An Investigation of the Usefulness of Accounting Estimates in Predicting Future Earnings and Cash Flows

This study examines the usefulness of accounting estimates in predicting future earnings and cash flows. Financial statements information reported as balance sheet items and or income statement items are based largely on managerial estimates. Accounting estimates can potentially improve the relevance of financial information and on the other hand because of limitations inherent to accounting estimates, their usefulness is open to question. In this research the usefulness of accounting estimates embedded in accruals is studied in form of their ability in predicting future performance indicators. We used the model of Lev et al (2010) in studying the usefulness of accounting estimates. So we examined the ability of accounting estimates in predicting two earnings measures (net income and operating income) and two cash flow measures (cash flow from operating activities and free cash flow) based on in-sample and out-of-sample prediction methods. The lagging values of accounting estimates have a limited ability in in-sample prediction of next year earnings and cash flows. In our out-of-sample test we predicted lagged performance indicators for year t+1, year t+2 as well as in aggregate years t+1 and t+2, and t+1 through t+3. We found that accounting estimates have a limited ability in predicting future earnings and they cannot predict future cash flows.