Currently, accrual based accounting is the most widely accepted standard for accounting valuations. Nevertheless, it is often argued, on theoretical grounds, that a cash basis approach is much more reliable to users. Our study focuses on the question of whether the accrual basis of accounting more reliable than the cash basis of accounting, where we compare the theoretical rational of interviewed industry professionals with theory.
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In order for us to better understand whether the cash basis of accounting or accrual basis of accounting provides more reliable information, we conducted three interviews with industry professionals. In general, we did not want to steer the comments and opinions of the professionals we interviewed, so we merely posed the question “Is accrual basis accounting or cash basis accounting more reliable? Why?”
The first interview conducted was with a C.F.O. of a company who provides outsourcing services which include financial record keeping, mutual fund accounting and advisory for corporations. After conducting our interview, the professional believes that the reliability of financial reporting should reflect the flow of resources or economic value of the company rather than focusing on the flow of cash alone. He mentioned that the valuation of assets and operating activities under cash basis accounting cannot fulfill the objective of reliability because the valuation of asset and recognition of revenue and expenses are affected by the timing of the payments. He strongly believes that the matching principle under accrual accounting could faithfully present the performance of a company by matching expense to associated revenue.
The second interview conducted was with a CGA with over 10 years of experience. His major duties include preparing the financial reports for small business owners. In his opinion, he considers an accounting approach which generates information with a high degree of verifiability and accuracy to be reliable. On the other hand, he also wants the information generated by a reliable accounting approach to encompass decision usefulness which will allow him to appraise the true value and actual performance of a firm. Moreover, he also postulated that the reliability of an accounting approach to a business will depend on the nature of the business. This can be summed up in his words, “[w]hat one business deems to be reliable information is not necessarily reliable information to a different company”. More specifically, he provided examples during the interview focussing on convenience stores and computer service providers which provide hosting and website design services. He stated that the cash basis of accounting would provide him with more reliable information.
The third professional interviewed is a Chartered Accountant with 35 years experience, who is currently a Controller for a medium size construction company, and he finds accrual accounting to be more reliable. His definition of reliability is that information which can better meet the needs of financial statement users and management, and help them in making and evaluating decisions for allocating scarce resources. According to him, accruals are more reliable and give a more accurate picture of the current and future financial position of the company by matching the costs of the period with its revenues.
Based on our research, there does not appear to be a general consensus among the professionals interviewed whether the accrual basis of accounting or the cash basis of accounting provides for more reliable information. Additionally, professional opinion also differs from that of the theoretical notion of cash basis accounting providing the most reliable information. However, what was in fact discovered is that users will deem either the cash basis of accounting or the accrual basis of accounting more reliable based on what they deem reliability to be, and what one professional may deem reliable is not necessarily what another professional would deem reliable because of the inherent usefulness of that information to the user.
Is Accrual Basis Accounting More Reliable than Cash Basis Accounting?
In order to make adequate financial decisions, users require information that they deem reliable, and that they can trust. Without reliable financial information, users would be unable to make reasonable decisions because they would not be aware if the information they are using to base their decisions on can be trusted, and hence reliable. In order to mitigate such a dilemma, it is important for a set of accounting standards to exist and that must be followed so that users can deem information reliable. This essay will address the question of whether accrual basis accounting or cash basis accounting provides more reliable information to users. Such a question has been a matter of long standing debate both at a theoretical and practical level. With this in mind, industry professionals have been interviewed and their opinions have been contrasted with the theoretical meaning of what reliability should provide. Our findings suggest that whether an accrual basis of accounting or a cash basis of accounting will provide more reliable information is dependent on the informational needs of the user. Before discussing our findings, a few parameters and definitions must be established to narrow the focus of this discussion.
To make adequate financial decisions, users require information that they can trust, and that they deem useful. With this being said, the concept of reliability of information “assures decision makers that the information represented in the financial records and financial statements captures the actual conditions and events of the reported entity” (VentureLine, 2009). Stated alternatively, reliability is a term describing “information that is reasonably free from error and bias and accurately presents the facts” (Conceptual, 2005). Reliability can be further broken down into its component parts: verifiability, representational faithfulness, and freedom from bias.
