Overview
“Accrual accounting is the heart and soul of corporate financial
reporting. It encourages companies to make estimates of a wide variety of key
financial variables and allocate revenue to specific quarters or periods of
time. Accrual accounting allows companies a great deal of flexibility, which is
appropriate. But it can also be a problem. Too many companies are taking
advantage of that latitude to push their estimates to the limits in order to boost
earnings. Most of it is perfectly legal, but that's no solace to investors who
are left to decipher hidden, confusing assumptions and judgments made in
reported earnings. Despite all the recent accounting reform, more work remains
to be done. Companies have to clean up their financial statements to give
investors transparent and consistent financial data or prepare to be punished
in the market. Wall Street is already catching on to the shenanigans on income,
balance-sheet, and cash-flow statements.” --- Business Week, OCTOBER 4, 2004, The New Earnings
Game
Accounting accruals represent non-cash
accumulations and can affect all four major accounting statements. Measuring these accumulations at the end of
an accounting period results in balance sheet items such as “Accounts
Payable,” “Accounts Receivable,”
“Deferred Taxes,” and “Goodwill.” The
other side of these account balances are income statement entries such as
“Accrued expenses,” “Accrued Revenues,” “Tax Expense,” and “Amortizations” that
are recognized by applying the matching
principle.
Accruals are of interest
to investors, because as you will learn in this lesson, they can relate to both past and estimated future cash
flows. In the academic research
literature, the famous “accruals anomaly” has placed accruals on center stage. The research showed that if you decompose accounting
income into accruals and cash income, you find that these components have
different implications for forecasting future income. This means you have to pay attention to
accruals separately from cash income.
Understanding Accounting Accruals
The difference between
“Accounting Income” and “Cash Income” result from accruals. The income statement is where you see
accounting accruals and their impact upon the measurement of revenues, gains,
expenses and losses. Operationally this
results from applying the matching principle
which binds together revenue and expense recognition over a period of time.
A quick history: this approach to accruals was popularized in the 1940 American
Accounting Association monograph by Professors W.A. Paton and A.C. Littleton’s
“An Introduction to Corporate Accounting Standards.” This monograph provided a comprehensive
rationale for historical cost accrual accounting, including highlighting the importance
of the matching principle. In this
monograph the accounting income statement received primary focus and the
balance sheet was treated as the residual of the income statement. Subsequent
to Paton and Littleton’s monograph fair value accounting and a second concept
of income, comprehensive income, evolved.
These developments resulted in the balance sheet also being recognized
as a primary driver of accruals that by-passed the Income Statement. This resulted in SFAS 130, Reporting of
Comprehensive Income, in 1997 establishing reporting standards in response to
these developments.
The objective of this
lesson is to become familiar with accounting accruals as applied in practice,
including providing an introduction to understanding the subtle relationships
between accruals and cash flows, and particularly how different accruals result
from both past and estimated future cash flows.
In the next section we
will exploit these developments by starting with Paton and Littleton’s income statement
insights within the context of the indirect form of the cash flow
statement. This treatment is then extended
to the Statement of Stockholders’ Equity to cover accruals that bypass the
accounting income statement.
Identifying Accounting Accruals: A Consolidated Cash Flow Statement Approach
The Consolidated
Statement of Cash Flows for companies that use the indirect method, provide a natural
starting place for learning about accruals.
This is because this statement reconciles opening and closing cash
balances by starting with the Accounting or Net Income and then undoes the adjustments
resulting from accrual accounting to get back to an estimate of cash
income. Further, these adjustments are
classified by activities (Operating, Investing and Financing) to provide
investors with additional information.
Consider EBAY for
adjustments related to Operating Activities.
Working from Left (Net Income) to Right (Net Cash Provided by Operating
Activities) in the screen below it is immediately apparent that EBAY has made a
number of adjustments. The bar chart
reveals the relative significance of each adjustment.
As a result, we will
first focus on sub sets of the accrual adjustments in this statement for EBAY.
Accruals at Work
Some major news for EBAY
in 2011 was the sale of Skype to Microsoft:
Accounting Accruals at Work: Skype, Cash Flows and Accounting Accruals
To see how accounting
accruals resulting from this transaction permeates through the accounting
reports consider first the Consolidated Cash Flow Statement which EBAY present
in indirect form. The Skype transaction was
for cash so it reflects a combination of accrual and non-accrual entries that influence
two parts of this statement: Cash Flow from Operating Activities and Cash
Flows from Investing Activities.
Recall a cash flow
statement is reconciling the opening and closing cash balance starting with
accounting net income. As a result, the
sale of Skype has a large gain associated with it in accounting net income plus
Microsoft paid cash for Skype so the cash account has to reflect EBAY’s share
which was in excess of 2-billion dollars.
How are these entries
reflected in this statement?
The accrual part of the
transaction is reflected in the gain, relative to the book value, from the sale
of Skype in accounting Income and the non-accrual part is the in excess of $2
billion cash received by EBAY from Microsoft.
