When financial reporting and earnings quality are combined, the overall quality of financial reports from a user’s perspective may be viewed as spanning a continuum from the highest to the lowest point.
Financial Reporting Quality Spectrum
A quality spectrum provides a basis for evaluating quality reports. It ranges from reports that are of high financial reporting quality and reflect high and sustainable earnings quality to reports that are not useful due to poor financial reporting quality.
- GAAP decision-useful, sustainable, and adequate returns: this first level consists of high-quality reports that provide useful information about high-quality earnings.
- High-quality financial reports conform to the GAAP of the country (i.e., IFRS, US GAAP, or other home countries GAAP), and embody the characteristics of decision-useful information such as relevance and objective representation.
- High-quality earnings indicate that there is an adequate level of investment return. They are derived from activities that a company will likely be able to sustain in future. Sustainable activities and earnings are those that are expected to recur in future.
- GAAP, decision-useful, but not sustainable; low earnings quality: this second level refers to circumstances in which high-quality reporting provides useful information which reflects results or earnings that are not sustainable and indicative of lower earnings quality.
- Within GAAP, but biased choices: biased choices give rise to financial reports which do not objectively represent economic phenomena. This impedes an investor’s ability to correctly assess a company’s past performance, accurately predict its future performance, and appropriately value it.
- Aggressive choices increase a company’s reported performance and financial position in the current period. They may, nevertheless, become counterproductive and decrease a company’s reported performance and financial position in later periods.
- Conservative choices decrease a company’s reported performance and financial position in the current period but may increase them in later periods.
- ‘Earnings smoothing’ refers to an understatement of earnings volatility. It may result from conservative choices made to understate earnings in periods when a company’s operations are performing well, and aggressive choices in periods when the company’s operations are struggling.
- Within GAAP, but earnings management: in this context, “earnings management” refers to the act of making intentional choices that create biased financial reports. Earnings can be “managed” upwards by taking real actions such as deferring expenses or by making accounting choices such as changing accounting estimates.
- Non-compliant accounting: financial reporting which departs from GAAP can generally be considered low quality. In cases of non-compliance, earnings quality is usually difficult or impossible to assess because no comparison can be made with earlier periods and/or other entities.
- Fictitious transactions: in this case, a company displays fictitious transactions in fabricated reports at the bottom level of the quality spectrum . The inspiration behind this move is to fraudulently obtain investments by misrepresenting performance and/or to obscure fraudulent misappropriation of company assets.
Which of the following statements is the most accurate?
- It is possible for fictitious transactions to be compliant with GAAP.
- Financial reporting which departs from GAAP are generally considered low quality.
- ‘GAAP decision-useful, sustainable, and adequate returns’ reflect results that are unsustainable and indicative of lower earnings quality.
The correct answer is B.
Financial reporting which departs from GAAP is generally considered low quality.
A is incorrect because fictitious transactions are fraudulent and not in any way compliant with GAAP.
C is incorrect because it is the level of ‘GAAP, decision-useful, but not sustainable; low earnings quality’ that the description refers to and not ‘GAAP decision-useful, sustainable, and adequate returns.’
At the highest spectrum of the financial reporting quality, we find earnings that most likely:
- Are compliant with GAAP.
- Use aggressive accounting choices.
- CUse conservative accounting choices.
The correct answer is A.
High-quality financial reporting is compliant with Generally Accepted Accounting Principles (GAAP). It does not show biased accounting choices such as aggressive and conservative accounting choices.