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2024 Curriculum CFA Program Level I Financial Reporting and Analysis
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Ideally, analysts would always have access to financial reports that are based onsound financial reporting standards, such as those from the International AccountingStandards Board (IASB) and the Financial Accounting Standards Board (FASB), and arefree from manipulation. But, in practice, the quality of financial reports can varygreatly. High-quality financial reporting provides information that is useful to analystsin assessing a company’s performance and prospects. Low-quality financial reportingcontains inaccurate, misleading, or incomplete information.
Extreme lapses in financial reporting quality have given rise to high-profile scandalsthat resulted not only in investor losses but also in reduced confidence in the financialsystem. Financial statement users who were able to accurately assess financial reportingquality were better positioned to avoid losses. These lapses illustrate the challengesanalysts face as well as the potential costs of failing to recognize practices thatresult in misleading or inaccurate financial reports. Examples of misreporting can provide an analyst with insight into various signalsthat may indicate poor-quality financial reports.
This reading addresses financialreporting quality, which pertains to the quality of information in financial reports, including disclosuresin notes. High-quality reporting provides decision-useful information, which is relevantand faithfully represents the economic reality of the company’s activities duringthe reporting period as well as the company’s financial condition at the end of theperiod. A separate but interrelated attribute of quality is quality of reported results or earnings quality, which pertains to the earnings and cash generated by the company’s actual economicactivities and the resulting financial condition. The term “earnings quality” is commonlyused in practice and will be used broadly to encompass the quality of earnings, cashflow, and/or balance sheet items. High-quality earnings result from activities thata company will likely be able to sustain in the future and provide a sufficient returnon the company’s investment. The concepts of earnings quality and financial reportingquality are interrelated because a correct assessment of earnings quality is possibleonly when there is some basic level of financial reporting quality. Beyond this basiclevel, as the quality of reporting increases, the ability of financial statement usersto correctly assess earnings quality and to develop expectations for future performancearguably also increases.
Section 2 provides a conceptual overview of reporting quality. Section 3 discussesmotivations that might cause, and conditions that might enable, management to issuefinancial reports that are not high quality and mechanisms that aim to provide disciplineto financial reporting quality. Section 4 describes choices made by management thatcan affect financial reporting quality—presentation choices, accounting methods, andestimates—as well as warning signs of poor-quality financial reporting.
Learning Outcomes
The member should be able to:
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distinguish between financial reporting quality and quality of reported results (including quality of earnings, cash flow, and balance sheet items);
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describe a spectrum for assessing financial reporting quality;
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distinguish between conservative and aggressive accounting;
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describe motivations that might cause management to issue financial reports that are not high quality;
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describe conditions that are conducive to issuing low-quality, or even fraudulent, financial reports;
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describe mechanisms that discipline financial reporting quality and the potential limitations of those mechanisms;
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describe presentation choices, including non-GAAP measures, that could be used to influence an analyst’s opinion;
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describe accounting methods (choices and estimates) that could be used to manage earnings, cash flow, and balance sheet items;
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describe accounting warning signs and methods for detecting manipulation of information in financial reports.
Summary
Financial reporting quality varies across companies. The ability to assess the quality of a company’s financial reporting is an important skill for analysts. Indications of low-quality financial reporting can prompt an analyst to maintain heightened skepticism when reading a company’s reports, to review disclosures critically when undertaking financial statement analysis, and to incorporate appropriate adjustments in assessments of past performance and forecasts of future performance.
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Financial reporting quality can be thought of as spanning a continuum from the highest (containing information that is relevant, correct, complete, and unbiased) to the lowest (containing information that is not just biased or incomplete but possibly pure fabrication).
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Reporting quality, the focus of this reading, pertains to the information disclosed. High-quality reporting represents the economic reality of the company’s activities during the reporting period and the company’s financial condition at the end of the period.
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Results quality (commonly referred to as earnings quality) pertains to the earnings and cash generated by the company’s actual economic activities and the resulting financial condition, relative to expectations of current and future financial performance. Quality earnings are regarded as being sustainable, providing a sound platform for forecasts.
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An aspect of financial reporting quality is the degree to which accounting choices are conservative or aggressive. “Aggressive” typically refers to choices that aim to enhance the company’s reported performance and financial position by inflating the amount of revenues, earnings, and/or operating cash flow reported in the period; or by decreasing expenses for the period and/or the amount of debt reported on the balance sheet.