Accrual Adjustment
The
above reveals a large negative adjustment to Operating Activities (circled in
red). This is undoing the effects of the
gain from this non re-occurring sale from operating activities, that is in the
Net Income number for the year.
Cash Adjustment
The Sale of Skype was for cash as
presented in the above news story and so the larger addition to Investing
Activities circled in blue reflects the accounting for the sale.
It is further observed that the gain
adjustment is less than the cash adjustment because the gain is net of the book
value. This also illustrates the
importance for an analyst to check whether a sale of an investment is for cash
or some combination of cash and stock.
Additional Accrual Adjustments: Past versus Future Cash Flows Effects
Many other accrual adjustments are
one-sided in relation to the Indirect Form of the Cash Flow Statement (i.e.,
Income Statement). That is, the
corresponding impact is on the Balance Sheet.
Consider the following set of EBAY adjustments:
For EBAY the change in Accounts
Receivable is a use of funds as Accounts Receivable have increased. Accounts Payable is a source of cash (because
payments have been delayed). The above
also reveals that Accrued Expenses and Other Liabilities have been a use of cash. The residual of these activities is on the
Balance Sheet in the following form:
Here the corresponding Balance Sheet
activity is consistent for Accounts Receivable – that is, increase in accounts
receivable over the year is a use of cash funds. Similarly, Accounts Payable is consistent
that is an increase in the Accounts Payable current liability is a source of
cash funds. The only strange activity in
the above is that “Accrued expenses and other liabilities” is a use of cash on
the Cash Flow Statement in the Consolidated Cash Flow Chart but it is also an
Increase in Liabilities on the Consolidated Balance Sheet. On the surface this is an inconsistent
treatment of accruals. This is because
Accrued Expenses suggests that the expenses have not been paid in cash but they
have been recognized on the income statement.
This would trigger an add-back because it is non-cash expense. However, the cash flow adjustment is the
opposite it is a decrease even though the Balance Sheet liability
increases.
This underscores the complexities
that face an analyst when attempting to disentangle accrual adjustments because
accruals are combined with aggregations. In these cases one looks to the footnotes for
clues regarding how to resolve these conflicts.
Good reporting will provide sufficient information in the footnote disclosures
even though this may be rather cryptic at times.
The one clue to the above EBAY
puzzle is the following footnote in relation to this Balance Sheet item:
“In the second quarter of 2011, we
settled multiple uncertain tax positions resulting in an overall decrease in
our unrecognized tax benefits. As of December 31, 2011, our liabilities for
unrecognized tax benefits were included in deferred and other tax liabilities,
net. As of December 31, 2010, $208.5 million of our liabilities for unrecognized
tax benefits were included in accrued expenses and other current liabilities
and the remaining amount is recorded as deferred and other tax liabilities.”
In other words EBAY has aggregated some sizeable non cash
tax related numbers into this balance sheet item (Accrued Expenses and Other
Current Liabilities) that pertained to tax benefits not recognized in
2010. If these benefits were recognized
in 2011 then this would explain why Accrued Expenses and Other Liabilities
results in a deduction in the EBAY’s cash flow statement. That is, the non-cash gain is subtracted out
of Net Income as an accrual adjustment. The Cash Flow Statement graph above is
consistent with this treatment. The
treatment for 2011 appropriately places additional tax benefits in the
“Deferred and Other Tax Liabilities” account for 2011 which reflects an
increase.
The cumulative effect of these tax adjustments end up in the
Provision for Income Taxes. This
provision can have a significant impact upon accounting accruals because it
does not equal the taxes actually paid.
Accruals that By-Pass the Income Statement: Other Comprehensive Income
There is an additional set of
accruals that do not affect the Income Statement. These arise primarily from Hedging
Activities, Unrealized Gains and Losses arising from Available-for-Sale
securities, Foreign Currency Translations and Defined Benefit Pension
liabilities. Although these items do not
impact Accounting Net Income they do impact the concept of Comprehensive Income
via a stockholders’ equity account referred to as “Other Comprehensive Income.”
For EBAY the current year’s accrual
adjustments for EBAY that impact Other Comprehensive Income are depicted below:
Given these are unrealized they will
not impact the income statement but instead will impact different parts of the
Consolidated Balance Sheet. However,
these items do have significant implications for financial analysts and
investors who are interested in forecasting current and future cash flows from
accruals.
Summary
Accounting accruals as Paton and
Littleton in 1940 observed are driven by the impact from the matching principle
which binds together revenues and expenses on the accounting income
statement. This in turn results in
accounting income not equaling cash income.
Today accruals are further driven by accounting developments subsequent
to Paton and Littleton such as fair value accounting and the concept of
comprehensive income. These concepts have
elevated the Balance Sheet to also being a driver of accruals because no longer
can this statement be viewed in the Paton and Littleton sense as purely the
residual of the income statement.
Investors and analysts are interested in accruals because by decomposing
accounting income into accruals plus cash income these two components behave
differently when used to predict future income.
This difference versus the market’s assessment of this difference lies
at the heart of the accruals anomaly.
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