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There are two methods of accounting - cash and accrual.
Under cash accounting, revenue and expenses are recorded only when cash is exchanged. This makes for simple book-keeping but is really only suitable for kids selling lemonade.
In most businesses, the cash inflow associated with a sale will rarely coincide with the cash outlays incurred to produce that sale. In such a world, revenues and expenses based on cash transfers will not match and financial accounts will fail to provide an accurate picture of the financial health of a business.
Accrual accounting, by contrast, is based on the matching principle which states that the timing of revenue and expenses should match. In theory, accrual accounting allows for more accurate accounts. In practice, it opens Pandora’s box when it comes to accounting manipulation.
Cash versus accrual accounting
Consider a company making glassware. The cash transaction associated with the purchase of the factory could have occurred years before the glassware for a given period is sold. The same might also apply to the furnaces used to make the glass, the trucks used for transport and indeed the licensing of the glassware designs.
These mismatches mean that expenses, as measured by cash accounting, would grossly understate the real cost of producing the glassware and thus overstate the profit of the business. Moreover, under cash accounting, it would be impossible to assess the liabilities of a company since none are recognized under cash accounting.
With accrual accounting, revenue is recognized when it is earned but not necessarily when the cash is actually received. Expenses are recognized in the period in which the related revenue is recognized, rather than when the related cash is paid.
The guiding principle is that companies should match expenses with revenue recognition, recording both at the same time. Unlike cash accounting, accrual accounting considers the current and expected cash flows associated with non-cash transactions, plus the implications for assets and liabilities.
Depreciation provides an example of the matching principle. Let's say that a company buys property, plant, and equipment for cash. Under accrual accounting, it will record a reduction in cash and an increase in long-term assets.
Accrual accounting aims to accurately represent the underlying transactions of a business, not just those with cash involved
No up-front expense is recorded. Since the asset will generate revenue over many years, the cost of the asset is spread over the expected lifetime to match the revenue it will generate.
Accrual accounting aims to accurately represent the underlying transactions of a business, not just those with cash involved, and thus to provide more accurate and informative financial statements that can be used to inform strategic decision making and investment decisions.
Accrual accounting is required for companies reporting their financial statements under generally accepted accounting practices (GAAP), which are issued through the standards of the Financial Accounting Standards Board (FASB).
Types of accruals
Four types of accruals are recorded on the balance sheet when following the accrual accounting method: accrued revenue, deferred revenue, accrued expenses and deferred or pre-paid expenses.
Accrued revenue occurs when a company has delivered a good or provided a service but has yet to receive payment. The revenue is posted to the income statement and the unpaid amount is posted to accrued revenue, an asset on the balance sheet. Revenue accruals are often seen in long-term projects, projects with milestones, and with structured loans.
In essence, accrued revenue indicates that a customer has promised to pay for certain goods or services in the future. As those goods and services are paid for, cash should rise and the accruals account should fall by the same amount. Inherent in accrual accounting is the risk that some cash payments might never be received and thus accruals can be adjusted with bad debt provisioning.
Accrued revenue is somewhat similar to accounts receivable, except that receivables are typically invoiced and a one-time payment is expected in a shorter time period. Revenue accruals feature prominently in account manipulation.
Deferred revenue occurs when a company receives cash before a good or service is delivered. It creates a liability called deferred revenue or unearned revenue.
It is a liability because the company has an obligation to deliver the good or service in the future. The annual payments received by a software company are an example of deferred revenue.
As each month of the year passes, the software company will reduce its unearned revenue and post its revenue for a month of service. Deferred revenue does not typically feature in account manipulation.
Accrued expenses tend to be simple housekeeping entries recorded at the end of each month. They are typically regular occurrences, such as rent, interest payments on loans and utility charges that have accrued during the period but have not yet been billed.
Accrued expenses differ from accounts payable, because accounts payable are essentially unpaid bills. If an invoice has been issued, it is accounts payable. If no bill has been issued, it is an accrued expense. Accrued expenses do not typically feature in account manipulation.
Deferred or prepaid expense occurs when a company pays cash for a good or service before it is delivered. This creates an asset called a deferred expense.
Some expenses, such as plant & equipment, interest payments, certain types of R&D and acquisitions can be “capitalized” with the expense posted slowly to the income statement as it accrues over time. Depreciation is the classic example of a deferred expense. The purchase of a patent would be another example.
