Learning Outcomes
After reading this article, you will be able to identify and evaluate key financial reporting quality indicators for CFA Level 1. You will recognize the characteristics of high- and low-quality reporting, distinguish between sustainable and unsustainable earnings, assess persistence, and appraise the importance of transparency and disclosure completeness in financial statements.
CFA Level 1 Syllabus
For CFA Level 1, you are required to understand how to evaluate the quality of financial reporting. In particular, revision for this topic should focus on the following:
- Recognizing the fundamental characteristics of quality and poor-quality financial reporting
- Identifying financial reporting quality indicators, including the sustainability and persistence of earnings, and transparency of disclosures
- Differentiating between recurring, non-recurring, and unsustainable items in income statements
- Understanding the impact of aggressive or conservative accounting choices on reported figures
- Assessing qualitative factors and red flags in reporting
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What are two key indicators that earnings in a financial statement are of high quality?
- List one warning sign of aggressive financial reporting.
- Why is the transparency of disclosures important for assessing reporting quality?
- True or false? High-quality financial reporting always results in higher reported net income.
Introduction
High-quality financial reporting enables users to assess a company’s true performance and financial position. Conversely, poor reporting quality impedes analysis, clouds valuation, and increases the risk of error in investment decisions. For the CFA exam, you must be able to identify indicators that signal the reliability and usefulness of reported information.
Key Term: financial reporting quality
The degree to which financial statements and disclosures accurately and completely present the company's performance and position, enabling informed decisions.
Identifying High-Quality Reporting
Financial statements are considered high quality when they are accurate, complete, free from bias or manipulation, and provide a faithful picture of a company's economic reality. High-quality reporting allows users to analyze trends, compare across firms, and detect risks.
Indicators of High-Quality Reporting
Common indicators include:
- Consistent, sustainable, and recurring earnings over time (persistence)
- Sufficient, clear, and timely disclosures on significant accounting policies, estimates, and uncertainties
- Transparency in recognition and measurement, avoiding cosmetic enhancements or obfuscation
- Realistic estimates and absence of frequent large estimate changes
Key Term: persistence
The extent to which a company's earnings are expected to recur in future periods.Key Term: sustainability
The likelihood that earnings and cash flows reported in the current period will continue over time.Key Term: transparency
The quality of disclosures and statements such that material items are clearly presented and significant policies, judgments, and risks are explained fully.
Common Red Flags and Low-Quality Indicators
Warning signs of low-quality reporting often include:
- Frequent adjustments, restatements, or changes in accounting policy lacking clear rationale
- Substantial non-recurring gains or loss items that have material impact on profits
- Unclear or minimal disclosure of significant accounting estimates or judgments
- Revenue or profit trends that diverge dramatically from cash flow trends
Aggressive Versus Conservative Reporting
Management may use estimation discretion and policy choice to present results in a more favorable light (aggressive reporting) or a more cautious, prudent fashion (conservative reporting).
Key Term: aggressive accounting
The use of policies or estimates that increase reported profit or assets, often accelerating recognition of revenues or deferring recognition of expenses and losses.Key Term: conservative accounting
The use of policies or estimates that recognize expenses or losses sooner, or revenues and gains later, leading to potentially understated performance in the short term.
Worked Example 1.1
Question:
A technology company reports record net income growth, driven largely by a one-off gain from a discontinued segment sale and revaluation of investment securities. However, operating cash flow has declined and major footnote disclosures are brief. What should an analyst conclude about reporting quality?
Answer:
The one-off gain and brief disclosures suggest that the increased income is not sustainable. Declining operating cash flow raises doubts about the persistence of reported earnings. The overall reporting quality is low despite impressive headline profits.
Assessing Sustainability, Persistence, and Recurring Items
For CFA exam questions, you should focus on whether reported earnings reflect recurring activities or are driven by non-recurring, transitory, or unsustainable items. High sustainable earnings are those expected to recur in future years and stem from core business activities, while unsustainable earnings result from asset sales, changes in estimates, or special circumstances.
Key Term: recurring earnings
Earnings from the company’s regular operations that are expected to continue in future periods.Key Term: non-recurring item
Income or loss relating to rare, unusual, or infrequent events unlikely to occur again—for example, legal settlements, restructuring costs, or asset sales.
Worked Example 1.2
Question:
A retailer reports net income including an insurance payout after a warehouse fire. If analysts do not adjust for this item, what is the risk?
Answer:
The net income appears artificially high and lacks persistence, as the insurance payout is a non-recurring gain not related to regular business performance. Relying on this income for forecasts could lead to significant error.
Exam Warning
Items such as restructuring charges, gains on asset sales, and changes in pension assumptions can distort earnings trends. Unless identified and adjusted for, these can mislead users about future profitability.
The Role of Disclosure Transparency
Disclosures in the notes and management discussion are key sources for evaluating reporting quality. High-quality disclosures:
- Detail significant accounting policies and associated estimates
- Fully explain changes in policy or estimates
- Provide breakdowns and explanations of one-off items and recurring core results
- Allow reconciliation of profits to cash flows
Poor-quality reporting may minimize explanations, obscure important transactions, or delay recognition of issues.
Assessing Aggressive or Conservative Practices
Look for patterns such as:
- Adjustments to previously disclosed estimates to reverse prior expenses or losses
- Changes to policy that materially increase earnings without transparent justification
- Capitalization of costs or deferred revenue recognition where previously expensed or recognized upfront
Questionable practices may increase reported profits in the short term but reduce reliability and usefulness for valuation and forecasting.
Worked Example 1.3
Question:
A manufacturing firm begins capitalizing substantially more product development costs, reducing current year’s expense while increasing future amortization. What questions should an analyst ask?
Answer:
Why has the policy changed? Is the justification disclosed and reasonable? What impact does this have on comparability, and are key earnings sustainability indicators now compromised?
Summary
High-quality financial reporting enables reliable analysis and comparison by reflecting true economic performance, with earnings that are recurring, sustainable, and well-supported by transparent disclosures. Persistent, core items are differentiated from special or unsustainable gains and losses. Aggressive or conservative practices, unclear estimation changes, or insufficient transparency reduce reporting quality and should be flagged for further analysis.
Key Point Checklist
This article has covered the following key knowledge points:
- Understand the main financial reporting quality indicators: persistence, sustainability, and transparency.
- Identify recurring versus non-recurring items in income statements.
- Evaluate the sufficiency and clarity of disclosures as a sign of reporting quality.
- Recognize common red flags for aggressive accounting, restatements, or policy changes.
- Assess the alignment of earnings trends and cash flow for quality assessment.
Key Terms and Concepts
- financial reporting quality
- persistence
- sustainability
- transparency
- recurring earnings
- non-recurring item
- aggressive accounting
- conservative accounting