Accrual duration Ilia D. Dichev Emory University December 15, 2016 Abstract: Accrual duration can be defined as the length of time between an accrual and its associated cash flow. This paper argues that accrual duration is a key factor in understanding the discretion in accruals. The function of accruals is to shift the recognition of associated cash flows across time, usually working in pairs of opening/closing accruals. By design, one side of the accrual pair shifts the recognition of the associated cash flow away from the period in which it occurs by recording an accrual with the same magnitude but the opposite sign in the same period. Thus, such zero-duration accruals are non-discretionary because the timing and magnitude of the associated cash flow pin down the timing and the magnitude of the concurrent accrual. The other side of the accrual pair shifts the recognition of the associated cash flow into some other time period(s), which involves using forward-looking estimates over the duration of the accrual, and therefore some discretion. In addition, accruals that have longer duration are more discretionary because longer horizons of estimation allow more discretion with respect to their timing and magnitude. Summarizing, accrual duration and accrual discretion are inextricably linked by the fundamentals of the accrual process. The study concludes with some thoughts on how to practically use accrual duration as a measure of accrual discretion. I appreciate helpful comments from Hal White, Valeri Nikolaev, Frank Zhang, Joseph Gerakos, Jim Leisenring, Yin Wang, Xiao Tian, and workshop participants at Rice University, INSEAD, ESSEC (Paris), University of Zurich, Tilburg University, Washington University, University of Miami, Hong Kong Polytechnic University, Chinese University of Hong Kong, UC – Berkeley, University of Tokyo, Kobe University, University of Melbourne, University of New South Wales, and Columbia University. Contact: Ilia Dichev [email protected] (404) 727-9353 1. Introduction Recording accruals is at the heart of accounting, and thus there has been much interest in their function and characteristics. A major theme in this interest is that there is considerable discretion in recording accruals, and understanding the nature of this discretion is a key to understanding the utility and cost of using accruals. More specifically, a prominent idea in this literature is that accruals can be usefully split into discretionary and non-discretionary components. The motivation is that non-discretionary accruals are driven by fundamentals like business activity and growth, while discretionary accruals are more subjective, and therefore more prone to managerial biases and manipulation.1 The volume of the discretionary accrual literature is substantial. Studies using discretionary accrual ideas or techniques certainly number in the dozens, and likely in the hundreds (Dechow, Ge, and Schrand 2010 and Francis, Olsson, Schipper 2008). While this sustained effort has produced a number of insights, the leading discretionary accrual models have been criticized as inadequate, and even misleading (Dechow, Sloan and Sweeney 1995, Ball 2013). Prompted by such criticisms, this study develops a new approach to identifying the discretion in accruals. The linchpin of this approach is closer attention to how accounting works, with a special emphasis on the mechanism and manifestations of accrual discretion. The main idea about the mechanism of accrual discretion is that recording accruals involves using forward- looking estimates, and it is the quality of these estimates that determines the benefits and the costs of using accruals. The manifestation of accrual discretion is in shifting the recognition of cash flows as components of income across time. Note that since income trues up to the corresponding cash flows, ultimately the only thing that accruals do is re-shuffle the timing of the recognition of cash flows over time. The implication is that both the benefits and the costs of 1 Many studies also use the term “abnormal accruals,” with a similar meaning. 1 accruals relate to timing, where the benefits of using accruals relate to recognizing cash flows into the “right” periods, while the costs of using accruals relate to recognizing cash flows into the “wrong” periods. For example, the benefit of the Accounts Receivable accrual is the more timely recognition of income (Revenue) at the time of sale as opposed to waiting for cash collections from customers. The cost of the Accounts Receivable accrual is that income may be allocated in the “wrong” way, for example the Accounts Receivable may be recorded too early or it may be overstated at inception which could necessitate restatements or write-downs later on. As developed in more detail further on, such recording of income into the “wrong” periods represents timing errors, which introduces noise into the measurement of income. The difficulty in implementing these ideas is that the main theoretical constructs, forward-looking estimates and timing errors, are