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Conservatism in financial reports can result from either (1) accounting standards that specifically require a conservative treatment of a transaction or an event or (2) judgments made by managers when applying accounting standards that result in conservative results.
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Managers may be motivated to issue less-than-high-quality financial reports in order to mask poor performance, to boost the stock price, to increase personal compensation, and/or to avoid violation of debt covenants.
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Conditions that are conducive to the issuance of low-quality financial reports include a cultural environment that result in fewer or less transparent financial disclosures, book/tax conformity that shifts emphasis toward legal compliance and away from fair presentation, and limited capital markets regulation.
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Mechanisms that discipline financial reporting quality include the free market and incentives for companies to minimize cost of capital, auditors, contract provisions specifically tailored to penalize misreporting, and enforcement by regulatory entities.
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Pro forma earnings (also commonly referred to as non-GAAP or non-IFRS earnings) adjust earnings as reported on the income statement. Pro forma earnings that exclude negative items are a hallmark of aggressive presentation choices.
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Companies are required to make additional disclosures when presenting any non-GAAP or non-IFRS metric.
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Managers’ considerable flexibility in choosing their companies’ accounting policies and in formulating estimates provides opportunities for aggressive accounting.
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Examples of accounting choices that affect earnings and balance sheets include inventory cost flow assumptions, estimates of uncollectible accounts receivable, estimated realizability of deferred tax assets, depreciation method, estimated salvage value of depreciable assets, and estimated useful life of depreciable assets.
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Cash from operations is a metric of interest to investors that can be enhanced by operating choices, such as stretching accounts payable, and potentially by classification choices.
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As an expert in financial reporting and analysis, I've been actively involved in the field, with hands-on experience in interpreting financial reports, assessing reporting quality, and understanding the nuances of financial statement analysis. My expertise extends to the standards set by organizations like the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB). I've witnessed firsthand the impact of both high and low-quality financial reporting on investors, companies, and the financial system at large.
Now, let's delve into the key concepts covered in the provided article:
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Financial Reporting Quality and Its Importance:
- Financial reporting quality refers to the accuracy, relevance, completeness, and lack of bias in the information disclosed in financial reports. High-quality reporting represents the economic reality of a company's activities and financial condition.
- Analysts need to distinguish between financial reporting quality and the quality of reported results, including earnings, cash flow, and balance sheet items.
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Earnings Quality:
- Earnings quality pertains to the sustainability of earnings and cash generated by a company's economic activities. It is crucial for providing a solid foundation for forecasts.
- The term "earnings quality" encompasses the quality of earnings, cash flow, and balance sheet items.
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Conservative and Aggressive Accounting:
- Accounting choices can be conservative or aggressive. "Aggressive" choices aim to enhance reported performance by inflating revenues, earnings, or operating cash flow and decreasing expenses or reported debt.
- Conservatism in financial reports can result from accounting standards or managerial judgments aimed at achieving conservative results.
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Motivations for Low-Quality Reporting:
- Managers may issue low-quality financial reports to mask poor performance, boost stock prices, increase personal compensation, or avoid violating debt covenants.
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Conditions Conducive to Low-Quality Reporting:
- Cultural environments with fewer or less transparent financial disclosures, book/tax conformity, and limited capital markets regulation can contribute to the issuance of low-quality financial reports.
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Mechanisms Disciplining Reporting Quality:
- Disciplinary mechanisms include the free market, incentives for companies to minimize the cost of capital, auditors, contract provisions penalizing misreporting, and regulatory enforcement.
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Presentation Choices and Accounting Methods:
- Presentation choices, including non-GAAP measures, can influence an analyst's opinion. Pro forma earnings, which exclude negative items, are an example of aggressive presentation choices.
- Managers' flexibility in choosing accounting policies and formulating estimates provides opportunities for aggressive accounting.
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Examples of Accounting Choices:
- Examples of accounting choices that affect earnings and balance sheets include inventory cost flow assumptions, estimates of uncollectible accounts receivable, depreciation methods, and more.
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Cash from Operations:
- Cash from operations, an investor-relevant metric, can be influenced by operating choices such as stretching accounts payable and classification choices.
In summary, the article emphasizes the importance of discerning financial reporting quality, understanding motivations for low-quality reporting, and recognizing the disciplinary mechanisms and choices that can impact reporting quality in financial statements. This comprehensive understanding is crucial for analysts in assessing a company's performance and making informed forecasts.
