QUALITY OF FINANCIAL

STATEMENTS
 INTRODUCTION

❑Annual report is one form of communication

between managers and stakeholders.
❑Therefore, financial reporting quality (FRQ)
in annual reports has to be taken into
consideration to enable users to make
informed decisions.
 INTRODUCTION……
❑The primary objective of financial reporting is to provide high-quality
information concerning economic entities, primarily financial in
nature and useful for economic decision making.
❑Provision of high quality financial information is very important
because it will positively influence capital providers and other
stakeholders in making investment, credit, and similar resource
allocation decisions that enhance the overall market efficiency.
 INTRODUCTION…….

❑Although IASB stresses the importance of high-

quality financial reports, one of the key problems is
how to measure this quality.
❑ Since different user groups will have dissimilar
preferences, perceived quality will deviate among
constituents.
MEASUREMENT METHODS TO ASSESS THE QUALITY
OF FINANCIAL REPORTING

❑Accrual Models
❑ Value Relevance Models
❑ The Qualitative Characteristics
 1. ACCRUAL MODELS

❑Accrual models are used to measure the extent of

earnings management under current rules and
legislation.
❑These models assume that managers use discretionary
accruals, i.e. accruals over which the manager can exert
some control, to manage earnings (Healy & Wahlen,
1999; Dechow et al., 1995).
 ACCRUAL MODELS…..

❑Earnings management is assumed to

negatively influence the quality of
financial reporting by reducing its
decision usefulness (e.g. Brown, 1999;
Van Tendeloo & Vanstraelen, 2005).
 ACCRUAL MODELS…..

❑The main advantages of using

discretionary accruals to measure
earnings management is that it can be
calculated based on the information in
the annual report.
 ACCRUAL MODELS…..
❑The main difficulty when using accrual models,
however, is how to distinguish between discretionary
and non-discretionary accruals (Healy& Wahlen, 1999).
❑Furthermore, it is only an indirect proxy of earnings
quality, excluding non-financial information.
 ACCRUAL MODELS…..
❑Therefore, the quality of financial reporting
information based on accrual models do not
provide direct and comprehensive evidence
concerning the quality of financial reporting
information and its dimensions of decision
usefulness (Healy & Wahlen, 1999).
 2. VALUE RELEVANCE MODELS

❑Value relevance models measure the

quality of financial reporting information by
focusing on the associations between
accounting figures and stock-market
reactions (e.g. Barth et al., 2001; Choi et al.,
1997; Nichols & Wahlen, 2004).
 VALUE RELEVANCE MODELS….
❑The stock price is assumed to represent the market value
of the firm, while accounting figures represent firm value
based on accounting procedures.
❑When both concepts are (strongly) correlated, i.e. changes
in accounting information correspond to changes in market
value of the firm, it is assumed that earnings information
provides relevant and reliable information (Nichols &
Wahlen, 2004).
 VALUE RELEVANCE MODELS….
❑This method is also used to examine earnings persistence,
predictive ability, and variability, as elements of earnings quality
(Schipper & Vincent, 2003; Francis et al., 2004).
❑The focus of value relevance literature on relevance and
faithful representation (reliability) is consistent with the
Conceptual Framework for Financial Reporting Exposure Draft,
as these notions are defined as the fundamental qualitative
characteristics.
 VALUE RELEVANCE MODELS….

❑However, this literature does not distinguish between relevance

and reliability, i.e. does not explicitly show whether or not
tradeoffs have been made when constructing accounting
figures.
❑In addition, the stock market may not be completely efficient.
As a consequence, stock prices may not represent the market
value of the firm completely accurate (Nichols & Wahlen, 2004).
 CONCLUSION
❑In conclusion, accrual models and value relevance
literature only focus on information disclosed in financial
statements to assess the financial reporting quality.
❑However, a comprehensive measurement tool of financial
reporting quality would at least include the complete
annual report, including both financial and non-financial
information.
3. ASSESSING QUALITY OF FINANCIAL REPORTING IN
TERMS OF THE QUALITATIVE CHARACTERISTICS

❑The financial reporting quality is measured

in terms of:
✓Fundamental characteristics; and
✓Enhancing qualitative characteristics
•
 A. THE FUNDAMENTAL QUALITATIVE
CHARACTERISTICS
❑The purpose of these characteristics is to distinguish between
useful information and information that is not useful or misleading.
❑They are the most important and determine the content of financial
reporting information.
❑These include:
✓ Relevance
✓ Faithful representation.
 RELEVANCE

❑Relevance is referred to as the capability “of making

a difference in the decisions made by users in their
capacity as capital providers” (IASB, 2008).
❑Financial information is capable of making a
difference in decisions if it has predictive value,
confirmatory value or both.
 Relevance……
Predictive value
❑Information is relevant if it helps users of the
financial statements in predicting future trends of
the business.
❑Predictive value is considered as most important
indicator of relevance in terms of decision
usefulness.
 Relevance……
❑ Predictive value is measured by using three items
I. The extent to which annual reports provide forward-looking statements. The forward-looking
statement usually describes management’s expectations for future years of the company.

