Analysis of Financial Statements, 3rd Edition

CHAPTER 3

The Quality of Financial Information

Shareholders and creditors depend on the financial statements of companies that are prepared according to generally accepted accounting standards (GAAP). These financial statements have important economic consequences that include determining management compensation, the credit quality of the company's debt obligations, and compliance with loan covenants. Yet despite the important economic consequences of these financial statements, a company's management has considerable flexibility in the choice of accounting methods and estimates. This flexibility, however, creates a situation in which the accounting choices that a company makes affect reported financial information.

The Sarbanes-Oxley Act of 2002 and the regulations and changes in accounting standards that followed increase the transparency of financial statements. Financial reporting by companies is considered transparent when it is easy for investors to understand the company's performance and financial condition. We associate transparency with a high quality of financial information. In terms of valuing companies, those companies with more transparent financial information will be associated with higher values than companies with nontransparent information, if everything else is the same. This is because the opaqueness of the financial information in the latter company increases the uncertainty with respect to the current and future performance of the company and, for that ...