Valuation Tutor Lessons: Understanding Accruals


 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.
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.


Post a Comment