CASH-BASIS AND ACCRUAL-BASIS
ACCOUNTING
CHAPTER 16
EVALUATING FINANCIAL REPORTING QUALITY
Accrual-Basis Accounting
Cash-Basis Accounting
• Financial statements reflect
transactions according to cash
flow.
Presenter’s name
Presenter’s title
dd Month yyyy
• Recognize revenues when
receive cash.
• Recognize expenses when
disburse cash.
• Financial statements reflect
transactions in the reporting
period in which they occur,
irrespective of the timing of cash
flow.
• Recognize revenues when
earned.
• Recognize expenses when
incurred.
2
Copyright © 2013 CFA Institute
CASH-BASIS AND ACCRUAL-BASIS
ACCOUNTING: EXAMPLE
CASH-BASIS AND ACCRUAL-BASIS
ACCOUNTING: EXAMPLE
During the year, there are two transactions:
1. One customer pays $20 upfront. Cadence has not yet performed the
service.
2. Second customer has not yet paid. Cadence has completed the
service.
At the start of the current year, the owner contributes $100
cash into the business.
Cadence Cycling Beginning Balance Sheet
ASSETS
Cash
CASH BASIS
LIABILITIES & EQUITY
$100
Liabilities
0
Equity
Total
$100
Common stock
$100
Total
$100
$20
Revenue
$25
Expenses
$0
Expenses
$0
Net income
Cash
Liabilities
Common stock
Retained earnings
Copyright © 2013 CFA Institute
3
ACCRUAL BASIS
Revenue
Copyright © 2013 CFA Institute
$20
$120
$0
$100
$20
Net Income
Cash
$25
$120
Accounts receivable
$25
Liabilities – Unearned revenue
$20
Common stock
Retained earnings
$100
$25
4
CASH-BASIS AND ACCRUAL-BASIS
ACCOUNTING: EXAMPLE
ACCRUAL-BASIS ACCOUNTING:
RELATIVE MERITS
During the year, there are two transactions:
1. One customer pays $20 upfront. Cadence has not yet performed the
service.
2. Second customer has not yet paid. Cadence has completed the service.
CASH BASIS
ACCRUAL BASIS
Net income
$20
Net Income
$25
Total beginning assets
$100
Total beginning assets
$145
Advantages of accrual basis relative to cash basis:
Total ending assets
$120
Total ending assets
$145
• More timely
• Better predictor of future cash flows
ROA
18.2%
ROA
20.4%
Disadvantages of accrual basis relative to cash basis:
• Requires estimates
• Involves more management discretion
Copyright © 2013 CFA Institute
5
Copyright © 2013 CFA Institute
6
MANAGEMENT’S MOTIVATIONS:
CAPITAL MARKETS
SOURCES OF ACCOUNTING DISCRETION
• Revenue recognition
• Motivation to report results that meet or exceed expectations: Positive
market reaction.
• Allowance for doubtful accounts and related provision for
bad debts
• Research provides evidence of propensity to meet or exceed various
thresholds:
• Depreciation choices
• Inventory choices
- Beat historical earnings.
• Choices related to goodwill and other noncurrent assets
- Beat consensus analysts’ forecasts.
• Evidence of propensity to barely meet or exceed these thresholds
suggests
• Choices related to taxes
• Pension choices
- Management possibly using discretion in reported earnings to
achieve target.
• Financial asset/liability valuation
- In the case of analysts’ forecasts, management possibly moving the
benchmark lower with strategic communications.
• Stock option expense estimates
Copyright © 2013 CFA Institute
7
Copyright © 2013 CFA Institute
8
MANAGEMENT’S MOTIVATIONS:
CONTRACTS
MECHANISMS DISCIPLINING THE FINANCIAL
REPORTING PROCESS
• External auditors
• Management compensation contracts
- Compensation linked explicitly to accounting measures
(e.g., ROA, ROS).
• Internal auditors, audit committee, and the board of directors
- Compensation linked to stock prices, which can be
affected by reported earnings numbers.
• Litigation
• Management certification
• Regulators
• General market scrutiny—for example,
• Debt contracts
- Financial journalists
- Covenants based on accounting measures.
- Short sellers
- Pricing structures linking interest cost to financial
performance.
- Activist institutions
- Employee unions
- Analysts
9
Copyright © 2013 CFA Institute
EARNINGS QUALITY
10
Copyright © 2013 CFA Institute
EARNINGS PERSISTENCE
• Earnings (operating income) can be viewed as two separate
components:
• Earnings that are considered to be higher quality:
- Operating cash flows, and
- When they exhibit persistence (i.e., when the reported
level of earnings can be expected to be sustained or
continued).
- Accruals (the difference between operating income and operating
cash flow).
• Research measures “persistence” as regression coefficients, using the
following regressions:
- When they are unbiased—neither too conservative nor
too aggressive.
