© 2000 American Accounting Association

Accounting Horizons
Vol. 14 No. 3
September 2000
pp. 353–363

COMMENTARY

Gregory J. Jonas and Jeannot Blanchet

Gregory J. Jonas and Jeannot Blanchet are Partners at Arthur
Andersen LLP.

Assessing Quality of Financial

Reporting
In the 1999 Report and Recommendations of the Blue Ribbon Committee on
Improving the Effectiveness of Corporate Audit Committees, Recommendation No. 8
states:

The Committee recommends that Generally Accepted Auditing Standards (GAAS)

require that a company’s outside auditor discuss with the audit committee the
auditor’s judgments about the quality, not just the acceptability, of the company’s
accounting principles as applied in its financial reporting; the discussion should
include such issues as the clarity of the company’s financial disclosures and
degree of aggressiveness or conservatism of the company’s accounting principles
and underlying estimates and other significant decisions made by management
in preparing the financial disclosure and reviewed by the outside auditors. This
requirement should be written in a way to encourage open, frank discussion and
to avoid boilerplate.

In response to this recommendation, the Auditing Standards Board (ASB) amended

Statement of Auditing Standards No. 61 (SAS No. 61) to require:

In connection with each SEC engagement, the auditor should discuss with the au-
dit committee the auditor’s judgments about the quality, not just the acceptability,
of the entity’s accounting principles as applied in its financial reporting….Objective
criteria have not been developed to aid in the consistent evaluation of the quality of
an entity’s accounting measurements and disclosures….

In light of these new requirements, auditors, audit committee members, and man-
agement are now struggling to define “quality of financial reporting.” In April 2000, the
AICPA issued Practice Alert No. 2000-02, Quality of Accounting Principles Guidance
for Discussions with Audit Committees, to assist auditors in complying with the new
requirements of SAS No. 61. The Practice Alert provides guidance on the manner and
timeliness of communications with audit committees, and lists ten categories of topics
that management and auditors should consider discussing during these communica-
tions. However, on the subject of quality, it states only:
354 Accounting Horizons/September 2000

Objective criteria have not been developed to aid in the consistent evaluation of an
entity’s accounting principles as applied in its financial statements. SAS No. 61, as
amended, directs the discussion with the audit committee to include items that have
a significant impact on whether the financial statements are representationally faith-
ful, verifiable, neutral, and consistent. These characteristics can serve as a basis for
a discussion of quality in the broadest sense of the word since these are among the
desired qualitative characteristics of accounting information as set forth in Finan-
cial Accounting Standards Board’s Concepts Statement No. 2, Qualitative Character-
istics of Accounting Information (CON2).

We are not aware of any comprehensive model going beyond the discussion in Con-
cepts Statement No. 2 that is designed to assess the quality of financial reporting as a
result of the Panel’s recommendations. In this commentary, we propose a tentative frame-
work that partners of our firm are using in discussions with audit committees and man-
agement. We hope it will generate debate among the financial-reporting community,
and perhaps will lead to the development of better or more complete models to assist
management, auditors, and audit committees assess quality of financial reporting.

Quality of Financial Statements vs. Quality of Financial Reporting

Although Recommendation No. 8 and SAS No. 61 specifically refer to quality of
financial reporting, by focusing on a company’s accounting principles they imply a
focus on financial statements. However, we believe that a comprehensive discussion
about quality should ultimately encompass more than financial statements; compa-
nies disseminate financial information in several other instances (e.g., press releases,
analysts’ briefings, etc.) and in several other ways (e.g., presentations, web sites,
etc.) than through financial statements. Although we developed our framework to
assess the quality of financial statements, it would also apply to financial informa-
tion, broadly defined.
A second point to remember is that financial reporting is not only an end prod-
uct, it is a process whose components are illustrated in Figure 1. Our framework
suggests that the quality of a company’s financial reporting ultimately depends on
the quality of each part of the financial-reporting process.

