Accrual accounting matches revenue with expenses, however accruals can be used to manipulate income and expenses. In the Forbes Magazine article, Cash Doesnt Lie, written by Daniel Fisher, the author discusses the use of negative accruals, changes to estimates and recognizing income before it is earned. Read the article and then:

a. Discuss the use of each of these three techniques and their effect on current and future earnings reporting. b. How should changes of accounting estimates that significantly affect income be reported? Should they be regarded as a change in accounting principle? c. Research revenue recognition and discuss the accounting rules violated that brought down the company Sunbeam.

Cash Doesn't Lie

Heres a vexing question for investors: Is Under Armour swimming in profits or struggling to get by? Different sections of its financial statements provide very different answers. The fast-growing athletic-apparel maker reported net income of $68.5 million last year and another $12 million in the first quarter of 2011. Its net profit margin doubled to 3.9%.

Under Armours cash flow statement tells a different story, however. Cash from operations was $85 million in the first quarter as it piled on $33 million in inventory and increased accounts receivable by another $57 million.

Accountants call earnings unaccompanied by increases in cash flow accruals, and theyve long been flagged as a sign of potential trouble. Under Armour says its adding inventory and receivables to better anticipate consumer demand, and that may indeed prove a sage strategy. But todays valuable inventory could be tomorrows worthless Beanie Babies. And receivables could turn into writeoffs instead of cash.

At the extreme, mounting accruals can point to earnings manipulation and outright fraud. Thats because managers have a much easier time faking reported earnings than actual cash in the bank. Exhibit One is Enron, which booked profits from multiyear gas and electricity contracts the day they were signed instead of as they paid off.

Every good manipulation flows through accruals, says Russell Lundholm, who now teaches accounting at the University of British Columbia. Thats why we start shopping there.

Accruals first gained widespread attention in the mid-1990s, when Richard G. Sloan, then a colleague of Lundholms at the University of Michigan, showed that high-accrual firms tend to turn in worse stock market returns than companies whose cash flow exceeds their paper earnings. A profit could be made by shorting the high-accrual stocks and buying the low-accrual ones. There was one problem with the existing research: It measured accruals as a percentage of assets, following common academic practice. It took one of Lundholms students, a Ph.D. candidate named Nader Hafzalla, to point out the obvious: If noncash earnings are suspect they should be measured against total earnings, not assets.

Lundholm was skeptical at first, but his student proved the theory after spending all night crunching stock market statistics. Whats more, the stocks found with the new method had very little overlap with those found with the old one. It was a new way of finding both cheap and overvalued stocks.

In a 2011 paper in the Accounting Review Lundholm and coauthor Matt Van Winkle (Hafzalla died in 2006) showed how firms in the top 10% in terms of negative accruals turned in annual returns 5.5 percentage points in excess of the market from 1998 to 2008. Those with high accrualsearnings without cashtrailed the market by 6.1 points a year. Buying the first group and shorting the second would have resulted in an 11.6% annual gain.

Lundholms accrual formula takes net income minus cash from operations and divides the result by net income. Lundholm uses trailing 12-month figures to account for seasonal swings in cash flow and earnings.

Firms with the highest accruals tend to have zero to slightly negative earnings but huge negative balances in cash from operations. In other words, theyre struggling to report a profit as cash rapidly drains from their bank accounts.

For such a simple accounting measure, accruals pick up some of managements fondest tricks. Managers might be tempted to keep production lines going in the face of flagging demand, for example, because the cost of those extra widgets doesnt hit the earnings until theyre sold. But the cash spent on raw materials shows up next quarter in the cash flow statement.

Accounts receivable also reflect sales that might become writeoffs when the buyer doesnt pay. Thats one of the things that brought down grillmaker Sunbeam, whose chief executive, Albert Chainsaw Al Dunlap, booked orders from dealers who hadnt actually paid for or taken delivery of its grills (FORBES, May 4, 1998).

Negative accruals are harder to understand. Say a company has poor earnings now but executives think next year will be better. They might have an incentive to write down assets and reduce the useful life of machinery so that when the recovery comes earnings look even better and last longer as profit margins begin their usual cyclical contraction.

Southwest Airlines might be one example. Last year it reduced the expected residual value of its planes from 15% to 10% of book value. The move added to the $628 million in depreciation on its $16 billion fleet of airplanes and reduced reported net income to $451 million, or only 28% of Southwests $1.6 billion in cash from operations. If an economic recovery increases demand for Southwests used 737s, management could decide to reverse the move.

Lundholm reckons that the current spate of asset writedowns and slimmed-down cost structures are setting the stage for earnings increases ahead.

Screening for accruals may work well for hedge funds, which can use computerized trading to assemble portfolios with hundreds of stocks on the long and short sides. But Lundholm says individuals can use the same technique on as few as five or ten stocks.

To find the best candidates, he says, look for companies that not only rack up extreme positive or negative accruals but also had earnings surprises going the other way. A company with high accruals that still cant make earnings estimates is struggling to keep up appearances. A company that writes off everything but the kitchen sink yet still beats estimates is clearly on the upswing.