Accrual Accounting
Before expanding on the three approaches, a review of accrual accounting is in order. The following point highlights the fundamental reason for the existence of accrual accounting: Over sufficiently long time periods, net income equals cash inflows minus cash outflows, other than cash flows with owners (for example, issuing or repurchasing common stock, and paying dividends). Asset and liability valuation and income measurement determine when and how the financial statements report these value changes. All value changes eventually affect net income and retained earnings
Before expanding on the three approaches, a review of accrual accounting is in order. The following point highlights the fundamental reason for the existence of accrual accounting: Over sufficiently long time periods, net income equals cash inflows minus cash outflows, other than cash flows with owners (for example, issuing or repurchasing common stock, and paying dividends). Asset and liability valuation and income measurement determine when and how the financial statements report these value changes. All value changes eventually affect net income and retained earnings
The ultimate goal of a firm is to create wealth for stakeholders by generating more cash inflows than it incurs cash outflows. Thus, a very simplistic option for reporting financial performance would be simply to report cash inflows and outflows. However, simply reporting cash inflows and outflows would suffer from timing issues as a measure of firm performance and financial condition. To review this basic premise, consider a stylized example of three transactions under accrual accounting versus cash flow reporting approaches, as presented in Exhibit 2.7.
In this stylized example, a firm purchases supplies (December 31, 2013), uses the supplies to provide services to a customer the next year, and collects cash for the billed services the following year. Under cash flow reporting, income from this transaction appears in three reporting periods in the following pattern: –$100, $0, and $1,000, whereas under accrual accounting, the net of $900 appears in a single period in which the activity occurs. In this example, we see that reporting cash inflows and outflows yields a series of performance measures that vary from negative to zero to positive, whereas accrual accounting measures and reports when and how the value changes are generated. The accrual accounting approach moves the timing of income and expenses to the period in which the real activity occurs (2014). The investment in supplies in 2013 and the collection of the account receivable in 2015 are handled by accruals, which can be thought of as ‘‘placeholders’’ on the balance sheet (assets in this example). Under accrual accounting, the supplies are classified as inventory, which, like many nonmonetary assets, is ‘‘an expense waiting to happen.’’ The amounts billed for services is classified as a receivable (with the offset being the revenue recorded), which, like many monetary assets, is a ‘‘cash inflow waiting to happen.’’
In this stylized example, a firm purchases supplies (December 31, 2013), uses the supplies to provide services to a customer the next year, and collects cash for the billed services the following year. Under cash flow reporting, income from this transaction appears in three reporting periods in the following pattern: –$100, $0, and $1,000, whereas under accrual accounting, the net of $900 appears in a single period in which the activity occurs. In this example, we see that reporting cash inflows and outflows yields a series of performance measures that vary from negative to zero to positive, whereas accrual accounting measures and reports when and how the value changes are generated. The accrual accounting approach moves the timing of income and expenses to the period in which the real activity occurs (2014). The investment in supplies in 2013 and the collection of the account receivable in 2015 are handled by accruals, which can be thought of as ‘‘placeholders’’ on the balance sheet (assets in this example). Under accrual accounting, the supplies are classified as inventory, which, like many nonmonetary assets, is ‘‘an expense waiting to happen.’’ The amounts billed for services is classified as a receivable (with the offset being the revenue recorded), which, like many monetary assets, is a ‘‘cash inflow waiting to happen.’’
Although stylized, this example is symbolic of real-world evidence. Noted accounting author Patricia Dechow examined the relative ability of cash flows and accounting earnings to capture firm performance. She predicts and finds that
‘‘… for firms in steady state (that is, firms with cash requirements for working capital, investments, and financing that are relatively stable), cash flows have few timing and matching problems and are a relatively useful measure of firm performance. However, for firms operating in volatile environments with large changes in their working capital and investment and financing activities, cash flows … have more severe timing and matching problems. Thus, cash flows’ ability to reflect firm performance will decline as the firms’ working capital requirements and investment and financing activities increase. Accruals … mitigate timing and matching problems in cash flows. As a consequence, earnings … better reflect firm performance than cash flows, in firms with more volatile operating, investment and financing activities …. [Finally], cash flows and earnings … [are] equally useful in industries with short operating cycles. However, in industries with long operating cycles, cash flows are … relatively poor measures of firm performanc
‘‘… for firms in steady state (that is, firms with cash requirements for working capital, investments, and financing that are relatively stable), cash flows have few timing and matching problems and are a relatively useful measure of firm performance. However, for firms operating in volatile environments with large changes in their working capital and investment and financing activities, cash flows … have more severe timing and matching problems. Thus, cash flows’ ability to reflect firm performance will decline as the firms’ working capital requirements and investment and financing activities increase. Accruals … mitigate timing and matching problems in cash flows. As a consequence, earnings … better reflect firm performance than cash flows, in firms with more volatile operating, investment and financing activities …. [Finally], cash flows and earnings … [are] equally useful in industries with short operating cycles. However, in industries with long operating cycles, cash flows are … relatively poor measures of firm performanc
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