Management Motivations for Low-quality Financial Reporting

When evaluating the quality of financial reports, it’s crucial to consider whether company managers might be motivated to issue reports that are not of high quality. If such motivations exist, analysts should assess whether the reporting environment supports or disciplines potential misreporting, taking into account mechanisms like the regulatory regime.

Motivations for Might Cause Management to Issue Financial
Reports that are not High quality

Managers may be driven to issue low-quality financial reports to due to the following reasons:

• Meeting Market Expectations: Managers often have incentives to meet or exceed market expectations, such as analysts’ forecasts, even without poor performance. Achieving these benchmarks can temporarily boost stock prices and enhance management compensation linked to stock price or reported earnings.
• Career Concerns and Incentive Compensation: Managers might be motivated by concerns about their future career opportunities or receiving bonuses tied to earnings targets. This can lead to accounting choices aimed at increasing earnings, such as accelerating revenue recognition or delaying expenses. Conversely, in strong performance periods, managers might delay revenues or accelerate expenses to “bank” earnings for future periods.
• Avoiding Debt Covenant Violations: Highly leveraged and unprofitable companies might inflate earnings to avoid violating debt covenants. However, overall, this motivation is less significant compared to others.

Conducive Conditions for Issuing Low-quality Financial Reports

Low-quality financial reporting can result from management choices or the financial reporting standards of a jurisdiction. Ultimately, the decision to issue low-quality or fraudulent reports lies with individuals. Understanding why individuals make such choices isn’t always straightforward.

Three conditions typically exist when low-quality financial reports are issued: opportunity, pressure or motivation, and rationalization, known as the fraud triangle.

• Opportunity. This can arise from internal conditions like poor internal controls, an ineffective board, or external conditions like accounting standards that allow divergent choices or have minimal consequences for inappropriate choices.
• Pressure or Motivation. This can come from personal incentives like bonuses or corporate needs like future financing concerns.
• Rationalization. It plays a crucial role in decision-making because if a decision-maker feels uneasy about a choice, they need to find a way to justify it to themselves. For instance, while aware of his wrongdoing, former Enron CFO Andrew Fastow followed procedures to justify his decisions by seeking management and board approval, legal and accounting opinions, and including appropriate disclosures. His actions, driven by incentives and corporate culture focused on short-term earnings rather than long-term value, ultimately led to legal consequences.

Question #1

Which of the following is least likely a motivating factor behind managers’ decision to deliberately issue low-quality financial reports?

1. The desire to get higher compensation.
2. The desire to avoid violating debt covenants.
3. The desire to report poor financial performance.

Solution

The correct answer is C.

Managers will issue financial reports of poor quality, i.e., increase revenues or reduce the cost of sales, to hide poor financial performance.

A and B are incorrect. They motivate managers to issue low-quality financial reports.

Question #2

A possible motivation for a manager to issue low-quality financial reports could be:

1. The manager’s poor administrative skills.
2. The manager’s compensation is tied to stock price performance.
3. The manager’s willingness to increase the market share of products significantly.

Solution

The correct answer is B.

Tying a manager’s cash compensation to the company’s earnings will motivate them to issue low-quality financial reports.