Different Approaches for Assessing Quality of Financial Reporting

In addition to the Panel’s Recommendation No. 8 and the resulting amend-
ment to SAS No. 61, a number of different approaches dealing with quality of
accounting principles and financial reporting have been discussed in various con-
texts, including:
• FASB Conceptual Framework
• 1994 POB Advisory Panel on Auditor Independence (“Kirk Committee”)
• Earnings persistence model
• SEC’s model in evaluating the quality of International Accounting Standards (IAS)
• 1994 AICPA Special Committee on Financial Reporting (“Jenkins Committee”)

These approaches are in two categories: user needs and shareholder/investor protec-
tion (Figure 2). User needs tend to focus on valuation-related issues. Shareholder/in-
vestor protection tends to focus more on corporate governance and stewardship-related
issues.
Assessing Quality of Financial Reporting 355

FIGURE 1
The Financial-Reporting Process

Company’s transactions
and events

Selection of accounting policies

Application of accounting policies

Estimates and judgments involved

Disclosures about transactions, events,

policies, estimates, and judgments

FIGURE 2
Focus of Prior Efforts to Define Quality of Accounting and Financial Reporting

Focus Recommended Approach

User Needs FASB Conceptual Framework
Earnings Persistence Model
Jenkins Committee Recommendations

Shareholder/Investor Protection Kirk Committee Recommendations

SEC
Panel’s Recommendation No. 8
SAS No. 61 (as amended)

User Needs
Under this category, the quality of financial reporting is determined in relation to
the usefulness of the financial information to the users (broadly defined as primarily
investors and creditors) of that information. The FASB Conceptual Framework is the
primary example of this model. In its Concepts Statements, the FASB argues that qual-
ity must be defined in terms of the overall objective of financial reporting, i.e., to pro-
vide users with information useful for making investment, credit, and similar decisions.
356 Accounting Horizons/September 2000

The FASB then defines the qualitative characteristics necessary for meeting the stated
objective, which are shown in Figure 3.
Under the FASB model, for financial information to be useful to users, it must be
relevant and reliable. A number of more specific qualitative characteristics related to
relevance and reliability (or, in the case of comparability and consistency, both) help
assess relevance and reliability. The FASB acknowledges that it is a subjective assess-
ment, and often there must be a trade-off between relevance and reliability.
The Jenkins Committee approach is closely aligned with the FASB model, but it
goes further in defining the underlying users’ needs for information by identifying seven
concepts:
• Analyze separately each business segment having diverse opportunities and risks
• Understand the nature of a company’s businesses
• Obtain a forward-looking perspective
• Understand management’s perspective
• Indicate the relative reliability of information in business reporting
• Understand a company’s performance relative to that of competitors and other
companies
• Understand promptly important changes affecting a company

To the extent that financial information caters to one or several of the above types
of users’ needs, it is deemed relevant information. The quality of that information is
then judged based on other qualitative characteristics similar to the FASB model, i.e.,
reliability and comparability.
The Earnings Persistence approach is also specifically based on the perspective of
investors. Financial information is deemed relevant if it assists investors in (1) distin-
guishing core earnings from noncore earnings, and (2) segregating the peripheral
financial items or business results from those integral to the ongoing business.

FIGURE 3
FASB’s Qualitative Characteristics of Financial Information

Decision Usefulness

Relevance   Reliability

Timeliness Verifiability Representational

Faithfulness
Predictive Feedback
Value Value
Comparability Neutrality
(including consistency)
Assessing Quality of Financial Reporting 357

All of these characteristics of information considered useful to users have explicit or

implicit links to the ultimate user goal: the determination of firm value or the assess-
ment of credit risk.

Shareholder/Investor Protection
Under this category, the quality of financial information is defined primarily in
relation to providing shareholders with “full and fair disclosure” (the SEC’s “investor
protection” principle). The underlying objective of the earnings management program
announced by Chairman Levitt and undertaken by the SEC over a year ago (Recom-
mendation No. 8 is one of the results of this program) is shareholder/investor protec-
tion. In that context, quality financial reporting is full and transparent financial infor-
mation that is not designed to obfuscate or mislead users.
Figure 4 shows that the approaches classified under the shareholder/investor pro-
tection category share several similar criteria for determining quality of accounting
principles and financial reporting.
Some of the above criteria are similar to those found under the user needs’
family of approaches. However, there is a fundamental distinction between the two
categories: the user-needs approach is primarily concerned with providing finan-
cial information that is relevant to users in making capital allocation/valuation

FIGURE 4
Criteria for Determining Quality of Accounting Principles and Financial Reporting

