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

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Accrual Accounting Framework Accrual Accounting Framework

Wild, Subramanyam and Halsey, 2003, pp. 80 Wild, Subramanyam and Halsey, 2003, pp. 80--9898

Accrual Concept Accrual Concept

Accrual accounting aims Accrual accounting aims to inform users about the consequences of to inform users about the consequences of business activities for a company

business activities for a company’ ’s future cash flows as soon as possible s future cash flows as soon as possible with a reasonable level of certainty

with a reasonable level of certainty

Achieved by recognizing Achieved by recognizing revenue earned and expenses incurred, revenue earned and expenses incurred, regardless of whether or not cash flows occur simultaneously regardless of whether or not cash flows occur simultaneously

Separation Separation of revenue and expense recognition from cash flows is of revenue and expense recognition from cash flows is facilitated with accrual adjustments

facilitated with accrual adjustments – – adjust cash inflows and cash adjust cash inflows and cash outflows to yield revenues and expenses

outflows to yield revenues and expenses

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Accrual Accounting Framework Accrual Accounting Framework

Wild, Subramanyam and Halsey, 2003, pp. 80 Wild, Subramanyam and Halsey, 2003, pp. 80--9898

Accrual Concept Accrual Concept

Judgment Judgment is a key part of accrual accounting, and rules and institutional is a key part of accrual accounting, and rules and institutiona l mechanisms exist to ensure reliability

mechanisms exist to ensure reliability

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Accruals and Cash Flows Accruals and Cash Flows Operating cash flow

Operating cash flow refers to cash from ongoing operating activities refers to cash from ongoing operating activities

Free cash flows

Free cash flows reflects the added effects of investments and divestments reflects the added effects of investments and divestments in operating assets

in operating assets

Free cash flow

Free cash flow represents cash that is free to be paid to dept and equity represents cash that is free to be paid to dept and equity holders

holders

Accruals

Accruals are the sum of accounting adjustments that make net income are the sum of accounting adjustments that make net income different from net cash flow

different from net cash flow

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Accruals and Cash Flows Accruals and Cash Flows

Accounting adjustments Accounting adjustments include those that affect income when there is include those that affect income when there is no cash impact (e.g. credit sales) and those that isolate cash f

no cash impact (e.g. credit sales) and those that isolate cash flow effects low effects from income (e.g. asset purchases)

from income (e.g. asset purchases)

Because of double entry Because of double entry, accruals affect the balance sheet by either , accruals affect the balance sheet by either increasing or decreasing asset or liability accounts by an equal increasing or decreasing asset or liability accounts by an equal amount amount

An accrual that increases income will also either increase an as An accrual that increases income will also either increase an asset or set or decrease a liability

decrease a liability

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Accruals and Cash Flows Accruals and Cash Flows

Short Short- -term accruals term accruals – – related to working capital items related to working capital items

Long Long- -term accruals term accruals – – such as depreciation and amortization such as depreciation and amortization

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Accrual Accounting Reduces Timing and Matching Problems Accrual Accounting Reduces Timing and Matching Problems

Difference Difference between accrual accounting and cash accounting is one of between accrual accounting and cash accounting is one of timing

timing and and matching matching

Accrual accounting overcomes both the timing and matching proble Accrual accounting overcomes both the timing and matching problems ms that are inherent in cash accounting

that are inherent in cash accounting

Timing problems Timing problems refer to refer to cash flows cash flows that do not occur that do not occur contemporaneously with the

contemporaneously with the business activities business activities

For example, sale occurs in the first quarter, but cash from the For example, sale occurs in the first quarter, but cash from the sale sale arrives in the second quarter

arrives in the second quarter

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Accrual Accounting Reduces Timing and Matching Accrual Accounting Reduces Timing and Matching Problems

Problems

Marching problems Marching problems refer to cash inflows and cash refer to cash inflows and cash outflows that occur from a business activity but are not outflows that occur from a business activity but are not matched in time with each other, such as:

matched in time with each other, such as:

Fees received from consulting that are not linked in time to wages Fees received from consulting that are not linked in time to wag es paid to consultants working on the project

paid to consultants working on the project

Timing Timing and and matching matching problems with cash flows arise for at problems with cash flows arise for at least two reasons:

least two reasons:

1.

