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Material changes in accounting estimates and the usefulness of earnings

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Abstract

This study provides insights into the efficacy of FASB ASC 250 by examining the impact of material changes in accounting estimates (MCEs) on the usefulness of earnings. We find that MCEs, on average, increase the usefulness of earnings measured by the predictive ability of earnings for future cash flows and investor responsiveness to earnings news. Although the results suggest that some firms time their implementation of MCEs to meet desired earnings targets, we also find that ASC 250 disclosures attract investors’ and regulators’ scrutiny, suggesting that MCEs are a costly earnings management tool. Collectively, our findings provide limited support for the widespread use of MCEs for earnings management and suggest that this use is much more nuanced than suggested by prior research. Finally, notwithstanding the benefits of ASC 250 disclosures, our descriptive analysis of related disclosures of accounting estimates suggests that there is room for further improvements in current disclosure practices and regulatory monitoring.

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Notes

  1. Examples of accounting estimates in financial statements include net realizable value of inventories and accounts receivable, property and casualty insurance loss reserves, estimates of revenues from long-term contracts, depreciation expense, impairment of long-lived assets, and pension and warranty expenses. See Appendix 1 for more examples.

  2. To be useful, accounting information must aid users in the assessment of firms’ prospective cash flows and attain a minimum level of relevance and reliability (now faithful representation). Beyond these minimum levels, usefulness may increase by sacrificing reliability for relevance or vice versa (FASB 1978, 1980, 2010).

  3. A full transcript of Robert Herdman’s speech can be found at https://www.sec.gov/news/speech/spch537.htm.

  4. This issue is pertinent to Chung et al. (2022), as it focuses on documenting the opportunistic timing of MCEs to achieve earnings targets.

  5. For instance, Jeffrey Mahoney, general counsel of the Council of Institutional Investors, states: “Investors as a group … want more disclosures about these estimates and they want auditors to tell them more about what they’ve done” (PCAOB Standing Advisory Group meeting on October 2, 2014 on Auditing Accounting Estimates and Fair Value Measurement, Unofficial transcript pages 69, 76). Moreover, in our manual inspection of some of the MCE disclosures, we similarly find that the disclosure is generally vague (Appendix 2 lists MCE disclosure examples.).

  6. Until the early 2000s, researchers did not distinguish between changes in accounting principles and changes in accounting estimates, although APB Opinion 20 required different accounting treatments. For example, studies in the 1980s and 1990s used both changes in accounting principles and changes in accounting estimates to examine how firms used accounting changes to achieve certain goals (Moses 1987; Lilien et al. 1988; Pincus and Wasley 1994).

  7. The FASB’s conceptual framework asserts that relevance and reliability (now faithful representation) are the two fundamental characteristics of decision usefulness of accounting information (FASB 1980, 2010). In 2010, the FASB replaced reliability (i.e., information that is verifiable, neutral, and representationally faithful) with faithful representation (i.e., information that is complete, neutral, and free from error). It also removed discussion of the trade-off between relevance and reliability. The 2010 revision to the conceptual framework left the definition of relevance largely unchanged, and predictive value continues to be a primary aspect of relevance. Regardless of the removal of the relevance-reliability trade-off discussion in SFAC No. 8 (FASB 2010), the trade-off still exists in accrual accounting as a practical matter, and we use it to motivate our analysis.

  8. We use the post-tax, current-quarter estimated net income impact reported in Audit Analytics. If this amount is not reported, we use the pre-tax estimated net income impact and estimate the post-tax amount based on the tax rate implied from the tax expense account. If only year-to-date amounts are reported, we estimate the quarterly impact by dividing the estimated net income impact by the number of the quarter. For example, if a firm reports an MCE and the related year-to-date income effects in the second quarter 10-Q, we would divide the year-to-date income effect by 2.

  9. In an untabulated sensitivity analysis, we use operating cash flows in q + 1, as the dependent variable to accommodate the possibility that certain estimates are realized one quarter ahead. Our results are not sensitive to this change.

