Firms' reported earnings and accruals
Firms' reported earnings often differ from their actual cash flows. This difference is referred to as "accruals" and represents the component of earnings that have not yet been received. Due to estimation errors, the value of accruals is not necessarily equal to the amount of cash that is received, causing high accruals in the current period in relation to low earnings in subsequent periods. This effect is called low earnings persistence of accruals.
In 2019, company A reports earnings of $100 million (i.e., operating income after depreciation). Cash flows and accruals are $20 million and $80 million, respectively. Company B also reports earnings of $100 million. Its cash flows and accruals are $70 million and $30 million, respectively.
Based on the concept of low earnings persistence of accruals, holding all other factors constant, A is expected to have lower earnings than B in 2020.
What are accruals?
Earnings reported in financial reports are often different from underlying cash flows. This difference is called "accruals". Large positive accruals indicate that a firm's earnings are much higher than its cash flow. Earnings and cash flow differ because accounting conventions regarding the timing and magnitude of revenues and expenses (revenue recognition and matching principles) are not necessarily based on actual cash inflows and outflows. For example, credit sales are counted toward earnings in the current period even though they have not yet been paid. Similarly, depreciation is deducted from revenue even though there is no cash outlay.
Accounting accruals are used to allow the financial effects of transactions and events to be recognized when they become probable rather than when payment is received. 1 Positive accruals anticipate probable future cash inflows, and negative accruals anticipate probable future cash outflows. For example, when products are sold on credit, a positive accrual is originated (an increase in receivables) that anticipates the cash inflow when payment is collected. When materials are purchased on credit, a negative accrual is originated (an increase in payables) that anticipates the cash outflow when suppliers are paid.
Accruals and cash flow realization
Accruals reverse when the cash flow they anticipate is realized. For example, when accounts receivable is collected, the receivable account decreases and the corresponding positive accrual reverts to zero. Similarly, negative accruals revert to zero when accounts payable are paid. As such, at the individual transaction level, all accruals ultimately reverse. However, accrual reversal does not necessarily mean cash flow realization. 1,2 For example, if inventory becomes obsolete, it must be written off. Similarly, when evidence indicates that receivables are fraudulent and unlikely to be collected, they also must be written off. In such cases, the original accrual reverses without an accompanying benefit or cash inflow, resulting in "accrual estimation errors".
Accrual estimation errors may arise due to financial reporting manipulation. 3 This is intentional and is an ex-ante characterization based on whether the accruals are estimated faithfully and appropriately. For example, a firm's accounts receivable increase if managers record sales prematurely. These accounts receivable may be fraudulent and uncollectable or collected at much lower than the initial estimate. Alternatively, a firm's current liabilities decrease if managers understate liabilities, such as warranty expenses. Eventually, the firm must pay more than the initial liabilities estimated. Accrual manipulation can violate generally accepted accounting principles (GAAP). For example, to boost current earnings, firms may capitalize overhead costs and exclude them when valuing inventory production, leading to large inventory errors and a mismatch between accruals and cash flow realization.
Accrual errors can also be made unintentionally, 1 which is an ex-post characterization of an accrual based on the difference between the accrual and the subsequently realized benefit. For example, at a point in time, market demand unexpectedly declines and inventory has to be sold at a lower price or is made obsolete. In this case, measurement errors arise without manipulation. Alternatively, GAAP requiring firms to carry assets at amounts differing from their expected values will also result in accrual estimation errors without manipulation.
Overall, accruals represent managers' estimation of future benefits (realization of cash flows) and reverse when either (i) expected future benefits are realized or (ii) there is evidence indicating that those benefits are unlikely to be realized. In the first case, accruals correctly anticipate future benefits. In the second case, accrual estimates are erroneous (i.e., accruals are written off and reversed without benefit realization), which can be caused by unintentional error or reporting manipulation and distortion.