not readily observable. To address this difficulty, the study looks more closely into the fundamentals of recording accruals. As is well- known, accruals work in pairs, i.e., the recognition of a cash flow in a period different from when it occurs is accomplished by recording a combination of an opening and a closing accrual. Notice that by design one side of this accrual pair coincides in time with the associated cash flow, while the other side occurs in a different period. The point is that shifting of the recognition of a cash flow is a two-step process, it is a shifting of a cash flow amount away from some period and into another period.2 Using the Accounts Receivable example to clarify the difference in the function and characteristics of these two steps, notice that when cash comes in from customers, the closing 2 For deferrals, the shifting away step comes with the opening accruals (e.g., the capitalization of PPE and Inventory at inception), and the shifting into another period step comes with the closing accruals (recoding the expense of Depreciation and Cost of Goods Sold). For accruals proper, the order of the two steps is reversed – the shifting into another period step comes with the opening accruals (e.g., the recognition of income at the inception of Accounts Receivable and the recognition of expense at the inception of Warranty Payable), and the shifting away step comes with the closing accrual (the extinguishment of Accounts Receivable with cash collections and Warranty Payable with cash payments). 2 accrual of Accounts Receivable is merely a matter of bookkeeping rather than discretion. For example, if $100 of cash comes in, the Accounts Receivable has to be reduced by $100, there is no other way to record the collection. In other words, shifting the recognition of a cash flow away from a period is accomplished by recording an accrual with the same magnitude and the opposite sign in the same period. Thus, such accruals are non-discretionary because the timing and the magnitude of the concurrent cash flow pin down the timing and magnitude of the associated accrual. In contrast, the opening accrual for Accounts Receivable is discretionary because it can be recorded sooner or later, and at larger or smaller amounts depending on estimates about satisfying the revenue recognition criterion and the future cash collections from customers. For deferrals like PPE and Inventory the sequence is reversed, the opening accrual is non- discretionary because it is merely the deferral of a known cash flow at a known time, and it is the allocation of these costs to later periods as depreciation or cost of goods sold where the discretion resides. The unifying point for deferrals and accruals proper is that recording accruals away from the periods of their associated cash flows always involves using some kind of forward-looking estimates (e.g., projected cash flows, useful lives) and therefore it is these accruals only that embody the notion of discretion in accounting. This intuition can be formalized and extended by introducing the notion of accrual duration. Accrual duration can be defined as the length of time between an accrual and its associated cash flow. The idea is that accrual duration captures the horizon of accrual estimation, and is therefore closely related to the discretion of accruals. Specifically, accruals that are concurrent with their associated cash flows have zero duration, and also have zero discretion because there is no estimation involved – as discussed earlier, the timing and 3 magnitude of the cash flow pin down the timing and magnitude of its associated concurrent accrual. But recording the other side of the relevant accrual pair involves estimation of future events, and is thus discretionary in timing and magnitude. Note also that accruals that have longer duration are more discretionary because estimation is unavoidably less certain over longer horizons. For example, recording the opening accrual for a 10-month Accounts Receivable is likely to be more discretionary than that for a one-month receivable. Summarizing, accrual duration and accrual discretion are inextricably linked by the fundamentals of the accrual process. The paper concludes with a discussion of the pros and cons of the accrual duration approach, and offers some observations on its possible empirical applications. The major attraction of this approach is that it applies to virtually all possible accruals. The major difficulty in implementation is the identification of the associated cash flows and accruals because current financial reporting provides only a patchwork of the necessary data. When the associated accruals and cash flows are available (e.g., for PPE, revenue accruals), it is possible to derive estimates of discretionary accruals using exact algebraic derivations, avoiding the vexing statistical and validity issues that plague existing discretionary accrual models. Absence of clean data necessitates reverting to statistical estimation, either at the level of individual or aggregate accruals.