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Subject 1. Quality of Financial Reports PDF Download
There are two related attributes of quality of a company's financial statements.

  • Financial reporting quality. Are reports GAAP-compliant? Do they accurately reflect the financial condition and operating success of a company? Are they useful in decision making?
  • Earnings quality. Earnings are considered to be high quality if they exhibit persistence and unbiased. Sustainable earnings enable better forecasts of future cash flows or earnings.

A correct assessment of earnings quality is possible only if we have some basic level of financial reporting quality. Low financial reporting quality makes it hard to assess earnings quality.

The quality of financial reporting can be thought of as spanning a continuum from the highest quality to the lowest.

GAAP, Decision-Useful, Sustainable, and Adequate Returns

  • GAAP compliance.
  • Useful: helpful in decision-making. Relevant, faithful representation and material.
  • Sustainable earnings indicate an adequate level of return on investment.

GAAP, Decision-Useful, but Sustainable?

  • GAAP compliance and useful.
  • But not sustainable earnings.

Biased Accounting Choices

  • Within GAAP.
  • Biased choices such as aggressive/conservative accounting, income smoothing, hidden reserves, and earnings management.

Departures from GAAP

It is difficult or impossible to assess earnings quality. Engaging in fraudulent financial reporting is fraud that provides no quality of earnings.

Potential problems that affect the quality of financial reporting broadly include:

  • Revenue and expense recognition on the income statement
  • Classification on the statement of cash flows
  • Recognition, classification, and measurement of assets and liabilities on the balance sheet

User Contributed Comments 1

User Comment
babic Assessing the quality of financial reports - both reporting quality and results quality - is an important analytical skill.
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I used your notes and passed ... highly recommended!


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