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. ...

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