Companies appear to manipulate the timing of changes in accounting estimates (CAEs) in their financial reporting to meet earnings benchmarks, researchers at the University of Richmond and Christopher Newport University say.
The researchers looked at 4,452 instances in which companies identified CAEs in the footnotes to their financial reports and found most of them corresponded to increases or decreases in earnings that brought them into alignment with analyst expectations.
The companies, the researchers said, “appear to time CAEs to meet earnings benchmarks or achieve other reporting objectives.”
Of the CAEs tracked between 2006 and 2018, 2,593 were income-increasing, enabling companies that otherwise would have fallen short to show their earnings aligned with analyst expectations, and 1,859 were income-decreasing.
The income-decreasing CAEs appear to have the same tactical goals as the income-increasing ones. If the companies were expecting to exceed expectations, the CAEs were used either to smooth out earnings by lowering them to something closer to benchmarks or to hide a financial hit by offsetting earnings that were on track to be well above expectations.
In some cases in which the companies were on track to fall well below benchmarks, they would use the CAEs to lower earnings even further, in essence taking a financial “big bath” as a way to put as much bad news as possible behind them at once.
In designing the study, the researchers assumed the CAEs themselves were appropriate. Their focus was limited just to timing — that is, although the CAEs were justified, the timing of their use appeared to be manipulated for tactical purposes.
“Most CAEs are fully justified and reasonable, and the ‘manipulation’ stems primarily from their timing, not the nature or appropriateness of the CAEs themselves,” the researchers said.
Most of the CAEs related to revenue recognition, liabilities and recognition. The Securities and Exchange Commission has consistently found revenue recognition to be the biggest problem source in financial reporting.
The study, “Do Firms Time Changes in Accounting Estimates to Manage Earnings?,” is forthcoming in Contemporary Accounting Research, published by the Canadian Academic Accounting Association. A summary was published by CooleyPubCo.