The Audit Analytics Accounting Quality + Risk Matrix (AQRM) makes it easy to identify accounting, audit, and governance red flags for public companies. This blog series breaks down the risks associated with specific firm-level events included in the AQRM.
Changes in accounting estimates (CAE) can be a significant accounting quality red flag. Management is able to use its own discretion in determining appropriate estimates for calculating the value of many accounts, like property, plant, and equipment (PPE).
A working paper by Anne Albrecht, Kyonghee Kim, and Kwang J. Lee found that “managers tend to disclose a positive CAE when it helps meet or beat earnings benchmark and make a negative CAE when it is unlikely to cause a negative earnings surprise.” Additionally, the researchers found that changes in accounting estimates were associated with lower quality earnings and financial reporting quality.
Further, in “Critical Accounting Estimate Disclosures and the Predictive Value of Earnings”, researcher Matthew Glendening found that “the predictive value of earnings with respect to future cash flows is negatively associated with the presence of a CAE disclosure.”
As part of our AQRM database, we flag firms disclosing changes in estimates and assign severity based on where the estimate affects the financial statements, as well as the net effect; higher line items and positive changes increase severity.
For example, Trinity Industries Inc [TRN] disclosed a significant change in estimate related to property, plant, and equipment for 2020.
According to the disclosure, the “change in estimate resulted in a decrease in depreciation expense and a corresponding increase in income from continuing operations of approximately $30.8 million, as well as an increase in net income of approximately $23.7 million.”
Interestingly, the change in estimate was accompanied by several other financial reporting red flags. These included a $358 million impairment and a poor Beneish M-score and Altman Z-score.
- Beneish M-score is a calculation of the quality of financial reporting; a red flag indicates the potential for fraud.
- Altman Z-score is a calculation that predicts the likelihood of a company’s solvency; a red flag indicates the potential for bankruptcy.
Changes in accounting estimates can carry significant risks. CAEs can lower financial reporting quality, as well as affect projections of future earnings. When CAEs are disclosed, they should be noted and carefully analyzed by investors. Leveraging the Audit Analytics database, stakeholders can remain informed of these, and many other risks to accounting reporting quality.
The Audit Analytics Accounting Quality + Risk Matrix (AQRM) can be used to monitor, compare, and evaluate the severity of company misstatements along with many other “red flag” disclosures. For more information, please contact us.
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