The Usefulness of Accounting Estimates for Predicting Cash Flows and Earnings

64 Pages Posted: 6 May 2005 Last revised: 2 Feb 2009

See all articles by Siyi Li

Siyi Li

University of Illinois at Chicago

Baruch Lev

New York University - Stern School of Business

Theodore Sougiannis

University of Illinois at Urbana-Champaign - Department of Accountancy

Multiple version iconThere are 2 versions of this paper

Date Written: January 20, 2009

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). 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 ever-increasing prevalence of estimates in accounting data, whether these opposing forces result in an improvement in the quality of financial information or not is among the most fundamental issues in accounting.

We examine in this study the contribution of accounting estimates embedded in accruals to the quality of financial information, as reflected by their usefulness in the prediction of enterprise cash flows and earnings. Our extensive out-of-sample tests, reflecting both the statistical and economic significance of estimates, indicate that accounting estimates beyond those in working capital items do not improve the prediction of cash flows. Estimates do, however, improve the prediction of next year's earnings, though not of subsequent years' earnings. Our economic significance tests corroborate that accounting estimates do not improve cash flow or earnings prediction. We conclude that the usefulness of accounting estimates to investors is limited, and provide suggestions for improving their usefulness.

JEL Classification: M41, G14, M43, M44

Suggested Citation

Li, Siyi and Lev, Baruch Itamar and Sougiannis, Theodore, The Usefulness of Accounting Estimates for Predicting Cash Flows and Earnings (January 20, 2009). Available at SSRN: https://ssrn.com/abstract=716641 or http://dx.doi.org/10.2139/ssrn.716641

Siyi Li

University of Illinois at Chicago ( email )

601 South Morgan Street
University Hall, Room 2303
Chicago, IL 60607
United States
312-996-0727 (Phone)

Baruch Itamar Lev (Contact Author)

New York University - Stern School of Business ( email )

40 West 4th Street, Suite 400
New York, NY 10012
United States
212-998-0028 (Phone)
212-995-4001 (Fax)

HOME PAGE: http://www.baruch-lev.com

Theodore Sougiannis

University of Illinois at Urbana-Champaign - Department of Accountancy ( email )

360 Wohlers Hall
1206 South Sixth Street
Champaign, IL 61820
United States
217-244-0555 (Phone)
217-244-0902 (Fax)

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