Portfolio Construction

Evaluating Financial Reporting Quality

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Evaluating Financial Reporting Quality

Chapter in International Financial Statement Analysis (Wiley, 2012)

This chapter touches on major themes in financial reporting quality. This is a broad area with considerable academic and practitioner research. Indeed, many of the techniques described here are used by analysts to make security recommendations and by asset managers in making portfolio allocation decisions. Among the points covered:

  • Financial reporting quality relates to the accuracy with which a company’s financial statements reflect its operating performance and can be used to forecast future cash flows. Understanding accruals is critical to understand and evaluate financial reporting quality.
  • The application of accrual accounting makes necessary use of judgment and discretion. On average, accrual accounting provides a superior picture to a cash basis accounting for forecasting future cash flows.
  • Earnings can be decomposed into cash and accrual components. The accrual component has been found to have less persistence than the cash component, so the cash component should receive a higher weighting in evaluating company performance.
  • Aggregate accruals ratios are useful to rank companies for the purpose of evaluating earnings quality. Companies with high (low) accruals ratios are companies with low (high) earnings quality. Companies with low (high) earnings quality tend to experience lower (higher) accounting rates of return and relatively lower excess stock returns in future periods.
  • Sources of accounting discretion include choices related to revenue recognition, depreciation choices, inventory choices, choices related to goodwill and other noncurrent assets, choices related to taxes, pension choices, financial asset/liability valuation, and stock option expense estimates.

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