Cash versus Accrual Accounting

ADS Cash versus Accrual Accounting
Even though predicting future cash flows is the primary goal of many users of financial
reporting, the model best able to achieve that goal is the accrual accounting model. A
competing model is cash basis accounting . Each model produces a periodic measure of
performance that could be used by investors and creditors for predicting future cash flows

CASH BASIS ACCOUNTING. 
Cash basis accounting produces a measure called net operating cash flow . This measure is the difference between cash receipts and cash payments from transactions related to providing goods and services to customers during a reporting period. Over the life of a company, net operating cash flow definitely is the variable of concern. However, over short periods of time, operating cash flows may not be indicative of the company’s long-run cash-generating ability. Sometimes a company pays or receives cash in one period that relates to performance in multiple periods.

For example, in one period a company receives cash that relates to prior period sales, or makes advance payments for costs related to future periods. Therefore, net operating cash flow may not be a good predictor of long-run cash-generating ability. To see this more clearly, consider Carter Company’s net operating cash flows during its first three years of  . Over this three-year period Carter generated a positive net operating cash flow of $60,000. At the end of the three-year period, Carter has no outstanding debts. Because total sales and cash receipts over the three-year period were each $300,000, nothing is owed to Carter by customers. Also, there are no uncompleted transactions at the end of the three-year period. In that sense, we can view this three-year period as a micro version of the entire life of a company.

Illustration 1-2

At the beginning of the first year, Carter prepaid $60,000 for three years’ rent on the facilities. The company also incurred utility costs of $10,000 per year over the period. However, during the first year only $5,000 actually was paid, with the remainder being paid the second year. Employee salary costs of $50,000 were paid in full each year. Is net operating cash flow for year 1 (negative $65,000 ) an accurate indicator of future cash-generating ability? 6 Clearly not, given that the next two years show positive net cash flows. Is the three-year pattern of net operating cash flows indicative of the company’s year-by-year performance? No, because the years in which Carter paid for rent and utilities  are not the same as the years in which Carter actually consumed those resources. Similarly, the amounts collected from customers are not the same as the amount of sales each period.



ACCRUAL ACCOUNTING.
If we measure Carter’s activities by the accrual accounting model, we get a more accurate prediction of future operating cash flows and a more reasonable portrayal of the periodic operating performance of the company. The accrual accounting model doesn’t focus only on cash flows. Instead, it also reflects other resources provided and consumed by operations during a period. The accrual accounting model’s measure of resources provided by business operations is called revenues, and the measure of resources sacrificed to earn revenues is called expenses. The difference between revenuesand expenses is net income, or net loss if expenses are greater than revenues. 7
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Revenue for year 1 is the $100,000 sales. Given that sales eventually are collected in cash, the year 1 revenue of $100,000 is a better measure of the inflow of resources from company operations than is the $50,000 cash collected from customers. Also, net income of $20,000 for year 1 appears to be a reasonable predictor of the company’s cash-generating ability, as total net operating cash flow for the three-year period is a positive $60,000 . Comparing the three-year pattern of net operating cash flows in Illustration 1–2 to the three-year

Illustration 1-3

pattern of net income , the net income pattern is more representative of Carter Company’s steady operating performance over the three-year period. 8 While this example is somewhat simplistic, it allows us to see the motivation for using the accrual accounting model. Accrual income attempts to measure the resource inflows and outflows generated by operations during the reporting period, which may not correspond to cash inflows and outflows. Does this mean that information about cash flows from operating activities is not useful? No. Indeed, one of the basic financial statements—the statement of cash flows—reports information about cash flows from operating, investing and financing activities, and provides important information to investors and creditors. 9 The key point is that focusing on accrual accounting as well as cash flows provides a more complete view of a company and its operations. ADS