Providing Managerial Incentives: Cash Flows versus Accrual Accounting

Many introductory finance texts present information on the capital budgeting process, including estimation of project cash flows. Typically, estimation of project cash flows begins with a calculation of net income. Getting from net income to cash flows requires accounting for non-cash items such as depreciation. Also important is the effect of changes in net operating working capital on cash flow. While students readily understand how to account for depreciation when calculating cash flow, they typically have much more difficulty understanding how and why changes in working capital affect cash flows. This paper develops a teaching example to show exactly how and why changes in net operating working capital affect cash flows. The example shows how to derive operating cash flows for a proposed project using the accrual accounting method and then shows a cash budget for the same project. Finally, the example shows that the discrepancy between the cash flows shown in the cash budget and the operating cash flows can be resolved by accounting for changes in working capital. A survey of students in an MBA managerial finance course indicates student satisfaction with the teaching example and gives evidence that students prefer the teaching example to explanations of the effect of working capital on project cash flows given in the assigned text.

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Predicting Cash Flow From Operations: Evidence On The Comparative Abilities For A Continuum Of Measures

Journal of Applied Business Research (JABR) ◽

10.19030/jabr.v17i3.2237 ◽

2011 ◽

Vol 17 (3) ◽

Cited By ~ 1

Author(s):

Charles E. Jordan ◽

Marilyn A. Waldron

Keyword(s):

Conceptual Framework ◽

Cash Flow ◽

Prediction Models ◽

Petroleum Industry ◽

Cash Flows ◽

Predictor Variables ◽

Accrual Accounting ◽

Operating Cash Flows ◽

Flow Prediction ◽

Cash Basis

Prior studies have attempted to confirm or reject the FASB's assertion in its Conceptual Framework that accrual accounting measures provide better information for predicting cash flows than do cash basis measures.  However, their results proved largely inconclusive and contradictory.  The current study identifies research constructs that may be driven these inconsistent findings and makes adjustments to mitigate their effects.  Univariate cash flow prediction models are developed for companies in the petroleum industry using a continuum of predictor variables.  In predicting operating cash flows, one variable, net earnings plus depreciation and amortization, consistently achieves superior results.

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An Experiment Of Student Understanding Of Accruals Versus Cash Flows

Journal of College Teaching & Learning (TLC) ◽

10.19030/tlc.v4i4.1616 ◽

2007 ◽

Vol 4 (4) ◽

Author(s):

Jose Eduardo Miranda-Lopez ◽

Linda M. Nichols

Keyword(s):

Cash Flow ◽

Experimental Approach ◽

Cash Flows ◽

Student Understanding ◽

The Other ◽

Accrual Accounting ◽

The Relationship ◽

Cash Basis ◽

Accounting Graduates ◽

The U.S

The concepts of both accrual accounting and cash basis accounting need to be thoroughly understood by accounting graduates as they enter the workplace. In making decisions, both managers and investors often may need to make adjustments from one basis to the other. But do students really understand these concepts? This study uses an experimental approach to determine if students in both the U.S. and Mexico understand the association between accrual and cash flow numbers in the area of depreciation. The results reveal that the majority of student participants in both countries do not understand the relationship between depreciation and cash flows. This suggests that the way depreciation is taught in intermediate accounting may need to be approached differently in order for students to understand the nature of depreciation and its effect on earnings and cash flows.

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A Test of Income Smoothing Using Pseudo Fiscal Years

Management Science ◽

10.1287/mnsc.2021.4158 ◽

2021 ◽

Author(s):

Dirk E. Black ◽

Spencer R. Pierce ◽

Wayne B. Thomas

Keyword(s):

