Improving Financial Reports by Revealing the Accuracy of Prior Estimates

Abstract

Several researchers (e.g., Lundholm, 1999; Ryan, 1997; Petroni, et al, 2001) have proposed a reporting mechanism to enhance the reliability of estimates and other forward-looking information in the financial reporting process. Their proposal requires companies to report reconciliations of prior year estimates to actual realizations as supplemental information in their financial reports. Such disclosures would enable investors to distinguish between accurate and opportunistic reporting behavior, and arguably should create incentives for companies to accurately estimate in the first place.

Our study provides evidence on these proposals to expand the reporting model. We develop predictions based on research in psychology and conduct an experiment within the context of an important intangible asset requiring estimation-software development costs. Our results show that the reporting mechanism proposed by Lundholm, Ryan, Petroni, and others is effective in communicating information about the accuracy of financial estimates. However, we find that all disclosures are not equally useful. The most-effective disclosures transparently describe the implications of misestimation (if any) on both the balance sheet and on earnings. Merely disclosing what the software development asset would have been (i.e., balance sheet effect only) under perfect foresight does not always lead investors to completely distinguish between accurate and opportunistic estimators. Our results also show that when the disclosures transparently describe the implications of misestimation, investors reward those who are accurate estimators but do not punish those who are inaccurate. We conclude that information about previous estimate accuracy is useful to investors, and that regulators should consider the transparency of disclosure formats, as all disclosures may not be equally effective in creating management incentives for accurate estimation. Further, the effectiveness of the proposed reporting mechanism for enhancing the reliability of financial reports appears to rest on the relative competitive advantage conferred upon firms that provide accurate estimates.

Keywords: Estimates, Disclosures, Opportunistic financial reporting, Intangibles

JEL Classification: M41, M43, M45