lec5 - Accrual Accounting Process: Part II 15.511 Corporate...

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1 Accrual Accounting Process: Part II 15.511 Corporate Accounting Summer 2003 Professor S.P. Kothari Sloan School of Management Massachusetts Institute of Technology June 14, 2003
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2 Agenda for Today ± Continue with the accrual process ± Intuition ± Mechanics ± Too many slides and a lot of details! ± Some of these are for self-study and for recitations
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3 Cash Flow Versus Accrual Accounting ± Cash flow accounting ± Measures performance by comparing the cash inflows of a certain time period to the cash outflows of that period (e.g., cash flow from operations). ± Accrual accounting ± Measures performance by comparing revenues (which are recognized when the earning process is complete) with expenses (which are recognized when assets are consumed or liabilities are created). ± Geared toward periodic performance measurement that is not skewed by investment, financing, and long-horizon operational activities
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Cash Flow Versus Accrual Accounting 4 ± Accrual accounting ± Based not only on cash transactions but also on credit transactions, barter exchanges, changes in prices, changes in form of assets or liabilities, and other transactions. ± Records events that have cash consequences for an enterprise ± But does not require a concurrent cash movement in order to record a transaction.
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Cash Flow Versus Accrual Accounting 5 ± Over the entire life of a corporation, total “income” under cash flow and accrual accounting is the same. ± However, cash receipts in a particular period may largely reflect the effects of activities of the enterprise in earlier periods. ± Similarly, many of the cash outlays may relate to activities and efforts to be undertaken in future periods. ± The matching principle in accrual accounting addresses this limitation of cash flow accounting.
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6 Cash Flow Versus Accrual Accounting ± Isn’t cash flow more important than earnings? ± What cash flows are important? ± Future cash flows! ± When compared to current cash flows, current earnings are more highly associated with future cash flows
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7 Cash Flow Versus Accrual Accounting ± Stock price = Present value of expected future cash flows. ± What is “Present Value?” ± Changes in stock prices = f(changes in expectations about future cash flows). ± When compared to cash flows, earnings have a stronger association with stock prices. ± Earnings are superior indicators of expected future cash flows.
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Accounting Earnings versus Stock Prices ± Top management’s incentive compensation is usually linked to stock prices and accounting earnings. ± Why not link it to stock prices alone? ± Stock prices are affected by economic factors that are outside of a manager’s control (e.g., macroeconomic, political factors). ± Consequently, stock prices may be a poor indicator of
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This note was uploaded on 04/05/2010 for the course FINANCE AN FRE6003 taught by Professor Marshall,ingridm during the Spring '09 term at NYU Poly.

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lec5 - Accrual Accounting Process: Part II 15.511 Corporate...

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