Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

SIMPLE ACCRUALS EXAMPLE

An illustration will show how accruals can be used to discover poor accounting. This simple example begins with an investment opportunity, initially just $100. I am not going to grow my investments, so I will invest only $100 every year thereafter. And I will track this investment for five years. This investment only generates a return one period from now. The return comes in the form of cash revenues equal to 165 percent of the investment and a cash cost equal to 55 percent. So, I invest $100 cash today. I then get $110 at the end of the period, and my investment expires. Thus, this investment generates a return of capital plus a 10 percent return in the next period, and so the IRR on this investment project is 10 percent. The correct accounting should be obvious. Clearly, I should capitalize the whole amount in the period I make the investment and then expense the whole amount in the next period. If I do so, invested capital is equal to book value and the accounting rate of return is equal to my IRR of 10 percent.

I will now show how, in turn, conservative and aggressive accounting assumptions alter the results. In my conservative accounting scenario, I initially capitalize only 80 percent of the investment. Ironically, this bad accounting is what the Financial Accounting Standards Board requires that companies do for all R&D (and marketing) expenditures. This is a real investment that generates future benefits, but I have to expense it all immediately. ...