Financial information which is deemed to be verifiable means that there is a comparability factor. This means that when something is verifiable, two professionals (e.g. accountant or auditor) working independently should be able to come up with similar results; in other words, a high degree of consensus among independent measurers is a quality of verifiability. The Statement of Financial Accounting Concept # 2 defines representational faithfulness as “correspondence or agreement between a measure or description and the phenomenon that it purports to represent.” In order to faithfully present the operations of a company and the underlying assets and liability, the value that is presented on the financial statement need to correspond to the information of the real item (Scott, 2009, p.26). To better understand this concept, consider the U.S. Securities and Exchange Commission statement which says “a map’s representational faithfulness may be determined by how well the map describes the coastline” (Speech by SEC Staff: Charting a Course for High Quality Financial Reporting). Freedom from bias can be achieved when financial statements provided by accountants are based on objective evidence and have no manipulation in their valuations for manager’s own purposes (Scott, 2009, p.26). However, managers have many motives to manipulate net income to achieve a desirable goal, such as bonuses, market incentive, debt covenant, political costs, etc. (Healy, 1985). Next, a brief discussion of the difference between accrual basis accounting and cash basis accounting will be provided.
Cash basis accounting only recognizes revenues and expenses when cash is actually collected and/or paid out, so accounts receivable would be valued at the cost of goods sold (Scott, 2009, p.42). Therefore, all financial information would be triggered by events which had already occurred in the past or current. This trait of cash accounting implies that the revenues and expenses would only be recognized under the known cash amount. Since cash basis accounting requires no estimates (Elmaleh), two independent professionals should generate the same or similar financial information if the same information is given. Cudia also claims that “cash-based information has the advantage of being relatively simple and readily verifiable” (Cudia, 2008, p.13).
Accrual basis accounting is more relevant than cash accounting since it is able to provide more useful information about the firm’s future cash flows (Scott, p.43). However, this also indicates accrual accounting to be less reliable due to the tradeoff characteristic of the relationship between reliability and relevancy. Specifically, accrual basis accounting includes estimations. Different from cash basis, accrual accounting requires recognizing revenue when the products are delivered or the services are provided. Frequently, part of the revenue recognized has not been collected yet and stays in the account receivable. In this case, accountants would be required to estimate the reasonable value of the allowance of doubtful accounts. Also, accountants would be required by the matching principle to estimate amortization expenses in order to match with revenues. Essentially, professional accountants and auditors would generate those estimates based on their professional experience and expert knowledge in order to predict future net cash flows. Therefore, the estimates make the financial information under accrual basis accounting more subjective. Watt also asserts in his paper that “estimates of those future net cash inflows are not verifiable because they depend on assumptions about the future that experts cannot agree upon.” (Watt, 2003, p.211) In theory, cash basis accounting should be more verifiable than the accrual basis accounting because cash basis does not contain any subjective estimates. In subsequent paragraphs, industry professionals opinions about which accounting method provides for more reliable information will be discussed. Also important to understand is the meaning of decision usefulness. It can be thought of as that information which a user deems necessary for making a decision.
One of the professionals interviewed for our research paper is a C.F.O. of a company who provides outsourcing services which include financial record keeping, mutual fund accounting and advisory for corporations.
After conducting our interview, the professional believes that the reliability of financial reporting should reflect the flow of resources or economic value of the company rather than focusing on the flow of cash alone. He mentioned that the valuation of assets and operating activities under cash basis accounting cannot fulfill the objective of reliability because the valuation of asset and recognition of revenue and expenses are affected by the timing of the payments. He strongly believes that the matching principle under accrual accounting could faithfully present the performance of a company by matching expense to associated revenue. This approach is also recommended by the Government Accounting Standards Advisory Board (GASAB), raising a similar argument as the opinion of the professional interviewed (Primer, p.2). The professional mentioned that the financial records that are being prepared for his clients need to capture the underlying value of financial assets, such as mutual funds and hedging contracts. The financial report for his clients need to use accrual basis accounting to capture all liability, revenue, expense and complex financial securities, otherwise the true performance of the company would mislead the management and investors of his clients.
Research on the topic of reliability was conducted before the interviews were held. A paper prepared by two financial analysts stated that the current financial reporting (accrual accounting) that is used to record derivatives, leases and non-cash compensation may diminish the usefulness of the financial statement due to reliability issues (Michael & Miklos, 2007, par. 2). They have argued that accrual basis accounting could in fact distort the underlying value of these complex financial instruments and other assets that are being recorded (Michael & Miklos, 2007, par. 5). Instances have also shown that investors have lost money and confidence as a result of aggressive accounting estimation that are being used by management (Mara, 2009). The results of the research were brought to the professional, and he explained that although accrual basis accounting may be subject to estimation errors and biases, he said that “business is not science and it cannot be 100% accurate”. Besides, he mentioned that everyone would have different benchmarks in determining the level of reliability and different definitions of reliability in financial reporting. He emphasized that accrual basis accounting could be used as long as it would provide over 90% of accuracy for financial reporting purposes.
