Accrual-based vs. cash-flow-based performance measures

Question 1

What is unused purchases recognised as at the end of a financial year, in an accrual accounting regime?

a) It is removed from the income statement
b) Accounts payable
c) Inventory
d) Opex
e) You do not consider them

Answer 1

c) Inventory

Question 2

When is purchases recognised in the cash flow statement?

a) The year they are used in production
b) The year the payment is maid and goes through
c) The year the final product are sold
d) Both c and d

Answer 2

b) The year the payment is maid and goes through

Question 3

_____________ recognises a transaction at the time when a sale is made rather than when cash is received from the customer

a) Accrual-based accounting
b) Cash flow accounting
c) By function method
d) None of the above

Answer 3

a) Accrual-based accounting

Question 4

_____________ is more prudent as it does not recognise a transaction until cash has been received from customers, i.e., when a transaction results in an inflow of cash

a) Accrual-based accounting
b) Cash flow accounting
c) By function method
d) None of the above

Answer 4

b) Cash flow accounting

Question 5

What is the cash-flow-based accounting criticised for?

a) Arbitrary cost allocation
b) Failure to account for uncompleted transactions
c) Alternative accounting policies
d) Time value of money
e) Cash flows can be manipulated
f) All of the above

Answer 5

b+e)

Failure to account for uncompleted transactions (no not match cash inflows with cash outflows from the same transaction  cash in- and outflows are significant in different periods)

Question 6

What is the accrual-based accounting criticised for?

a) Arbitrary cost allocation
b) Failure to account for uncompleted transactions
c) Alternative accounting policies
d) Time value of money
e) Cash flows can be manipulated
f) All of the above

Answer 6

a, c+d)

• Arbitrary cost allocation (amortisation of intangible assets) and accounting estimates (estimating uncollectible accounts receivable)
• Alternative accounting policies (FIFO vs. average costs for inventory accounting
• Time value of money is ignored (inflation: since revenue is measured at current prices and operating expenses are measured at historical prices (costs), firm’s earnings capacity will generally be overvalued in timed of (large) inflation)

Question 7

Which of the following are pros for using EBITDA as a performance measure, and why?

a) Not including depreciation
b) Time value of money is ignored
c) It is not affected by changes in accounting regulation
d) It does not include tax
e) Eliminates differences in accounting policies
f) All of the above

Answer 7

a, d+e)

• Not including depreciation -> avoid depreciation policy issues
• Not including tax -> avoid impact of estimates related to deferred tax
• Eliminates differences in accounting policies between companies and across national borders

Question 8

Which of the following are cons for using EBITDA as a performance measure, and why?

a) Difficult to justify that a significant portion of a firm’s costs is excluded from operations
b) Depreciation is a proxy for the use of resources (PPE) that is needed in generating earnings. Thus, EBITDA includes the benefits (revenues) from those resources but excludes the related costs
c) Difficult to compare organically growing companies with companies growing through acquisitions (expensing vs. capitalising goodwill)
d) Change in accounting regulation from expensing investment in intangible assets to capitalisation of intangible assets
e) Do not account for investments in non-current assets or investments in working capital
f) Do not account for non-cash items included in operating earnings such as provisions related restructuring, etc.
g) All of the above

Answer 8

g) All of the above

• Difficult to justify that a significant portion of a firm’s costs is excluded from operations
• Depreciation is a proxy for the use of resources (PPE) that is needed in generating earnings. Thus, EBITDA includes the benefits (revenues) from those resources but excludes the related costs
• Difficult to compare organically growing companies with companies growing through acquisitions (expensing vs. capitalising goodwill)
• Change in accounting regulation from expensing investment in intangible assets to capitalisation of intangible assets
• Do not account for investments in non-current assets or investments in working capital
• Do not account for non-cash items included in operating earnings such as provisions related restructuring, etc.