FSA Ch. 6: Accounting Quality

High Quality Accounting Information

portrays fairly and completely the economic effects of a firm’s decisions and actions and paints an accurate economic portrait of the firm’s financial position, performance, and risk. That is, high-quality accounting information maximizes economic content and minimizes measurement error and bias

3 elements:

1. Economic information content

2. Measurement error

   1. Bias

Measurement error

occurs when managers, in good faith, make estimates that turn out to be wrong

• errors tend to cancel out over time and across the many estimates that managers must make in a given year, yielding high-quality accounting numbers

Bias

Bias occurs when managers apply accounting standards that are inherently slanted in one direction (for example, standards that require asset write-downs and do not permit asset write-ups) and when managers take advantage of the estimation process to report intentionally optimistic or pessimistic accounting numbers. Neutral application of accounting standards reduces bias and yields high-quality accounting numbers

Earnings Management

occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reporting accounting numbers

• includes managers’ choices, judgments, and estimates that are necessary but that mask the underlying economic performance of a firm

Upwards:

to increase the manager’s compensation under compensation contracts based on earnings or stock prices.

to influence stock prices positively (or delay stock price declines) by meeting or beating the market’s expectations for earnings, managers’ own earnings forecasts, and prior period’s earnings, and to maintain a smooth earnings time-series to cause the firm to appear less risky.

to enhance job security for senior management by influencing the outcomes of transactions that affect corporate control, such as proxy fights and takeovers.

to allow the firm to obtain debt financing at a lower cost by appearing more profitable or less risky, avoid violation of debt covenants, or influence the effects of other binding constraints from accounting-based contracts.

to influence short-term share price performance and increase the economic benefits to the firm from engaging in initial public and seasoned equity offerings and using firm shares in acquisitions.

to increase share prices prior to a sale of their personal ownership interests (insider selling) in order to maximize gains from the sale.

Downwards:

to discourage entry into the industry by potential competitors.

to reduce the probability of antitrust actions against the firm or other regulatory interventions or political interference related to tax issues, capital requirements (e.g., for banks), and import relief.

to suppress stock prices and thus yield favorable terms when taking a company private.

to decrease share prices prior to managers’ insider share purchases in order to maximize manager gains from future share sales.

to create opportunities to report higher earnings in future periods.

Beneish Manipulation Model

developed both a 12- and an 8-factor model to identify the financial characteristics of firms likely to engage in earnings manipulation:

The 12-factor model relies on a combination of financial statement items and changes in stock prices for a firm’s shares.

The 8-factor model uses only financial statement items.