Accrual accounting seeks to temporally match expenses to revenues. That is, it corrects for time differences between when the cash from revenues is actually received by a business and when expenses are paid out by that business.
For example, in selling a product, firms frequently pay out cash for the manufacture of a widget and then pay to house that widget in a warehouse or retail location that was built at some earlier time. Cash from the sale of the widget sometimes comes in well after its manufacture date. Accrual accounting attempts to calculate those future earnings relative to the cost to produce them. Additionally, accrual accounting tries to quantify the cost of the wear and tear on equipment (i.e., depreciation) so that the value lost through usage is matched to the revenues earned by the product manufactured. And so on for many other business activities.
Given its philosophical underpinnings, accrual accounting, not surprisingly, relies on abstraction and human judgment. As it relates to the latter, accrual accounting is complex because it asks for judgment from the business executives themselves as well as their auditors, and, of course, from the research analysts and portfolio managers who are trying to assess the accuracy of those judgments. Throw in the economic incentives handed out to business executives, and you have a built-in impetus to nudge and fudge financial numbers in a preferred direction.
All of this, of course, raises the question of our recent CFA Institute Financial NewsBrief poll: How accurate is accrual accounting in capturing actual business reality? Since many investing decisions depend on the accuracy of accrual accounting, this is a vital question.
How accurate is accrual accounting in capturing actual business reality?
Reassuringly, three quarters of the 568 respondents believe that accrual accounting captures at least half of the reality of a business, while the smallest category of poll participants (7%) believe that it is accurate a quarter of the time or less. Whew!
But many respondents recognize that the accrual accounting lens is a bit greasy, as the second smallest segment of respondents (8%) believe the image shining through the accrual accounting lens is at least 90% accurate. About two in three participants understand accrual accounting provides a less-than-perfect image of business reality (i.e., the combination of the groups ranging from 50–89%), but that, at the very least, half of what they are seeing is real. That is, they are at least 50% confident that accrual accounting represents real business activities. What was surprising to those of us inside of CFA Institute — who had placed our bets on the 76–89% category — is that the largest group of respondents picked the 50–75% range. So accounting standard setters, are you listening? Readers of CFA Institute Financial NewsBrief feel there is some work to do.
These results raise a natural question: What would help make accrual accounting more accurate? More thorough audits? Better internal accounting software and controls? Inclusion of economic, social, and governance (ESG) factors so the actual footprint of the business was better represented? Unified global accounting standards? Less complex businesses? And so on. We promise to revisit this question in a future poll.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author's employer.
30 Comments
I think what the issue might be is that people are confused with what GAAP is. While GAAP used to be primarily focused on accrual basis account - which requires that revenues be recognized in the period in which a sale is made and expenses in the period in which they are incurred, this is no longer the case. For at least the last 20 years, the Financial Accounting Standards Board has focused on fair value accounting, rather than pure accrual accounting. By its very nature, fair value accounting gives management significant leeway in the numbers that it reports. Thus, what is reported may not be a company's actual financial position on the balance sheet date or its results of operations for the period covered by the profit and loss statement.
For small businesses not required to produce GAAP financial statements, the AICPA has developed the Financial Reporting Framework for Small and Medium-sized Entities, which follows accrual principles much more closely than current GAAP.
Hello Michael,
Thank you for taking the time to comment. I consider the information you provided to be invaluable; thank you.
Yours, in service,
Jason
Hello Jason ,
How about using accrual accounting in business valuations and preparing business plans ?
I am Ahmed From Egypt and preparing for CFA level 2 and Appreciate if you give me your opinion in this regard.
Thanks ,
Ahmed
Hello Ahmed in Misr,
An excellent question! Thanks for taking the time to ask it of me. Here I am going to share my opinion - recognize it is my opinion and not necessarily the opinion of CFA Institute. Me personally? I think accrual accounting is at least 75% reflective of reality. I also think that in order to really make use of it, that you need to study accounting so that you can learn the tricks that executives might use in order to skew reality in their favor. I had a professor in graduate school that would begin a class like this:
* It is 15 November, you are the controller at a publicly traded firm, your annual bonus is based on net income growing by 7% this year, currently it has only grown 6%, and your wife wants to go on an expensive vacation to Dubai. What do you do in order to make sure that you help your wife be happy?
To me this is the correct approach for analysts to learning accounting. Debits and credits are interesting, but when you combine accounting with contexts, motivations, and frailties then you get true insight. If you know how to get information out of financial statements then they are extremely helpful raw material in accurate valuations of businesses, in my opinion.
Yours, in service,
Jason
PS - My wife and I honeymooned in Misr, and it is our favorite country!
I hope the holiday wasn't around the 15th of December, around when target-affecting decisions had to be made :p.
IMO the population polled skews the results. The analyst community is only of value if their personal models of reality are different from accrual accounting. When you are trained to model cash flows, when you are paid to produce cash flows, you will believe that cash flows measure reality.
But I have never heard a rational argument why some analyst's (or mgmt) $$ for maintenance capX is a better measure of long-run requirements than the accountant's depreciation. Certainly lumpy capX from one particular year is not valid for any valuation that is supposed to see into the future.