SEC Model
to Assess
Recommendation No. 8 SAS No. 61 Kirk Committee Quality of IAS
Clarity of disclosures Clarity, consistency, Clarity of financial Transparency
and completeness of disclosure practices
accounting information
and disclosures
Degree of Conservative,
aggressiveness or moderate, or
conservatism of extreme choices of
accounting principles accounting
and underlying principles
estimates
Consistency of Common or minority Comparability
application of practices
accounting policies
Items that have a
significant impact on
representational
faithfulness,
verifiability, neutrality,
and consistency of
accounting information
Full disclosure
358 Accounting Horizons/September 2000

decisions, while the shareholder/investor protection approach is concerned with en-

suring users are provided with as much information as possible (information suffi-
ciency), in as transparent a fashion as possible (information competency). The objec-
tives of each approach are not necessarily mutually exclusive; in many respects, they
reinforce each other.

Our Proposed Framework

In developing our framework, we have obviously drawn on the work that has
been done by the various committees and organizations discussed in the previous
section. But our predominant consideration is to align our framework with the per-
spective of those who use financial reporting: investors and creditors, and their advi-
sors, who are making or influencing decisions about capital allocation. As the cus-
tomers of financial reporting, the users define reporting quality. We therefore asked
ourselves, “How does the user assess the quality of a company’s reporting?” The ele-
ments of the proposed framework represent our answers to this question.
The FASB’s Concepts Statements represent the most advanced thinking done to
date on the objectives and characteristics of quality financial reporting, and offer an
excellent starting point for developing a framework. In addition to the qualitative
characteristics of the FASB model, we have integrated additional elements from the
other approaches we thought would provide additional insights into reporting qual-
ity (Figure 5).
We have also developed a series of questions that audit committee members,
auditors, and management could ask to assess the quality of a company’s reporting
(see the Appendix). (The numbers included in the boxes in Figure 5 refer to the re-
spective sections in the Appendix.)
By dissecting reporting quality into specific parts, the framework enables audit
committees, auditors, and management to engage in substantive conversations about
quality. As you work through these elements, you also realize that they are distinct
yet interdependent. For example, quality financial information that is relevant is
not useful if it is not reliable. In addition, there will be trade-offs across the ele-
ments. For example, a company may appropriately sacrifice consistency in the inter-
est of a new and better method of reporting. Hopefully, the framework will help
everyone involved look beyond the requirements of compliance to the requirements
and expectations of investors.
We believe it is both essential and possible to develop a common framework for
assessing quality of financial reporting. A common framework would promote a com-
mon vocabulary and understanding about quality among audit committee members,
management, and auditors. It would, over time, promote benchmarking among com-
panies and encourage improvements in reporting by setting a high standard. Our
framework is an attempt to generate the level of discussion and debate needed to
develop a framework that is generally accepted among auditors, audit committees,
and boards.
Assessing Quality of Financial Reporting 359

FIGURE 5
Proposed Framework

Decision Usefulness

Clarity
Relevance   Reliability (11)

Timeliness Verifiability Representational

Predictive Feedback (4) (5) Faithfulness
Value Value (7)
(3)

Comparability
(including Consistency) Neutrality
(9 and 10) (8)
Earnings Disaggregated
Persistence Information Completeness
(1) (2) (6)
360 Accounting Horizons/September 2000

APPENDIX
Questions to Assess Quality of Financial Reporting

1. Relevance/Predictive Value/Earnings Persistence

This characteristic focuses on the distinction between components of earnings that are
unusual or nonrecurring vs. those that are expected to persist in the future. Predictive
value, in this sense, relates to the usefulness of information to the investor who wants to
evaluate (predict) the company’s future prospects; it does not mean the value of the infor-
mation as a prediction. A shorthand way of thinking about earnings persistence is to ask
whether the information is useful in assessing the likely levels of recurring earnings, i.e.,
the company’s sustainable earnings potential.

1.1 What specific elements of the financial statements (format, note disclosure, etc.) and
related disclosures (including MD&A, press releases, etc.) are useful in understand-
ing the company’s sustainable earnings?
1.2 When identifying unusual or nonrecurring items for disclosure, are both gains and losses
given equal importance?
1.3 To what extent was the timing of transactions managed in order to occur (or not occur)
in the reported period? What was the purpose of managing the timing? How did that
affect the predictive value of the reported results?