  10. Surprise is measured using IBES “street earnings,” which can exclude items that appear in GAAP earnings. Common non-GAAP exclusions include stock-based compensation, restructuring charges, depreciation, and taxes, all estimates that may also be an MCE. If an MCE is excluded by IBES, we would back out the MCE from a number that already excludes the MCE. To assess this issue, we manually compared the Reg G reconciliation reported within the press release to the IBES actual number for a random sample of 30 MCE observations. Based on this hand collection, we estimate that less than 15 percent of our MCE observations are impacted by potential double-counting. As a sensitivity analysis, we re-estimate our results within a sample of MCE observations where the IBES actuals reported equals GAAP and find similar results to those reported here.

  11. Like prior research, we use the IBES unadjusted database to obtain quarterly actual earnings per share (EPS) and quarterly consensus analyst forecasts (e.g., Payne and Thomas 2003; Doyle et al. 2013). If the actual EPS is equal to or greater than the median forecast, the firm meets or beats the analyst forecast (i.e., MB = 1). If the actual EPS is less than the median forecast, the firm misses the analyst forecast (i.e., MB = 0).

  12. We find similar results when we define Pre-MCE Extreme Beat as pre-MCE earnings exceeding the median analyst forecast by more than $0.02.

  13. Chung et al. (2022) additionally control for whether the MCE was first disclosed in a 10-K filing. Our model captures this control by including quarter-year fixed effects.

  14. In untabulated results, we limit the sample to only observations where the filing date and earnings announcement date are the same and find similar results.

  15. As a sensitivity test, we re-estimate the results in Table 6 within subsample of firms that report at least one MCE and a further restricted subsample of the three quarters preceding the MCE and the MCE quarter. We continue to find similar results.

  16. 310 out of 1,170 positive MCEs (26.5 percent) are classified as Timed Positive MCE, and 508 out of 889 negative MCEs (57.1 percent) are classified as Timed Negative MCE. The frequencies are not tabulated but available upon request.

  17. Research suggests that fraud is an extreme instance of earnings management, and therefore the elements of the fraud triangle may apply to less egregious activities (Ettredge et al. 2010; Trompeter et al. 2014; Albrecht et al. 2018).

  18. Pre-MCE Just Miss is excluded from the Timed Negative MCE model because, by definition, they are mutually exclusive.

  19. This result does not imply that the mean effect of negative MCEs on the meet/beat likelihood is positive. Figure 1 Panel B suggests that negative MCEs shift the distribution of earnings surprises to the left, suggesting that negative MCEs on average decrease the likelihood of meet/beat.

  20. We conduct a Chi2 test of coefficients and find a test statistic equal to 2.86 and significant at the p < 0.10 level.

  21. While MCE is a quarterly disclosure, quantitative CAE disclosures are reported annually.

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Acknowledgements

We thank Richard Sloan (editor) and the anonymous reviewer for their invaluable comments and suggestions. We also thank Brant Christensen, Jere Francis, Inder Khurana, Melissa Lewis-Western, Joshua Lee, Karen Nelson, Sukesh Patro, Mark Riley, Roy Schmardebeck, Ken Shaw, and the workshop participants at the Securities and Exchange Commission, the 2017 FARS midyear meeting, 2017 AAA annual meeting, 2018 EAA annual conference, Northern Illinois University, Texas Christian University, University of Missouri-Columbia, and the 2020 Texas Lonestar conference for their feedback.

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Authors and Affiliations

  1. Neeley School of Business, Texas Christian University, TCU Box 298530, Fort Worth, TX, 76129, USA

    Anne Albrecht

  2. Trulaske College of Business, University of Missouri-Columbia, Columbia, MO, 65211, USA

    Matt Glendening

  3. Eli Broad College of Business, Michigan State University, 632 Bogue St. N206, East Lansing, MI, 48824, USA

    Kyonghee Kim

  4. Seoul, Korea

    Kwang J. Lee

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  1. Anne Albrecht
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Appendices

Appendix 1

1.1 Examples of accounting estimates

(Obtained from PCAOB interim standard AU 342 Auditing Accounting Estimates)

Category

Examples

Revenue

Airline passenger revenue, subscription income, freight and cargo revenue, dues income, losses on sales contracts

