It’s A-ccrual World

Foreword from ShareInvestor

This article “It’s A-ccrual World” by Cai Haoxiang was first published in The Business Times on 04 Aug 2014 and is reproduced in this blog in its entirety.

LOOKING at my monthly Internet and handphone bills one day many years ago, I was stumped when recording them down. For which month should I record my bill expenditure?

A typical bill has a date that the bill was made, say July 20. I might receive the bill a few days later.

But the actual payment through Giro – the outward transfer of cash from my bank account – takes place two weeks later, in August.

To add to the confusion, the bill could be for services used in a previous month, say from June 14 to July 13.

“Should I record my handphone bill for the month when the money to pay it goes out of my bank account, or for the month when I receive the bill?” I asked an accountant friend.

Her reply was unequivocal. “Record it in the month you get the bill.”

“But the money hasn’t gone out of my bank account yet!” I protested.

She stuck to her guns. Expenses, once incurred, are recorded immediately in her books, whether payment has been made or not.

It was a mind-boggling concept. And I didn’t understand it then, but it was my first introduction to the world of accrual accounting.

Payback Time

What are accruals? The root word is to accrue, meaning to build up over time. This is typically used to describe the building up of a sum of money.

For example, if you withdraw a sum of money from your Central Provident Fund (CPF) to pay for a flat, the withdrawn sum still accrues at a 2.5 per cent interest rate – the interest one would have earned had the money not been taken out.

This accrued interest is typically paid back to one’s own CPF account when the flat is sold.

Because you have to pay back something, I like to think of accruals in the karmic sense: what you do will come back and haunt you. Eventually, it’ll be payback time.

This is like a Chinese martial warrior or Japanese samurai taking revenge on the bad guy who killed his master, 10 years later.

If you don’t read Chinese martial arts novels or samurai manga, the appropriate Western cultural payback-time reference comes from The Princess Bride novel and movie. A fictional Spanish fencer whose father was killed by a nobleman finally takes revenge with his well-rehearsed oath of vengeance: “Hello. My name is Inigo Montoya. You killed my father. Prepare to die.”

Understanding Accruals

Accruals are not just the bane of the nobleman whose life was in question. Investors who do not know any better often bear the brunt of an accounting system that, at first glance, is not very intuitive.

Novice investors might be shocked by how easily the income statement, which they pay heavy attention to, can be manipulated.

The accrual system is not to blame – it is the best way a business can reflect its operations. But because managers can decide when to recognise revenue and expenses, investors must look beyond the income statement to evaluate a company’s health.

Accruals are recorded on a company’s balance sheet. The easiest accrual concept to understand is a receivable, which is recorded when a sale is made but the customer cannot pay fully in cash immediately.

The Big Four

If a company’s receivables keep increasing beyond the speed at which their revenues are growing, one can reasonably wonder if its customers plan to pay back their debts.

But an investor who does not look at accounts receivables will only see the increase in revenue.

Payables, which is what a company owes suppliers, can also be manipulated to give the illusion of health. A company struggling with its cashflow can strike a deal to pay its suppliers later.

This increases operating cashflows in the short term, improving cashflow ratios. But in the long term, suppliers will still put pressure on the company to pay.

There are four other types of accrual-related accounts that can appear on a company’s balance sheet: deferred revenue, accrued expenses, deferred expenses, and accrued revenue.

Deferred or unearned revenue describes money received in exchange for a service that has yet to be fully delivered.

For example, Microsoft licenses its Windows, Office and other systems to companies for many years. A tech giant like Microsoft had US$25.2 billion of unearned revenue as of June 30, 2014. Investors can use that number to forecast how much revenue will be coming in the future.

Deferred revenue is recorded as a liability, because this is a service owed. As the service gets delivered, the liability gets reduced, and revenue is recognised on the income statement.

Also on the liability side are accrued expenses. Companies accrue expenses when they commit to paying workers or utilities bills but have not actually paid out the cash yet.

As the wages get paid in later periods, this liability decreases together with cash on the asset side.

On the asset side, there are deferred or prepaid expenses, kept as assets until they are consumed.

This represents money that the company has paid for a service, for example advance rent, but the service is yet to be delivered.

Earned Money

When the company first pays, an expense is not recognised, but the prepaid expense account goes up. When the company actually uses the service, say for insurance paid in advance, prepaid expenses fall while an expense is recognised on the income statement.

Finally, accrued or unbilled revenue refers to money the company has earned by providing a service of some sort, and recognised in revenue, but has not yet billed the customer.

These are assets. Once the customer gets billed, the amount due gets shifted to accounts receivable, where it sits until cash payment comes in.

Dealing With Accruals

All this can be very confusing when you encounter it for the first time.

But knowing about accruals might allow you to predict the earnings potential of your stock.

A landmark study was done in 1996 by Richard Sloan, then with the University of Pennsylvania. He found the so-called “accrual anomaly”, where share prices of companies with low accruals outperformed companies with large accruals, due to the earnings of companies with large accruals reversing and sparking a selloff. It sparked a wave of studies and hedge funds trading on this strategy.

But calculating accruals requires some work.

You have to subtract total non-debt liabilities from total non-cash-and-investrments assets. You can also subtract cash flows from operations and investments from net income (essentially, stripping net income of free cash flow) to get a sense of accruals.

To compare between companies, you can make an accrual ratio by dividing the difference between this and last year’s accruals by the average accrual level in these two years.

If accruals or accrual ratios are increasing or are higher than industry peers, it is worth thinking whether the company has quality earnings.

Hey, we never said this was going to be easy. It’s accrual, cruel world.