Managerial Estimates: Accounting*s Soft Underbelly

Report
By Baruch Lev
New York University
[email protected]
Baruch-lev.com
September 2012
At A Glance
Estimates underlie most financial information items.
The reliability of estimates is increasingly challenged
by volatile business environment and managers’
manipulation.
Investors are unable to assess reliability of estimates.
The result: increasing financial information
uncertainty and decreasing usefulness.
Proposed remedial changes to the accounting system.
2
The Pervasiveness of Estimates
Most financial statement items (accounts receivable,
inventory, fixed assets, sales of long term products,
pension expense, etc.) are based on managers’
estimates and forecasts; often multiple estimates.
These estimates and the consequent reliability of
financial information are increasingly challenged by:
 Deregulation, globalization, and fast technological
changes, all enhancing business uncertainty, and making
accounting forecasts (asset write-offs, options expense)
increasingly difficult.
 Managers’ manipulation of financial information by
misestimates and biased forecasts. They can do it with
impunity.
3
Investors Unable to Assess Impact and
Reliability of Estimates
“GE brings good things to life” (but not to accounting):
“We estimate total long-term contract revenues…We
measure long-term contract revenues by applying our
contract-specific estimated margin rates to incurred
costs. We routinely update our estimates of future costs
for agreements in process…We provide for any loss that
we expect to incur on these agreements when the loss is
probable.” (GE 2010 financial report).
Shouldn’t investors know how much of GE’s total 2010 revenue of $150
billion is based on estimates.
4
Investors Unable…Continued
Investors are generally unable to determine the impact
of estimates on key financial statement items (e.g., how
much of earnings is fact, and how much estimate?)
Investors unable to assess reliability of estimates. For
most accounting estimates, the ex post realizations are
not reported (e.g., the multiple estimates underlying
the stock option expense). An invitation manipulation.
Managers are rarely tracking the quality of their
estimates and projections—crucial of improving the
estimation procedures. Auditors too are largely
uninterested.
5
Standard-Setters constantly increase the prevalence and
impact of estimates in financial reports: assets and
goodwill write-offs, fair value accounting, stock option
expense, etc.
6
The Result: Increase in Earnings
Uncertainty
Average Standard Deviation of Net Income (ROA) for S&P 500 Firms
from 1960s to 2000
0.09
0.08
0.07
0.06
0.05
0.04
0.03
1960s
1970s
1980s
1990s
2000s
Decade
7
Relevance-Challenged Earnings Have Low
Predictive-Ability*
We compared the predictive-ability of net earnings with
that of gross profit, cash from operations, and free cash
flows (the latter three are less affected by estimates than
net earnings) regarding future values of these series (out
of sample).
Results indicate that net earnings generally perform the
worst of the four measure. It is best only in predicting
next-year’s earnings. It is worst in beyond-one-year
predictions. Cash flows outperforms earnings in
predicting cash flows.
Source: Lev, Li and Sougiannis, "The Usefulness of accounting estimates for predicting cash flows and
earnings," Review of Accounting Studies, 2010
8
So, What’s To Be Done?
Various suggestions have been made to mitigate the
adverse effects of unreliable estimates on the
usefulness of financial information.
None received serious consideration by accounting
policymakers.
None received serious attention by accounting
researcher.
A sad Commentary
9
Yuji Ijiri’s Separation of facts from
Forecasts*
Income Statement
Facts
Forecasts
Total
Revenue
Expenses
Net Income
*Yuji Ijiri, "Cash is a fact, but income is a forecast," working paper, 2002.
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Jim Ohlson’s Gradation of Reliability
The income statement should reflect gradations of
reliability.
 Revenues and expenses not subject to estimates (recall
GE).
 Items subject to high quality estimates (bad debt
expense, warranties expense).
 Items subject to low-reliability estimates (stock options
expense, gains/losses from Level 3 fair values).
 Net income.
11
Lundholm’s Suggestion for Comparison of
Estimates with Ex-Post Realizations
A routine comparison in financial reports of key
estimates with realizations, and managers comments
on the deviations.
This will do wonders to improve managers’ ex-ante
incentives to provide reliable estimates.
Lundholm, R., "Reporting on the past: A new approach to improving accounting today,"
Accounting Horizons, 1999.
12
Lev-Ryan-Wu’s Proposal for a Required
Revision of Earnings for Major
Misestimates*
Research has documented that the history (pattern) of
earnings matters to investors (Barth, Elliott, Finn,
1999), and that revisions of this history affects
investors’ decisions (Lev, Ryan, Wu, 2008).
Significant deviations between estimates and
realizations change the pattern of earnings, and
therefore call for disclosure of revised earnings.
The result: an improved “history of the firm.”
This is done routinely in the national income numbers
(GDP, unemployment).
*Lev, Ryan and Wu, "Rewriting earnings history, "Review of Accounting Studies, 2008.
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Lastly,
Hoping against hope that this conference will consider
seriously the major vulnerability of accounting: the everincreasing adverse impact of managerial estimates and
projections on the quality of financial information.
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