Accounting Estimates: Pervasive, Yet of Questionable Usefulness

Abstract

Estimates and projections are embedded in most financial statement items. These estimates potentially improve the relevance of financial information by providing managers the means to convey to investors forward-looking, inside information (e.g., on future collections from customers via the bad debt provision, or on expected assets' cash flows reflected in impairment charges). On the other hand, the quality of financial information is compromised by: (i) the increasing difficulty of making reliable forecasts in a fast-changing, often turbulent economy, and (ii) the frequent managerial misuse of estimates to manipulate financial data. Given the prevalence of estimates in accounting data, whether these opposing forces result in an improvement in the quality of financial information or not is arguably the most fundamental issue in accounting.

We examine in this study the contribution of accounting estimates embedded in accruals to the quality of financial information by focusing on the major use of this information by investors - the prediction of enterprise cash flows and earnings. Our extensive tests, reflecting both the statistical and economic significance of estimates, indicate that, by and large, accounting accruals and the estimates they embed do not improve the quality of financial information in terms of enhancing the prediction of enterprise performance. Accruals do not improve the prediction of cash flows, beyond that achieved by current cash flows, and improve only marginally the prediction of earnings. This latter improvement, however, appears to be economically insignificant. Thus, the objective difficulties of generating reliable estimates and projections in a volatile economy, and their frequent misuse by managers appear to offset the positive role of estimates in conveying forward looking information to investors.