I disagree completely with the author's claim that it is accrual accounting that "relies on abstraction and human judgment". Accrual accounting uses actual transaction prices and uses judgement only to allocate the transactions over time. But over the long run those reported rev/exp will always add up exactly to the sum of the actual transactions.
Contrast that with cash models used by analysts where the $$ input are invented with no necessity that they get validated/corrected by actual transactions - ever. If the analysts' estimates of maintenance capX were booked in the accounts instead of depreciation, the size of assets on the balance sheet would balloon into improbably high values, that would only correct when the asset was sold/chucked out.
I agree with the first comment above about today's prevalence of mark-to-market accounting (which I hate). It has been my impression that the movement toward this non-transaction accounting has been BECAUSE of lobbying by the financial analysts community. I believe they have done us a great dis-service.
Hello Chris,
Thanks for taking the time to share your thoughts with folks reading my post. Clearly you are a passionate advocate of your opinions of accrual accounting and other forms of accounting. Nice of you to share that with each of us. Also, in my 20+ years as an analyst I have never met anyone who is looking for her or his model to be different from reality. The pursuit of accountants and analysts is the same: bringing our minds, and the models created by them, into accord with reality. The respondents to this poll believed that accrual accounting was better than half a representation of reality. In most models of reality that would be considered high praise, especially ones where human judgment/free-will is involved.
Yours, in service,
Jason
This is the "chicken-or-egg" problem. As I understand it, analysts rely on financial reporting information to develop their valuation models. But, financial accounting includes many very soft accruals, among those are: (1) estimates on revenue from long-term contracts and estimates of the related costs assocated with those revenues, (2) the allowance for losses on receivables and loans, (3) reserves for contingencies, (4) recorded amonunts for intangibles and goodwill acquired in a business combination and the related subsequent impairment losses, (5) valuations associated with financial hedges and hedged instruments, etc. etc. etc.
As I say to my students, we don't know the company's actual "numbers", we just know what they report. We'll know the actual numbers when they are liquidated. That's when cash accounting "catches-up" with accrual accounting.
Hello Rich,
Thank you for taking the time to weigh-in on the article : ) Regarding how the information provided in financial reporting is used...usually well before a valuation model is created comes financial statement analysis with its common-size work, ratio analysis, adjustments, and so forth. This is GAAP accounting, more than just pure accrual accounting. But as analysts we are certainly aware of the parts of accrual accoutning that are soft.
Thank you for including your list of some of the soft assumptions. May I add one of those soft bits that is certainly open to squishy judgments is depreciation and its partner, useful lives? There are many such judgments undertaken by business people, their accountants, and auditors to try and best reflect the tenor and direction of the company.
Last, thanks for tuning into The Enterprising Investor!
Yours, in service,
Jason
Chris, I respectfully disagree with your assertion that 'the movement toward this non-transaction accounting has been BECAUSE of lobbying by the financial analysts community.' I have been involved on the 'anti' side of this movement since its inception. In 2008, 'CFA Magazine' published one of my broadsides against fair-value accounting [FVA]; the same year, 'Strategic Finance' (the flagship publication of the Institute of Management Accountants' published a much longer, detailed piece that I wrote in strong opposition to FVA. I am happy to send PDFs of either or both of these to anyone who sends a note to me via [email protected].
In point of fact, we got FVA because the SEC said to FASB, in effect, 'No more Enrons.' Enron, you may recall, got into trouble for a number of reasons, not the least of which was that it valued the derivatives that Enron itself created. It inflated those values, which led to a dreadfully over-priced stock, when finally collapsed in 2002. Two of Enron's senior executives--CEO Jeff Skilling and CFO Andy Fastow--went to prison as a direct result. A third, chairman Ken Lay, died before he could be tried; had he lived, doubtless he would have joined Skilling and Fastow in a much-deserved trip to the slammer.
'No More Enrons' gave us SFAS 157 ("Fair Value Measurements"), which later morphed into ASC 820. The implementation side of FVA for M&A plays out in ASC 805 ("Business Combinations"). In my view, ASC 820 and ASC 805 constitute prime examples of the bad that can happen when 65 really smart people--the headcount @ FASB--have far too much time on their hands.
For those who might not aware, the definition of 'Fair Value' is not--repeat, NOT--the price that actually occurred in a transaction. It is defined thusly: "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." In other words, the price is not what was actually paid, but the price that could be obtained in some future--and almost always hypothetical--transaction. It's an 'exit price'.
In typical bean-counter fashion--and I am a CPA so I take license to use that characterization--the FASB folks failed to consider the incentives that such a definition would create: a bazaar (bizarre?) where assets and liabilities are traded in a frenzy, but creating annuity streams of revenue from high-value products and services is a secondary consideration. In my view, it's the greatest hoax since 'One size fits all.' I've done a slug of work under ASC 805 for clients and I can attest that if there's a difference between FVA and astrology, I've never detected it.
As to your reference to the analyst community, everything I've seen, and everything I've heard from others who are closer to the buy-side of that community, tells me that they ignore the 'impairments' in asset values, especially intangibles (usually Goodwill), as a result of annual impairment-testing. They just plain ignore it. That's why this bad idea of FVA didn't originate with them. It started @ the SEC.