The number of changes in accounting estimates by SEC-registered entities in 2016 was the greatest since 2000, the first year for which Audit Analytics has analyzed all annual and quarterly SEC filings.
There was a total of 820 such changes last year, up from 628 in 2015, the auditing research firm reports in a Tuesday blog post. The long-run average is about 550 changed estimates per year.
The surge was largely driven by changes to pension accounting estimates. There were 210 of those in 2016, compared with just 24 a year earlier. At least partly responsible for the increase in such estimates was a fast-accelerating trend of companies switching to the “spot-rate” method of calculating the present value of future pension obligations.
The trend was sparked by AT&T, which disclosed the change in early 2014. Within two years, several dozen companies followed suit. Historically, pension-related changes have accounted for only 4% of changed accounting estimates (see chart at the end of the article.)
Historically, pension-plan sponsors determined a discount rate for performing the calculation using a weighted average of 30-year Treasuries. Under the spot-rate method, plan sponsors use individual spot rates derived from a high-quality corporate bond yield curve and match them with separate expected pension-plan cash flows for each future year, rather than a single weighted average.
The spot-rate method is thought to provide a more precise measurement, but it can also improve a company’s financial results, at least in the short term. Indeed, Audit Analytics suggests, changes to accounting estimates in general may be evidence of “earnings management.”
Over time, the ratio of changed accounting estimates that have caused a positive impact on income to those that have exerted a negative effect has been about 1.3 to 1, according to the Audit Analytics data. “This suggests perhaps that management is more likely to make a change in an accounting estimate if it is expected to benefit income,” writes John Pakaluk, author of the blog post. He adds, “Changes in accounting estimates could be an area ripe for earnings management.”
Last year, that ratio was about 1.6 to 1, the highest in the 17 years for which the research firm has tracked such changes.
Accounting estimates are notoriously difficult to audit. “Some of the more complex figures require judgments about future events,” Pakaluk writes. “For example, a certain number of accounts receivable will not be collected, but neither the actual bad accounts nor the specific number of them is known. Therefore, some model is used to estimate the number of doubtful accounts (essentially, invoices that won’t ever get paid).”
Depreciation of assets, provisions for legal contingencies, hedging, and derivative valuations all require estimates, which always are based partly on assumptions, he notes.
For the sake of comparability between periods, under ASC 250-10-45-19 such assumptions are expected to remain the same unless a good reason arises to change them. When these assumptions are changed, they must be disclosed if they are material.
“A change in estimate is made at the discretion of management and affects the operating results of the period in which the change occurs,” writes Pakaluk. “This makes it an information-rich disclosure, specifically with respect to the quality of earnings.”
Suppose a company changes the estimate of its “sales return and allowance” reserve, thereby boosting its earnings for a period by 10%. But does that 10% bump represent growth? How much does it reflect the underlying economic reality?
“These are very important questions for a user of financial statements, but these changes in estimates and their impact on the income statement are often buried in the footnotes or in the MD&A,” notes Pakaluk. Frequent, unusual, or opaque changes in accounting estimates should capture the attention of users of financial statements, he adds.
The chart below shows the most common types of changes to accounting estimates among the almost 10,000 such changes Audit Analytics has analyzed for the past 17 years.