Financial reporting is one of the primary duties of a financial accountant. By maintaining the integrity of the components of a financial statement, he can earn the trust of the investors and ensure that the company's assets are invested appropriately. But to maintain the reliability of the financial statements is not an easy job as the method to produce financial reports are always changing. Accounting has always been a reactive service, changing and developing to meet the practical needs created by the environment in which it operates.
Therefore, a financial accountant is always required to be skeptical and maintain a proactive approach when analyzing financial statements. A statement depicting a profit figure was always welcomed by investors until the Enron and WorldCom scandal. These scams highlight the issue that accounting numbers are acquiescent. And they are getting squishier as the use of estimates in the company account increases. This vulnerability of accounting figures puts investors' capital at risk by misleading them to unprofitable investment ventures.
Due to rapid changes in business operations accounting has shifted from simple tallying of cash transactions to "accrual accounting", where profits and expenses are recorded when incurred and forward-looking estimates are playing a critical role in measuring company profits. These estimates got a bigger boost when assets and liabilities were recorded at 'fair-value' rather than at historic cost. The argument was that fair-value numbers were up-to-date and more relevant than historic cost.
But it also gave a precaution that heavier reliance on estimates might result in volatile profits. Post Enron scandal efforts were made by the both side of the Atlantic to urge companies utilize 'fair value' methods to value their assets and liabilities. In June, in its report, America's Securities and Exchange Commission, endorsed fair-value accounting, so that accounts are more simplified and reduce structuring of transactions by firms. However, critics still believe that estimates are still prone to manipulation.
Brauch Lev of New York University's Stern School of Business, and Siyi Li and Theodore Sougiannis, from the University of Illionis at Urbana-Champaign, in their study concluded that estimates, which they were expecting to improve the decision making of the managers by giving them a means to impart their forward-looking views, were not useful at all. In other words they were not reliable and did not really help investors to predict company's future earnings and cash flows.
The three analyzed 3,500-4,500 companies a year from 1988 to 2002 trying to "predict" future performance with five models in which historic cash flows and estimates were used to different degrees. The trio concluded that cash flows gave a robust future prediction, but when estimates were added they got little help in predicting future performance. Mr. Lev blamed the fast-changing, complex world, and earning manipulation for the difficulty of making a good estimate.