Quality of Financial Reports and Earnings

Financial reporting quality relates to the quality of the information that is contained in financial reports, including note disclosures. High-quality reporting provides relevant, decision-useful information, which objectively represents the economic reality of a company’s activities during the reporting period. Further, high-quality reporting captures a company’s financial condition at the end of the reporting period.

Quality of reported results or earnings quality relates to the earnings and cash generated by a company’s actual economic activities and the resulting financial condition. High-quality earnings result from activities that a company will likely be able to sustain in the future and which will plow back adequate returns on the company’s investment.

Financial Reporting Quality vs. Quality of Reported Results

Financial reporting quality and earnings quality are interrelated attributes of quality. They arise from the fact that a correct assessment of earnings quality is possible only when there is at least a basic level of financial reporting quality. As the quality of reporting increases, the ability of users of financial statements to correctly assess earnings quality and subsequently develop future performance expectations will most likely also increase.

Financial Reporting Quality

Financial reporting quality can vary significantly across companies. High-quality reports will contain information that is relevant, complete, neutral, and accurate, thereby enabling assessment. The lowest-quality reports will, however, contain information that is subjective and fabricated.

When financial reporting quality is low, valuations and assessment earnings quality are compromised. Consequently, the information provided will not be useful in the assessment of a company’s performance. By and large, this hurts the investment-related decisions a company makes.

Earnings Quality

Earnings quality can range from high and sustainable to low and unsustainable. Providers of resources however prefer high and sustainable earnings.

High earnings quality increases a company’s value, while low earnings quality decreases company value.

Question 1

Information provided by a low-quality earnings quality 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 information that is subjective and fabricated.

C is incorrect. It is earnings quality, and 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.