When business transactions are conducted by the exchange of assets on site, there is no ambiguity in revenue recognition. In practice, however, transactions are often conducted without immediate asset exchange. For example, construction projects that take more than a year to complete. Recognizing revenues and expenses strictly following cash flows may significantly underestimate firms’ operating activities.

Both cash basis accounting, as well as accrual basis accounting have an impact on net income. The accrual basis is more reflective of the firms’ operating activities rather than cash basis accounting.

There are serious concerns of accruals, however, when they are misused. The infamous case is WorldCom who reported billions in illusory earnings (http://www.cbsnews.com/news/world-class-scandal-at-worldcom/ ). The other concern of using accruals, though probably less damaging, compared to the WorldCom case, is that managers may use accruals to manipulate earnings for a given period to realize possible personal benefits such as receiving higher bonus.

Discuss:

1. If you were an investor in a rent-to-own business that takes more than a year to collect revenues while the customers take immediate possession of the goods: Would you prefer to have the income statement prepared by cash basis or by accrual basis and why?
2. If you were an investor of a construction company with projects that take more than a year to complete, what is your income statement preparation preference and why? If you choose the accrual basis, what can shareholders do to ensure the appropriate use of accruals?