Detecting Financial Reporting Quality Issues for CFA Level 1

In Reading 33 of the CFA Institute curriculum we emerge from hundreds of pages of in-depth focus on individual financial statements to return to a 10,000 foot view about how to interpret management's statements. This blog post breaks down the first section of the CFA reading to look at what quality earnings look like and then the common reasons management might manipulate reported results. 

Quality of Financial Reporting and Earnings

The quality of financial reporting is determined by how useful the information is. We define this as information that is:

  • Decision useful
  • Relevant – Timely, material
  • A faithful representation of the facts – Complete, neutral, error free

Essentially we want management to clearly present financial results in a way that is easy to interpret and helpful in understanding the results and how they were obtained.

The quality of company earnings is about the sustainability and level of a company’s earnings (as opposed to how they are reported).

High quality earnings should be judged based on:

  • The sustainability of the earnings
    • Can be measured as the % of earnings expected to continue in the future
    • Look for greater market share and or greater efficiency
  • The level of the earnings and margins
    • High enough to sustain company’s existence over time
    • Provide an adequate return to investors
  • The quality of the balance sheet

Earnings Quality Frameworks

This is in the weeds.

There are many frameworks for evaluating earnings quality. Here is the U.S. GAAP framework from the curriculum: 

  1. Best: Decision useful, GAAP compliant, sustainable & adequate earnings
  2. 2nd Best: Decision useful, GAAP compliant, low earnings quality
  3. Middle: GAAP compliant, biased reporting choices/estimates, low earnings quality
  4. Lower Middle: GAAP compliant, earnings actively managed or massaged
  5. Getting terrible: Not compliant, but earnings are accurate reflections
  6. Worst: Not compliant, fictitious or fraudulent numbers are reported

Management Motivation to Manipulate Earnings

Why might management report low quality earnings?

Managers are human, they may have career, financial, or reputational tied up in their company’s earnings.

Specific goals might include: 

  • Meeting or exceeding EPS benchmarks, especially when tied to compensation
  • Beating earnings guidance
  • Avoiding negative debt covenants (for highly levered companies)
  • Improving perception of the firm with customers/suppliers

Note: When benchmarks are beat management might then employ conservative principles in order to “bank” earnings for future period.

Tactics to Manipulate Earnings

Tactics to improve either current or future performance include:

Improve performance in the current period

  • Prematurely recognize revenue
  • Increase profit via non-recurring transactions (sell something)
  • Defer expenses to later periods
  • Remeasure assets (liabilities) at a higher (lower) value

Improve performance in later periods

  • Save current income to be reported later
  • Recognize future expenses in the current period

Company Conditions that Increase Odds of Low-Quality Financial Reporting

Low quality or fraudulent financial reporting usually stems from a combination of motivation, opportunity, and rationalization. 

  • Weak internal company controls
  • The board of directors fails to provide oversight
  • Relevant accounting standards provide significant discretionary latitude
  • Penalties for fraud are minimal or nonexistent