The professional prefers accrual accounting over cash basis because he stated that cash basis accounting would provide inaccurate measurements for financial reporting purposes. The reasoning is that cash basis may be reliable due to freedom from bias and subjective estimation, but it only reflects some of the past and current operating activities and fails to provide information about future obligations of his clients’ company for transactions that are incurred in the current period. He mentioned that cash basis accounting would tend to overstate net income and understate expenses and liabilities because expenses and liabilities that have been incurred may not be recorded until payment is settled in the future. Besides, business transactions are less likely to use cash consideration as most of the sales are credit sales, and credit sales would not be recorded if cash basis is used. In addition, the professional mentioned that management may want to manage their risk by entering into hedge contracts and these contracts do not encounter much cash outflow or are even entered at zero cost with another party. These contracts will increase the complexity of financial reporting and cash basis accounting cannot present the full picture of the financial position of a company.
Cash basis accounting would not capture the future obligation of the company such as hedging contracts, asset retirement obligations and other complex financial instruments. Thus, given the inaccurate reporting under cash basis accounting, the professional stated that cash basis is not reliable as compared to accrual basis accounting because it fails to present the economic value of the company and fails to reflect the true operating activities in the net income; hence, not being reliable. As a result, he cannot use cash basis accounting for his clients because it does not provide reliable information for their business purposes such as management performance evaluation, forecasting, and business strategic planning. The professional specified that cash basis accounting does not provide any reliability in the financial report and this is critical for him when performing any advising or financial record keeping services for his clients. Thus, the interviewee indicated that accrual basis accounting is more reliable than cash basis accounting because it could fulfill his needs.
Cash basis accounting is more reliable than accrual basis accounting according to theory, however, this is different from what the professional (C.F.O.) suggested. The first difference is due to the different definition of reliability in financial reporting. According to the theory, a reliable financial report should be free of bias and faithfully represent the value of the real item (Scott, 2009, p.26). In contrast, the professional considers a reliable financial report to reflect the full performance of a company in a given period and provide predictive information for the investors. The criteria that the professional used to determine reliability of a financial report is different than what theory suggested. Second, theory suggested that cash basis accounting is more reliable because no estimation is needed when the financial report is being prepared. On the contrary, the interviewee feels that a financial report would be considered reliable if it could capture the full financial position of a company. These include the underlying liabilities, expense and other complex financial instruments. Despite the fact that the professional acknowledges that estimation error or management bias could exist when accrual basis accounting is used, he still holds that accrual is more reliable if it could provide accurate information 90% of the time. This suggested that what theories suggest to be reliable does not necessary equate to what professional deem to be reliable.
Another professional interviewed is a CGA with over 10 years of experience. His major duties include preparing the financial reports for small business owners. In his opinion, he considers an accounting approach which generates information with a high degree of verifiability and accuracy to be reliable. On the other hand, he also wants the information generated by a reliable accounting approach to encompass decision usefulness which will allow him to appraise the true value and actual performance of a firm. Moreover, he also postulated that the reliability of an accounting approach to a business will depend on the nature of the business. This can be summed up in his words, “[w]hat one business deems to be reliable information is not necessarily reliable information to a different company”. More specifically, he provided examples during the interview focussing on convenience stores and computer service providers which provide hosting and website design services.
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Firstly, he considers accounting information generated by using cash accounting to be more objective than under the accrual basis of accounting because there is no estimation in cash accounting. Without estimates, accounting information based on certain cash flows in the past or current could be easily verified. He is convinced that the higher degree of verifiability allows for professional consensus, and would likely reflect that the information is more accurate. For accrual accounting, the professional argued that it contains too many estimates which are based on professional judgement even though GAAP provides a framework for accountants to follow in order to make reasonably, qualified estimates. The reason he gave is that no single rule can cover all factors in every area. In other words, different areas or industries have quiet different factors that accountants need to use their professional judgement to analyze in order to make a reasonable estimate. Therefore, professional judgements are still necessary. In this regard, estimates make accrual accounting less verifiable and therefore less reliable than cash accounting.