A company purchasing a software subscription also represents a simpler example of a deferred expense. As each month of the year passes, the company reduces the prepaid expense account and simultaneously records a month of software expenses.
Deferred expenses feature prominently in account manipulation and accounting fraud.
Using accrual accounting in accounting manipulation
The problem with both revenue accruals and deferred expenses is that parties outside a company have little or no clarity what is happening within these respective accounts on the balance sheet.
With accrued revenue, the difference between fulfilment and payment can take months or even years. Meanwhile, all revenue accruals tend to get mixed in the same pot, making accruals for specific transactions impossible to track.
The same applies to capitalized expenses. In most cases it is impossible to see what expenses are being capitalized. These factors mean that those outside a company can typically only see what is happening to accruals, depreciation and capitalized expenses in aggregate.
The lack of transparency means that revenue accruals and deferred expenses provide an ideal vehicle for companies wishing to manipulate their accounts.
The lack of transparency means that revenue accruals and deferred expenses provide an ideal vehicle for companies wishing to manipulate their accounts. Accrued revenue is used to inflate revenue, while deferred expenses are used to reduce expenses. Both are frequently used in unison to manipulate earnings and profit margins.
In our previous post on deferred accounting, we explained how deferred expenses can be used to manipulate accounts. In particular, we discussed how the improper capitalization of random expenses is frequently used to create bogus asset accounts. This is the most common way in which deferred accounting is used to understate expenses and inflate earnings.
The process is frequently termed snowballing because the subsequent amortization costs get larger every year. Enron wrote the book on snowballing. When the amortization cost becomes too large, the assets created by expense capitalization are subsequently written off.
This affects profits in a single year but preserves the impression of high margin and thus high profitability in ongoing operations.
Accrual abuse is as prevalent as the manipulation of deferred expenses. It is a simple matter for a company to manipulate revenue by posting revenue and thus revenue accruals prior to the full provision of services or the delivery of goods.
For truly fraudulent companies, it is a relatively simple matter to fake revenue using accruals. In most cases this is done through related companies. If properly done, even a master forensic accountant will struggle to confirm fraudulent accruals.
Since all accruals go in the same bucket, revenue accruals are often difficult to disentangle even after a company has failed due to fraud.
In companies with rapid volume growth, revenue accruals can be inflated to make earnings and margins appear better than they really are. This was a common ploy during the Chinese property boom when developers would frequently record pre-sales as sales even though construction had barely begun.
Since sales were growing at 20 percent plus and accrual accounting is complex, it was difficult for outsiders to conclusively say when the developers were manipulating accruals even though accruals were enormous in relation to cash flow.
Large intangible assets
In the simplest sense, accruals represent the difference between a firm’s accounting earnings and its underlying cash flow. Large positive accruals indicate that earnings are much higher than cash flows. If a firm has large accruals in relation to its cash flow and balance sheet, this can be a red flag of account manipulation.
Similarly, abnormally large intangible assets or other large asset accounts can also indicate manipulation. In many cases, companies that manipulate earnings will have unusually large asset write downs or restatements of past earnings with big adjustments to accrued earnings.
These typically happen either in very good years for earnings or in bad years where the company elects to “kitchen sink” its losses.
The relationship between earnings and cash flow can differ significantly between industries due to accounting conventions with respect to revenue recognition and matching principles. If a firm has large accruals or capitalized expenses in relation to its industry, this can be an even stronger red flag.
Numerous studies have demonstrated an inverse relationship between the size of a company’s accruals and its future stock returns. The implication is that the more a company inflates current earnings with accrued revenue, the more likely it is that earnings in future years will disappoint.
Numerous studies have found a connection between abnormal discretionary accruals and insider trading.
The volatility of accruals can also be a red flag for account manipulation. Numerous studies have found a connection between abnormal discretionary accruals and insider trading.
One study of the Taiwan market in 2013 found that “insiders take advantage of private information on abnormal accruals to time their trading and manipulate accruals opportunistically to mislead the stock market prior to their planned trading.”
A different study of the US market in 2018, showed that “insider trading dominated by sell trades has a positive association with discretionary accruals.”
The final word on accrual accounting
The bottom line is that accrual accounting serves a very useful purpose but, due to the lack of transparency, provides an open door for companies to manipulate earnings.
Investors, creditors and analysts looking to understand the risk of account manipulation in companies need to understand the critical role played by accruals and the improper capitalization of expense in fraudulent companies.
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