1.2 The Need for High Quality Information

Public companies in the United States and around the world are required to provide reports to their investors regarding the financial condition of their companies. As you have learned in previous accounting courses, these reports include income statements, balance sheets, statements of cash flows along with the accompanying schedules and notes. This information is relied upon by investors to make their investment decisions, by creditors to make lending decisions, and by other parties that include vendors, customers, and potential merger or acquisition partners. It is extremely important that this information be reliable since significant sums of money are at stake in these investment and lending decisions.

The ability of users of the financial statements to trust the information they are provided is important to the user of that information, but also benefits the company providing the information. To illustrate how providing high quality information to investors can help the company that issues the information, consider the relationship between risk and return which is often discussed in finance courses. A user of the financial statements of an entity who views the information they obtain as being low quality, or risky, will demand a higher return for his or her investment in that entity. For example, investors will demand a higher expected return for their investment if they believe the investment to be risky. A lender that is uncertain as to the ability of a borrower to repay a loan will either not make the loan or will often make the loan at higher interest rates and/or fees to help offset the cost of the additional risk she faces. Thus, the borrower will end up paying more for the loan simply because the information he provided to the lender was unreliable. This increased cost that is due to the riskiness of the investment is often called the risk premium.

Companies can avoid paying risk premiums by providing high quality, accurate information. Unfortunately, the information provided to the public is not always accurate. To illustrate how and why this can happen think about the last time you made a significant purchase, such as a used car. The person selling you the car wanted to sell you the car for as much money as possible. Therefore, they had the incentive to distort or gloss over negative information that might be important to you in making your purchase decision. They probably focused on the benefits or positive features of the vehicle rather than on its problems. In addition, the person selling the vehicle may have told you something incorrect about the vehicle because he or she didn’t know any better. Perhaps they were unaware of a mechanical problem, and therefore told you there were no mechanical problems with the vehicle.

As the example above illustrates, low quality information can be caused by either intentional or unintentional misstatements of that information. Unintentional misstatements in the financial statements often occur due to weak internal controls, unqualified staff, human judgment errors, or lack of attention to detail in the financial reporting process. These types of misstatements do not involve an intentional effort on the part of management to deceive investors. Rather, they represent oversights by the company that prepared the misstated information.

On the other hand, members of management, who prepare the financial statements, have significant incentives to intentionally misstate the financial statements to make the company appear more profitable than it is. These pressures to manipulate financial statements come from several sources. For example, pressures to meet analyst or other market expectations can be tremendous. Many company executives hold significant amounts of stock and stock options that directly tie their financial worth to the performance of the company. While compensating management in this way has many benefits, it can also have the negative effect of leading to intentional misstatements of financial information in order to drive the stock price up, thereby increasing the value of that manager's stock or option holdings. This risk that management might mislead investors in order to profit from gains in the stock price is referred to as moral hazard. Billions of dollars have been lost by investors due to false financial statements issued by the companies they invest in. For example, an October 2001 revelation that Enron Corporation had issued fraudulent financial statements over a period of several years resulted in a loss of approximately $60 billion of market value.