Financial reporting quality varies across companies.
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 provides no quality of earnings.
Conservative and Aggressive Accounting
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 a 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 the amount of expenses reported in the period and/or the amount of debt reported on the balance sheet.
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 necessarily made by managers when applying accounting standards that result in more or less conservative results.
An example of conservatism in the oil and gas industry is the revenue recognition accounting standard. This standard permits recognition of revenue only at the time of shipment rather than closer to the time of actual value creation (which is the time of discovery).
Big Bath Accounting
The strategy of manipulating a company's income statement to make poor results look even worse. The big bath is often implemented in a bad year to artificially enhance next year's earnings. The big rise in earnings might result in a larger bonus for executives.
Cookie Jar Reserve Accounting
Companies shift earnings around by creating overly large reserve accounts in good years then drawing them down in bad years.