Changes in Accounting Estimates: Are the Current Disclosure Requirements Sufficient to Deter Managerial Opportunism?
73 Pages Posted: 21 Nov 2017
Date Written: November 17, 2017
In light of the concerns about inherent measurement uncertainty and subjectivity embedded in accounting estimates and the demand for new auditing standards on accounting estimates, this study provides detailed documentation of firms’ practice in making material changes in accounting estimates (CAEs) – CAEs that are subject to mandatory disclosure in accordance with Accounting Standard Codification 250 (ASC 250). The result suggests that anticipated impacts of CAEs on earnings in the context of meeting or beating analyst forecasts significantly influence managers’ decision to make CAEs. Regarding the impact of CAEs on earnings attributes, we find that earnings for the CAE quarter is less persistent, suggesting that CAEs are often a one-off adjustment to revenue or expenses. We also find that financial reports are more likely misstated, subject to SEC inquiries (i.e., SEC comment letters), and are more difficult to read. Reflecting auditors’ view on CAEs as a source of audit risk, audit fees increase significantly in the year when the firm makes a material CAE. Finally, abnormal returns around earnings announcements suggest that investors do not fully understand the impact of CAEs on future cash flows in spite of the disclosure requirements – investors only partially discount the meet/beat premiums when the meet/beat is aided by a positive CAE, leaving a significant net benefit to firms. These findings, together, provide strong evidence of managers’ self-serving biases in their CAE decisions and support the need for enhanced CAE disclosure.
Keywords: Material Change in Accounting Estimate, Meet/Beat, Earnings Distribution, Financial Reporting Quality, Earnings Persistence
JEL Classification: M41, M48
Suggested Citation: Suggested Citation