Cash is King

Accrual v. cash accounting
March 9, 2017

Switching to cash accounting from accrual accounting is more than an academic exercise

Revenue is vanity. Profit is sanity. And that cash is a reality is popular vernacular in the world of business. And academia is catching on. In Are Cash Flow Better Stock Return Predictors Than Profits, authors Mr. Foerster, et al present a definitive thesis: cash basis financials provide a better financial picture, compared to accrual based financials. Using pricing data from October 1994 to December 2013, the authors discoverd that cash basis accounting illuminates hidden trends. In a nutshell, here are the mechanics in the author’s own words: 

“We begin with the main cash inflow of sales, adjusted for changes in accounts receivable, deferred revenue and other cash inflow from operations. We then subtract cost of goods sold as well as selling, general and administrative expenses and then adjust for changes in accounts payable from operations and changes in inventories. The result is our estimate of net cash flow from operations.” 

“Next, we estimate net cash flow from operations, after financing activities, by subtracting interest expenses and adjusting for other financing income and expenses. We then estimate net cash flows from operations after financing and tax activities by subtracting cash flows related to tax activities – including taxes on the income statements, adjusted for changes in accounts-payable and deferred taxes.” 

There are five apparent benefits to performing this somewhat tedious exercise. First, cash-based accounting demonstrated a higher ability to demonstrate increase in market value. Second, cash-based accounting brought to light trends hidden in accrual accounting. For example, while accrual accounting may hide a company’s inability to collect cash from clients, cash-based accounting would clear this impotency. Third, cash based accounting is more intuitive than accrual based accounting.

Fourth, accrual-based accounting embeds plenty of nonsense. Take future increase in rent income, for example, that is often recognized in the present while a tenant is expected to pay it in the future. This accounting shenanigan is known as straight line adjusting for rent increase. Or, take the incidence where because a cash outflow is heading towards the improvement of a property, it is unrecognized in the income statement.  s

But there are pitfalls to cash based accounting too. First, it is not an exact science but often the subjective work of an analyst. Second, cash based accounting is volatile compared to accrual based reporting. If a company repaints a portfolio of buildings, for example, it would incur an immediate expense in one year under cash based accounting, while the expenditure would amoritze over a stretch of time in accrual based accounting.

I am up for the challenge, though. In the near future, I will demonstrate the cash accounting technique. My hope is that it will (1) reveal new information in terms of operating, investing and financing performance and (2) demonstrate how the conversion process works.