Analysis implications of accrual accounting

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Accrual accounting is ingrained in modern business. Wall Street focuses on accrual income, not cash flows. We know that accrual accounting is superior to cash accounting in measuring performance and financial condition, and in forecasting future cash flows.Still, accrual accounting has limitations. Consequently, should accrual accounting numbersalways be used in business analysis and valuation, or should they sometimes beabandoned in favor of hard cash flows? If accrual accounting is used, how does one deal with its limitations? What is the role of cash flows in a world of accrual accounting? This section provides some answers to these questions. We begin with the myths and truths of both accrual and cash accounting. Then we discuss the role of accruals and cash flows in financial statement analysis.

Myths and Truths about Accruals and Cash Flows
Several assertions exist regarding accruals and cash flows both positive and negative. It is important for an analyst to know which assertions are true and which are not.

Accruals and Cash Flows Myths. There are several myths and misconceptions about accrual accounting, income, and cash flow: 

• Myth: Because company value depends on future cash flows, only current cash flows arerelevant for valuation. Even if we accept that company value depends only on future cash flows, there is no reason to necessarily link current cash flows with future cash flows. We already showed that current income is a better predictor of future cash flows than is current cash flow. We also showed that income better explains stock prices than does cash flow.
• Myth: All cash flows are value relevant. Many types of cash flows do not affect company value for example, cash collected from customers on account. Also, certain types of cash flows are negatively related to company value for example, capital expenditures reduce free cash flow but usually increase company value. Exhibit 2.7 provides additional examples.

• Myth: All accrual accounting adjustments are value irrelevant. It is true that “cosmetic” accounting adjustments such as alternative accounting methods for the same underlying business activity do not yield different valuations. However, not all accounting adjustments are cosmetic. A main goal of accrual accounting is to make adjustments for transactions that have future cash flow implications, even when no cash inflows or cash outflows occur contemporaneously an example is a credit sale as shown in Exhibit 2.7.
• Myth: Cash flows cannot be manipulated. Not only is this statement false, it is probably easier to manipulate cash flow than to manipulate income. For example, cash flows can be increased by delaying either capital expenditures or the payment of expenses, or by accelerating cash collections from customers
• Myth: All income is manipulated. Some managers do manage income, and the frequency of this practice may be increasing. However, SEC enforcement actions targeted at fraudulent financial reporting and restatements of previously issued financial statements affect a small percentage of publicly traded companies.
• Myth: It is impossible to consistently manage income upward in the long run. Some users assert it is impossible to manage income upward year after year because accounting rules dictate that accruals eventually reverse; that is, accrual accounting and cash accounting coincide in the long run. Still, most companies can aggressively manage income upward for several years at a time. Further, a growth company can manage income upward for an even longer period because current period upward adjustments likely exceed the reversal of smaller adjustments from prior years. Also, some companies take a “big bath” when they experience a bad period to recognize delayedexpenses or aggressively record future expenses. This enables a company to more easily manage income upward in future periods because of fewer reversals from prior accruals.

Accruals and Cash Flows Truths

Logic and evidence point to several notable truths about accrual accounting, income, and cash flow: Truth: Accrual accounting (income) is more relevant than cash flow. Both conceptually and practically, accrual income is more relevant than cash flow in measuring financial condition and performance and in valuation. Note that this statement does not challenge the obvious relevance of future cash flows. Instead, it points out that current cash flow is less relevant than current income.

Truth: Cash flows are more reliable than accruals

This statement is true and it suggests cash flows can and do play an important complementary role with accruals. However, extreme statements, such as “cash flows cannot be manipulated,” are untrue. When analyzing cash flows, we also must remember they are more volatile than income.

Truth: Accrual accounting numbers are subject to accounting distortions.

 The existence of alternative accounting methods along with earnings management reduces both comparability and consistency of accrual accounting numbers. Also, arbitrary accounting rules and estimation errors can yield accounting distortions. A financial analysis or valuation that ignores these facts, and accounting adjustments, is likely to produce erroneous results. For example, a valuation method that simply uses price-to-earnings ratios computed using reported income is less effective.
 

Truth: Company value can be determined by using accrual accounting numbers. 

Some individuals wrongly state that value is determined only on the basis of discounted cash flows.

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