Financial Reporting Quality Vs. Quality of Reported Results

Generally, analysts would always have access to financial reports that follow strong financial reporting standards, such as those issued by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB), and that are free from any manipulation. However, in reality, the quality of financial reports can vary significantly. High-quality financial reporting offers information that is valuable for analysts in evaluating a company’s performance and future prospects. In contrast, low-quality financial reporting may include incorrect, misleading, or incomplete information.

Financial Reporting Quality vs. Quality of Reported Results

Financial reporting quality, focuses on the reliability and usefulness of information provided in financial reports, including notes and disclosures. As such, high-quality financial reporting offers relevant information that accurately reflects the economic activities of a company during the reporting period, as well as its financial condition at the end of the period.

On the other hand, earnings quality pertains to the earnings and cash flow generated by the company’s actual economic activities and the resulting financial position.

More specifically, “earnings quality” is a term often used to describe the reliability and sustainability of earnings, cash flows, or balance sheet items. High-quality earnings are those generated from activities that are likely to continue in the future and that provide an adequate return on investment.

Earnings quality and financial reporting quality are closely linked because an accurate assessment of earnings quality requires a basic level of financial reporting quality. As financial reporting quality improves, the ability of users to accurately evaluate earnings quality and predict future performance also improves.

Consider the following table:

$$
\begin{array}{l|c|c}
& \text { Low Reporting} & \text { High Reporting Quality } \\&\text{Quality }&\text{Quality }\\
\hline \begin{array}{l}
\text { High Earning  } \\
\text {(Results) Quality }
\end{array} & \begin{array}{l}
\text { Low financial reporting } \\
\text { quality impedes } \\
\text { assessment of earnings } \\
\text { quality and impedes } \\
\text { valuation. }
\end{array} & \begin{array}{l}
\text { High financial reporting } \\
\text { quality enables assessment. } \\
\text { High earnings quality } \\
\text { increases company value. }
\end{array} \\
\hline \begin{array}{l}
\text { Low Earning} \\
\text { (Results) Quality }
\end{array} & \begin{array}{l}
\text { Low financial reporting } \\
\text { quality impedes } \\
\text { assessment of earnings } \\
\text { quality and impedes } \\
\text { valuation. }
\end{array} & \begin{array}{l}
\text { High financial reporting } \\
\text { quality enables assessment. } \\
\text { Low earnings quality } \\
\text { decreases company value. }
\end{array} \\
\end{array}
$$

High-quality financial reports provide information that is relevant, complete, neutral, and free from errors. In contrast, the lowest-quality reports may contain information that is entirely fabricated. The quality of earnings can also vary, ranging from high and sustainable to low and unsustainable. Resource providers typically prefer earnings that are both high in quality and sustainable.

When combining the measures of financial reporting quality and earnings quality, the overall quality of financial reports can be viewed on a continuum. This continuum spans from the highest quality reports, which offer high financial reporting quality and reflect high and sustainable earnings quality, to the lowest quality reports, which are not useful due to poor financial reporting quality.

Question 1

Information provided by low-quality earnings most likely pertains to:

1. Low earnings quality decreases company value.
2. High-quality financial reports contain information that is subjective and fabricated.
3. Financial reporting quality can range from high and sustainable to low and unsustainable.

Solution

The correct answer is A.

Low earnings quality decreases company value.

B is incorrect. Low-quality, not high-quality, financial reports contain subjective and fabricated information.

C is incorrect. It is earnings quality, not financial reporting quality, which can range from high and sustainable to low and unsustainable.

Question 2

To determine the quality of the information provided in the financial reports of a given company, an analyst should most likely examine:

1. The quality of earnings.
2. The quality of the financial reports.
3. Both the quality of the financial reports and the quality of earnings.

Solution

The correct answer is B.

To determine the quality of the information provided in the financial reports of a given company, an analyst should examine the quality of the financial reports. In addition, they should check the quality of earnings to verify the sustainability of the earnings.