Management Motivations for Low-quality Financial Reporting

Several reasons would lead a company’s management to issue low-quality financial reports. However, the prevalence of this practice is mitigated by the existence of a robust regulatory regime that disciplines financial reporting quality.

Management Motivations for Low-quality Financial Reporting

The main motivations behind the issuance of low-quality financial reports by company management include the following:

• Hiding poor performance, such as loss of market share or low profitability. This usually arises from:
  • The desire to meet or beat market expectations is reflected in analysts’ or management’s forecasts. Such forecasts usually lead to an increase in stock price and management compensation that is linked to stock or earnings performance; or
  • Concerns over career and incentive compensation. For example, a manager may be worried that a poorly performing company may limit his future career opportunities or that he may not receive a bonus based on exceeding an earnings target.
• Avoidance of debt covenant violations. This can make managers inflate earnings and is particularly important for highly leveraged and unprofitable companies.

The decision to issue low-quality financial reports ultimately lies in the hands of individuals. For these individuals, namely managers, to succeed, the conditions must be convenient.

Conducive Conditions for Issuing Low-quality Financial Reports

The issuance of low-quality financial reports is subject to three conditions.

These are:

1. Opportunity: this may be presented either by internal or external factors. Internal factors include poor internal controls or an ineffective board of directors. External conditions include the use of accounting standards that provide scope for divergent choices or minor consequences for making inappropriate choices.
2. Motivation: this can result from the pressure on a manager to meet specific criteria either for personal gratification, such as receipt of a bonus or for corporate reasons, such as concerns about future financing.
3. Rationalization: when concerned about whether a choice is correct, an individual will use rationalization to justify the choice to themselves.

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.