Evaluating Quality of Financial Reports (2024)

Two ways to enjoy this Refresher Reading

Available to members only. Login required.

Introduction

The ability to assess the quality of reported financial information can be a valuableskill. An analyst or investor who can recognize high-quality financial reporting canhave greater confidence in analysis based on those financial reports and the resultinginvestment decisions. Similarly, an analyst or investor who can recognize poor financialreporting quality early—before deficiencies become widely known—is more likely tomake profitable investment decisions or to reduce or even avoid losses.

An example of early recognition of an ultimate financial disaster is James Chanos’sshort position in Enron in November 2000 —more than a year before Enron filed for bankruptcy protection (in December 2001).Despite Enron’s high profile and reputation,Chanos had a negative view of Enron based on both quantitative and qualitative factors.Chanos noted that Enron’s return on capital was both lower than comparable companies’return on capital and lower than the company’s own cost of capital. Qualitative factorscontributing to Chanos’s view included the company’s aggressive revenue recognitionpolicy, its complex and difficult-to-understand disclosures on related-party transactions,and one-time earnings-boosting gains. Later events that substantiated Chanos’s perspectiveincluded sales of the company’s stock by insiders and the resignation of senior executives.

Another example of early recognition of eventual financial troubles is June 2001 reportsby analyst Enitan Adebonojo. These reports highlighted questionable accounting byRoyal Ahold, a European food retailer. The questionable accounting included “claimingprofits of acquired firms as ‘organic growth,’ booking capital gains from sale-and-leasebackdeals as profit, and keeping billions in debt off its balance sheet.”In 2003, Royal Ahold announced that it had significantly overstated its profits inthe prior two years. The CEO and CFO resigned, various regulators announced investigations,and Royal Ahold’s market value dropped significantly.

This reading focuses on reporting quality and the interrelated attribute of resultsquality. Reporting quality pertains to the information disclosed in financial reports. High-quality reportingprovides decision-useful information—information that is relevant and faithfully representsthe economic reality of the company’s activities during the reporting period and thecompany’s financial condition at the end of the period. A separate, but interrelated,attribute of quality is results or earnings quality, which pertains to the earnings and cash generated by the company’s actual economicactivities and the resulting financial condition relative to expectations of currentand future financial performance. Note that the term “earnings quality” is more commonlyused in practice than “results quality,” so throughout this reading, earnings qualityis used broadly to encompass the quality of earnings, cash flow, and/or balance sheetitems.

High-quality earnings reflect an adequate level of return on investment and are derivedfrom activities that a company will likely be able to sustain in the future. Thus,high-quality earnings increase the value of a company more than low-quality earnings.When reported earnings are described as being high quality, it means that the company’sunderlying economic performance was good (i.e., value enhancing), and it also impliesthat the company had high reporting quality (i.e., that the information that the companycalculated and disclosed was a good reflection of the economic reality).

Earnings can be termed “low quality” either because the reported information properlyrepresents genuinely bad performance or because the reported information misrepresentseconomic reality. In theory, a company could have low-quality earnings while simultaneouslyhaving high reporting quality. Consider a company with low-quality earnings—for example,one whose only source of earnings in a period is a one-off settlement of a lawsuitwithout which the company would have reported huge losses. The company could nonethelesshave high reporting quality if it calculated its results properly and provided decision-usefulinformation. Although it is theoretically possible that a company could have low-qualityearnings while simultaneously having high reporting quality, experiencing poor financialperformance can motivate the company’s management to misreport.

This reading begins in Section 2 with a description of a conceptual framework forand potential problems with financial reporting quality. This is followed in Section3 with a discussion of how to evaluate financial reporting quality. Sections 4, 5,and 6 focus on the quality of reported earnings, cash flows, and balance sheets, respectively.Section 7 covers sources of information about risk. A summary and practice problemsin the CFA Institute item set format complete the reading.

The member should be able to:

1. demonstrate the use of a conceptual framework for assessing the quality of a company’s financial reports;

2. explain potential problems that affect the quality of financial reports;

3. describe how to evaluate the quality of a company’s financial reports;

4. evaluate the quality of a company’s financial reports;

5. describe the concept of sustainable (persistent) earnings;

6. describe indicators of earnings quality;

7. explain mean reversion in earnings and how the accruals component of earnings affects the speed of mean reversion;

8. evaluate the earnings quality of a company;

9. describe indicators of cash flow quality;

10. evaluate the cash flow quality of a company;

11. describe indicators of balance sheet quality;

12. evaluate the balance sheet quality of a company;

13. describe sources of information about risk.