Credit transactions Credit transactions reduce the ability of cash flows to track reduce the ability of cash flows to track business activities in a timely manner

business activities in a timely manner

2.

Costs Costs often are incurred before their benefits are realized often are incurred before their benefits are realized

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Accrual Accounting Reduces Timing and Matching Accrual Accounting Reduces Timing and Matching Problems

Problems

However, over the life of a company, cash flows However, over the life of a company, cash flows and and accrual income

accrual income are equal are equal

Once all business activities are conducted, the timing and Once all business activities are conducted, the timing and matching problems are resolved

matching problems are resolved

The shorter the time periods, the more evident are the The shorter the time periods, the more evident are the limitations of cash flow accounting

limitations of cash flow accounting

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Accrual Process

Accrual Process – – Revenue Recognition and Expense Revenue Recognition and Expense Matching

Matching

Revenue recognition and expense matching Revenue recognition and expense matching 1. Revenue recognition

1. Revenue recognition

Revenues are earned when the company delivers its Revenues are earned when the company delivers its products

products

Revenues are realized when cash is acquired Revenues are realized when cash is acquired

Revenues are realizable when asset acquired for products Revenues are realizable when asset acquired for products

delivered is convertible to cash (c.f. receivables)

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Accrual Process

Accrual Process – – Revenue Recognition and Expense Revenue Recognition and Expense Matching

Matching 2. Expense matching 2. Expense matching Accrual accounting

Accrual accounting – – expenses are matched with their corresponding expenses are matched with their corresponding revenues

revenues

Product costs

Product costs are recognized when the product is delivered are recognized when the product is delivered

All product costs are lumped together in

All product costs are lumped together in cost of sales cost of sales but remain as but remain as inventory

inventory until matched with revenues until matched with revenues

Period costs

Period costs usually are matched with revenues of the period usually are matched with revenues of the period (c.f. marketing expenses, administrative expenses) (c.f. marketing expenses, administrative expenses)

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Short

Short- - and Long- and Long -term Accruals term Accruals

Short- Short -term accruals refer to short term accruals refer to short- -term timing difference term timing difference between income and cash flows (c.f. working capital between income and cash flows (c.f. working capital accruals)

accruals)

Arise primarily from inventories and credit transactions Arise primarily from inventories and credit transactions (receivables and payables

(receivables and payables – – debtors, creditors, prepaid debtors, creditors, prepaid expenses, advances received)

expenses, advances received)

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Short

Short- - and Long- and Long -term Accruals term Accruals

Long- Long -term accruals arise from capitalization term accruals arise from capitalization

Asset capitalization is the process of deferring costs Asset capitalization is the process of deferring costs incurred in the current period whose benefits are expected incurred in the current period whose benefits are expected in future periods

in future periods (long (long- -term assets such as plant and equipment, term assets such as plant and equipment, and goodwill)

and goodwill)

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Short

Short- - and Long- and Long -term Accruals term Accruals

Accounting for long- Accounting for long -term accruals is more complex and term accruals is more complex and subjective than that for short

subjective than that for short- -term accruals term accruals

Cash- Cash -flow implications of short flow implications of short- -term accruals are more term accruals are more direct and readily determinable

direct and readily determinable

Short- Short -term accruals are more useful in company valuation term accruals are more useful in company valuation (Dechow, 194)

(Dechow, 194)

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Relevance and Limitations of Accrual Accounting Relevance and Limitations of Accrual Accounting Relevance of Accrual Accounting

Relevance of Accrual Accounting

Conceptual relevance of Accrual Accounting Conceptual relevance of Accrual Accounting

