Machine learning improves accounting estimates: evidence from insurance payments
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Machine learning improves accounting estimates: evidence from insurance payments Kexing Ding 1,2 & Baruch Lev 3 & Xuan Peng 1,2 & Ting Sun 4 & Miklos A. Vasarhelyi 2
# Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract Managerial estimates are ubiquitous in accounting: most balance sheet and income statement items are based on estimates; some, such as the pension and employee stock options expenses, derive from multiple estimates. These estimates are affected by objective estimation errors as well as by managerial manipulation, thereby harming the reliability and relevance of financial reports. We show that machine learning can substantially improve managerial estimates. Specifically, using insurance companies’ data on loss reserves (future customer claims) estimates and realizations, we document that the loss estimates generated by machine learning were superior to actual managerial estimates reported in financial statements in four out of five insurance lines examined. Our evidence suggests that machine learning techniques can be highly useful to managers and auditors in improving accounting estimates, thereby enhancing the usefulness of financial information to investors. Keywords Machine learning . Accounting estimates * Miklos A. Vasarhelyi [email protected] Kexing Ding [email protected] Baruch Lev [email protected] Xuan Peng [email protected] Ting Sun [email protected]
1
Southwestern University of Finance and Economics, Newark, NJ, USA
2
Rutgers the State University of New Jersey, New Brunswick, NJ, USA
3
Stern School of Business, New York University, New York, NY, USA
4
The College of New Jersey, Ewing Township, NJ, USA
K. Ding et al.
1 Introduction The PCAOB recently introduced a new standard for auditing accounting estimates, stating: Accounting estimates are an essential part of financial statements. Most companies’ financial statements reflect accounts or amounts in disclosures that require estimation. Accounting estimates are pervasive in financial statements, often substantially affecting a company’s financial position and results of operations… The evolution of financial reporting frameworks toward greater use of estimates includes expanded use of fair value measurements that need to be estimated (PCAOB 2018, p. 3). Indeed, most financial statement items are based on subjective managerial estimates: fixed assets are presented net of depreciation―an estimate―and accounts receivables, net of estimated bad debts. Liabilities, like pensions and post-retirement benefits are estimates, and revenues from long-term projects or from contracts with future deliverables include estimates. Many expenses, such as the stock options or warranty expenses, also require estimates. Some items, like the pension expense, are based on multiple estimates, some of which, such as the expected gain on pension assets, are essentially guesses. Generally effective audit procedures, such as obtaining third-party confirmations of assets and liabilities, are inapplicable to estimate
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