If motivation exists, an analyst should consider whether the reporting environment is conducive to managers’ misreporting. It is important to consider mechanisms within the reporting environment that discipline financial reporting quality, such as the regulatory regime.
Motivations
Managers may be motivated to issue financial reports that are not high quality to mask poor performance, such as a loss of market share or lower profitability than competitors.
- Even when there is no need to mask poor performance, managers frequently have incentives to meet or beat market expectations as reflected in analysts’ forecasts or management’s own forecasts. Exceeding forecasts may increase the stock price, if only temporarily. Additionally, exceeding forecasts can increase management compensation that is linked to increases in stock price or to reported earnings.
- Career concerns and incentive compensation may motivate accounting choices.
Avoiding debt covenant violations can motivate managers to inflate earnings.
Conditions Conducive to Issuing Low-Quality Financial Reports
Three conditions exist when low-quality financial reports are issued: opportunity, pressure or motivation, and rationalisation—sometimes referred to as the fraud triangle.
Opportunity can be the result of internal conditions, such as poor internal controls or an ineffective board of directors, or external conditions, such as accounting standards that provide scope for divergent choices or minimal consequences for an inappropriate choice.
Motivation can result from pressure to meet some criteria for personal reasons, such as a bonus, or corporate reasons, such as concern about financing in the future.
Rationalisation is important because if a decision maker is concerned about a choice, that person needs to be able to justify it to him- or herself.