2. Relevance/Predictive Value/Disaggregated Information

This characteristic focuses on how segmented information about a company’s business

allows investors to better understand a company’s prospects. A shorthand way of thinking
about the predictive value of disaggregated information is to ask whether the information
permits users to identify and assess the differing opportunities and risks contained within
the company’s various businesses.

2.1 What specific aspects of the company’s disaggregated information, taken as a whole,
lead you to believe that the company has communicated a sufficiently complete under-
standing of its various business opportunities and risks?
2.2 How does the discussion of the company’s business segments in MD&A and other non-
financial statement reports (including discussions with analysts or reporters) comple-
ment the segment information presented in the financial statements? What specific
examples illustrate how the respective disclosures complement each other?
2.3 Does the information presented in the segment footnote convey a financial picture that
is consistent with underlying businesses within each segment?

3. Relevance/Feedback Value

This characteristic focuses on the usefulness of information in telling us about the past.
Feedback, in this sense, confirms (or corrects) our prior expectations. A shorthand way of
thinking about feedback value is to ask whether the information allows investors to under-
stand how management’s past actions and decisions have affected the company’s current
financial position and results.

3.1 What specific disclosures made as part of a company’s financial reporting (including
MD&A, press releases, and other communications of a financial nature) demonstrate
that the information is adequate in assessing whether reported results confirm previous
Assessing Quality of Financial Reporting 361

expectations? In other words, how much information is provided about management’s

previous expectations that confirm or deny such expectations, and reasons for expecta-
tions not being met?
3.2 Do the reported results (including the company’s financial position) provide feedback to
investors as to how various market events and significant transactions affected the com-
pany? What specific elements within the financial statements (or MD&A) illustrate this?

4. Relevance/Timeliness

This characteristic focuses on having information before it becomes irrelevant. A short-

hand way of thinking about timeliness is to ask whether the information would have been
more useful had it been available earlier.

4.1 In what way does the company go beyond merely complying with SEC filing require-
ments in term of timeliness?
4.2 How does the company compare with its competitors in the timely publishing of its
financial statements?
4.3 What new ways of communicating financial information (e.g., Internet communica-
tions, etc.) has the company used or begun to consider?
4.4 How does the company ensure that it provides the same information to all interested
users at the same time?

5. Reliability/Verifiability

This characteristic focuses on accuracy, use of estimates, reliance on assumptions, ability

to quantify and measure, and the level of support or evidence. A shorthand way of thinking
about whether information is verifiable is to ask whether a sufficiently knowledgeable
third party would look at the underlying data and derive a similar result.

5.1 What are the most judgmental aspects of the company’s financial reporting from a
measurement perspective? How does the information in the financial statements allow
a reader to understand what those aspects are?
5.2 What information in the financial statements (and MD&A) communicates the significant
estimates and assumptions used to develop financial information? Where there is a
range of possible outcomes, how does the company communicate that range to investors?
5.3 How does the company assess whether its significant estimates and assumptions are
based on the best information available? Does the company use independent specialists
or sophisticated quantitative techniques to validate or develop key estimates and
assumptions?
5.4 What materiality thresholds does the company use for recording transactions and
preparing its financial statements? How are these thresholds communicated to account-
ing, sales, purchasing, and other appropriate personnel?

6. Reliability/Completeness

This characteristic focuses on comprehensiveness, balance, inclusiveness, and transpar-

ency. A shorthand way of thinking about whether information is complete is to ask whether
it tells the whole story.

6.1 What are the most significant events of the past year and how are those communicated
to investors? Is the information presented in an even-handed manner? What specific
elements within the financial statements (or MD&A) illustrate this?
362 Accounting Horizons/September 2000

6.2 What negative events or unsatisfactory outcomes occurred during the year and how are
those presented in the financial statements (and MD&A)? What process did manage-
ment follow to ensure the story was told fairly and impartially?
6.3 What positive events or outstanding outcomes occurred during the year and how are
those presented in the financial statements (and MD&A)? Is the weight placed on
these events appropriately balanced with other events?

7. Reliability/Substance

This characteristic is referred to as “representational faithfulness” in the accounting lit-

erature. It focuses on whether the financial information is consistent with the facts, re-
flects the substance of events, and portrays the underlying economics of the transaction. A
shorthand way of thinking about substance is to ask whether the information is an honest
and clear portrayal of what happened.

