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Measuring Financial Performance: Is the Cash flow Method Superior to that of the Accrual Basis?

Around two thousand five hundred years ago, the Greek philosopher Heraclitus noted that “nothing endures but change” (Wikiquote, 2010). This simple axiom, if I may, is the main underlying factor that influences our behavior when it comes to interacting with the outside sphere at any point of time. Given man’s inquisitive behavior, sciences were devised to explain the outside world. However, since these sciences are nothing but a mere reflection of what we know, it is by no coincidence that they are in a continual state of work-in-progress.  From an accounting perspective, whether the art of bookkeeping is maintained according to the rules devised by “stone counters [as was the practice some 10,000 years ago]” (Atkinson, 2002), or the more complex accrual basis, accounting will continually change to better serve the needs of the stakeholders. Accountants, essentially, are communicators.

But, one must humbly observe, that words have the power of changing the world; thus the duties of an accountant are ever so important. Within this ever-changing, sensitive, backdrop does the latest accounting contention arise: is the cash-flow method superior to that of the accrual?

In a nutshell, the cash-flow methods calls for recognizing transactions as cash is physically exchanged between two parties. Proponents of this method claim that the figures provided by the accountants are more factual, since they are backed by already executed transactions. As for the accrual basis of accounting method, transactions are recognized as their execution is earned [regardless of whether or not cash has been exchanged]. The proponents on this side of the camp claim that “accrual accounting information more fully reflects the overall effects of periodic managerial decisions” (Kwon, 1989).

To that respect, according to the two dominant, non-governmental, accounting bodies, the FASB [Financial Accounting Standards Board] and IASB [International Financial Reporting Standards], companies that claim adherence to either standard must provide statements that have an accrual and cash-flow outlooks. It is to be noted that adhering to one of the standards signifies that the financial statements have been prepared in accordance to accepted bookkeeping practices; facilitating comparability. This is of utmost importance to a lot of companies, as they seek capital from various sources.

Given the high-profile, “cooking the books” (Datar, 2002), scandals of companies in recent years, it has been proposed, by the cash-flow method advocates, that if accountants drop the accrual method as they prepare the financial statements, confidence would once again be restored in the financial reporting profession. They also claim that the difficulties, and controversies, of devising a unified set of global accounting standards would be a thing of the past.

To test this claim, it is best to start by clarifying the term confidence in a financial reporting context. “The success of a firm depends ultimately, on its ability to generate cash receipts in excess of disbursements” (Dechow,1994). The beneficiaries of these excess cash receipts are essentially the stakeholders of the company; most probably the shareholders, but could include employees, other parties, etc. [this is a company/country/culture specific]. These stakeholders are the financiers of companies. The commitment of backing a company is highly influenced, along with other factors, by the stake-holders’ confidence that the financial statements have been prepared in manner reflective of the actual financial reality of the company.

To that accord, if the cash-flow method was the only prevalent way of transmitting financial information to the stakeholders, that would not necessarily restore confidence in financial reporting. “If people [managers] are dishonest, any system [or method] is vulnerable” (Quinn, 2003). Managers may time cash disbursement to their benefit; especially that management compensation is closely tied to performance. Also, since projects could extend beyond one-year, inaccuracies creep into the cash-flow method. For example, this method will falsely portray a loss for a company in the first year on a given project and a profit on the second; provided that revenue will come only on the second year. This scenario shows the superiority and flexibility of the accrual basis method since it more accurately reflects the reality of the financial situation.

However, many successful companies that are profitable on paper declare bankruptcy, as they mismanaged their handling of cash, the bloodline of any organization. Each method complements the other. If we liken the cash-flow method to short-term war skirmishes and the accrual method to the overall war result, a war general should be concerned with winning both; as each is dependant upon the other. The way to restore confidence in the financial reporting sector, should lay along the lines of needing “good ethics and a good system of governance“ (Quinn, 2003).

Coming back to the claim, dropping the accrual method will remove the controversies surrounding a unified set of global accounting standards, it could be argued either way. The cash-flow method is more clear cut when it comes to what constitutes a completed transaction. Thus any issues related to cultural views, status of national accounting profession, taxation (to name a few) automatically become more or less irrelevant. Though if bookkeeping is handled in such a clinical fashion, other sets of issues will arise. For example, profit seeking investors will have a problem with financial statements that deal only with liquidity. Therefore, it may seem that controversies surrounding a unified set of global accounting standards might be lessened if the cash-flow method  is solely used; this claim is not entirely true. Needless to say, given the improvements in technology, a unified set of global accounting standards is required  regardless of which method is put in use; as various economies are linked via global transactions. “No man [or in that regards a country/economy] is an island” (Donne, 1839). “The rapid spread of the financial crisis” (Anon, 2009) in 2008 is a testament of that.

Youssef Aboul-Naja