Managing the Risk of Misleading Financial Metrics in Annual Reports: A First Step towards Providing Assurance over Management's Discussion

Abstract

Recent public policy initiatives seek greater transparency in financial reporting through an honest, balanced and thorough management discussion of company performance in the annual report. Management’s discussion invariably includes key performance indicators, such as financial ratios, relevant to external stakeholders. We model the impact of accounting estimates, assumptions, choices and errors on the risk of misleading financial ratios. This framework is illustrated through good and bad examples of financial reporting practices and by simulation of financial data of public companies. We provide a structured approach to inform policymakers, auditors and other stakeholders of the incremental financial reporting risk that accompanies current regulatory efforts.

Keywords: Audit Risk, Financial Ratio, Financial Reporting Transparency, MD&A

JEL Classification: C11, C15, C44, D81, M41, M40, M49