Biased choices result in financial reports that do not faithfully represent the economic substance of what is being reported. The problem with bias in financial reporting, as with other deficiencies in reporting quality, is that it impedes an investor’s ability to correctly assess a company’s past performance, to accurately forecast future performance, and thus to appropriately value the company.
Choices are deemed to be “aggressive” if they increase a company’s reported performance and financial position in the period under review. The choice can increase the amount of revenues, earnings, or operating cash flow reported for the period, or decrease expenses, or reduce the level of debt reported on the balance sheet. Aggressive choices may lead to a reduction in the company’s reported performance and in its financial position in later periods.
In contrast, choices are deemed “conservative” if they decrease a company’s performance and financial position in the reporting period. This can include lowering the reported revenues, earnings, or operating cash flow reported or increasing expenses, or recording a higher level of debt on the balance sheet. Conservative choices may lead to a rise in the company’s reported performance and financial position in later periods.
Another type of bias is understatement of earnings volatility, so-called earnings smoothing. Earnings smoothing can result from conservative choices to understate earnings in periods when a company’s operations are performing well, building up (often hidden) reserves that allow aggressive choices in periods when its operations are struggling.
Biased choices can be made not only in the context of reported amounts but also in the context of how information is presented. For example, companies can disclose information transparently, which facilitates analysis, or they can disclose it in a manner that aims to obscure unfavourable or emphasise favourable information.
Although choices exist within GAAP for the presentation of a desired economic picture, non-GAAP reporting adds yet another dimension of management discretion. Non-GAAP reporting of financial metrics not in compliance with generally accepted accounting principles, such as US GAAP and IFRS, includes both financial metrics and operating metrics.
Non-GAAP financial reporting has become increasingly common, presenting challenges to analysts. An important challenge is that non-GAAP financial reporting diminishes comparability across financial statements. The adjustments that companies make to create non-GAAP earnings.