• Sustainable earnings enable better forecasts of future cash
flows or earnings.
Earningst+1 = 0 + 1Earningst + 
(1)
Earningst+1 = 0+ 1Accrualst + 2Cash Flowst + 
(2)
where earnings, accruals, and cash flows are all scaled by total assets.
• Evidence that 1 is consistently smaller than 2 indicates that the cash
flow component of earnings is more persistent than the accruals
component.
Copyright © 2013 CFA Institute
11
Copyright © 2013 CFA Institute
12
MEASURES OF EARNINGS QUALITY:
BALANCE-SHEET-BASED ACCRUALS RATIO
MEASURES OF EARNINGS QUALITY
• Contrasting financial statements prepared on a cash basis to those
prepared on an accrual basis is a natural way to identify the extent of
discretion embedded in the reported financial statements.
• Effectively, this amounts to comparing a pure change in cash measure
of earnings with the reported earnings under accrual accounting. The
difference is aggregate accruals or the accrual component of earnings.
• Decompose reported accrual-based earnings into the cash flow and accrual
component, using information on the balance sheet.
• Define net operating assets (NOA):
Totalassets
Cash
• How do you decompose reported accrual earnings into a cash flow and
accrual component?
- Focus on information in the balance sheet, or
- Focus on information in the statement of cash flows
Aggregateaccruals
13
MEASURES OF EARNINGS QUALITY: CASH
FLOW STATEMENT-BASED ACCRUALS RATIO
Copyright © 2013 CFA Institute
/
/2
Copyright © 2013 CFA Institute
14
• However, the two approaches (balance sheet and statement of cash
flows) will not generate the exact same numbers.
• Differences are typically small and can be ignored for the purpose of
developing earnings quality measures.
• The typical correlation between a broad accrual measure based on
balance sheet data with one based on statement of cash flow data is in
excess of 0.80.
• The two approaches (balance sheet and statement of cash flows) are
conceptually equivalent.
• Adjust for size differences by scaling total accruals by average NOA:
Accrualsratio
MEASURES OF EARNINGS QUALITY
• Measure total accruals for the period as the difference between net
income and cash flow (from operating and investing):
/
• Adjust for size differences by scaling total accruals by average NOA:
Accrualsratio
Aggregateaccruals
Totaldebt
• Measure total accruals for the period as the change in NOA:
Aggregate accruals = Accrual-based earnings – Cash earnings
Copyright © 2013 CFA Institute
Totalliabilities
• An analyst should compare companies using the same method across
companies.
/2
15
Copyright © 2013 CFA Institute
16
A QUALITY-OF-EARNINGS COMPARISON
OF TWO COMPANIES
MEASURES OF EARNINGS QUALITY
• Research provides validation of these measures of
earnings quality.
• Measures identify companies in advance of restatement
announcements.
• Measures are leading indicators of U.S. SEC enforcement
actions.
Balance-Sheet-Based Accrual Ratio
/
2006
(%)
2005
(%)
Siemens
14.2
18.7
General Electric
11.6
4.1
2006
(%)
2005
(%)
Siemens
8.4
18.3
General Electric
9.0
3.3
Cash-Flow-Statement-Based Accrual Ratio
Accrualsratio
Copyright © 2013 CFA Institute
17
POTENTIAL PROBLEMS THAT AFFECT THE QUALITY
OF FINANCIAL REPORTING: REVENUE RECOGNITION
• Revenue recognition issues
Copyright © 2013 CFA Institute
18
INAPPROPRIATE REVENUE RECOGNITION:
EXAMPLE
• Diebold, Incorporated, has been engaged in an ongoing discussion
with the Securities and Exchange Commission (SEC) regarding the
company’s practice of recognizing certain revenue on a “bill and hold”
basis within its North America business segment. As a result of these
discussions, Diebold will discontinue the use of bill and hold as a
method of revenue recognition in both its North America and
international businesses.
- Revenue misstatement
- Accelerating revenue
• Inappropriate revenue recognition
- SEC enforcement actions
- Restatements
• The change in the company’s revenue recognition practice, and the
potential amendment of prior financial statements, would only affect the
timing of recognition of certain revenue. Although the percentage of the
company’s global bill and hold revenue varied from period to period, it
represented 11% of Diebold’s total consolidated revenue in 2006.
