The remainder of the paper is organized as follows.

Section 2 describes how

changes in credibility affect the usefulness of information for decision-making, provides
institutional background on accounting defects and their correction, and develops our
research hypotheses.
This paper investigates whether detectable attenuation effects are also present in
the relation between accounting information and observed equity values once the
credibility of the financial statements has been called into question.
If attenuation effects
are present, the coefficient estimates for the accounting variables in the valuation model
will decline in response to discovered accounting defects.
Preparation of financial statements in conformity with accounting principles generally accepted in the United States of
America (GAAP) requires management to make estimates and assumptions that affect reported amounts presented and
disclosed in our Consolidated Financial Statements. Significant estimates and assumptions in theseConsolidated
Financial Statements require the exercise of judgment and are used for, but not limited to, allowance for doubtful
accounts, estimates of future cash flows and other assumptions associated with goodwill and long-lived asset impairment
tests, useful lives for depreciation and amortization, warranty programs, determination of discount and other rate
assumptions for pension and other postretirement benefit expenses, restructuring costs, income taxes and deferred tax
valuation allowances, lease classification, and contingencies. Due to the inherent uncertainty involved in making
estimates, actual results reported in future periods may be different from these estimates.
In contrast to the results for total assets, estimates (excluding fair value estimates) make up on average less
than 10 percent of the total liabilities of the companies studied.

While estimates are less often used to compute total liabilities, management and Audit Committees
nevertheless need to ensure there are no potential understatements of these liabilities.

This does not suggest that less attention should be paid to the liability side of the balance sheet.

The understatement of liabilities, such as provisions made for legal lawsuits and other contingencies can also
be significant.
Estimates are by their very nature subjective," says Ong Pang Thye, Head of Audit, KPMG in Singapore.
"They are underpinned by the nature and reliability of the information used to form these accounting estimates,
which can vary widely.

Furthermore, methods and assumptions used to derive these estimates may change each year as the
accountants calculating the estimates gain experience about market conditions. This could mean that asset
values across a number of financial years may not be comparable.

As little as a one percent fluctuation in the total asset value can result in as much as a 38 percent change in
net profit and up to a 50 percent change in comprehensive income. The impact of inaccurate estimates on
asset values (including fair value estimates) can therefore be significant.

KPMG says that the results of its study suggest that a significant proportion of the total assets of companies
are not based on easily verifiable numbers. Management and Audit Committee members therefore need to be
aware of items in the financial statements derived from or supported by estimates.

Total asset values depicted on the balance sheets of company financial statements play a crucial role in
conveying the financial health of a company to stakeholders and investors, Ong added, Companies must
therefore not overlook the importance of having people with the right expertise in making accurate estimates
when preparing financial statement.
Given that some form of human judgement is required to derive these estimates, a significant proportion of
total asset values reflected in existing financial statements are therefore at risk of being subjected to some
form of bias or mis-statement in their derivation.

Accounting requires the use of estimates in the preparation of financial statements where precise amounts
cannot be established. Estimates are inherently subjective and therefore lack precision as they involve the use
of management's foresight in determining values included in the financial statements. Where estimates are not
based on objective and verifiable information, they can reduce the reliability of accounting information.
Financial statements are susceptible to fraud and errors which can undermine the overall credibility and
reliability of information contained in them. Deliberate manipulation of financial statements that is geared
towards achieving predetermined results (also known as 'window dressing') has been a unfortunate reality in
the recent past as has been popularized by major accounting disasters such as the Enron Scandal.
The use of professional judgment by the preparers of financial statements is important in applying accounting
policies in a manner that is consistent with the economic reality of an entity's transactions. However,
differences in the interpretation of the requirements of accounting standards and their application to practical
scenarios will always be inevitable. The greater the use of judgment involved, the more subjective financial
statements would tend to be.

