Level 1 CFA® Exam:
Context & Management’s Motivations
CFA Exam: Key Management’s Motives and Conditions to Issue Low-Quality Financial Statements
star content check off when doneIn Lesson 2, we will dive into the key motivations that might be driving the management to issue low-quality financial reports. We will also try to understand what are the circumstances that support such decisions. Specifically, we will cover:
- key management’s motives and conditions to issue low-quality financial statements, and
- regulatory and industry oversight over financial statement quality.
We begin with the management’s motives.
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For the management to issue low-quality reports, appropriate circumstances need to exist. We list three key conditions:
- opportunity – opportunity usually exists when the internal controls and culture of the firm are not robust enough to counteract or disclose biased or fraudulent financial reporting on time. Usually, it is accompanied by poor governance demonstrated by the top management. Moreover, vague accounting standards might create an opportunity as it might be more difficult for both internal and external parties to challenge the application of the accounting rules.
- motivation – as discussed above, usually personal motivations exist for the top management to manipulate the results for personal gain whether linked to remuneration or reputation.
- rationalization – processes or culture in the company might also create the circumstances that support untrue financial reporting. When the company has a culture of aggressively seeking profits, it is easier for the top management to justify to themselves that the manipulation or judgmental application of accounting standards is the right thing to do.
The risks that the financial statements might be biased due to the motives and circumstances listed above are clear to the market participants and analysts. Let’s now consider what are the mechanisms to mitigate that risk and discipline financial reporting quality.
Here, we cover the key mechanisms that discipline financial reporting quality. We also explain what are the limitations of these mechanisms (see: audit).
We name four key mechanisms:
- markets,
- market regulatory authorities,
- auditors,
- private contracts.
Markets
Markets are competitive and companies need to compete for investors’ money. Multiple factors can impact the level of trust that investors have towards companies seeking capital. High-quality financial reporting definitely builds such trust and decreases investment risk. With investors willing to invest in the company, the company will be able to source the capital at a cheaper cost.
Market Regulatory Authorities
Unfortunately, the vision of having a lower cost of capital is not always sufficient for companies to produce high-quality reporting due to the motives discussed earlier. Therefore, regulators and governments have established market regulatory authorities whose role is to provide guidance, objectives, and principles concerning high-quality financial reporting for financial markets.
One such organization is the International Organization of Securities Commission (IOSCO) with approx. 120 securities regulators and 80 other securities market participants as members. European Securities and Market Authorities (ESMA) in the European Union, Financial Conduct Authority (FCA) in the United Kingdom, and Securities and Exchange Commission (SEC) in the US are the key market regulatory authorities in the European and US markets. In APAC, we can list institutions such as Japan’s Financial Services Agency, China’s Securities Regulatory Commission, and Securities and Exchange Board in India.
Key elements of sound high-quality financial reporting regimes:
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Auditors, especially independent external auditors, play a crucial role in ensuring that the financial statements of public companies do represent the true and unbiased performance of the companies. It is worth mentioning that not only public companies are audited by independent auditors. Private companies may be required to undergo independent audits as well, e.g., to meet the requirements set by the lenders.
An unqualified opinion represents, with some level of assurance, that the financial report complies with GAAP and fairly presents the company’s performance. An adverse opinion, on the other hand, manifests that the independent auditor spotted material issues, misstatements, or weaknesses within the financial statements or their components.
While the review conducted by the auditors provides additional assurance on the quality of financial statements for analysts, investors, and other users, we need to note that there are certain limitations within the auditing process such as:
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The last important mechanism we have to mention is the process of private contracting.
Regulators and auditors are not the only bodies that may influence the financial reporting process. Banks and other capital providers usually set strict requirements for the companies that they lend money to. The borrowers have to provide frequent and high-quality performance reports, e.g., to ensure that debt covenants have not been breached.
Other capital providers such as capital investors may also include legally binding contractual provisions that would allow them to withdraw the funds invested if the quality of performance reporting is unsatisfactory. Thus, investors also have the means to discipline the company and ensure that the presented reporting is fair and accurate.
Company XYZ has taken a USD 15 million bullet loan (the company is required to pay interest only, while the principal is repaid in the full amount at the end of the loan term) from Big Bank Inc. to buy a commercial building valued USD 30 million. The other half of the price is financed with the company’s own funds. Company XYZ is planning to lease the building to tenants. The bank requires the company to constantly maintain the loan-to-value ratio below 60%. After a couple of years, the global economy deteriorates and the valuation of properties drops significantly (by approx. 20%) in the region where Company XYZ operates. However, the company’s management fails to reassess the current market value of the commercial building funded by the loan from Big Bank Inc. Discuss the motivations of the management to apply a constant valuation of the commercial building in its books.
Taking into consideration the economy and changes in property valuation, it is highly probable that the current value of the commercial building has decreased.
Assuming the average changes in the valuation of 20%, the current value of the property would amount to approx. USD 24 million (80% x USD 30m).
If that is the case, the current LTV ratio equals 62.5% (USD 15m of the principal / USD 24m of property value).
In such a case, the bank would usually require Company XYZ to either repay a portion of the loan or provide an additional asset as collateral. Both of those situations are not welcome by the management and potentially they might be the motivations behind the management’s failure to reassess the property value.
In real life, banks discipline companies to accurately reflect the value of their assets in the financial statements by monitoring the valuation of the property and requiring companies to frequently revalue the properties (e.g., with the help of independent valuers).
- The management may be tempted to bias the company’s financial statements when some specific motivations and conditions exist.
- Key motivations for the management are the poor performance of the company, the temptation to beat market expectations, and the will to adhere to debt covenants.
- Key conditions that need to exist for the management to issue biased financial statements are opportunity, motivation, and rationalization.
- There are 4 major mechanisms to promote high-quality financial reporting and hinder low-quality one: market, market regulatory authorities, auditors, and private contracts.
- Market will promote high-quality reporting through a higher valuation and easier access to capital.
- Market regulatory authorities will establish a set of rules and requirements for the market participants and public companies to force high-quality financial reporting.
- An auditor's opinion on financial statements (either unqualified (clean) or adverse) will help the markets to assess the risk of financial statements being inaccurate or erroneous.
- Private contracting, while not being the key mechanism, will also motivate companies to faithfully report their performance.