The Qualitative of Financial Reporting

ACCOUNTING HORIZONS Supplement 2003 pp. 77-96

The Quality of Financial Statements: Perspectives from the Recent Stock Market Bubble

Stephen H. Penman

SYNOPSIS: During the recent stock market bubble, the traditionat financial reporting model was assailed as a backward-looking system, out of date in the Information Age. With the bursting of the bubble, the quality of financial reporting is again under scrutiny, but now for not adhering to traditional principles of sound earnings measurement and asset and liability recognition. This paper is a retrospective on the quality of financial reporting during the 1990s. Did reporting under U.S. GAAP perform well during the bubble, or was its quality suspect? My premise is that financial reporting should serve as an anchor during bubbles, to check speculative beliefs. With a focus on the shareholder as customer, the paper asks whether shareholders were well served or whether financial reporting helped to pyramid earnings and stock prices. The scorecard is mixed. A number of quality features of accounting are identified. Inevitable imperfections due to measurement difficulties are recognized, as a quality warning to analysts and investors. A number of failures of GAAP and financial disclosures are identified that, if not recognized, can promote momentum investing and stock market bubbles.

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INTRODUCTION oncems about the quality of accounting intensify as economies turn down, companies founder, and investors lose. With the bursting of the recent stock market bubble, the quality of accounting is again under scrutiny. This essay questions the quality of fmancial reporting against the backdrop ofthe stock market bubble. Bubbles work like a pyramiding chain letter. Speculative beliefs feed rising stock prices that beget even higher prices, spurred on by fiirther speculation. Momentum investing displaces fundamental investing. One role of accounting is to interrupt the chain letter, to challenge speculative beliefs, and so...