Analyst Forecasts ◽

Managerial Incentives ◽

Cash Flows ◽

Income Smoothing ◽

Fourth Quarter ◽

Integral Approach ◽

Fiscal Year ◽

Estimation Errors ◽

Cross Sectional ◽

Earnings Volatility

The purpose of our study is to further understand managerial incentives that affect the volatility of reported earnings. Prior research suggests that the volatility of fourth-quarter earnings may be affected by the integral approach to accounting (i.e., “settling up” of accrual estimation errors in the first three quarters of the fiscal year) or earnings management to meet certain reporting objectives (e.g., analyst forecasts). We suggest that another factor affecting fourth-quarter earnings is managers’ intentional smoothing of fiscal-year earnings. For each firm, we create pseudo-year earnings using four consecutive quarters other than the four quarters of the reported fiscal year. We then compare the earnings volatility of pseudo years to the earnings volatility of the firm’s own reported fiscal year. We find evidence consistent with fourth-quarter accruals reflecting managerial incentives to smooth fiscal-year earnings. This conclusion is validated by several cross-sectional tests, the pattern in quarterly cash flows and accruals, and several robustness tests. Overall, we contribute to the literature exploring alternative explanations for the differential volatility of fiscal-year and fourth-quarter earnings. This paper was accepted by Brian Bushee, accounting.

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Using Artificial Neural Networks To Examine Semiotic Theories Of Accounting Accruals

Journal of Business & Economics Research (JBER) ◽

10.19030/jber.v2i12.2951 ◽

2011 ◽

Vol 2 (12) ◽

Cited By ~ 1

Author(s):

Harlan L. Etheridge ◽

Kathy H. Y. Hsu

Keyword(s):

Neural Networks ◽

Artificial Neural Networks ◽

Cash Flows ◽

Information Value ◽

Font Size ◽

Accrual Accounting ◽

Accounting Data ◽

Pragmatic Information ◽

Accounting Accruals ◽

Future Cash Flows

Although the primary purpose of accounting is to communicate information, few studies have investigated the communicative nature of accounting.  This study uses semiotics, a theory of signs and signals, to examine the purpose and usefulness of accounting accruals with a popular tool in forecasting--artificial neural networks.  Two primary theories are proposed by this study.  The Theory of the Functions of Accounting Accruals categories accounting accruals by their basic functions and states that two general types of accounting accruals exist: syntactic accruals and semantic accruals.  Syntactic accounting accruals reflect incomplete transactions under a system of cash receipts and cash disbursements.  Semantic accounting accruals present messages in a different format than their counterparts in a system of cash receipts and cash disbursements.  The Theory of the Pragmatic Information of Accounting Accruals states that accounting accruals contain pragmatic information (value) because of their functions.  The pragmatic information (value) of accounting accruals is examined by comparing the ability of accrual accounting data to forecast future cash flows compared to that of cash-flow accounting data.  Forecasts are made using backpropagation neural networks.  The results indicate that both syntactic  and semantic accounting accruals contain pragmatic information (have value when forecasting future cash flows).  The study provides evidence of the pragmatic information (value) of annual accounting accruals.  However, no evidence was found in support of the pragmatic information (value) of quarterly accounting accruals.  This result implies that annual accrual accounting data is a better predictor of future cash flows than cash-flow data while quarterly accrual accounting data is not.

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The pricing of earnings and cash flows and an affirmation of accrual accounting

Review of Accounting Studies ◽

10.1007/s11142-009-9109-4 ◽

2009 ◽

Vol 14 (4) ◽

pp. 453-479 ◽

Cited By ~ 41

Author(s):

Stephen H. Penman ◽

Nir Yehuda

Keyword(s):

Cash Flows ◽

Accrual Accounting

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North Pole Car Wash: A Teaching Case Demonstrating The Advantages Of Accrual Basis Accounting

Journal of Business Case Studies (JBCS) ◽

10.19030/jbcs.v14i3.10195 ◽

2018 ◽

Vol 14 (3) ◽

pp. 17-24

Author(s):

Paul M. Clikeman

Keyword(s):

Financial Reporting ◽

Cash Flows ◽

Financial Statement ◽

Accrual Accounting ◽

Accounting Standard ◽

Teaching Case ◽

Future Performance ◽

Car Wash ◽

Accrual Basis ◽

Cash Basis

Given the significance of accrual accounting to financial reporting, it is important for students to understand why accounting standard setters have chosen accrual basis over cash basis accounting. This teaching case illustrates the superiority of accrual basis earnings over cash flows when financial statement users wish to evaluate past operating performance and/or predict future performance. The case, which requires only 20-25 minutes of class time, enables students to discern for themselves the relative advantages of accrual accounting.

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