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Managers can make it more or less easy for an analyst to assess the firm’s accounting quality and to use its financial statements to understand business reality. While accounting rules require a certain amount of minimum disclosure, managers have considerable choice in the matter. Disclosure quality, therefore, is an important dimension of a firm’s accounting quality. In assessing a firm’s disclosure quality, an analyst could ask the following questions:

• Does the company provide adequate disclosures to assess the firm’s business strategy and its economic consequences? For example, some firms use the Letter to the Shareholders in their annual report to clearly lay out the firm’s industry conditions, its competitive position, and management’s plans for the future. Others use the Letter to puff up the firm’s financial performance and gloss over any competitive difficulties the firm might be facing.

• Do the footnotes adequately explain the key accounting policies and assumptions and their logic? For example, if a firm’s revenue and expense recognition policies differ from industry norms, the firm can explain its choices in a footnote. Similarly, when there are significant changes in a firm’s policies, footnotes can be used to disclose the reasons.

• Does the firm adequately explain its current performance? The Management Discussion and Analysis section of the firm’s annual report provides an opportunity to help analysts understand the reasons behind the firm’s performance changes. Some firms use this section to link financial performance to business conditions. For example, if profit margins went down in a period, was it because of price competition or because of increases in manufacturing costs? If the selling and general administrative expenses went up, was it because the firm is investing in a differentiation strategy, or because unproductive overhead expenses were creeping up?

• If accounting rules and conventions restrict the firm from measuring its key success factors appropriately, does the firm provide adequate additional disclosure to help outsiders understand how these factors are being managed? For example, if a firm invests in product quality and customer service, accounting rules do not allow the management to capitalize these outlays, even when the future benefits are certain. The firm’s Management Discussion and Analysis can be used to highlight how these outlays are being managed and their performance consequences. For example, the firm can disclose physical indexes of defect rates and customer satisfaction so that outsiders can assess the progress being made in these areas and the future cash flow consequences of these actions.

• If a firm is in multiple business segments, what is the quality of segment disclosure? Some firms provide excellent discussion of their performance by product segments and geographic segments. Others lump many different businesses into one broad segment. The level of competition in an industry and management’s willingness to share desegregated performance data influence a firm’s quality of segment disclosure.

• How forthcoming is the management with respect to bad news? A firm’s disclosure quality is most clearly revealed by the way management deals with bad news. Does it adequately explain the reasons for poor performance? Does the company clearly articulate its strategy, if any, to address the company’s performance problems?

• How good is the firm’s investor relations program? Does the firm provide fact books with detailed data on the firm’s business and performance? Is the management accessible to analysts?

When managers have accounting flexibility, they can use it either to communicate their firm’s economic situation or to hide true performance. Some of the strategy questions one could ask in examining how managers exercise their accounting flexibility include the following:

• How do the firm’s accounting policies compare to the norms in the industry? If they are dissimilar, is it because the firm’s competitive strategy is unique? For example, consider a firm that reports a lower warranty allowance than the industry average. One explanation is that the firm competes on the basis of high quality and has in-vested considerable resources to reduce the rate of product failure. An alternative explanation is that the firm is merely understating its warranty liabilities.

• Does management face strong incentives to use accounting discretion for earnings management? For example, is the firm close to violating bond covenants? Or, are the managers having difficulty meeting accounting-based bonus targets? Does management own significant stock? Is the firm in the middle of a proxy fight or union negotiations? Managers may also make accounting decisions to reduce tax payments, or to influence the perceptions of the firm’s competitors.

• Has the firm changed any of its policies or estimates? What is the justification? What is the impact of these changes? For example, if warranty expenses decreased, is it because the firm made significant investments to improve quality?

• Have the company’s policies and estimates been realistic in the past? For example, firms may overstate their revenues and understate their expenses during the year by manipulating quarterly reports, which are not subject to a full-blown external audit. However, the auditing process at the end of the fiscal year forces such companies to make large fourth-quarter adjustments, providing an opportunity for the analyst to assess the quality of the firm’s interim reporting. Similarly, firms that expense acquisition goodwill too slowly will be forced to take a large write-off later. A history of write-offs may be, therefore, a sign of prior earnings management.