Conceptual superiority of accrual accounting over cash Conceptual superiority of accrual accounting over cash flows arises because the accrual

flows arises because the accrual- -based income statement based income statement and balance sheet are

and balance sheet are more relevant more relevant for measuring a for measuring a company

company’ ’s present and future cash s present and future cash- -generating capacity generating capacity

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Relevance of short

Relevance of short- -term accruals term accruals

Improve the relevance Improve the relevance of accounting by helping record of accounting by helping record revenues when earned and expenses when incurred revenues when earned and expenses when incurred

Income number Income number that better reflects profitability and also that better reflects profitability and also creates current assets and current liabilities that provide creates current assets and current liabilities that provide useful information about financial position

useful information about financial position

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Relevance of long

Relevance of long- -term accruals term accruals

Free cash flow (FCF) is computed by subtracting investments in Free cash flow (FCF) is computed by subtracting investments in long- long -term operating assets from operating cash flow term operating assets from operating cash flow

Problems for FCF:

1.1.

Investments are usually large and occur infrequently – Investments are usually large and occur infrequently – induce induce volatility in FCF

volatility in FCF

2.

FCF treats capital growth and capital replacement synonymously FCF treats capital growth and capital replacement synonymously

Investments in new projects Investments in new projects often bode well for a firm often bode well for a firm – – Yet, all Yet, all capital expenditures reduce FCF

capital expenditures reduce FCF

FCF is negative in the growth stage FCF is negative in the growth stage but positive in the decline stage but positive in the decline stage – – sending a reverse message about a firm sending a reverse message about a firm’ ’s prospects s prospects

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Relevance of long

Relevance of long- -term accruals term accruals

Accrual accounting overcomes these limitations in FCF by Accrual accounting overcomes these limitations in FCF by capitalizing investments

capitalizing investments in long in long- -term assets and allocating their term assets and allocating their costs over future benefits periods

costs over future benefits periods

Capitalization and allocation Capitalization and allocation improves the relevance of income improves the relevance of income both by

both by reducing its volatility reducing its volatility and by matching and by matching costs of long costs of long- -term term investments to their benefits

investments to their benefits

Superiority of accruals Superiority of accruals in providing relevant information in providing relevant information

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Financial performance:

Revenue recognition Revenue recognition ensures all revenues earned in a period are ensures all revenues earned in a period are accounted for

accounted for

Matching Matching ensures that only expenses attributable to revenues earned ensures that only expenses attributable to revenues earned in a period are recorded

in a period are recorded

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Financial position Financial position

Accounting system based on cash flows produces a balance sheet Accounting system based on cash flows produces a balance sheet that fails to reflect the financial position

that fails to reflect the financial position

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Predicting future cash flows Predicting future cash flows

Accrual income

Accrual income is a superior predictor of future cash flows is a superior predictor of future cash flows 1. 1. Through revenue recognition, it reflects future cash flow Through revenue recognition, it reflects future cash flow

consequences consequences

E.g. Credit sale today forecast cash to be received in the futur E.g. Credit sale today forecast cash to be received in the future e

2. 2. Accrual accounting better aligns inflows and outflows over the t Accrual accounting better aligns inflows and outflows over the time ime through the matching process

through the matching process

Accrual accounting is conceptually and empirically more relevant Accrual accounting is conceptually and empirically more relevant than cash flows

than cash flows

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Accruals Can Be a Double

Accruals Can Be a Double- -Edged Sword Edged Sword

Accrual accounting introduces judgment Accrual accounting introduces judgment into accounting with into accounting with various estimations and adjustments

various estimations and adjustments

Allowing managerial judgment Allowing managerial judgment should increase the relevance of should increase the relevance of accounting information

accounting information

Use of judgment Use of judgment can reduce comparability and consistency of can reduce comparability and consistency of

financial statements, leading to accounting distortion