In theory, accounting is supposed to be black and white, with binary decision-making processes and no wiggle room. In practice, however, not all figures shown in financial statements are unequivocal. In some cases, the lines are blurry because transactions are complex and require significant judgment calls by management.
To illustrate, let’s think about a defense contractor that uses the percentage of completion method of accounting to record revenue from a long-term contract that spans over multiple years (and in some, cases, decades). How would one estimate the percentage of the contract that is complete at any specific point of time? That is why periodic changes in the initial estimates need to be recorded.
Changes in Accounting Estimates (CAEs) are a normal part of periodic reviews of both current and future benefits and obligations. These estimates are recorded as new information appears. From an accounting perspective, the disclosure is governed by ASC 250, which requires all material changes in estimates to be disclosed.
Yet, there is a concern that changes in estimates could be used opportunistically by management to improve short-term results. Recently, regulators also expressed concerns about substantial risk in auditing estimates. Let’s look at this quote from the PCAOB proposal to enhance auditing of the estimates:
Three recent academic working papers, using data from our Changes in Accounting Estimates dataset, shed light on the question of whether changes in estimates increase transparency or, alternatively, are misused to hide short-term weakness.
Below, we provide a brief overview of each paper. Interestingly, although the working papers look at different metrics to measure financial quality, the conclusions were uniform: changes in estimates are used to provide short-term benefits and do not improve quality of the financial reporting.
“Changes in Accounting Estimates: Are the Current Disclosure Requirements Sufficient to Deter Managerial Opportunism?”1 – A. Albrecht, K. Kim, K. Lee
This paper looks into the timing of CAE disclosures and how they affect the quality of financial reporting and earnings.
The analysis looks at 2,293 CAEs disclosed in annual (10-K) and quarterly (10-Q) reports between December 15, 2005 and fiscal year 2015. Using the Audit Analytics description for each CAE, these are classified into 15 categories involving changes to Revenue Recognition, Liabilities, Accruals or Reserves, Depreciation and others.
Overall, the data shows that firms are more likely to announce a positive CAE when the earnings are likely to miss consensus analyst forecasts. On the other hand, firms are more likely to announce a negative CAE when the earnings already exceed forecasts and the change is unlikely to lead to negative earnings.
Regarding the quality of financial reporting, the results show that companies with CAEs are more likely to file restatements and receive SEC comment letters.
The study also looks into the temporal variation and finds that the opportunistic disclosure of CAEs in the fourth quarter is much lower due to the annual audits by external auditors.
“Do Managers Successfully Shop for Compliant Auditors? Evidence from Accounting Estimates” -M. DeFond, J. Zhang, Y. Zhao
This paper focuses on opinion shopping,which is defined by the SEC as “the search for an auditor who’s willing to support a proposed accounting treatment designed to help a firm achieve its reporting objectives even though that treatment might frustrate reliable reporting”.
This analysis goes beyond the traditional idea of opinion shopping, such as firms switching auditors in order to avoid an unfavorable audit opinion, and focuses on managers being able to achieve opportunistic reporting objectives through the switch to a more compliant successor auditor that possesses less information about the firm’s underlying economics relative to the incumbent. For this reason, the study expects changes in accounting estimates related to opinion shopping to be both income increasing and discretionary. This is because incumbent auditors have fewer reasons to disagree with income decreasing changes in accounting estimates, as auditors rarely get sued for earnings understatements but for earnings overstatements.
The data used to test this hypothesis includes all firms with available data that changed auditors at least once between 2004-2015. Final data was comprised of 8,484 firm-year observations, which includes 1,528 unique firms, 1,809 auditor changes and 586 CAEs.
The analysis compares firms’ likelihood to report CAEs three years before an auditor change and three years after the change. The results show that the likelihood of a discretionary income increase in CAEs increases by 123.5% from the pre-change of auditor moment.
Expecting poorer financial reporting quality associated with CAEs, the analysis also investigates five results that are common consequences of earnings management. They find that changes in estimates are associated with a higher likelihood of meeting or surpassing earnings targets, fewer going concern opinions, more restatements, higher discretionary accruals, and a decline in annual stock returns.
These results show ex-post evidence of managers shopping for more accommodating auditors. However, the authors of this paper also expect managers to think about the ex-ante likelihood of successor auditors accepting income discretionary changes in accounting estimates. Adopting the framework from Lennox (2000), they find that firms are more likely to switch to auditors whose clients have a higher likelihood of income increasing changes in accounting estimates.
“The Association between Changes in Accounting Estimates and Accounting Restatements” -P.Beaulieu, B.L. Hayes, L. Timoshenko
Lastly, this paper studies the relation between changes in accounting estimates and restatements. The hypothesis is that CAEs are positively associated with subsequent restatements that correct intentional or unintentional misstatements.
This analysis looks at roughly 70,000 firm quarter observations from the S&P 1500 and found 2,112 CAEs.
Using logistic regression, the paper finds a positive relationship between CAEs and subsequent restatements. More specifically, the presence of a CAE is positively associated with an increased likelihood of a subsequent restatement to correct the intentional misstatement. Hence, since restatements reflect low earnings and audit quality, this description may also be attached to changes in accounting estimates. Overall, these have important consequences for a company.
Reasons such as these are why the paper supports auditors in their negotiations with clients regarding changes in accounting estimates; audit firms should be very skeptical about CAEs due to the consequences they carry.
Conclusion
All three working papers found evidence that CAEs can lead to lower quality of financial reporting. Whether it may be from opinion shopping, managerial opportunism or an unintentional misstatement, these CAEs have been positively associated to subsequent restatements. This can lead to poorer financial quality which, in turn, can impede the assessment of earnings quality making it harder to accurately assess a company’s performance.
For more information on Changes in Accounting Estimates, please email us at info@auditanalytics.com or call (508) 476-7007.
1. Note: The authors changed the title of the working paper (as linked) to “Changes in Accounting Estimates and Mandatory Disclosure”↩