1.2 The Need for High-Quality Information

Public companiesPublic companies: A company that sells ownership interests to members of the general public through public exchange markets. 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, and 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 because significant sums of money are at stake in these investment and lending decisions.

It is important that the users of the financial statements can trust the information they are provided. This trust 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. An investor who views the information in financial statements as being low quality, or risky, will demand a higher return for his or her investment in that entity. A lender that is uncertain of the borrower’s ability 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.risk premium.: The difference between the return demanded by investors and the return that would be demanded in the absence of any associated risk.

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 making a significant purchase, such as a used car. The person selling you the car wants to sell you the car for as much money as possible. Therefore, he has the incentive to distort or gloss over negative information that might be important to you in making your purchase decision. He 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 know any better. Perhaps he was unaware of a mechanical problem, so he 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 information. Unintentional misstatements in 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.

For an example of a misstatement, watch “Information Asymmetry: Buying a Used Car”:

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 hazardmoral hazard: A situation when a party makes risky decisions because they are sheltered from the consequences of their behavior.. 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 revelation1 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.