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Subject 3. Context for Assessing Financial Reporting Quality
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-quality

Motivations for managers to issue less than high quality financial reports:

  • Mask poor performance
  • Boost stock price
  • Improve incentive compensation
  • Meet debt covenants

Management might have an incentive to manipulate earnings lower as well, possibly to smooth higher earnings in the current quarter into weaker quarters.

Conditions conductive to issuing low-quality financial reports:

  • Opportunity is generally provided through weaknesses in internal controls.
  • Motivation can be imposed due to personal financial problems or unrealistic deadlines and performance goals.
  • Rationalization occurs when an individual develops a justification for fraudulent activities.

Mechanisms that discipline financial reporting quality:

  • The free market. A company seeking to minimize its long-term cost of capital should aim to provide high-quality financial reports.
  • Enforcement by market regulatory authorities, which plays a central role in encouraging high-quality financial reporting.
  • Auditors. An audit is intended to provide assurance that a company's financial reports are presented fairly. There are, however, inherent limitations. Auditors are only able to offer "reasonable assurance" of the truth and fairness of financial statements rather than absolute assurance.
  • Private contracts. External parties such as lenders and investors are motivated to ensure the quality of financial reports is high.
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