Management is responsible for making the estimates required in the preparation of the financial statements. It is the audit
committee's role to understand and evaluate the most significant accounting estimates. To do so, the audit committee
must understand the methodology used in making the estimates, the major assumptions used, the sensitivity of the
outcome (e.g., how would the accounting estimate change if changes were made in the assumptions), and the overall
reasonableness of the result.
By their very nature, all accounting estimates involve some degree of measurement uncertainty. GAAP requires that the
nature of a measurement uncertainty that is material should be disclosed when it is reasonably possible that the
recognized amount could change by a material amount in the near term, except when disclosing the amount would have a
significant adverse effect on the entity. When this amount is not disclosed, the financial statements should indicate the
reasons for non-disclosure. It is important for audit committees to understand the above principle when assessing the
presentation of accounting estimates and measurement uncertainties in the financial statements.
Audit committees should understand that securities regulators have been particularly concerned about companies that
have "smoothed earnings" through the use of accounting estimates. The popular phrase "cookie-jar reserves" is used to
describe situations where management has established reserves in good times and drawn down those reserves in bad
times. This practice does not produce an accurate or reliable presentation of the corporation's actual earnings, but rather
artificially smoothes earnings to present a picture of stable growth, when the reality is something different.
Audit committees should insist that management prepare a report for each quarterly audit committee meeting describing
all significant estimates/reserves indicating any changes made since the last report and the reasons for those changes.
Audit committees should also require the external auditor to provide his or her opinion on the reasonableness of the
estimates/reserves, including any changes to them.
Finally, audit committees should step back and assess the overall impact of the estimates and judgments, and determine
whether they, individually and in the aggregate, fairly present the economic reality of the corporation and its performance
in the accounting period.
Financial statements provide investors and analysts with information about a companys ability to manage its financial
transactions and build value in the organization. Accountants gather information to use when creating the financial
statements. This information includes both actual dollar amounts and estimated amounts. Accounting estimates require the
accountant to determine what financial value to record when the actual amount is unknown.
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Purpose
Accounting estimates improve the accuracy of the financial statements. Investors and analysts make decisions based on
the financial statements. The accountant has an obligation to create these statements to the best of her ability. When the
accountant knows that financial activities occurred, even if the dollar amount is unknown, she needs to reflect those
activities. Estimating the value of those activities allows her to include that impact in the financial statements.
Basis
For the accounting estimates to be useful, the accountant needs a reliable basis for estimating those numbers. She might
use historical information, documentation or personal calculations to estimate the numbers. Historical information
provides a reliable basis for numbers that rarely change. Documentation provides a good basis when the accountant uses a
vendor contract to estimate the numbers. If she calculates the estimate using her own calculations, she needs to document
those calculations. The accountant needs to keep notes regarding the basis she uses for future reference.
Examples
Accounting estimates include depreciation calculations, warranty claims or bad debts. Depreciation calculations require
the accountant to estimate the number of years the asset the company will use the asset and the value of the asset at the
end of the asset's life. Warranty claim estimates require the accountant to estimate the number of customers who will file
warranty claims and the cost of the repairs for each claim. Bad debt estimates require the accountant to estimate the
number of customers who will default on their accounts and the dollar value of those accounts.
Changes
In some cases, the accountant reviews prior estimates and revises them. The accountant uses the revised estimates to
calculate numbers to use in the financial records and in the financial statements. The change only applies going forward.
The accountant does not change past reporting.
Changes in accounting and financial reporting are inevitable. Most happen because in preparing periodic financial
statements, companies must make estimates and judgments to allocate costs and revenues. Other changes arise from
management decisions about the appropriate accounting methods for preparing these statements.
Under Statement no. 154, all voluntary changes in principle now must be retrospectively applied to previous-period
financial statements, unless such application is impracticable or FASB mandates another approach. Impracticable
conditions exist if a company is unable to apply the new principle after making every reasonable effort or if CPAs cannot
document assumptions about managements intent in the prior periods or gather estimates needed to apply the principle
in those periods.
o Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in
preparing and presenting financial statements.
o A change in accounting estimate is an adjustment of the carrying amount of an asset or liability, or related
expense, resulting from reassessing the expected future benefits and obligations associated with that asset or
liability.
o International Financial Reporting Standardsare standards and interpretations adopted by the International
Accounting Standards Board (IASB). They comprise:
o International Financial Reporting Standards (IFRSs)
o International Accounting Standards (IASs)
o Interpretations developed by the International Financial Reporting Interpretations Committee (IFRIC) or the
former Standing Interpretations Committee (SIC) and approved by the IASB.
o Materiality. Omissions or misstatements of items are material if they could, by their size or nature, individually or
collectively, influence the economic decisions of users taken on the basis of the financial statements.
o Prior period errors are omissions from, and misstatements in, an entity's financial statements for one or more prior
periods arising from a failure to use, or misuse of, reliable information that was available and could reasonably be
expected to have been obtained and taken into account in preparing those statements. Such errors result from
mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud.