Question

Explain the benefits of accrual accounting.
When trying to predict future cash flow and future earnings, would you rather use current earnings or current cash flows? Cite some empirical evidence.

Answer 1

Benefits of Accrual Accounting

  

• Accrual accounting allows business owner to get to know actual profitability of company.
• For running business smoothly,lot of organisation depends on credit.Many ratios with accrual accounting are calculated that become basis for decision making for any financial institution before giving credit.
• It clearly shows flow of revenue & expenses.It follow Matching principle where profit occurred matches with expenses incurred.
• It helps management or Financial managers to make better use of company resources.

When you have to make decision basically for investing in project ,then you will consider future cash flow not future earnings because there are some expenses which are non cash but they are considered in calculation of earning like depreciation or amortization expense.

Let us understand by small example

There are three firms with 10%profit after tax .Firm A distribute all to shareholders .Firm 2 reinvest it & grow @5% per year .Firm 3 reinvest this money & borrowed fund at 10% and its earnings grow by 20%.

Now If u discount future earning , you have to make adjustment of these changes that occurred in capital.