Getting The Hang Of Accruals

Foreword from ShareInvestor

This article “Getting The Hang Of Accruals” by Cai Haoxiang was first published in The Business Times on 04 Aug 2014 and is reproduced in this blog in its entirety.

Timing issues over revenue and expense recognition and cash movements underpin accounting,

ACCRUALS are one of the most important concepts that investors have to understand, if they are to read financial statements with a deeper level of understanding. Most accounting statements are based on the accrual, instead of the cash, system of accounting.

In the latter, revenues and expenses are recorded only when they are received or paid out in cash. This might work for very small businesses, but it can present an erroneous picture for investors of larger ones.

Under the accrual system, revenues are recorded once a sale is made and a customer is billed. Whether the customer has paid is irrelevant, though we assume that the customer is of good credit and will eventually pay up.

More Accurate Reflection

Similarly, once expenses are incurred – that is, once you are billed by a supplier – you record down the spending as an expense, regardless of when you plan to pay the supplier.

Imagine there is a mooncake seller, Lotus Limited, that sells the round pastries to two customers in September every year when the mid-Autumn festival typically occurs.

There is no demand for mooncakes at any other time. People buy mooncakes from Lotus only in September, as this is a seasonal business.

Lotus buys the ingredients and equipment necessary to make the pastries: lotus seed paste, flour, mooncake moulds. It makes the mooncakes and sells them all at the beginning of September.

Customer A buys S$1,000 worth of mooncakes and pays immediately in cash.

Customer B buys S$11,000 of mooncakes, but does not have the cash right away. So he negotiates a deal with Lotus where he pays S$1,000 a month from October, then November, then December, and then for eight more months until August 2015.

So Lotus will get S$1,000 every single month for a year. Is it therefore accurate to say that the company makes a consistent level of sales all year round?

Imagine there is a green tea seller called Quench Inc. Quench sells tea all year round, but all its customers pay it only in September.

Is it accurate to say that Quench runs a seasonal business, since it receives a lot of cash only in September every year?

The most accurate reflection of both Lotus’s mooncake business and Quench’s green tea business is when income is recorded when earned, not paid. In this case, Lotus records a S$12,000 revenue in September 2014, while Quench records revenue for every month in which the sales were made. The money that is not paid to the companies by the end of an accounting period will be recorded as receivables.

So, for example, by the end of 2014, Lotus has yet to collect S$8,000. Its statements for 2014 will thus show S$8,000 in receivables. Receivables, together with cash, show up on a company’s assets in its balance sheet.

Earnings Management

As it collects S$1,000 in each subsequent month, Lotus will decrease its receivables by S$1,000 and increase its cash by S$1,000. There is no need to make any more changes to its revenue, because the relevant revenue earned was already recorded in September.

The use of accrual accounting might make more financial sense, but it has side-effects. Depending on the assumptions used, management has a lot of leeway to fiddle with their quarterly, or even annual earnings numbers.

Suppose analysts project that Lotus will make S$30,000 of sales in 2015, because they believe that customer C, who has a voracious appetite for mooncakes, will buy S$18,000 worth of mooncakes in addition to the S$12,000 of mooncakes that customers A and B usually buy.

But September comes, and customer C suddenly decided that he prefers to eat chocolate cakes instead of mooncakes.

He sends his apologies to Lotus. He plans to order only S$1,000 worth of mooncakes. Sales will fall far short of analyst expectations, and the stock price might take a hammering when word gets out. Management, whose remuneration might be tied to the stock price, will want to prevent that from happening.

Management thus strikes a deal with customer C: why don’t we sell you those S$18,000 worth of mooncakes, in advance? That is, we will bill you for the mooncakes first and record that extra S$18,000 of revenue.

But we will only deliver the mooncakes to you the following year, in 2016, when your appetite for mooncakes might come back. To sweeten the deal, maybe we’ll give you even more mooncakes.

This is a so-called “bill-and-hold” arrangement, when goods are only delivered at a later date, even when the customer is sent the bill earlier. This way, the company can choose to inflate revenues for one year, even though the goods are technically only sold the following year. It is a controversial practice.

Another way to raise revenues and profits is to have looser credit policies for customers. People always like to pay later, instead of now. They can take the money they would otherwise have paid and invest it in something else.

So if Lotus wants to attract more customers, it can always promise to let them pay later. In the meantime, it ensures it has enough money to pay for the materials to make mooncakes by borrowing from a bank. Alternatively, it can also buy the lotus seed paste and flour from its suppliers on credit.

This way, revenue and profit can appear to grow year after year, even when the company is actually seeing a constant outflow of cash during the time customers are deferring their payments.

Cash Management

What happens if suppliers are unwilling to sell on such lenient terms and demands cash immediately, and Lotus does not have the cash on hand, and its banks refuse to lend to it anymore?

Then it will be in trouble. A company that cannot pay back its suppliers on time will acquire a bad reputation, and nobody will want to do business with it.

Cash management is thus an integral part of any business. Companies have to strike a balance between attracting more business by allowing customers to pay them later, but not so late that there is a chance the customers might not be able to pay at all, or that the company will run out of cash.

Similarly, they have to balance between being a good customer to their suppliers, and paying on time, versus convincing them to give more lenient payment terms so it can divert cash for other more pressing needs.

To conclude, accruals form the basis of financial statements for most companies around the world. This is because companies engage in a series of transactions with other parties that do not immediately result in money changing hands.

Nevertheless, recording sales when made, and expenses when incurred, offers the best way for investors to make sense of a company’s business.

Because of the huge discretion managers have in deciding when a sale is made and when an expense is incurred, companies can “manage” their earnings – creating the impression of steady profitability and revenue growth, when the actual picture might be more volatile and complex.