Conflicts of interest exist between management and capital market participants because shareholders are interested in the economic reality of a firm’s transactions and managers are under pressure to report information that will satisfy them. Berman and Knight (2008) inform us that handling the company’s finances is both an art and a science (Berman & Knight, 2008). While firms are encouraged to follow the Generally Accepted Accounting Principles (GAAP) parameters in their bookkeeping procedures, conflicts of interest can affect the quality and reality of their reports. Miller (2002) asserts that some firms believe Quality Financial Reporting (QFR) offers stockholders more certainty; others argue it reveals too much information to competitors (Miller, 2002).
The following scenarios can help illustrate how conflicts of interest between management and shareholders can alter a firm’s economic reality by the quality of their reports. Fraser and Ormiston (2010) suggest that red flags are raised immediately when a cash statement reveals significant changes that show a decrease in accounts receivable (A/R) and an increase in cash from operating activities (Fraser & Ormiston, 2010). This could result from a strategy some managers used under duress to inflate CFO figures by selling A/R for cash to appease shareholders. Conflicts of interest can also affect accounting procedures that may occur at a natural gas company, for instance, that utilizes fracking practices. Because of the demand to find alternative gas resources, this industry is banking on the lower rates they offer consumers and managers are under pressure to provide data that supports the enterprise is profitable while environmentally safe. If for example, management has knowledge the industry is not environmentally safe, in an effort to maintain operations, they may use incomplete reporting tactics to shield this data as long as they can along with any other questionable investing activities that could reveal unethical practices such as funds diverted to falsify results. One method shareholders can use to verify the firm’s claims is to scrutinize the outflows of the investment activities and review the notes for clues. Managers want to achieve desired outcomes and shareholders want to hear a company is financially healthy. Because of this component, it presents opportunities for conflicts of interest to develop that can affect the quality of reports that will alter a firm’s economic reality.
Due to the winter holidays, there will be no new posts for the next few weeks. Look for a new blog post Monday, January 6 where I take a closer look at what Annual Report financial ratios reveal.
Thank you for tuning in everyone! Wishing you all a very beautiful winter holiday season.
Berman, K., & Knight, J. (2008). Financial intelligence for entrepreneurs. Boston, MA: Harvard Business School Press.
Fraser, L., & Ormiston, A. (2010). Understanding financial statements. Pearson Education.
Miller, P. (2002, April). Quality Financial Reporting. Retrieved November 25, 2013, from Journal of Accountancy: http://www.journalofaccountancy.com/Issues/2002/Apr/QualityFinancialReporting.htm