The usefulness of accounting estimates for predicting cash flows and earnings

Accounting estimates and projections potentially improve the relevance of financial information by providing managers a venue to convey to investors forward-looking, inside information. The quality of financial information is, however, compromised by the increasing difficulty of making reliable estimates and forecasts and the frequent managerial misuse of estimates. Given the ever-increasing prevalence of estimates in accounting data, particularly due to the move to fair value accounting, whether these opposing forces result in an improvement in the quality of financial information is among the most fundamental issues in accounting. We examine 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 out-of-sample prediction tests indicate that accounting estimates beyond those in working capital items (excluding inventory) 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. We conclude that the usefulness of accounting estimates to investors is limited and provide suggestions for improving the usefulness of estimates.