Financial Reporting Quality: Definition
__Financial reporting quality__ basically refers to whether or not the information presented includes all the relevant information for decision making and whether or not the information presented truly represents the activities of the company not only at the end of the period but during the period.
Assume that an analyst is reviewing two financial reports from different companies. One report includes notes to the financial statements that indicate the method of depreciation and inventory valuation method, which are both acceptable under US GAAP. The other report states that depreciation and inventory valuation are calculated in accordance with US GAAP, but it does not identify the methods. What do you think about the financial reporting quality of these two statements?
No. The second statement is missing relevant information necessary for useful decision making.
Right!
In order for an analyst to have useful information for decision making, it is necessary to know the methods used to compute inventory and depreciation, even if the method chosen is in accordance with US GAAP because the different methods can lead to different results on the financial statements. High-quality financial reporting includes note disclosures with all relevant information presented.
Incorrect. The information that is lacking is necessary information for decision making, and without it, these financial statements are of a low quality.
The analyst compares two more sets of financial statements. Both include the balance sheet, statement of cash flows, and statement of retained earnings. One set does not include an income statement, but a note that indicates that the statement of retained earnings indicates net income earned in the period and an income statement is not necessary. How do you think these financial statements compare in quality?
Incorrect. High-quality reports include all the relevant information of activities throughout the period and at the end of the period.
Correct.
The income statement is a necessary financial report to provide relevant information regarding the activities of the company during the period. Without it, the financial reports are incomplete.
No. The statement of retained earnings alone is not sufficient to report the activities of the company throughout the period.
__Earnings quality__ relates to how the economic activities of the company were able to generate the earnings and cash flows reported. In other words, what types of earnings did the company have that generated profits and cash flows, and more importantly, will the company be able to continue to generate those earnings and cash flows in the future.
What do you think would be a source of income that indicates high-quality earnings?
Yes!
Merchandise sales are expected to continue as this is a regular reoccurring activity of the business.
Incorrect.
Gains on selling assets typically do not occur on a regular basis and therefore are not considered a high-quality source of earnings.
No.
Floods are not a typical reoccurring activity, and this type of income is not likely to occur in the near future.
Consider two companies with the following summarized income statements:
| Income Statement | Company A (in USD) | Company B (in USD) |
|------------------|-----------|-----------|
| Sales Revenue | 500,000 | 500,000 |
| Cost of Sales | 350,000 | 200,000 |
| Gross Profit | 150,000 | 300,000 |
| Fixed Expenses | 50,000 | 200,000 |
| Net Income | 100,000 | 100,000 |
Which company do you think has higher-quality earnings?
No.
Earnings quality is not based on net income.
Correct.
Company A has superior earnings quality due to the lower fixed costs.
Financial reporting quality and earnings quality are interrelated. Without high-quality financial reports, a company might not present the information necessary to analyze the company's earnings quality and determine its value.
No.
Although both companies have identical sales revenue and net income at this time, consider what the impact on earnings might be if sales revenues were reduced.
Suppose instead that a retail merchandise company presented its income statement as shown below:
| Income Statement | |
|------------------------|---------|
| Revenues: | |
| Merchandise Sales | 100,000 |
| Cost of Sales | 70,000 |
| Gross Profit | 30,000 |
| Expenses: | |
| Operating Expenses | 30,000 |
| Gain on Restructuring | 55,000 |
| Net Income | 55,000 |
Now what can you say about the quality of earnings for this company?
Not quite.
While this may be true, it doesn’t tell you much about the quality of the earnings generated.
Not necessarily.
The gross profit margin by itself does not indicate a great deal about the quality of earnings.
Correct.
A key piece of information in this income statement is that the company had a large restructuring gain, which may not be likely to occur again in the near future. That could lead to significantly lower earnings or losses in the future based on the other components of net income.
You must have a high-quality report to evaluate the earnings quality, which ultimately influences the value of the company.
In summary:
[[summary]]
Both are presented in accordance with US GAAP, which means they are fine
The first statement is of higher quality as it reports the methods used
The second statement is of higher quality because it does not present unnecessary information
They both include the total net income, so they are comparable in quality
The missing income statement indicates low-quality reporting
The statement of retained earnings is sufficient for reporting net income
Merchandise sales
Gain on the sale of an asset
Insurance proceeds that exceed losses from flood damage
They have equal quality earnings
Company A
Company B
The company generated high net income in proportion to sales
The company has a high gross profit margin
The net income is derived from a gain that is unlikely to occur again in the near future
Continue
Continue
Continue
Continue