II. To what extent the annual reports discloses information in terms of business opportunities and
risks. It provides insight into possible future scenarios for the company.

III. To what extent the company uses of fair value. It is often claimed that fair value accounting
provides more relevant information than historical cost because it represents the current value
of assets, instead of the purchase price.
 Relevance……
Confirmatory value
❑Information has confirmatory value “if it confirms or changes
past (or present) expectations based on previous evaluations”
(IASB, 2008).
❑Same piece of information which assists users in confirming
their past predictions may also be helpful in forming future
forecasts.
 Relevance……

❑Example:
A company discloses an increase in Earnings Per Share
(EPS) from $5 to $6 since the last reporting period. The
information is relevant to investors as it may assist them in
confirming their past predictions regarding the profitability
of the company and will also help them in forecasting future
trend in the earnings of the company.
 Relevance……

❑Relevance is affected by the materiality

of information contained in the financial
statements because only material
information influences the economic
decisions of its users.
 Relevance……

Example:
A default by a customer who owes $1000 to a company having
net assets of worth $10 million is not relevant to the decision
making needs of users of the financial statements. However, if the
amount of default is, say, $2 million, the information becomes
relevant to the users as it may affect their view regarding the
financial performance and position of the company.
 FAITHFUL REPRESENTATION

❑The financial information in the financial

reports should represent what it purports to
represent.
❑Meaning, it should show what really are
present and what really happened, as the
case may be.
FAITHFUL REPRESENTATION……

❑Faithful representation is measured by

referring to the following items:
✓Neutrality
✓Completeness
✓Freedom from material error
 FAITHFUL REPRESENTATION……

❑Neutrality: is defined as “fairness and freedom

from bias intended to attain a predetermined result
or to induce a particular behaviour.
❑Neutral information does not colour the image it
communicates to influence behaviour in a
particular direction” (IASB, 2008).
 FAITHFUL REPRESENTATION……
❑However, an annual report can never be completely
free from bias, since economic phenomena presented
in annual reports are frequently measured under
conditions of uncertainty.
❑Many estimates and assumptions are included in the
annual report.
FAITHFUL REPRESENTATION……

❑Completeness, i.e. adequate or full

disclosure of all necessary information
❑Freedom from material error i.e. no
inaccuracies and omissions.
 TAKE A NOTE ON THE FOLLOWING
❑It is difficult to measure faithful representation directly by only
assessing the annual report.
❑Nevertheless, the auditors’ report adds value to financial reporting
information by providing reasonable assurance about the degree to
which the annual report represents economic phenomena faithfully.
❑Additionally, an increasingly important consideration in the annual
report related to faithful representation is the corporate governance
statement.
 B. ENHANCING QUALITATIVE
CHARACTERISTICS

❑The enhancing qualitative characteristics include:

✓ understandability,
✓ comparability,
✓ verifiability
✓ timeliness
❑These can improve decision usefulness when the fundamental
qualitative characteristics are established
 Understandability

❑Information is understandable when it enables

users to comprehend the meaning of such
information (IASB, 2008).
❑ Understandability will increase when information
is classified, characterized, and presented clearly
and concisely.
 Understandability…….

❑Furthermore, disclosure information, and in

particular the notes to the balance sheet and
income statement, may be valuable in terms
of explaining and providing more insight into
figures presented in the financial statements.
 Understandability…….

❑Additionally, the presence of

tabular or graphic formats may
improve understandability by
clarifying relationships and ensuring
conciseness.
 Comparability

The quality of information that enables

users to identify similarities in and
differences between two sets of
economic phenomena” (IASB, 2008).
 Comparability…..
❑Comparable information enables
comparisons within the entity and across
entities.
❑When comparisons are made within the
entity, information is compared from one
accounting period to another.
 Comparability……

❑Comparability of information across entities enables

analysis of similarities and differences between different
companies.
❑Comparability includes consistency. “Consistency refers
to the use of the same accounting policies and
procedures, either from period to period within an entity or
in a single period across entities” (IASB, 2008).
 Timeliness

❑“Timeliness means having information available to

decision makers before it loses its capacity to
influence decisions” (IASB, 2008).
❑Information shouldn't be significantly delayed or
else it will be of little or no value.
 Verifiability

❑Financial information is verifiable when it

enables knowledgeable and independent
observer to reach consensus on whether a
particular depiction of an event or transaction
is a faithful representation.
 Verifiability…
❑Financial information should be supported by
evidence to permit independent individuals to
check them and see whether such information
is faithfully represented.
❑In other words, information is verifiable if it
can be audited.
 REVIEW QUESTION

Annual report is among the forms of communication between managers and other
stakeholders. Therefore, financial reporting quality (FRQ) in annual reports has to be taken
into consideration to enable users to make informed decisions.
REQUIRED:
I. Explain Accrual models and value relevance models as measurement methods used in
assessing quality of financial reports
II. Assess the quality of financial reporting basing on the fundamental qualitative
characteristics.