“GAAP, decision-useful, sustainable, and adequate returns,” are high-quality reports that provide useful information about high-quality earnings.
- High-quality financial reports conform to the generally accepted accounting principles (GAAP) of the jurisdiction, such as International Financial Reporting Standards (IFRS), US GAAP, or other home-country GAAP. The exhibit uses the term GAAP to refer generically to the accounting standards accepted in a company’s jurisdiction.
- In addition to conforming to GAAP, high-quality financial reports also embody the characteristics of decision-useful information, such as those defined in the Conceptual Framework. Recall that the fundamental characteristics of useful information are relevance and faithful representation. Relevant information is defined as information that can affect a decision and encompasses the notion of materiality. (Information is considered material if “omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity.”) Faithful representation of economic events is complete, neutral, and free from error.
The Conceptual Framework also enumerates enhancing characteristics of useful information: comparability, verifiability, timeliness, and understandability.
High-quality information results when these and other trade-offs are made in an unbiased, skillful manner.
- High-quality earnings indicate an adequate level of return on investment and derive from activities that a company likely will be able to sustain in the future. An adequate level of return on investment exceeds the cost of the investment and also equals or exceeds the expected return. Sustainable activities and sustainable earnings are those expected to recur in the future. Sustainable earnings that provide a high return on investment contribute to higher valuation of a company and its securities.
GAAP, Decision-Useful, but Sustainable?
“GAAP, decision-useful, but sustainable?” refers to circumstances in which high-quality reporting provides useful information, but that information reflects results or earnings that are not sustainable (lower earnings quality). The earnings may not be sustainable because the company cannot expect earnings that generate the same level of return on investment in the future or because the earnings, although replicable, will not generate sufficient return on investment to sustain the company. Earnings quality is low in both cases. Reporting can be high quality even when the economic reality being depicted is not of high quality.
