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Welcome back. In this video,
we're going to discuss accrual accounting or as my students like to call it,
"Why can't I just focus on cash".
When I decide to do a video on accrual accounting,
I thought I would find a nice concise definition of accrual accounting for you.
It turns out that's a lot more complicated than I thought it would be.
The FASB, that's the accounting rule makers in the United States,
has spread the definition of accrual accounting throughout their conceptual statements.
I took a look at International Financial Reporting Standards
but it's the same sort of thing,
most the definitions of accrual accounting appear to be circular.
They include the word accrual in them.
So I've put together for you
paraphrase of what accrual accounting is according to those standards.
The idea of accrual accounting is to capture the financial effects of
a transaction or some sort of change in
circumstance in the period in which the event actually occurs.
We can compare that to its biggest competitor, cash flow accounting.
In cash flow accounting,
we only record a transaction or event when impacts the cash account.
That's probably not very clear still which is why
those standards centers spent so much time
and so many different lines trying to explain this.
But I decided I could make it clear for you if I gave you a couple of examples.
Let's think about prepaying for an apartment.
Let's imagine your first child has just gone off to
college and you've decided to prepay the rent for the entire year.
Maybe it was the only way to get the apartment because in
the past people have walked out on
the landlord and now they want to make sure they're paid.
So it ends up costing you,
let's say $10,000 for the year.
Your child is dismayed that they're going to sleep in this place,
and then one night it will cost them $10,000.
The landlord required the check on that first night.
Your child is thinking about this in a cash accounting view of the transaction.
They're saying, hey once the money is gone so is the value.
So that first night was really costly and that view of the world,
all the rest of the nights are free.
From an accrual view of the transaction,
we would recognize that the cash is
gone but we would say we now have something different,
a right to the entire year of use of that apartment.
If I think about what each night costs me,
it's costs me 1/365th of the total amount that I paid.
Let's look at another example.
You show up two weeks later to visit your child,
and now it's your turn to be dismayed because they've got
a brand new corvette in the parking place for that apartment.
They tell you not to worry at all.
They went down and talked with the corvette salesman and he said look it's actually free.
You don't have to pay us until January.
Again, your child's taking the cash accounting view of the transaction.
No cash has gone yet so nothing has happened.
We haven't given up any value,
we're just driving that corvette for free.
You're dismayed because you're taking the accrual accounting view of the transaction.
You know a big payment is due in three months,
so an event actually has occurred and it
has changed the financial position of your child.
You also realized that every time your child drives that corvette,
they're using up some of its value.
OK. Those are two pretty straightforward examples and we've been picking on your child.
Let's think about something you might do.
You've got a best friend and they're between jobs right now.
They're telling you they're pretty sure something great is coming up.
You've loan them money before they've always repaid you and when they've
repaid you they've even taken you out to
a nice dinner so there was a little extra payoff.
So you go ahead and loan them money again but you've got to explain this to your spouse.
Now you could go in and say,
look don't take that cash accounting view
that would say the cash is gone and values disappeared.
Let's take an accrual accounting view.
But if your spouse has taken an accounting course before they'll say sure.
But even under accrual accounting,
it depends on how certain we are that we're going to be repaid.
Maybe the value is still there,
plus we're going to get a dinner.
On the other hand,
if they're between jobs for a long time or something great never comes along.
Then we may have really lost that value.
This is pointed out to you that accrual accounting does require judgment.
I wish that I could tell you that accrual accounting equals reality.
Every time you see an accrual accounting number,
you know truth, at least economic reality.
The problem is that as we can see from our example of loaning our friend,
there's also measurement error.
Our friend thinks something really great is coming but they're not sure about that.
And you know in fact, even if we think of the examples
that seem more straightforward there's still some measurement error.
We believe that our child is going to use that apartment for the entire year,
but if after two months they decide
this college isn't the right thing for me I'm going to go sell corvettes.
They may move and now we've only gotten two months of benefit out of it,
instead of the 12 months we were expecting.
In almost every situation we can think of there's some sort of measurement error.
Now if it was only measurement error,
we probably still would be OK.
Who's going to know more about the company and what's going on?
The closest thing to reality,
the manager or people outside the company, probably the manager.
The problem is that along with measurement error,
we get this thing called bias.
Biases when the manager,
because of the measurement error,
has all this room and they're more
likely to go one way or another within that measurement error.
Sometimes that bias is intentional.
Maybe your buddy actually told you,
I don't know when another job is going to come.
But you loaned him money because he's your good friend and you felt like you had to.
But when your spouse asked you about it you say,
yeah he felt like something great might come.
You've intentionally biased your number to try to
make it seem like you haven't really given up that value.
On the other hand, often that bias is not intentional.
If you were to go to my colleagues in psychology here at the university,
they could point out many many ways that
our mind fools us-- it systematically makes errors.
And a lot of the biases that we see in
accounting are because of those psychological errors.
For example, there's a well-known bias that says when you
are affiliated with something you have a more positive view of it.
Let's look at our example with our friend.
Because he's our buddy,
we might be sure great things really are going to happen for him,
because of our affiliation with them we have a positive bias.
So within that measurement error,
we tend to look on the high end where we think things are going to work out well for us.
Managers do this with their companies all the time.
Often they've stayed working for the company because they really believe in it.
Since they really believe in it,
when there's measurement error they tend to believe that
they're going to get the good outcome within that measurement error.
That sort of bias can really make it hard for us to use the accounting information.
Every time that you see an accounting number,
you should be aware that it includes the economic reality you're trying to get at.
But also because of measurement error and bias,
it may not quite give you the answer you were hoping for.
You'll need to think about where measurement error could come from.
And given the size of the measurement error,
what's the potential bias that the manager may face?
Now don't blame the accountants for this.
It would be nice if accountants could just tell you the future perfectly.
They can't, no business person can.
So what's built into the accounting is the uncertainty that every business person faces.
And it's just a reality that we're going to have to deal with in business.
What you're seeing here is one of the basic tradeoffs in
accounting which is the tradeoff between relevance and reliability.
In an accounting number what we would really like to get is the relevant information.
The closest thing to the reality of what's going to happen.
But in some situations the measurement error is so large and our concern about
bias is so great that we decide we have to go to a more reliable number instead.
Often that more reliable number is what happened with cash.
When we do something like that,
you should understand that we've made a very clear tradeoff between
the relevant information that you wanted to
get and the reliable information that you could get.
In most situations the accrual accounting number is going to do
a much better job of capturing relevance for us.
But remember how I was telling you about biases?
We all seem to have biases towards reliability and towards simplicity.
Those sort of biases mean that often we
try to convince ourselves that cash is the right answer.
In fact, people often say things like cash is king.
Well cash may be king when you don't have it
but cash isn't king in telling us about the future.
I can tell you that even I frequently slip back
into the idea that this is really confusing,
so I'll just understand what's happening with cash.
In fact, all of us are going to slip back to cash at some point.
That's just something that's going to occur.
Every time that you start to think that way though,
step back and ask yourself,
Is there a way that I could get more relevant information?
Hopefully, you'll ask yourself that before you fall.
In the next video,
I'm going to talk to you about the balance sheet so that we can better
understand how it helps us in answering these accrual accounting questions.
Greg MillerProfessor
