How Accounting Choices and Estimates Affect Earnings and Balance Sheets Assumptions about inventory cost flows provide another example of how accounting choices can affect financial reporting. Companies may assume that their purchases of inventory items are sold to customers on a first-in, first-out (FIFO) basis, with the result that the remaining inventory reflects the most…
An understanding of the choices that companies make in financial reporting is fundamental to evaluating the overall quality—both financial reporting and earnings quality—of the reports produced. Choices exist both in how information is presented (financial reporting quality) and in how financial results are calculated (earnings quality). Choices in presentation (financial reporting quality) may be transparent…
Market Regulatory Authorities Typical features of a regulatory regime that most directly affect financial reporting quality include the following: Auditors Audit opinions provide financial statement users with some assurance that the information complies with the relevant set of accounting standards and presents the company’s information fairly. Private Contracting Aspects of private contracts, such as loan…
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…
Some investors may prefer or be perceived to prefer conservative rather than aggressive accounting choices, because a positive surprise is acceptable. In contrast, management may make, or be perceived to make, aggressive accounting choices because they increase the company’s reported performance and financial position. Aggressive accounting choices in the period under review may decrease the…
Financial reporting that departs from GAAP generally can be considered to be low quality. In such situations, earnings quality is likely difficult or impossible to assess because comparisons with earlier periods and/or other entities cannot be made. At the bottom of the quality spectrum, fabricated reports portray fictitious events, either to deceive investors by misrepresenting…
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…
“GAAP, decision-useful, sustainable, and adequate returns,” are high-quality reports that provide useful information about high-quality earnings. 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. GAAP, Decision-Useful, but Sustainable? “GAAP, decision-useful, but sustainable?” refers to circumstances…
Ideally, analysts would always have access to financial reports that are based on sound financial reporting standards, such as those from the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB), and that are free from manipulation. But, in practice, the quality of financial reports can vary greatly. High-quality financial reporting provides…
Differences in tax rates can be an important driver of value. Generally, three types of tax rates are relevant to analysts: Differences between the statutory tax rate and the effective tax rate can arise for many reasons. Tax credits, withholding tax on dividends, adjustments to previous years, and expenses not deductible for tax purposes are…