LOS B requires us to:
describe a spectrum for assessing financial reporting quality
The financial reporting quality could be good or bad depending upon, whether it meets the requirements of the applicable reporting standards, the information so provided meets the characteristics of quality information, etc. There could be a whole spectrum of the quality of financial reporting starting from very good to poor.
The quality levels from the best to the worst can be categorized as follows:
a. High-Quality Reporting. High-quality financial reports have the following characteristics:
i. they conform to the applicable reporting standards,
ii. they are at par with all the characteristics of decision-useful information, such as relevancy, faithful representation, etc.
iii. they also meet the enhancing characteristics of information such as comparability, verifiability, timeliness, etc.
b. High-Quality Earnings. High-quality earnings are characterized by:
i. conformance to applicable reporting standards,
ii. availability of decision-useful information,
iii. the returns are also sustainable and adequate, that either exceeds the cost of capital or meets/exceeds the expected returns.
c. High-quality reporting but low-quality earnings. Such earnings are characterized by the following:
i. adherence to the applicable reporting standards,
ii. availability of decision-useful information, but
iii. low-quality earnings, which are either not sustainable or are not adequate.
d. Low-quality reporting. The low reporting quality may be of two types:
i. which adheres to the applicable reporting standards, but maybe a result of biased accounting choices. The accountants may choose to follow aggressive accounting policies or conservative accounting policies, depending upon the requirement of inflated or deflated profits, or a company may go in for a combination of both, in order to smoothen the earnings (and decrease the volatility of earnings).
ii. This confirms the applicable reporting standards, but there may be bias in the presentation. This may be done by obscuring the unfavorable information and highlighting the favorable information. Such actions from the accountants are usually a result of poor earning quality or may be due to poor internal controls.
iii. This confirms the reporting standards, but there is earnings management by the company. This is done by making intentional choices and taking deliberate actions to influence the reported earnings and their interpretations. This could be a result of real actions such as deferment of expenses, or as a result of accounting choices.
e. Departures from applicable accounting standards. The company may follow non-compliant accounting resulting in poor financial reporting quality or may record fictitious transactions. This results in unreliable financial reports.