• Does the firm structure any significant business transactions so that it can achieve certain accounting objectives? For example, leasing firms can alter lease terms (the length of the lease or the bargain purchase option at the end of the lease term) so that the transactions qualify as sales-type leases for the lessors. Firms may structure a takeover transaction (equity financing rather than debt financing) so that they can use the pooling of interests method rather than the purchase method of accounting. Finally, a firm can alter the way it finances (coupon rate and the terms of conversion for a convertible bond issue) so that its reported earnings per share is not diluted. Such behavior may suggest that the firm’s managers are willing to expend economic resources merely to achieve an accounting objective.

Not all firms have equal flexibility in choosing their key accounting policies and estimates. Some firms’ accounting choice is severely constrained by accounting standards and conventions. For example, even though research and development is a key success factor for biotechnology companies, managers have no accounting discretion in reporting on this activity. Similarly, even though marketing and brand building are key to the success of consumer goods firms, they are required to expense all their marketing out-lays. In contrast, managing credit risk is one of the critical success factors for banks, and bank managers have the freedom to estimate expected defaults on their loans. Similarly, software developers have the flexibility to decide at what points in their development cycles the outlays can be capitalized.

If managers have little flexibility in choosing accounting policies and estimates related to their key success factors (as in the case of biotechnology firms), accounting data are likely to be less informative for understanding the firm’s economics. In contrast, if managers have considerable flexibility in choosing the policies and estimates (as in the case of software developers), accounting numbers have the potential to be informative, depending upon how managers exercise this flexibility. Regardless of the degree of accounting flexibility a firm’s managers have in measuring their key success factors and risks, they will have some flexibility with respect to several other accounting policies.

For example, all firms have to make choices with respect to depreciation policy (straight-line or accelerated methods), inventory accounting policy (LIFO,FIFO, or Average Cost), policy for amortizing goodwill (write-off over forty years or less), and policies regarding the estimation of pension and other post employment benefits (expected return on plan assets, discount rate for liabilities, and rate of increase in wages and health care costs). Since all these policy choices can have a significant impact on the reported performance of a firm, they offer an opportunity for the firm to manage its reported numbers.

A firm’s industry characteristics and its own competitive strategy determine its key success factors and risks. One of the goals of financial statement analysis is to evaluate how well these success factors and risks are being managed by the firm. In accounting analysis, therefore, the analyst should identify and evaluate the policies and the estimates the firm uses to measure its critical factors and risks. For example, one of the key success factors in the leasing business is to make accurate forecasts of residual values of the leased equipment at the end of the lease terms. For a firm in the equipment leasing industry, therefore, one of the most important accounting policies is the way residual values are recorded. Residual values influence the company’s reported profits and its asset base. If residual values are overestimated, the firm runs the risk of having to take large write-offs in the future.

Key success factors in the banking industry include interest and credit risk management; in the retail industry, inventory management is a key success factor; and for a manufacturer competing on product quality and innovation, research and development and product defects after the sale are key areas of concern. In each of these cases, the analyst has to identify the accounting measures the firm uses to capture these business constructs, the policies that determine how the measures are implemented, and the key estimates embedded in these policies. For example, the accounting measure a bank uses to capture credit risk is its loan loss reserves, and the accounting measure that captures product quality for a manufacturer is its warranty expenses and reserves.

Now we will discuss one by one a series of steps that an analyst can follow to evaluate a firm’s accounting quality.

Step 1: Identify Key Accounting Policies

Step 2: Assess Accounting Flexibility

Step 3: Evaluate Accounting Strategy

Step 4: Evaluate the Quality of Disclosure

Step 5: Identify Potential Red Flags

Step 6: Undo Accounting Distortions

The legal environment in which accounting disputes between managers, auditors, and investors are adjudicated can also have a significant effect on the quality of reported numbers. The threat of lawsuits and resulting penalties have the beneficial effect of improving the accuracy of disclosure.

