Launched back in 2013, the Audit Analytics Changes in Accounting Estimates database now has nearly 18 years worth of changes in accounting estimate disclosures. We’ve analyzed all annual and quarterly SEC filings going back to January 1, 2000.
We have just short of 10,000 changes in accounting estimates in our database. From 2000 to 2017 (2017 is omitted from the chart below since it’s a partial year), there is an average of about 550 per year.
You’ll notice a big increase from 2000 to 2003/2004, at which point the total number fluctuates up and down, but never drops below 400. While more research is needed, it may have to do with the accounting standard SFAS 154 which was issued in May 2005. One of the biggest changes that came as a result of that standard was that changes in depreciation methods began to be treated as changes in estimates, as opposed to changes in accounting principle (which follow a different rule for accounting).
So, what is a change in accounting estimate?
While some numbers in financial statements are relatively straightforward, others can be complex. Some of the more complex figures require judgments about future events. For example, a certain number of accounts receivable will not be collected, but neither the actual bad accounts nor the specific number of them is known. Therefore, some model is used to estimate the number of doubtful accounts (essentially, invoices that won’t ever get paid).
The allowance for doubtful accounts, the method of depreciation of assets, provisions for legal contingencies, hedging and derivative valuations — all of these things require estimates, and estimates always involve some assumptions.
For the sake of comparability between periods, such assumptions are expected to remain the same, unless a good reason arises to change them (ASC 250-10-45-19). When these assumptions are changed, they must be disclosed if they are material.
A change in estimate is made at the discretion of management, and affects the operating results of the period in which the change occurs. This makes it an information-rich disclosure, specifically with respect to the quality of earnings. Suppose a company changes the estimate of its Sales Return and Allowance reserve, which increases revenue and earnings for the period by 10%. Does that 10% bump represent growth? How much does it reflect the underlying economic reality? These are very important questions for a user of financial statements, but these changes in estimates and their impact on the income statement are often buried in the footnotes or in the MD&A. They are often material to the financial statements, and are notoriously difficult to audit. Changes in accounting estimates could be an area ripe for “earnings management”. Frequent, unusual, or opaque changes in accounting estimates should capture the attention of users of financial statements.
We have scoured every quarterly and annual filing looking for these disclosures, which are available in the Changes in Accounting Estimates database in the Accounting + Oversight subscription.
Applications of this dataset include as a database, email alerts, in the AQRM due diligence tool, and for scholarly archival research. (For more insight into this dataset, you can see all the blogs we’ve written about it here.)
Positive vs. Negative Impacts on Income of Changes in Accounting Estimates by Year
Changes in estimates impact a company’s income statement by increasing or decreasing costs and incomes. Over the 17 year period from 2000 to 2016, positive impacts outnumber negative impacts almost every year, at a rate of about 1.3 to 1.
This suggests perhaps that management is more likely to make a change in accounting estimate if it is expected to benefit income.
Top 10 Most Common Categories of Changes in Accounting Estimates
The most common types of changes in accounting estimate relate to depreciation and amortization. More than 1 out of 5 records in the database relate to this category. The next most common issue is percentage of completion and contract accounting revenue recognition. You can see the rest of the top-10 categories in the table below.
Changes in Accounting Estimates are one of the many quality-of-financial-reporting data-points that we track in our Accounting Quality + Risk Matrix. We’ve discussed before the massive impact such accounting adjustments can have on earnings figures. Interestingly, these adjustments are often not discussed in earnings releases or in earnings conference calls (Netflix provides a past example). Nevertheless, changes in accounting estimates can clearly have an impact on earnings and on comparability, and any user of financial statements would benefit from transparency and disclosure.
For more information on Changes in Accounting Estimates, please email us at info@auditanalytics.com or call (508) 476-7007.