Changes in Accounting Estimates: Underlying Economic Reality or Earnings Management
43 Pages Posted: 29 Jan 2019 Last revised: 15 Feb 2019
Date Written: December 10, 2018
We examine whether companies strategically change accounting estimates to manipulate earnings (“earnings management” hypothesis) or whether these modifications represent changes in the underlying fundamentals (“economic reality” hypothesis). Using audit fees to discriminate between the two hypotheses, we find no evidence that auditors charge an incremental fee for changes in accounting estimates which is consistent with the economic reality hypothesis. More directly, we find a strong association between the underlying macro-economic factors and changes in accounting estimates. Relying on conventional earnings management proxies, we find no evidence that changes in accounting estimates are used to manage earnings. Finally, our results indicate that typically “financially troubled” companies undergoing major corporate restructuring are expected to change their accounting estimates over subsequent periods because they are more vulnerable to macro-economic shocks and more likely to update prior estimates.
Keywords: change in accounting estimates, audit effort, audit fees, and earnings management
JEL Classification: M40, M41, M42
Suggested Citation: Suggested Citation