm with a large reported restructuring charge to earnings should:
    1. view expenses reported in prior years as overstated.
    2. disregard it because it is solely related to past events.
    3. consider making pro forma adjustments to prior years’ earnings.