However, the potential for a significant legal liability might also discourage managers and auditors from supporting accounting proposals requiring risky forecasts, such as forward looking disclosures. This type of concern is of-ten expressed by the auditing community in the U.S.

There are three potential sources of noise and bias in accounting data:

1. the noise and bias introduced by rigidity in accounting rules
2. random forecast errors
3. systematic reporting choices made by corporate managers to achieve specific objectives

Each of these factors is discussed below.

ACCOUNTING RULES: Accounting rules introduce noise and bias because it is often difficult to restrict management discretion without reducing the information content of accounting data. For example, the Statement of Financial Accounting Standards No. 2 issued by the FASB  requires firms to expense research outlays when they are incurred. Clearly, some research expenditures have future value while others do not. However, because SFAS  No. 2 does not allow firms to distinguish between the two types of expenditures, it leads to a systematic distortion of reported accounting numbers. Broadly speaking, the degree of distortion introduced by accounting standards depends on howwell uniform accounting standards capture the nature of a firm’s transactions.

FORECAST ERRORS: Another source of noise in accounting data arises from pure forecast error, because managers cannot predict future consequences of current transactions perfectly. For example, when a firm sells products on credit, accrual accounting requires managers to make a judgment on the probability of collecting payments from customers. If payments are deemed “reasonably certain,” the firm treats the transactions as sales, creating accounts receivable on its balance sheet. Managers then make an estimate of the proportion of receivables that will not be collected. Because managers do not have perfect foresight, actual defaults are likely to be different from estimated customer defaults, leading to a forecast error. The extent of errors in managers’ accounting forecasts depends on a variety of factors, including the complexity of the business transactions, the predictability of the firm’s environment, and unforeseen economy-wide changes.

MANAGERS’ ACCOUNTING CHOICES: Corporate managers also introduce noise and bias into accounting data through their own accounting decisions. Managers have a variety of incentives to exercise their accounting discretion to achieve certain objectives, leading to systematic influences on their firms’ reporting:

• Accounting-based debt covenants: Managers may make accounting decisions to meet certain contractual obligations in their debt covenants. For example, firms lending agreements with banks and other debt holders require them to meet covenants related to interest coverage, working capital ratios, and net worth, all defined in terms of accounting numbers. Violation of these constraints may be costly be-cause it allows lenders to demand immediate payment of their loans. Managers of firms close to violating debt covenants have an incentive to select accounting policies and estimates to reduce the probability of covenant violation. The debt covenant motivation for managers’ accounting decisions has been analyzed by a number of accounting researchers.

• Management compensation: Another motivation for managers’ accounting choice comes from the fact that their compensation and job security are often tied to re-ported profits. For example, many top managers receive bonus compensation if they exceed certain pre specified profit targets. This provides motivation for managers to choose accounting policies and estimates to maximize their expected compensation.

• Corporate control contests:  In corporate control contests, including hostile takeovers and proxy fights, competing management groups attempt to win over the firm’s shareholders. Accounting numbers are used extensively in debating managers’ performance in these contests. Therefore, managers may make accounting decisions to influence investor perceptions in corporate control contests.

• Tax considerations: Managers may also make reporting choices to trade off between financial reporting and tax considerations. For example, U.S. firms are required to use LIFO  inventory accounting for shareholder reporting in order to use it for tax reporting. Under LIFO, when prices are rising, firms report lower profits, thereby reducing tax payments. Some firms may forgo the tax reduction in order to report higher profits in their financial statements.

• Regulatory considerations:  Since accounting numbers are used by regulators in a variety of contexts, managers of some firms may make accounting decisions to influence regulatory outcomes. Examples of regulatory situations where accounting numbers are used include antitrust actions, import tariffs to protect domestic industries, and tax policies.

