Modelling the accruals process and assessing unexpected accruals*

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3 The accrual process in detail 3.1 The role of accruals Accruals are the temporary adjustment between income and cash flow during a period. Income is the by-product of accrual accounting that records the financial effect of an entity as it occurs rather than when the cash flow is realized (Statement of Financial Accounting Concepts, No. 6 Paragraph 139). It is defined in Statement of Financial Accounting Concepts, No.1 Paragraph 45 (and similarly in Statement of Financial Accounting Concepts, No. 5 Paragraphs 36 and 38) as performance measures that relate the benefits from and to the costs of operations and other transactions, events, and circumstances that affect an enterprise during a period. 6 Essentially, income matches the obligations against the claims of cash flow during a period while cash flow matches realized cash outlays against actual cash receipts. However, the realization of cash flow and claims to and obligations of cash flow (i.e., income) need not occur in the same period. Specifically, the income recognized in a particular period t is attributable to the cash flow realized at, before, and after this period, while the cash flow realized in the same period are attributable to the income recognized at, before, and after this period. Accruals, as the difference between the two, are equal to 6 According to SFAC 5-36, income is a measure of performance during a period that is concerned primarily with the extent to which asset inflows, associated with substantially completed cash-to-cash cycles, exceed asset outflows, associated directly or indirectly with the same cycles. Furthermore, SFAC 5-38 says that income focuses on what the entity has received or reasonably expects to receive for its output (revenues) and what it sacrifices to produce and distribute that output (expenses). Income also includes results of the entity‟s incidental or peripheral transactions and some effects of other events and circumstances stemming from the environment (gains and losses). 12
t t TACC CNICFt T t t t titti CNI tiCNItCNItiCFtCFtCFt i1 T t t titi CNI tiCNItiCFtCFt i1 where CNI is the comprehensive net income, CF is the cash flow from non-equity sources (i.e., CFt = ∆CASHt+Dt), and T represents the number of periods it takes accruals to reverse. The subscript denotes the period where cash flow is realized and the superscript denotes the period where income is recognized. This identity is first highlighted in Dechow and Dichev (2002). 7 The two components of accruals are the accrued component and the deferred component, in which their cash flow realization respectively supersedes and precedes the associated income recognition. While the former includes outstanding expenses and accrued revenue, the latter includes revenue received in advance, expenses paid in advance, and depreciation and amortization expenses. Since accruals are temporary adjustments, the initiation of an accrual item will be reversed in the latter periods. In particular, the accrued component of accruals is initiated when it is recognized in income and reversed when its associated cash flow is realized. Alternatively, the deferred component of accruals is initiated when the cash flow is realized and reversed when they are recognized in income. The initiated accrued component ( CNI ) and the reversed deferred component ( CNI ) are t t i embedded in recognized income. They are the accruals that shift cash flow realized before and after period t to income recognition in period t. Alternatively, the reversed accrued component 7 t t Income recognised and realised in period t equals cash flow realised and recognised in period t, i.e. CNIt CFt (3) t t i . 13
Page 1 and 2: Modelling the accruals process and
Page 3 and 4: insights into what unexpected accru
Page 5 and 6: attributed to the firm‟s biased a
Page 7 and 8: 2 Direct and indirect method to cal
Page 9 and 10: flow associated with income recogni
Page 11: change in net financial obligations
Page 15 and 16: period of income recognition and ca
Page 17 and 18: expenses or receive less revenue in
Page 19 and 20: any accounting distortions (conserv
Page 21 and 22: this paper). Combining the normal a
Page 23 and 24: 4 Assessing unexpected accruals mea
Page 25 and 26: firm j and the benchmark firms. The
Page 27 and 28: If there is no deviation in operati
Page 29 and 30: accruals is highly positive (negati
Page 31 and 32: These restrictions respectively imp
Page 33 and 34: The second source of contamination
Page 35 and 36: Even if the use of changes in cash
Page 37 and 38: The item m m CNI , 1 a a CNI
Page 39 and 40: Hence, to manage earnings downward
Page 41 and 42: 6 Conclusion My analysis reveals th
Page 43 and 44: References Ball, R., Shivakumar, L.
Page 45 and 46: Appendix 1: Derivation of Normal Ac
Page 47 and 48: accrued (initiated deferred) propor
Page 49 and 50: The portion of underlying income in
Page 51 and 52: Hence, the correlation between norm
Page 53 and 54: Table 2: Summary of Accruals Compon
Page 55 and 56: Table 4: Summary of the Bias in Une

Modelling the accruals process and assessing unexpected accruals*

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