Reading 32: Financial Reporting Quality (Manipulative accounting methods…
Reading 32: Financial Reporting Quality
Financial Reporting Quality vs. Quality of Reported Results
Financial Reporting Quality
The characteristics of a Financial Statement.
High-quality financial reporting adheres to GAAP and is useful in term of relevance and faithful representation.
Financial Reporting Quality Spectrum
(regarding FS quality and Earnings quality)
Highest: Reporting is compliant with GAAP and decision-useful; earnings are sustainable and adequate.
Reporting is compliant and decision-useful, but earning quality is low
Reporting is compliant; but reporting choices and estimates are biased; earning quality is low
Reporting is compliant; but earnings are actively manipulated
Reporting is not compliant, but numbers presented are based on actual economic activities
Quality of Reported Results
The level and sustainability of a firm's earnings, cash flows and balance sheet items.
High-quality earnings are high enough to provide the firm's investor with adequate return and are sustainable in the future period.
Conservative vs. Agressive Accounting
Tend to decrease a company's reported earnings and financial position for current period.
Tend to increase reported earnings or financial position for the current period.
Some managers employ conservative accounting during high-earning period and aggressive accounting during low-earning period to artificially smooth earnings.
Pressure to meet or exceed earning targets.
Improve perception for the firm in public
Meet the terms of debt covenant.
Conditions that encouraging low-quality report
Weak internal control
Wide ranges of acceptable accounting treatment
Financial Reporting Quality Discipline mechanism
Companies are required to provide periodic financial statement & notes, MM&A, and obtain independent audit
Clean Audit opinion offer assurance that FS are free from material errors but DOES NOT GUARANTEE there is no error or fraud.
Non-GAAP Presentation Choices
Can be used to attempt to influence analyst's opinion
IFRS requires firms to define and explain any non-GAAP measures and reconcile them with the most comparable IFRS measures.
Manipulative accounting methods
Revenue recognition choices, such as shipping terms, accelerating shipments, bill-and-hold transactions.
Estimates of reserves for uncollectible account or warranty expenses
Depreciation methods, estimates of useful lives and salvage values and recognition of impairments.
Valuation allowance on deferred tax assets
Inventory cost flow methods
Capitalization of expense
Accounting warning signs & Manipulation Detecting Methods
Accounting warning signs
Revenue growth out of line with comparable firms; changes in revenue recognition methods, lack of transparency about revenue recognition.
Decrease overtime in turnover ratios (inventory, receivables, total assets, etc.)
Bill-and-hold, barter, or related party transaction
Net income not supported by CFO
Capitalization decisions, depreciation methods, useful lives, salvage value out of lines with comparable firms
Forth-quarter earning pattern not caused by seasonality
Frequent appearance of non-recurring items
Emphasis on non-GAAP measures, minima information and disclosure in Financial Report.