Title LM10 Financial Reporting Quality IFT Notes.pdf ✅

LM10 Financial Reporting Quality 2025 Level I Notes © IFT. All rights reserved 1 LM10 Financial Reporting Quality 1&2. Introduction & Conceptual Overview .................................................................................................... 2 3 – 5. Quality Spectrum of Financial Reports ................................................................................................ 2 6. Differentiate between Conservative and Aggressive Accounting ..................................................... 3 7. Context for Assessing Financial Reporting Quality ................................................................................ 3 8. Mechanisms that Discipline Financial Reporting Quality .................................................................... 4 9. Detection of Financial Reporting Quality Issues: Introduction & Presentation Choices ......... 6 10 - 12. Accounting Choices and Estimates and Their Effects ................................................................ 7 13. Warning Signs .................................................................................................................................................11 Summary ...................................................................................................................................................................14 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM10 Financial Reporting Quality 2025 Level I Notes © IFT. All rights reserved 2 1&2. Introduction & Conceptual Overview There are two main interrelated concepts that will be discussed in detail in this reading: financial reporting quality and earnings quality. Financial reporting quality: High-quality financial reporting provides information that is useful to analysts in assessing a company’s performance and prospects. They contain information that is relevant, complete, neutral, and free from error. High-quality reporting helps in making the right decision as it depicts the true economic reality of a company for the reporting period. Low-quality financial reporting contains inaccurate, misleading, or incomplete information. Earnings quality: High-quality earnings result from activities that a company will likely be able to sustain in the future and provide a sufficient return on the company’s investment. If the return on investment is greater than the cost of funds, then it indicates high earnings quality. Sustainability is the key here. For example, assume a company uses accrual-based earnings in a quarter. It has high accounts receivable and as a result reports high earnings, which is not sustainable in the following quarters. This implies earnings quality is low. 3 – 5. Quality Spectrum of Financial Reports Combining the two aspects – financial reporting quality and earnings quality, we get a spectrum spanning from highest to lowest. Let us now look at the characteristics of reporting/earnings quality as we move down along the spectrum as shown in the exhibit below. 1. Reporting is GAAP compliant and decision useful. The earnings are also sustainable and adequate. 2. Reporting is GAAP compliant and decision useful. However, earnings quality is low,

LM10 Financial Reporting Quality 2025 Level I Notes © IFT. All rights reserved 4 Conditions Conducive to Issuing Low-Quality Financial Reports The three conditions conducive for issuing low-quality financial reports are presented below: Opportunity: It can be the result of weak internal controls, ineffective board of directors, and accounting standards that allow a range of choices. Motivation: It can result from pressure to meet some criteria for some personal reasons. Rationalization: It can result from justifying a wrong choice as seen in Enron’s case. Enron’s CFO sought board approvals, legal and accounting opinions for misstated financial statements. 8. Mechanisms that Discipline Financial Reporting Quality Market Regulatory Authorities Regulators in every country can play a key role in enforcing financial reporting quality. Examples of regulatory authorities include:  the SEC (Securities Exchange Commission).  SEBI (Securities and Exchange Board of India).  Securities and Futures Commission in Hong Kong. These regulatory authorities are members of an international organization called the International Organization of Securities Commissions (IOSCO), comprising 120 regulatory authorities and 80 securities market participants like the stock exchanges. The actual regulation, however, is enforced through each individual regulatory authority in a country. The features of any regulatory regime such as the SEC that affect financial reporting quality include the following:  Registration requirements: Publicly traded companies must register securities before offering securities for sale to the public. A registration document (often known as a prospectus in an Initial Public Offering) contains current financial statements, future prospects of the company, and securities being offered.  Disclosure requirements: Publicly traded companies are required to make public periodic reports such as financial statements.  Auditing requirements: The financial statements must be audited by an independent auditor that states the statements conform to the accounting standards.