Do Accounting Estimates Get More Accurate With Experience and Does The Market Care: The Case of SFAS 106

Abstract

This paper posits that the precision of accounting estimates should be an increasing function of experience due to learning effects. Using a sample of 747 observations for 305 firms for the period 1993–96 with complete data available on the COMPUSTAT, CRSP, and COMPACT DISCLOSURE databases, the paper conducts regression analyses to examine the precision of two estimates (discount rates and health care cost inflation rates) required under SFAS 106. Tests show that the estimation errors for the health care cost inflation estimates decrease with experience, but those for discounts rates do not. The results persist after controlling for the profile of participants of the health care plan, predisclosure uncertainty, and propensity to manipulate by managers. The results are consistent with “learning effect” for health care cost inflation rates that were being estimated for the first time, while no such effect is visible for discount rates that had been estimated in the past for pension plans. The paper also hypothesizes that the market rewards perceived precision of accounting estimates attributable to learning effect. Cross‐sectional tests confirm that the valuation coefficient of postretirement benefit obligations increases in absolute value as the estimation errors decline, suggesting that the market relies more on reported accounting estimates as their perceived precision improves. Thus, the extant research findings of weak or non‐existent value relevance of SEAS 106 liabilities may have been confined to the initial period after the adoption of SEAS 106 when the measurement errors were high. The documented evidence of improvement in precision provides support for FASB's claim that the reliability of accounting estimates, especially those required by complex standards such as SEAS 106, should improve with experience. The evidence of improvement in value‐relevance should also be reassuring for FASB, since one of the intended benefits of SEAS 106 was to provide value relevant information to the investors.

Citation

Asthana, S. (2002), "Do Accounting Estimates Get More Accurate With Experience and Does The Market Care: The Case of SFAS 106", Review of Accounting and Finance, Vol. 1 No. 2, pp. 23-43. https://doi.org/10.1108/eb026983