Motivations to Issue Low-quality Financial Reports

Several reasons would lead a company’s management to issue low-quality financial reports. The prevalence of this practice is, however, 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 managements 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 as reflected in analysts’ forecasts and/or management’s own 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.

Question 1

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

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 cost of sales, in order to hide poor financial performance.

Options A and B are factors that 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 being 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.