Moreover, the CGA also mentioned that the difference in the income statement using accrual basis accounting and cash basis accounting is immaterial. He further explained that small businesses do not have a large cost of investment compared to large corporations, and on this note, the need for allocating the cost of capital using accrual basis accounting is less important. The professional also mentioned that it is important to consider that small businesses have a shorter cyclical and high turnover of inventory. Even small business who are in the service sector have a short turnover cycle and their expense and liability are usually settled within a short period of time. As a result, there are usually not very many accounts in the financial statement that needed to be accrued.
In terms of faithfully representing the performance of a small business, the professional said that monitoring the cash flow of a small business is critical because small businesses must produce income statement and balance sheet information that will help him analyze whether the business will generate enough cash flows to meet the payment for suppliers, bank loans, and instalment payments to the Canada Revenue Agency. He said a financial statement that is prepared using accrual basis accounting may not have any material difference compared to cash basis accounting. The reason is that small businesses usually have a small amount of bad debt expense because sales are usually settled in cash or credit sales using credit cards, which would bear the risk of uncollectable amounts. Therefore, he asserts that cash basis is more reliable to restaurants and convenience stores because it can better represent the true value of such businesses and better measure their performance. Since those businesses (restaurants and convenience stores) generally do not have significant financial investments or significant amounts of receivables or liabilities, the estimates of future cash flows are not as important as compared to large businesses. As a result, the true value of a business is largely determined by the cash on hand, and the performance of the business can be evaluated better by considering its net cash flows.
Nevertheless, the professional mentioned that accrual basis accounting should be more reliable if the business has a larger outstanding receivable and the amount of receivable is relatively large relative to the net asset of the company. These businesses may include computer service providers or businesses which have a longer cyclical business cycle. Small businesses that require larger investments in equipment, patents and other capital should also use accrual basis accounting to allocate these expenses, where accrual basis accounting would provide more reliable information over cash basis accounting because it is more accurate in reflecting the performance of the company.
Based on the interview conducted with the professional mentioned above, whether cash basis accounting would provide more reliable information over accrual basis accounting depends on the nature of the business and its underlying processes.
The last professional interviewed is a CA with 35 years experience, who is currently a Controller for a medium size construction company; he finds accrual accounting to be more reliable. His definition of reliability is that information which can better meet the needs of financial statement users and management, and help them in making and evaluating decisions for allocating scarce resources. According to him, accruals are more reliable and give a more accurate picture of the current and future financial position of the company by matching the costs of the period with its revenues. Therefore, it helps users to better comprehend the current profitability of the company and also predict the future profitability more reliably than cash accounting. This is because cash accounting merely emphasizes cash received and paid out. For example, expenditures can be capitalized under accrual accounting when there is enough evidence that cash flow will be realized and this helps users reliably predict financial performance of the firm. On other hand, cash accounting would only recognize this as disbursement of cash.
The CA said that cash accounting has timing and matching problems that accruals have helped overcome to better measure the performance of the company. First, the net cash flows could suffer from matching problems because the cash inflows and cash outflows or revenues and expenses from a particular productive activity are recognized in different measurement intervals. For example, cash received for a service that is going to be performed next period is recognized as revenue under cash basis, even though the company has not provide any service yet. Accrual accounting deals with this problem through the matching of expanses and revenue for the period no matter when the cash is received or the disbursement is paid out. Also, accrual accounting, according to this professional, has the revenue recognition principle that mitigates the timing problem of cash accounting by providing rules for the timing of revenue recognition that can reflect closely the financial position of the company; providing reliable information about the company. The revenue recognition principle requires revenues to be recognized when a firm has performed all, or a substantial portion of services, and the receipt of cash is reasonably certain. To explain, the professional used the example of a bridge building company that has a construction contract that takes several accounting periods to complete and the payment by the customer occurs on a periodic basis during the construction of the bridge. Under GAAP, periodic recognition periods are used to recognize the completed portion of the construction, providing for reliable information to understand how much of the project has been completed to date. Therefore, this professional finds that accrual improves earnings to measure the company’s current and future profitability, and provides a more reliable measure of persistent earning power.
Sloan (1996) points out that accruals involve many estimations and judgments that are subject to management manipulation and errors. However, according to the professional interviewed, accruals are more informative because they reduce the information asymmetry between managers and users by allowing the managers to incorporate into financial statements what they internally know into the financial statement. Also, this professional acknowledges that accruals are also required to be objective and verifiable. For example, expenditures can only be capitalized when there is objective and verifiable evidence that the cash flows will be realized in the future. Requiring objectivity and verifiability limits management’s discretion. Finally, cash accounting, as this professional said, can also be manipulated by deferring payments and selling account receivable, for example.
