Managerial Estimates: Accounting’s Soft Underbelly

1. Managerial Estimates: Accounting’s Soft Underbelly By Baruch Lev New York University blev@stern.nyu.edu Baruch-lev.com September 2012

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. The Result: Increase in Earnings Uncertainty

8. 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

9. 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

10. Yuji Ijiri’s Separation of facts from Forecasts* *Yuji Ijiri, "Cash is a fact, but income is a forecast," working paper, 2002.

11. 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.

12. 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.

13. 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.

14. Lastly, Hoping against hope that this conference will consider seriously the major vulnerability of accounting: the ever-increasing adverse impact of managerial estimates and projections on the quality of financial information.