Brain Teaser 4: Cash Basis or Accrual Basis? Is Accrual Accounting Superior to Cash Basis?

Brain Teaser 4: Cash Basis or Accrual Basis?Is Accrual Accounting Superior to Cash Basis?Alicia:In the finance literature, there seems to be an emphasis on cash. Stock prices are discussed as the present value of future cash flows. Most of the capital budgeting applications in which investment decisions are made appear to focus on the cash required at acquisition and the cash flows expected during the life of that investment. If cash is so important, why is accrual accounting the focus in GAAP?John:A problem with just following the cash is that you can collect cash or pay cash and really have little economic activity underlying those cash exchanges. Indeed, I can structure terms of payment almost any way I choose in a contract, including so-called balloon payments, where almost all the cash changes hands at the end of a contract. If all accounting statements did was track the cash, little information would be provided as to how the cash had actually been generated, invested, or lost.Alicia:Last night on the news, there was a story about a college student who had managed to run up almost $20,000 in credit card debt, while still an undergraduate. On a cash basis, if someone thought he had received that $20,000 for some actual economic service, that would clearly be way off the mark. I mean, cash acquired through debt has to be different from cash that one receives because he or she has performed some service or sold some asset. In fact, receiving cash from selling something is not at all the same as receiving cash as an employee for providing services. After all, you can only sell an asset once, whereas services can continue to be provided, generating recurring cash flows.John:I remember someone once asserting that cash flow was all that was important, and accountants just “mess things up” by imposing the accrual accounting framework on the analysis of cash flows. It made no sense when I heard it, and the more I learn about economic activity, the less sense that assertion makes. Besides, we accountants, after all, do prepare statements of cash flow as well. However, we respect the differences in operating, financing, and investing activities.Alicia:Of course, I’ve never quite understood why we call interest an “operating item” and not a “financing item.” Nonetheless, I agree that the Statement of Cash Flows alone or the publication of an entity’s bank statement would in no way reflect performance effectively. Yet, it is obvious that many investors are at least confused as to the nature of accrual accounting and its importance relative to cash flow analysis.John:I wonder whether GAAP explain the importance of accrual accounting relative to a cash basis.Alicia:Let’s find out.QUESTION:When is a “cash-basis method” used within the accounting literature? Do you view such a method as complementary or preferable to accrual accounting in the settings you have identified?

Alicia:In the finance literature, there seems to be an emphasis on cash. Stock prices are discussed asthe present value of future cash flows. Most of the capital budgeting applications in which…

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