Evaluating the Quality of Financial Reports

The collapse of Enron in the early 2000s, which was a result of massive financial manipulation, gave rise to a new era of financial reporting supervision with the establishment of the Sarbanes-Oxley Act in 2002. The Act required all executives to give certified and accurate financial information. Various mechanisms were put in place to reduce financial accounting irregularities (Cunningham, 2005). Managers are therefore required to have a clear understanding of the regulations put in place and the bodies which enforce them in order to conform with them accordingly.

Issuance of financial reports and sale of securities to the public is monitored by such organizations as:

The Financial Accounting Standards Board (FASB)

The Securities and Exchange Commission (SEC), and

The Financial Industry Regulatory Authority (FIRA)

The Financial Accounting Standards Board (FASB) has developed the financial accounting standards to be used in the U.S. since 1973. Its function is to oversee the preparation of financial reports by non-governmental entities. FASB ensures that financial statements contain information relevant for sound decision making. The Securities and Exchange Commission (SEC) has been charged with the statutory authority of establishing reporting standards for U.S. public companies. Although it does not develop the Generally Accepted Accounting Principles (GAAP), it has power to monitor financial reporting. The SEC seeks its authority from three security laws: The Securities Act of 1933 (SEC, 2012b), The Securities Exchange Act of 1934 (SEC, 2012c), The Investment Company Act of 1940 (SEC, 2012a), The Sarbanes-Oxley Act of 2002 (SEC, 2005), and The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (SEC, 2014).

The Financial Industry Regulatory Authority (FIRA) regulates securities firms conducting business with the public in the U.S. The International Accounting Standards Board (IASB) develops and Publishes International Financial Reporting Standards through the help of its 15-full time members from different countries working with stakeholders all over the world.

The usefulness of financial reports to readers depends on report quality. The conceptual framework for financial reporting categorizes qualitative characteristics of financial reports into two broad categories: fundamental qualitative characteristics, which include relevance and faithful representation, and enhancing qualitative characteristics, which make financial reports more useful and include comparability, timeliness, verifiability, and understandability. Presentation of financial reporting is limited by materiality and cost constraints. There exist differences in U.S. reporting requirements and the international requirements, although efforts have been undertaken to congregate the U.S. GAAP rules with the international financial reporting rules (Oxford Analytica, 2009). Differences in U.S. reporting requirements and international financial reporting are evident in terms of asset value, revenue recognition, research and development, inventory and discontinued operations.

It is a requirement by law that financial statements of a public company be audited by an external auditing body that reviews the company’s operations and the financial statements to ensure that they are accurate and are in conformity with proper internal controls. They also help cross-check financial statements for creative accounting tricks that companies can use to mislead the public. These include false reporting of revenue, assets, expenses and liabilities.

Forbes School of Business Faculty

References:

Cunningham, C. (2005). The gain and pain of Sarbanes-Oxley. Forbes. 

Oxford Analytica. (2009). Accounting for a difference of opinion. Forbes. 

Discussion 1

Referencing this week’s readings and lecture, describe the quality issues related to reporting revenue. What is the importance of understanding various inventory valuation methods in determining the quality of reported profits?