As financial analysts, we need to understand the motivations that company
management might have to present low quality financial information or low
quality financial reports. If the motivations exist then we need to
understand what sorts of conditions are conducive to issuing low quality
financial reports. And finally we as analysts need to be aware of the
mechanisms that discipline financial reporting quality. Let's start with
Motivations. One of the major motivations for company
management to present low quality information is to hide a performance,
let's say that the company is facing difficult economic times and the company
believes that these difficult economic times are just temporary. What management
might do is some form of earnings management, in this particular period,
with the thought that the numbers will then improve in the future anyway, so
simplistically hiding poor performance is one motivation for presenting low
quality financial reports. Another important one is to meet or exceed
earnings expectations. This is particularly important for listed
companies where companies that are followed by investors or analysts will
generally have an expected earnings number so analysts will have their
expectations about the earnings number for a particular quarter, and if it turns
out that the reported earnings fall below those expectations, then generally,
the stock price will take a hit. Management knows what those expectations
are and in order to meet or exceed those expectations they might manipulate or
manage the earnings. A related item is to meet or exceed prior year results or
some other benchmark. I mentioned prior year results because very often
numbers are compared with the same number in the previous year or the same
number in the previous comparable quarter. As an example, for let's say a
company in a cyclic business, the earnings number for the fourth quarter
in 2013 will be compared with earnings in the fourth quarter of 2012. Management
knows that the reported earnings number here will be compared with the reported
earnings number from the same quarter last year and if there are certain
expectations that this earnings number must exceed the earnings number from
this quarter, management might try to manipulate the earnings. There might be
career concerns and incentive compensation, so let's take career
concerns first. Senior management would like the world to believe that the
companies that they are managing are performing well. Let's take this one step
further. Let's say that the CFO of a company is planning to look for
employment at another firm, obviously what the CFO would like is to present
good performance numbers at the company where he currently is because this will
help with his negotiation position at the next company. A related point is
incentive compensation where senior managers are often compensated based on
the earnings numbers so there is inherently a motivation to present high
earnings numbers so that the bonuses are higher. Next, we move into Conditions
Conducive to Issuing Low Quality Financial Reports. Broadly speaking there
are three conditions which if they exist then the probability of low quality
financial reports is very high, and the three conditions are shown here; one is
Motivation, that we discussed on the previous slide, another is the
Opportunity to present low quality reports, and the third is Rationalization.
Let's discuss opportunity in a little more detail. Let's say that at a given
company the internal controls are weak, in other words, the CFO
can find it easy to manage earnings. Related to that is an ineffective Board
of Directors. As we see in the readings on corporate governance, ideally the
board of directors should be keeping track of the numbers that are being
presented. Let's say that the board of directors is weak, perhaps the board of
directors is very closely aligned with the senior management, then that creates
an opportunity to present low quality reports. If a company is operating in a
region where the Accounting Standards allow a range of choices then management
might be tempted to use the standards that give numbers or produce earnings
numbers that are relatively high or that meet what the managers want. Motivations,
we have talked about on the previous slide, and finally, Rationalization. Those
who are managing earnings will try to rationalize their behavior and if a
company is operating in an environment where it is relatively easy for managers
to rationalize their behavior, there the probability of presenting low-quality
financial reports will be high. We now come to the Mechanisms that Discipline
Financial Reporting Quality. One of the mechanisms is the market itself. This is
the market for raising financial capital. If a company is presenting low-quality
financial information then the riskiness associated with that company will be
high, in other words, investors will perceive this company to be high risk. If
investors perceive this company to be high risk, they will value this company
at a low level, in other words, the required return that investors will
demand will be high so this becomes very costly for companies, the cost of capital
is high and that is because the information being presented is low
quality so this enough itself serves as an incentive to present high quality
financial information, but as we've discussed there can be several
conflicting incentives, so senior management might be more concerned with
their compensation so they would have an incentive to overstate earnings. Because
of this there is the need for regulatory authorities. In the United States, the
regulatory authority is the Securities and Exchange Commission, and in fact, in
every country where there are publicly listed companies and securities markets
there will be some regulatory authority. In India, for example, we have the
Securities and Exchange Board of India. In Pakistan, we have a SECP. In Hong Kong,
we have the Securities and Futures Commission and so on. Now these
regulatory authorities are members of an entity called the International
Organization of Securities Commissions or IOSCO. This is essentially an
umbrella organization of the various regulators and also of other security
market participants such as stock exchanges, but the IOSCO can also be
thought of as the global standard setter for the securities sector. The actual
regulation though will happen through the particular regulatory authority in
each jurisdiction, so let's just take the SEC in the United States. The SEC is
responsible for overseeing approximately 9,100 US public companies, along with
investment advisors, brokers, dealers and securities exchanges. According to the
curriculum, in 2002, the SEC reported that it had filed 515 enforcement actions for
financial reporting violations during the preceding five year period. It is
important for you to recognize the typical features of regulatory
regime, and those are listed over here. The regulatory entity, such as the SEC,
will generally have registration requirements, so publicly listed
companies need to register and there are certain registration requirements even
private companies which are private limited companies, in certain countries,
have registration requirements. There are disclosure requirements obviously
depending on whether the company is public or not, the disclosure
requirements will vary. The disclosure requirements tend to be very high for
listed companies. There are auditing requirements so companies must be
audited by an independent third-party auditor on a regular basis. Management is
required to present a commentary on the performance of the company. There are
responsibilities statements, for example, in the United States we have the
Sarbanes-Oxley Act and under this, senior management is required to submit formal
certification that the information presented is reasonably accurate, and if
this does not happen or if information presented is not accurate then the
senior management is going to be charged with criminal offense and if this does
not happen then senior management can go to jail. Regulatory review of filings. So
the regulatory authority actually reviews the filings and it's extremely
important that there be some form of an enforcement mechanism. All these
regulations will only work if there is a credible threat of enforcement. The role
of auditors has been mentioned before, but it is important enough that it's
being discussed again. Auditors provide third-party verification of financial
statements. We've talked about auditors and the sorts of reports that they might
present in other readings. Here we just want to point out that even though an
auditor gives a favorable view that is not a guarantee that financial reporting
quality is high and we say this for several reasons. One
reason is that the information that is reviewed by auditors is prepared and
presented by the company so the company gives information to the auditor and the
auditor is reviewing that information. It is conceivable that the company presents
biased reports or biased numbers to the auditor. Another point is that audits are
typically based on a sample and the sample might not necessarily reveal what
is going on with the overall company. A third point is that there might be an
expectations gap between the auditors role and the public's expectations of
the auditors. An audit is not typically intended to detect fraud, it is intended
to provide assurance that financial reports are fairly presented, and the
fourth point is that companies being audited pay the auditor and that might
create a potential conflict of interest. The final point on the slide has to do
with private contractor and I'll use an example from before. Let's say that we
have a company that needs money and this gets a substantial amount of money from
a bank. The bank is in a sense the private contractor, and let's say that
when lending money there is this legal agreement that allows the bank to
monitor the financial reports of the company. This will create an incentive
for the company to produce high-quality financial reports.