Given that the interest in a business organization depends on its ability to generate favourable future cash flows, a performance measure exclusively based on realized cash flows (especially during a short period) cannot adequately provide useful information to assess if a firm’s performance is successful.Īn alternative to a reporting system based on realized cash flows is the accrual-basis financial reporting system whose primary product is net income, or earnings, as a measure of performance.Īccruals are adjustments for earned revenues and incurred expenses that are not recognized in the accounts yet. In other terms, cash flows are characterized by a lack of information content about the future as they cannot show inter-period relationships. (2) highlights that the magnitude of the difference between revenues and cash flows for each period is directly and positively related to the proportion of sales on credit for which cash will be not collected until the next accounting period α, and the larger is the change in revenues ∆ Rev t.Įven if the model is only focused on revenues from sales, it is readily generalizable to all other accounting features, and suggests that, when firms are not in a steady state, realized cash flows are expected to be a relatively poor measure of firm performance because they suffer from the abovementioned timing and matching problems, and are less able to reflect firm performance. In this case, Rev t ≠ Rev t − 1 and it follows that: 3Īs reported in Dechow, Eq. However, the steady-state assumption is an oversimplification because it is quite rare that a firm does not have an increase (or a decrease) in sales over each period. This means that in a steady-state firm, there will be no difference between the accounting numbers reported under the cash-basis system and the realized economic benefit. In such settings, if a steady-state firm is defined as one that is neither growing nor declining, it follows that Rev t = Rev t − 1. Therefore, realized cash flows will differ from the economic net benefits realized in each period to the extent to which credit sales are not included in realized cash flows and the latter embody the inflows of credit sales from the previous period. It must be noted that in this model, α is assumed as a constant for each accounting period, so cash collected in the accounting period t is composed of both the proportion α of sales made in the period t − 1 that have not been collected yet, and the proportion 1 − α of sales made and cashed in the period t. Where Cash t represents cash collected in the accounting period t, Rev stands for the revenues generated from sales made during accounting periods t and t − 1, and α is the proportion of sales for which cash is not collected until the next accounting period. Specifically, her results highlight that changes in net cash flows and in operating cash flows have an average negative autocorrelation ( Figure 1), with the latter being smaller than the former.Ĭash t = 1 − α ∗ Rev t + α ∗ Rev t − 1 E1 ĭechow starts investigating whether cash flows have time-series properties which could be consistent with the idea that cash flows suffer from matching problems. For this reason, it can be assumed that realized cash flows undergo timing and matching problems which cause them to be a ‘noisy’ measure of firm performance. However, over a finite time interval, the mere recognition of realized cash flows could not be necessarily useful because of the net cash flows’ fluctuations, with cash inflows and outflows that follow the firm’s investment and financing activities as well as the firm’s operating activities. In this case, income is computed as the difference between cash receipts from revenues and cash payments for expenses. Therefore, under the cash accounting method, revenues are recognized in the accounting period in which the payment is received, and expenses in the period in which the payment is made. As stated by Lee, the cash flow reporting system is based on the periodic recognition of cash inflows and outflows, which are not affected by credit transactions and arbitrary accounting allocations. Since in the accounting field, sometimes it holds that profit is a point of view, while cash is a reality, and the interest of many accounting information users is addressed towards cash. In fact, the well-known information issue related to the information asymmetry between insiders and capital providers creates a demand for internally generated measures of performance to be reported over finite time intervals. Information obtained from the financial reporting activity represent the most relevant data that a firm can disclose to the benefit of a wide group of stakeholders.
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