Accounting Quality Alarm Bell: Changes in Accounting Estimates
In a recent blog post, research and data provider Audit Analytics notes that changes in accounting estimates (CAEs) “can be a significant accounting quality red flag.” Changes in estimates are inherently judgmental, and management has considerable latitude in deciding the timing and amount of such adjustments. As AA observes, “Management is able to use its own discretion in determining appropriate estimates for calculating the value of many accounts, like property, plant, and equipment.”
AA cites studies that show that changes in accounting estimates frequently indicate poor quality accounting. For example, in Mandatory Disclosure and Management Discretion: On the Case of Changes, Anne Albrecht (Neeley School of Business, Texas Christian University), Kyonghee Kim (Eli Broad College of Business, Michigan State University) and Kwang J. Lee (KAIST College of Business, Korea Advanced Institute of Science and Technology) characterize changes in accounting estimates as “an additional measure of earnings management.” These authors state that “managers tend to implement a positive CAE when it helps meet or beat earnings benchmark and a negative CAE when it is unlikely to cause a negative earnings surprise.” Moreover, they find that “financial reports containing CAEs are more likely misstated and subject to the SEC inquiries.”
AA concludes its analysis with this observation: “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.” Audit committees may want to consider taking the same approach and making sure that they understand the basis and motivation for any changes in estimates.