Accruals and Cash Flows. Accrual Accounting Framework. Accrual Accounting Framework Wild, Subramanyam and Halsey, 2003, pp

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1 Accrual Accounting Framework Wild, Subramanyam and Halsey, 2003, pp Accrual Concept Accrual Accrual accounting aims to inform users about the consequences of business activities for a company s s future cash flows as soon as possible with a reasonable level of certainty Achieved Achieved by recognizing revenue earned and expenses incurred, regardless of whether or not cash flows occur simultaneously Separation of revenue and expense recognition from cash flows is facilitated with accrual adjustments adjust cash inflows and cash outflows to yield revenues and expenses 1 Accrual Accounting Framework Wild, Subramanyam and Halsey, 2003, pp Accrual Concept Judgment is a key part of accrual accounting, and rules and institutional mechanisms exist to ensure reliability 2 Accruals and Cash Flows Operating cash flow refers to cash from ongoing operating activities Free cash flows reflects the added effects of investments and divestments in operating assets Free cash flow represents cash that is free to be paid to dept and equity holders Accruals are the sum of accounting adjustments that make net income different from net cash flow 3

2 Accruals and Cash Flows Accounting adjustments include those that affect income when there is no cash impact (e.g. credit sales) and those that isolate cash flow f effects from income (e.g. asset purchases) Because Because of double entry,, accruals affect the balance sheet by either increasing or decreasing asset or liability accounts by an equal amount An An accrual that increases income will also either increase an asset set or decrease a liability 4 Accruals and Cash Flows Short-term term accruals related to working capital items Long-term accruals such as depreciation and amortization 5 Accrual Accounting Reduces Timing and Matching Problems Difference between accrual accounting and cash accounting is one of timing and matching Accrual Accrual accounting overcomes both the timing and matching problems that are inherent in cash accounting Timing Timing problems refer to cash flows that do not occur contemporaneously with the business activities For For example, sale occurs in the first quarter, but cash from the sale arrives in the second quarter 6

3 Accrual Accounting Reduces Timing and Matching Problems Marching problems refer to cash inflows and cash outflows that occur from a business activity but are not matched in time with each other, such as: Fees received from consulting that are not linked in time to wages paid to consultants working on the project Timing and matching problems with cash flows arise for at least two reasons: 1. Credit transactions reduce the ability of cash flows to track business activities in a timely manner 2. Costs often are incurred before their benefits are realized 7 Accrual Accounting Reduces Timing and Matching Problems However, over the life of a company, cash flows and accrual income are equal Once all business activities are conducted, the timing and matching problems are resolved The shorter the time periods, the more evident are the limitations of cash flow accounting 8 Accrual Process Revenue Recognition and Expense Matching Revenue recognition and expense matching 1. Revenue recognition Revenues are earned when the company delivers its products Revenues are realized when cash is acquired Revenues are realizable when asset acquired for products delivered is convertible to cash (c.f. receivables) 9

4 Accrual Process Revenue Recognition and Expense Matching 2. Expense matching Accrual accounting expenses are matched with their corresponding revenues Product costs are recognized when the product is delivered All product costs are lumped together in cost of sales but remain as inventory until matched with revenues Period costs usually are matched with revenues of the period (c.f. marketing expenses, administrative expenses) 10 Short- and Long-term Accruals Short-term term accruals refer to short-term term timing difference between income and cash flows (c.f. working capital accruals) Arise primarily from inventories and credit transactions (receivables and payables debtors, creditors, prepaid expenses, advances received) 11 Short- and Long-term Accruals Long-term accruals arise from capitalization Asset capitalization is the process of deferring costs incurred in the current period whose benefits are expected in future periods (long-term assets such as plant and equipment, and goodwill) 12

5 Short- and Long-term Accruals Accounting for long-term accruals is more complex and subjective than that for short-term term accruals Cash-flow implications of short-term term accruals are more direct and readily determinable Short-term term accruals are more useful in company valuation (Dechow, 194) 13 Relevance and Limitations of Accrual Accounting Relevance of Accrual Accounting Conceptual relevance of Accrual Accounting Conceptual superiority of accrual accounting over cash flows arises because the accrual-based income statement and balance sheet are more relevant for measuring a company s s present and future cash-generating capacity 14 Relevance of short-term term accruals Improve the relevance of accounting by helping record revenues when earned and expenses when incurred Income number that better reflects profitability and also creates current assets and current liabilities that provide useful information about financial position 15

6 Relevance of long-term accruals Free cash flow (FCF) is computed by subtracting investments in long-term operating assets from operating cash flow Problems for FCF: 1. Investments are usually large and occur infrequently induce volatility in FCF 2. FCF treats capital growth and capital replacement synonymously Investments in new projects often bode well for a firm Yet, all capital expenditures reduce FCF FCF is negative in the growth stage but positive in the decline stage sending a reverse message about a firm s s prospects 16 Relevance of long-term accruals Accrual accounting overcomes these limitations in FCF by capitalizing investments in long-term assets and allocating their costs over future benefits periods Capitalization and allocation improves the relevance of income both by reducing its volatility and by matching costs of long-term investments to their benefits Superiority of accruals in providing relevant information 17 Financial performance: Revenue recognition ensures all revenues earned in a period are accounted for Matching ensures that only expenses attributable to revenues earned in a period are recorded 18

7 Financial position Accounting system based on cash flows produces a balance sheet that fails to reflect the financial position 19 Predicting future cash flows Accrual income is a superior predictor of future cash flows 1. Through revenue recognition, it reflects future cash flow consequences E.g. Credit sale today forecast cash to be received in the future 2. Accrual accounting better aligns inflows and outflows over the time t through the matching process Accrual accounting is conceptually and empirically more relevant than cash flows 20 Accruals Can Be a Double-Edged Sword Accrual accounting introduces judgment into accounting with various estimations and adjustments Allowing managerial judgment should increase the relevance of accounting information Use of judgment can reduce comparability and consistency of financial statements, leading to accounting distortion 21