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.