7.1 When the company selects accounting principles, how does it assess whether the se-
lected principles will appropriately convey the underlying economics of the transac-
tions? What accounting principles changed during the year and how were they assessed?
7.2 When the company enters into significant or complex transactions for which the ac-
counting literature is not black and white, how does the company assess whether its
accounting is appropriate? What is management’s philosophy toward the application
of accounting principles in these circumstances?
7.3 To what extent does the company enter into (or modify) transactions in order to achieve
a specific accounting result? In those situations, how does management ensure that
the accounting is an honest and clear portrayal of the substance and purpose of the
transaction?
7.4 To the extent that the accounting literature precludes the company from portraying
the transaction according to its substance, what information does the company pro-
vide (in the footnotes and the MD&A) to supplement the investor’s understanding?

8. Reliability/Neutrality

This characteristic focuses on objectivity and balance. A shorthand way of thinking about
whether the information is neutral is to ask whether it conveys facts in an unbiased man-
ner, i.e., without an intent to influence the investor’s opinion or behavior.

8.1 Looking at the significant judgments discussed in 5.1 (verifiability), how neutral
was management’s assessment of the likely outcome? What specific examples illus-
trate this?
8.2 Although characteristics such as “aggressiveness” and “conservatism” mean different
things to different people, one way or another, they suggest some type of bias. Think-
ing about those two terms, how close to “neutral” is the company’s accounting for and
disclosure of significant events and transactions?
8.3 Reflecting on the answer to 7.1 (assessing alternative accounting principles),
how does neutrality factor into management’s selection of accounting principles? Will
the selected accounting principles present a balanced view?

9. Comparability

This characteristic focuses on accounting for similar transactions and events in the same
way, as well as accounting differently for dissimilar transactions and events. Accordingly,
comparability should not be confused with uniformity or consistency. A shorthand way of
Assessing Quality of Financial Reporting 363

thinking about comparability is to ask whether the information is prepared in a way that
lends itself to informed comparisons with other companies.

9.1 How do the company’s accounting policies, disclosures, format of financial statements,
and other financial communications compare to the company’s competitors? In what
specific respects are they judged to be of better or worse quality (i.e., which of the
qualitative characteristics discussed in this model do they best meet)?
9.2 If a selected accounting policy reflects a specific industry practice, is it the prevailing
practice? If not, is that practice in accordance with accounting requirements specifi-
cally codified as part of GAAP (as opposed to being only a less prevailing, noncodified
industry practice)?

10. Consistency

This characteristic focuses on conformity from period to period with unchanging policies
and procedures. A shorthand way of thinking about consistency is to ask whether the infor-
mation is prepared in a way that lends itself to appropriate comparisons of a company’s
business performance over a period of time.

10.1 What changes, if any, have there been in the company’s accounting policies or in
management’s application of the policies and the use of estimates and judgments? In
what way are those changes an improvement over past practices (i.e., which of the
qualitative characteristics discussed in this model do they best meet)? To what spe-
cific disclosures can you point in order to demonstrate that the effect of the changes
on all periods presented has been appropriately disclosed?
10.2 What indication, if any, is there that changes in the company’s accounting policies, in
the application of those policies, or in the use of estimates and judgments are moti-
vated by management’s desire to achieve a specific accounting result?

11. Clarity

This characteristic focuses on the understandability (also covered in the FASB framework
as a characteristic of the users of financial statements rather than of the information it-
self), organization, and comprehension of the information. A shorthand way of thinking
about clarity is to ask whether the company’s financial information is presented in an
organized, clear, and concise fashion, appropriately balancing brevity with sufficiency.

11.1 In what way do the company’s disclosures go beyond complying with the absolute
minimum requirements of GAAP (i.e., how do they further explain transactions or
events)?
11.2 How well organized and easy to follow is the company’s presentation of its informa-
tion (considering the constraints of GAAP)?
11.3 Is the language used in the financial reports easily understandable by nonaccountants?
How has the company applied “plain English” concepts to its financial information?
11.4 How has the company made use, in its financial reports, of simple, clear graphs and
charts to enhance the understandability of the financial information?
11.5 Do the financial statements and other disclosures (e.g., MD&A) form a comprehen-
sive, cohesive, and coherent set of financial information that “tells the whole story”?