A high quality of reported earnings provides useful information about company performance and future prospects. There is less chance of manipulation as it provides complete and accurate information. Low quality earnings on the other hand provides incomplete, inaccurate and inadequate information about the firm. There are very high chances of manipulation which may leads to a scandal. Some of the areas where the firms can manipulate their reported earnings may be due to biased accounting choices such as
Not faithful representation economic circumstances in which the firm is operating.
Aggressive approach may increase revenues, earnings, cash flow from operations (CFO) in the current year and it may decrease the company reported performance in later periods .
Conservative approach: in contrast with aggressive approach it may reduce revenues, earnings, CFO in the current year and it may increase the company reported performance in later periods.
Underestimation of earnings volatility (“earning smoothing”).
Empirical evidence shows that in majority of cases when the following conditions exist, low quality of financial reports exists :-
Opportunity:- It can be result of internal conditions. Ex- lack of internal controls, ineffective board of directors or it may external conditions such as accounting standards.
Motivation:- Motivated to meet certain reporting level for some personal reasons like as bonus, corporate reasons etc.
Rationalization:- If an individual is concerned about a choice.
Some of the mechanisms that could help in bringing about a discipline and improve the financial reporting quality are :-
Marketing regulatory authorities:- It helps to minimise the cost of capital and maximize the reporting quality. So, many of the world’s securities regulators are member of IOSCO (International organisation of securities commissions).
Auditors:- Audit provides financial statement to users with some assurance that the information complies with the relevant set of accounting standards and presents the company information.
Private contracting :- They monitor the company’s performance to ensure the company’s financial reports are of high quality. Ex- Loan agreements or investment contracts.