• Capital market considerations:  Managers may make accounting decisions to influence the perceptions of capital markets. When there are information asymmetries between managers and outsiders, this strategy may succeed in influencing investor perceptions, at least temporarily.

• Stakeholder considerations: Managers may also make accounting decisions to influence the perception of important stakeholders in the firm. For example, since labor unions can use healthy profits as a basis for demanding wage increases, managers may make accounting decisions to decrease income when they are facing union contract negotiations. In countries like Germany, where labor unions are strong, these considerations appear to play an important role in firms’ accounting policy. Other important stakeholders that firms may wish to influence through their financial reports include suppliers and customers.

• Competitive considerations: The dynamics of competition in an industry might also influence a firm’s reporting choices. For example, a firm’s segment disclosure decisions may be influenced by its concern that disaggregated disclosure may help competitors in their business decisions. Similarly, firms may not disclose data on their margins by product line for fear of giving away proprietary information. Finally, firms may discourage new entrants by making income-decreasing accounting choices.

Because the mechanisms that limit managers’ ability to distort accounting data them-selves add noise, it is not optimal to use accounting regulation to eliminate managerial flexibility completely. Therefore, real-world accounting systems leave considerable room for managers to influence financial statement data. The net result is that information in corporate financial reports is noisy and biased, even in the presence of accounting regulation and external auditing.

The objective of accounting analysis is to evaluate the degree to which a firm’s accounting captures its underlying business reality and to “un-do” any accounting distortions. When potential distortions are large, accounting analysis can add considerable value.

Broadly defined as a verification of the integrity of the reported financial statements by someone other than the preparer, external auditing ensures that managers use accounting rules and conventions consistently over time, and that their accounting estimates are reasonable. In the U.S., all listed companies are required to have their financial statements audited by an independent public accountant.

The standards and procedures to be followed by independent auditors are set by the American Institute of Certified Public Accountants (AICPA). These standards are known as Generally Accepted Auditing Standards (GAAS). While auditors issue an opinion on published financial statements, it is important to remember that the primary responsibility for the statements still rests with corporate managers.

Auditing improves the quality and credibility of accounting data by limiting a firm’s ability to distort financial statements to suit its own purposes. However, third-party auditing may also reduce the quality of financial reporting because it constrains the kind of accounting rules and conventions that evolve over time. For example, the FASB considers the views of auditors in the standard-setting process. Auditors are likely to argue against accounting standards that produce numbers which are difficult to audit, even if the proposed rules produce relevant information for investors.

Given that it is difficult for outside investors to determine whether managers have used their accounting flexibility to signal their proprietary information or merely to disguise reality, a number of accounting conventions have evolved to mitigate the problem. Accounting conventions and standards promulgated by the standard-setting bodies limit potential distortions that managers can introduce into reported accounting numbers. In the United States, the Securities and Exchange Commission (SEC) has the legal authority to set accounting standards. The SEC typically relies on private sector accounting bodies to undertake this task. Since 1973 accounting standards in the United States have been set by the Financial Accounting Standards Board (FASB). There are similar private sector or public sector accounting standard-setting bodies in many other countries. In addition, the International Accounting Standards Committee (IASC) has been attempting to set worldwide accounting standards, though IASC’s pronouncements are not legally binding as of now.

Uniform accounting standards attempt to reduce managers’ ability to record similar economic transactions in dissimilar ways either over time or across firms. Thus they create a uniform accounting language and increase the credibility of financial statements by limiting a firm’s ability to distort them. Increased uniformity from accounting standards, however, comes at the expense of reduced flexibility for managers to reflect genuine business differences in a firm’s accounting decisions. Rigid accounting standards work best for economic transactions whose accounting treatment is not predicated on managers’ proprietary information. However, when there is a significant business judgment involved in assessing a transaction’s economic consequences, rigid standards are likely to be dysfunctional, because they prevent managers from using their superior business knowledge. Further, if accounting standards are too rigid, they may induce managers to expend economic resources to restructure business transactions to achieve a desired accounting result.