Low earnings persistence of accruals
The extent to which the anticipated future benefits measured by accruals are realized in terms of actual cash flows is referred to as the earnings persistence of accruals. 4 The accrual component of earnings typically incorporates estimates of future cash flows, deferrals of past cash flows, allocations, and valuations, all of which involve higher subjectivity than simply measuring periodic cash flows. As such, accruals are less persistent than cash flow. 4,5 In other words, current accruals have less power than current cash flow to predict subsequent earnings.
Suppose that there are two firms, A and B, with the same level of reported earnings. Firm A reports a higher level of accruals than firm B. Low persistence of accruals means that A is expected to have lower earnings or profitability than B in the coming years.
Accruals have low earnings persistence because of accrual measurement errors, as discussed above. 1 That is, higher accruals are likely to be associated with lower subsequent earnings because the future benefits they anticipate have not been realized. Accruals are more likely to have measurement errors when they have low reliability. 6 Accrual reliability is affected by the following factors.
When the valuation of assets and transactions involves significant subjectivity and the information used in it is hard to verify, there may be large errors regarding future benefits and obligations, leading to accrual measurement errors and a mismatch between accrual reversal and cash flow realization. This problem can be intensified by managerial unfaithfulness. 3 Managers have leeway with respect to the timing and measurement of revenues and expenses. They also have discretion regarding decisions on special items such as restructuring charges and write-offs. To achieve career or other personal objectives, managers may manipulate or distort financial reporting, leading to high earnings and accruals in the current period and low performance in subsequent periods .
Below is a reliability assessment for assets that are main sources of accruals. 6
Receivables require the estimation of uncollectables and are a common earnings management tool. E.g., accounts receivable increase if managers record sales prematurely.
Inventory accruals entail various cost flow assumptions/allocations and subjective write-downs. E.g., capitalization and exclusion of overhead costs in valuing the production of inventory.
Accounts receivable represent the firm’s financial obligations and are measured with a relatively high degree of reliability.
Fixed assets, such as PP&E
Fixed assets involve subjective depreciation, capitalization, and write-down decisions. E.g., the use of accelerated depreciation for tax purposes and regular depreciation for book purposes.
Financial assets, e.g., short-term debt, long-term receivables, and interest-bearing financial obligations.
Financial assets are usually tradable and their value can be estimated with high reliability.
Other reasons for low future profitability following high accruals
In the absence of accrual estimation errors, high accruals are still likely to relate to low subsequent profitability due to diminishing marginal returns on investments. 7 Firms are likely to invest in the most profitable projects first and less profitable investments later, leading to a decline in returns as more investments are made.
Non-current accruals increase as firms make new capital investments. New capital investments depress subsequent profitability (usually measured by ROA: earnings/total assets) because new capital investments increase total assets and thereby inflate the denominator of ROA. As a result, even if accruals have no effect on subsequent earnings (i.e., the numerator of ROA), ROA will still decline. If new capital is spent on less favorable investment opportunities, ROA will decline even more.
Even if accruals are estimated perfectly and the scale of the firm is fixed, product market shocks may cause accruals to be negatively associated with subsequent earnings and profitability. 8 For example, increased demand will increase firm profits and working capital (and thus accruals). High profits will attract new firms to the industry, causing an increase in competition. At the same time, input prices will increase in response to the increased competition, leading to higher inventory costs today but lower future profits when inventory is sold. Eventually, earnings and profitability are driven back to their long-term equilibrium levels. As a result, accruals are positively associated with current profits but negatively associated with subsequent profits.
Accruals are the difference between firms’ reported earnings and underlying cash flows and represent estimates of future benefits and obligations. The accrual component of earnings is less persistent than the cash flow component in predicting firms' future earnings and profitability because accrual estimation involves subjectivity and is susceptible to managerial manipulation. These biases lead to accrual measurement errors and the non-realization of anticipated benefits. Moreover, even if there are no measurement errors, high accruals are associated with lower subsequent profitability because of diminishing marginal returns on investment or product market shocks.
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