In this new paper by a group of academics from the University of Richmond (and elsewhere), the authors explore whether companies might be timing when they record changes in their accounting estimates (CAEs) to meet earnings benchmarks.  Because accounting estimates are “by their nature forward-looking, often subjective and difficult to quantify with precision,” they would seem to offer an excellent “opportunity for management to misrepresent the firm’s financial performance.” CAEs, the authors suggest, may be used to meet or beat earnings benchmarks or, alternatively, to smooth earnings or take a “big bath” when the current period’s earnings are particularly low.  For purposes of the study, the authors assumed that “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 study concludes, particularly with respect to analyst forecast earnings, that companies do indeed “appear to time CAEs to meet earnings benchmarks or achieve other reporting objectives.”  It’s worth noting that the SEC has recently brought charges in a couple of cases involving earnings or expense management (see this PubCo post and this PubCo post), so violations resulting from earnings management practices appear to be a focus for Enforcement.

SFAS 154 requires that material changes in estimates be separately disclosed in the financial statement notes, a requirement that allowed the authors to use disclosure of a material CAE as a way to identify companies that implemented accounting estimate changes. The authors looked at 4,452 CAEs between 2006 and 2018, including 2,593 income-increasing CAEs and 1,859 income-decreasing CAEs for 1,997 companies. Quarters with CAEs were used as a “treatment group” and quarters for the same companies without CAEs as the control group.  The authors contended that, “if CAEs are neutrally implemented, they would not correlate with predictable outcomes, such as meeting an earnings benchmark.” In that case, the company would be implementing the CAE simply to “improve the informational quality of the financial statements and better reflect the firm’s economic reality.” But if the company were manipulating earnings, “then CAE-related decisions will be influenced by pre-CAE earnings. As such, the main question of interest is whether we can discern a statistically significant relation between pre-CAE earnings and the timing of CAEs.” Accordingly, the analysis was directed at identifying the “inceptive circumstances” that triggered the implementation of CAEs, rather than the financial outcomes of the CAEs.

The authors looked at three earnings benchmarks—zero earnings, prior-year earnings and analysts’ forecasted earnings; however, the “most revealing” results surrounded the analyst forecast benchmark. The authors’ hypothesis was that proximity of pre-CAE earnings (earnings before the application of a CAE) to the benchmark influences the decision, and, not surprisingly, that theory seems to have been corroborated in the findings. Among other things, the authors found that companies become more likely to implement income-decreasing CAEs as their pre-CAE earnings decline further below the benchmark. But companies also become more likely to implement income-decreasing CAEs as pre-CAE earnings rise above the benchmark. That is, the authors found that companies are more likely to implement income-decreasing CAEs “the further their earnings deviate from the forecast, regardless of the direction. This finding simultaneously corroborates both of [their] two main explanations for timing income-decreasing CAEs: 1) taking a financial ‘big bath’ when pre-CAE earnings are already very low compared to the earnings benchmark, and 2) implementing income-decreasing CAEs when pre-CAE earnings are well above the benchmark, allowing the firm to absorb the earnings decrease and still meet forecasted earnings.”  But that idea also played out to some extent with regard to income-increasing CAEs: the likelihood of implementing an income-increasing CAE increased the more pre-CAE earnings dropped below analysts’ forecast benchmark; implementation then became less likely as pre-CAE earnings approached the benchmark. When the benchmark is met, “the probability drops noticeably and remains relatively constant…. If the benchmark has already been attained, [companies] no longer have an incentive to strategically time an income-increasing CAE.”

The authors speculate that companies with pre-CAE earnings

“below a benchmark have incentives to implement an income-increasing CAE, if possible. However, as their pre-CAE earnings approach the benchmark, they may become more reticent to do so, perhaps because they anticipate an even greater need for the earnings boost in an upcoming quarter, or because it appears increasingly likely that pre-CAE earnings may actually push past the benchmark or get close enough to be deemed acceptable to firm management without the CAE. Furthermore, as earnings rise above the benchmark, the incentive to make an income-increasing CAE dissipates as any benefit associated with beating the benchmark has already been realized. When pre-CAE earnings are well below the benchmark, firms might use this as an opportunity to take a financial ‘big bath’ and implement an income-decreasing CAE. Alternatively, when earnings are well above the benchmark, there is an opportunity to ‘bury bad news’ which may encourage firms to implement an income-decreasing CAE. However, if the pre-CAE earnings are above the benchmark but the cushion is small, firms may be reticent to implement an income-decreasing CAE out of fear of missing the benchmark as a result.”

The authors found the biggest proportion of CAEs among manufacturing companies (44.0%), with 59.6% income-increasing CAEs, followed by the services industry (20.1%), with 55.7% income-increasing CAEs. The CAEs related most often to revenue recognition, liabilities and depreciation, whether for manufacturing (37.5%, 20.4%, and 9.6%) or services (26.3%, 24.2%, and 17.1%).

Posted by Cydney Posner