What Are Accruals?
In order to illustrate exactly what accruals are and how they affect earnings, we begin with a simple example. Let us assume that Bill and Ted are two budding entrepreneurs who each decide to set up lemonade stands. Bill
starts his first day of business by buying $100 of lemonade, $10 of cups, and renting a lemonade stand for $10/day. This costs him a total of $120, all of which he pays for in cash. By the end of the day, he has sold all of his lemonade and used all his cups. All his customers pay him in cash and his total cash proceeds are $200. Figure 2.1 summarizes the financial statements that Bill produces at the end of this first day. His first day’s earnings are pretty simple to compute. He ends the day with net income of $200 – $120 = $80. Bill’s balance sheet is also very simple. Bill started his business by contributing $120 in cash (the other side of the balance sheet records his equity ownership stake). He finished the first day with $200 in cash, and so his earnings were $80, his operating cash flows were $80 and his equity ownership stake increased by $80.
Ted, on the other hand, starts his first day by buying $1,000 of lemonade, $100 of cups and a fancy new lemonade stand for $1,000. This costs him a total of $2,100, all of which he pays for in cash. By the end of the first day, he has sold about 10% of his lemonade and has used up about 10% of his cups. Ted also sold his lemonade for a total of $200, but half of his customers were short on cash and so he agreed that they could stop by
and pay him the next day, collecting only $100 in cash on his first day. His lemonade stand is now a bit sticky, but it is holding up well and he hopes to get a further 99 days of usage out of it.
Unlike Bill, Ted needs an accountant to help him determine his earnings. One thing he knows for sure is that he is now out of pocket $2,000 in cash, because he had to invest $2,100 to start the business and only collected $100 of cash on the first day. However, he still has heaps of lemonade and cups and a nearly new lemonade stand. Ted’s accountant tells him that, because he sold about 10% of his lemonade and used about 10% of his
cups, the remaining lemonade is worth about $900 and the remaining cups are worth about $90, so Ted has $990 worth of inventory. Ted explains to his accountant that he is still owed $100 for the day’s lemonade sales and that he expects to collect the cash tomorrow. The accountant says, “Are you sure these customers will come back and pay you?” Ted says, “Are you calling me a liar?” at which point the accountant promptly tells Ted that he also has $100 worth of accounts receivable. The accountant also notices the sticky lemonade stand and says, “Is this yours?” Ted says, “Yes, and I expect to get another 99 days use out of that beauty,” upon which the accountant tells Ted that he has “property, plant, and equipment” worth $990. After hitting a few buttons on his calculator, the accountant tells Tedhe now has a balance sheet with $2,080 worth of noncash assets ($990 of inventory plus $100 of accounts receivable plus $990 of fixed assets). When Ted started the day, he had no noncash assets. The increase in noncash assets for the period is therefore $2,080. This increase in noncash assets represents the accruals for the period. The accountant tells Ted that a quick way to figure out his earnings for the period is to add the accruals to the net cash flows for the period. Cash is –$2,000 and accruals are $2,080, and so his first day’s net income is also $80.
Figure 2.1 provides the financial statements for the two businesses. As you can see, Bill and Ted both generated earnings of $80. Moreover, they are both in the same line of business, but their first day’s operations were far from the same. Bill’s income of $80 is all made of a net cash inflow. Ted’s income, in contrast, is made up of $2,080 worth of accruals less $2,000 worth of net cash outflows. Intuitively, while Ted had a net cash outflow of $2,000, the accrual accounting process tells us that his business also generated $2,080 of anticipated future benefits. These anticipated future benefits are recorded as assets on the balance sheet. Their existence and valuation is determined by applying generally accepted accounting principles (GAAP) to information about the business that Ted has provided to his accountant.
In the context of this example, both Graham and Dodd (1934) and Sloan (1996) argued that Ted’s earnings are more uncertain, because they depend on accounting estimates of future benefits. For example, what if Ted’s customers don’t come back and pay him tomorrow? Or what if some of his lemonade inventory goes missing? In either case, $80 will have turned out to be too high an estimate of the earnings that was ultimately generated on the first day. Of course, it is also possible that Ted could end up making more than $80. A grateful customer could come back and pay Ted more than
is owed, or Ted could discover he had more lemonade than he thought. This latter scenario would make for a nice dream, but it is, unfortunately, not a very good description of reality. In most cases of businesses with soaring inventory and receivables, these assets turn out to be worth less than their initial carrying value. We will examine one such case in the next subsection. For this reason, we often say that earnings like Ted’s are of lower quality than earnings like Bill’s. Bill’s earnings have been realized in cash, while Ted’s earnings consist primarily of accruals, which anticipate
the realization of estimated future benefits. When we see a business in which most of the earnings come from accruals, it is more likely that some of the anticipated benefits will not be realized and so earnings will turn out to have been overstated.