In terms of theory, theory did not agree with the professionals opinions. A technique of manipulating financial statements used by managers, who always have many motives to manipulate financial statements, is discretionary accruals. Accruals granted management ways to manipulate financial statements, such as the fraud of WorldCom and Enron that made the company look more profitable to investors and didn’t give a true picture of the company’s financial position (Dechow et al., 1994, p.26). Accruals involve much more estimation and subjectivity of managers, as Sloan (1996) points out, which makes it more subject to errors and manager bias than cash accounting. Account receivables, for example, are accruals that are commonly used by managers to manipulate earnings since they involve subjective estimation of uncollectable amount that could be used to understate or overstate net income for any given period. Thus, managers can use account receivables to manipulate income by using methods like trade loading and revenue recognition (Dechow et al., 1994, p.14).
On the contrary, cash accounting, according to Sloan (1996), is less subject to errors and bias because cash receipts are only recognized when they are received and disbursements are recognized when they are paid out. Therefore, it does not give as much room for managers to manipulate valuations of accounts for their own purposes. According to Sloan (1996), besides the fact that cash accounting is less subjected to error and bias, it is also less likely to reverse, which makes it more persistent that accruals.
It is clear that the theory of reliability differed from the opinions of the professional interviewed because his reason for preferring accruals coming from the rationality that accruals give a better measure of a company’s current performance for any given period, and provides a more relevant measure of persistent earning power than cash accounting by the matching and revenue recognition principles. Also, he pointed out that having many estimations and judgments in calculating accruals does not make cash accounting better because cash also can be manipulated by managers. In addition, he said that this would reduce the information asymmetry and make the financial statements more informative. Additionally, increasing the responsibility of managers to follow GAAP could reduce manipulations that can be perpetrated by managers and ensure accrual have more freedom of bias, such as the introduction of Sarbanes-Oxley Act.
Based on the interviews with industry professionals, it is evident that a clear consensus of whether cash basis accounting or accrual basis accounting does not exist. Instead, a compromise position may be best.
In Canada, private enterprises are the only entities that can utilize a compromise of the two methods. In 2002, Accounting Standard Board (AcSB) [1] issued Section 1300 Differential Reporting in the Canadian Institute of Chartered Accountants (CICA) Handbook. An eligible company that could switch to differential reporting would be one that is non-publicly accountable and the shareholders must unanimously consent (Hilton, 2008, p. 51). The cost-benefit constraint from the conceptual framework [2] is used to justify the use of differential reporting established for private enterprises. Most private enterprises lack the resources to prepare financial statements in accordance with generally accepted accounting principles (GAAP) and the costs of doing so would outweigh the benefits.
It allows for differences in accounting treatment for private enterprises in the form of options. Under differential reporting, cash accounting or even a mixed model of cash accounting and accrual accounting is possible. There is extensive information on implementation guidelines for such enterprises that want to employ such model. An approach that the United Nations Conference on Trade and Development (UNCTAD) has proposed is “a simple accruals-based accounting, based on that set out in international accounting standards, but closely linked to cash transactions” (UNCTAD, 2003, p.4). This non-GAAP solution could produce more reliable information for some elements of the financial statement by incorporating elements of cash accounting that provides more representational faithfulness, verifiability and the freedom from management biases that accrual accounting basis does. A study by Krishnan and Largay concludes that past cash flow data are more useful than past earnings and other accrual data in predicting future cash flows (Krishnan, 2000, p.218). For the private companies that can adopt such it model they can provide more reliable information by meeting the informational needs of users of predicting future cash flows. The ability to predict future cash flow is significant to private businesses because the continuance of operations of their business is dependant upon it.
With the adoption date of International Financial Reporting Standards (IFRS) approaching [3] , private enterprises are also affected by the convergence of the standards. Under the new standards, private enterprises may use standards applicable to publicly accountable enterprises or alternatively they may report using proposed standards for private enterprises. The proposed standards are similar to differential reporting standard currently in use. One notable difference is that unanimous consent of shareholder is not required under the new standards (Accounting Standards Board, 2009, par. 7). Depending on the intentions of the company [4] , this may cause an influx of private companies adopting the proposed alternative standard
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