Contracts

Revenue to be earned, costs to be incurred, percent of completion

Receivables

Uncollectible receivables, allowance for loan losses, uncollectible pledges

Inventories

Obsolete inventory, net realizable value of inventories where future selling prices and future costs are involved, losses on purchase commitments

Financial Instruments

Valuation of securities, trading versus investment security classification, probability of high correlation of a hedge, sales of securities with puts and calls

Leases

Initial direct costs, executory costs, residual values

Property, Plant & Equipment, Intangibles

Useful lives and residual values, depreciation and amortization methods, recoverability of costs, recoverable reserves

Litigation

Probability of loss, amount of loss

Tax and Interest

Annual effective tax rate in interim reporting, imputed interest rates on receivables and payables

Accruals

Property and casualty insurance company loss reserves, compensation in stock option plans and deferred plans, warranty claims, taxes on real and personal property, renegotiation refunds, actuarial assumptions in pension costs

Other

Losses and net realizable value on disposal of segment or restructuring of a business, fair values in nonmonetary exchanges, interim period costs in interim reporting

  1. * This list is not all-inclusive

Appendix 2

2.1 Disclosure on material changes in estimates (examples)

2.1.1 From Boeing Co 6/30/12 10-Q filed on 7/25/12

Contract accounting is used for development and production activities predominantly by Defense, Space & Security (BDS). Contract accounting involves a judgmental process of estimating total sales and costs for each contract resulting in the development of estimated cost of sales percentages. Changes in estimated revenues, cost of sales and the related effect on operating income are recognized using a cumulative catch-up adjustment which recognizes in the current period the cumulative effect of the changes on current and prior periods based on a contract’s percent complete. For the six and three months ended June 30, 2012, net favorable cumulative catch-up adjustments, including reach-forward losses, across all BDS contracts increased operating earnings by $234 million and $122 million and earnings per share by $0.20 and $0.11. For the six and three months ended June 30, 2011, net favorable cumulative catch-up adjustments, including reach-forward losses, increased operating earnings by $153 million and $100 million and earnings per share by $0.14 and $0.09.

2.1.2 From Google Inc. 6/30/2013 10-Q filed on 7/25/13

The preparation of consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates. On an ongoing basis, we evaluate our estimates, including those related to the accounts receivable and sales allowances, fair values of financial instruments, intangible assets and goodwill, useful lives of intangible assets and property and equipment, fair values of stock-based awards, inventory valuations, income taxes, and contingent liabilities, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.

In the second quarter of 2013, we revised the estimated useful lives of certain types of property and equipment which resulted in an additional depreciation expense of $121 million during the three months ended June 30, 2013.

2.1.3 From Zale Corp 10/31/11 10-Q filed on 12/8/11

We offer our Fine Jewelry customers lifetime warranties on certain products that cover sizing and breakage with an option to purchase theft protection for a two-year period. ASC 605–20, Revenue Recognition-Services, requires recognition of warranty revenue on a straight-line basis until sufficient cost history exists. Once sufficient cost history is obtained, revenue is required to be recognized in proportion to when costs are expected to be incurred. The Company has historically recognized revenue from lifetime warranties on a straight-line basis over a five-year period because sufficient evidence of the pattern of costs incurred was not available. During the first quarter of fiscal year 2012, we began recognizing revenue related to lifetime warranty sales in proportion to when the expected costs will be incurred, which we estimate will be over an eight-year period. The deferred revenue balance as of July 31, 2011 related to lifetime warranties will be recognized prospectively, in proportion to the remaining estimated warranty costs. The change in estimate related to the pattern of revenue recognition and the life of the warranties is the result of accumulating additional historical evidence over the five-year period that we have been selling the lifetime warranties. The change in estimate increased revenues by $6.3 million during the first quarter of fiscal year 2012. In addition, net loss and net loss per share improved by $5.9 million and $0.18 per share during the first quarter of fiscal year 2012.

Appendix 3

Table 11 Variable description
Full size table

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Albrecht, A., Glendening, M., Kim, K. et al. Material changes in accounting estimates and the usefulness of earnings. Rev Account Stud (2023). https://doi.org/10.1007/s11142-023-09759-8

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