Lesson 3 of 8 · All lessons in this module
- Reporting quality, earnings quality and the quality spectrum
- Conservative versus aggressive accounting
- Why managers misreport, and what keeps them honest
- Presentation choices and non-GAAP measures
- Accounting choices and estimates that manage earnings and the balance sheet
- Integrated cases: what accounting choices do to the numbers
- Choices that affect operating cash flow
- Warning signs and how to detect manipulationVideo lesson
Lesson 3 of 8 · 15 min
Why managers misreport, and what keeps them honest
Low-quality reports usually need a motive, an opportunity and a way for the person to justify it; markets, regulators, auditors and private contracts push back, but each has limits.
In short
- Motivations: mask poor performance, meet or beat expectations (analysts' or management's own forecasts), career concerns and incentive pay, and avoiding debt covenant breaches.
- In a strong year managers may bank earnings for next year by delaying revenue or accelerating expenses.
- The fraud triangle: opportunity (weak controls, weak board, flexible standards, small penalties), motivation or pressure (bonus, financing worries) and rationalisation (justifying the choice to oneself).
- Conditions that favour low-quality reporting also include cultures with less transparent disclosure, book/tax conformity and weak capital-market regulation.
- Discipline: capital markets (cost of capital), regulators (registration, disclosure, audit, management commentary, responsibility statements, review of filings, enforcement), auditors and private contracts.
- Audit limits: relies on company information, uses sampling, is not designed to find fraud (the expectations gap) and is paid for by the audited company.
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