• Warning signs of revenue misstatement
- Large increases in accounts receivable
- Examine days’ sales outstanding (DSO)
- Consider in context
- Large decreases in unearned revenue
Copyright © 2013 CFA Institute
19
Copyright © 2013 CFA Institute
20
INDICATOR OF POTENTIAL REVENUE RECOGNITION
ISSUES: REVENUE VS. CASH COLLECTIONS
2006
Revenue
2005
$2,906,232
$2,587,049
Plus decrease (minus increase) in accounts
receivable
65,468
(92,703)
Plus increase in deferred income
34,786
43,273
$3,006,486
$2,537,619
96.7%
101.9%
Equals cash collected from customers
Revenue/Cash collected from customers
Copyright © 2013 CFA Institute
21
POTENTIAL PROBLEMS THAT AFFECT THE QUALITY
OF FINANCIAL REPORTING: EXPENSE RECOGNITION
“Improper accounting for bill-and-hold transactions usually involves the
recording of revenue from a sale, even though the customer has not
taken title of the product and assumed the risks and rewards of
ownership of the products specified in the customer’s purchase order or
sales agreement. In a typical bill-and-hold transaction, the seller does
not ship the product or ships it to a delivery site other than the
customer’s site. These transactions may be recognized legitimately
under GAAP when special criteria are met, including being done
pursuant to the buyer’s request.”
“Report Pursuant to Section 704 of the Sarbanes–Oxley Act of 2002”
U.S. SEC
- Understating expenses.
- Deferring expenses.
- Classifying ordinary expenses as nonrecurring or nonoperating.
• Warning signs of expense misstatement
- Change in depreciation assumptions.
- Ratio of depreciation relative to the gross value of PP&E or change in
depreciation relative to sales compared with other companies.
- Asset growth relative to sales growth.
- Large positive unexpected increase in core operating margin and a
contemporaneous negative special item or nonrecurring charge.
- Inconsistency regarding items of expenses in operating income.
23
22
Copyright © 2013 CFA Institute
ACCOUNTING WARNING SIGNS: EXPENSES
Inconsistency over time in the
items included in operating
revenues and operating
expenses.
Classification of ordinary
expenses as nonrecurring or
nonoperating.
Increases in the core operating
margin [(Sales – COGS –
SGA)/Sales] accompanied by
spikes in negative special
items.
Use of nonconservative
depreciation and amortization
estimates, assumptions, or
methods—for example, long
depreciable lives.
• Expense recognition issues
Copyright © 2013 CFA Institute
INAPPROPRIATE REVENUE RECOGNITION:
EXAMPLE
Copyright © 2013 CFA Institute
May indicate opportunistic use of
discretion to boost reported operating
income.
May reflect an attempt to mask a decline
in operating performance.
May indicate opportunistic classification
of recurring expenses as nonrecurring.
May indicate actions taken to boost
current reported income. Changes in
assumptions may indicate an attempt to
mask problems with underlying
performance in the current period.
24
POTENTIAL PROBLEMS THAT AFFECT THE QUALITY
OF FINANCIAL REPORTING: BALANCE SHEET ISSUES
ACCOUNTING WARNING SIGNS: EXPENSES
Buildup of high inventory levels relative
to sales or decrease in inventory
turnover ratios.
Deferral of expenses by capitalizing
expenditures as an asset—for example:
May indicate obsolete inventory
or failure to take needed
inventory write-downs.
May boost current income at the
expense of future income;

May mask problems with
underlying business
performance.
May allow company to “save”
profits in one period to be used
when needed in a later period;
May be used to smooth
earnings and mask underlying
earnings variability.
Customer acquisition costs
 Product development costs
Use of reserves, such as
restructuring or impairment charges
reversed in a subsequent period;
Use of high or low level of bad debt
reserves relative to peers.
Copyright © 2013 CFA Institute
- Off-balance-sheet debt—that is, operating leases.
- Goodwill.
• Warning signs of balance sheet issues:
- Changes in reported goodwill.
- Goodwill amounts when market capitalization is less than
book value of equity.
25
POTENTIAL PROBLEMS THAT AFFECT THE QUALITY
OF FINANCIAL REPORTING: CASH FLOW ISSUES
• Statement of cash flow issues
- Classification issues in the cash flow statement
- Omitted investing and financing activities
- Real earnings management activity
Copyright © 2013 CFA Institute
• Balance sheet issues:
27
26
Copyright © 2013 CFA Institute
SUMMARY
• Financial reporting quality relates to the accuracy with which a
company’s reported financial statements reflect its operating
performance and to their usefulness for forecasting future cash flows.
Understanding the properties of accruals is critical for understanding and
evaluating financial reporting quality.
• The application of accrual accounting makes necessary use of judgment
and discretion. On average, accrual accounting provides a superior
picture to a cash-basis accounting for forecasting future cash flows.
• Earnings can be decomposed into cash and accrual components. The
accrual component has been found to have less persistence than the
cash component, and therefore, (1) earnings with higher accrual
components are less persistent than earnings with smaller accrual
components, all else being equal, and (2) the cash component of
earnings should receive a higher weighting in evaluating company
performance.
• Aggregate accruals ratios are useful to rank companies for the purpose
of evaluating earnings quality.
Copyright © 2013 CFA Institute
28