Both accountants and financiers are interested in firm value. But the principal difference between them is that the accountants try to approximate changes in the current value of the firm, while the latter try to understand the exact timing of hard cash inflows and outflows over the entire future. The former want to learn about earnings, the latter want to learn about cash flows.
The main difference between these two concepts of income and cash flows are accruals: economic transactions that have delayed cash implications. For example, if I owe your firm $10,000
and have committed to paying you tomorrow, the accountant would record your current firm value to be $10,000 (perhaps time- and credit-risk adjusted). In contrast, the financier would consider this to be a zero cash-flow—until tomorrow, when the payment actually occurs. The contrast is that the accountant wants the financial statements to be a good representation of the economic value of the firm today (i.e., you already own the payment commitment), instead of a representation of the exact timing of inflows and outflows. The financier needs the timing of cash flows for the NPV analysis instead.
Accruals can be classified into long-term accruals and short-term accruals. The primary long-term accrual is depreciation, which is the allocation of the cost of an asset over a period of time. For example, when a financier purchases a maintenance-free machine, he sees a machine that costs a lot of cash today, and produces cash flows in the future. If the machine needs to be replaced every 20 years, then the financier sees a sharp spike in cash outflows every 20 years, followed by no further expenditures (but hopefully many cash inflows).
The accountant, however, sees the machine as an asset that uses up a fraction of its value each year. So, an accountant would try to determine an amount by which the machine deteriorates in each year, and would only consider this prorated deterioration to be the annual outflow (called an expense). The purchase of a $1 million machine would therefore not be an earnings reduction of $1 million in the first year, followed by $0 in the remaining 19 years. Instead, it would be an expense of $50,000 in each of 20 years. (This is a very common method of depreciation and is called straight-line depreciation.)
To complicate matters further, accountants often use different standardized depreciation schedules over which particular assets are depreciated. These are called impairment rules, and you already know the straight-line rule. Houses, for example, are commonly depreciated straight-line over 30 years—often regardless of whether the house is constructed of wood or brick. The predetermined value schedule is usually not accurate: For example, if investors have recently developed a taste for old buildings, it could be that a building’s value has doubled since its construction, even though the financial statements might record this building to be worth nothing. (Even this is oversimplified. On occasion, accountants invoke procedures that allow them to reduce the value of an asset midway through its accounting life—but more often downward than upward.) Another common impairment rule is accelerated depreciation, which is especially important in a tax context. (But we are straying too far.)
If the machine happens to continue working after 20 years, the financials which have just treated the machine as a $50,000 expense in Year 20 will now treat it as a $0 expense in Year 21. It remains worth $0 because it cannot depreciate any further—it has already been fully depreciated. The financier sees no difference between Year 20 and Year 21, just as long as the machine continues to work.
Short-term accruals come in a variety of guises. To a financier, what matters is the timing of cash coming in and cash going out. A sale for credit is not cash until the company has collected the cash. To the accountant, if the firm sells $100 worth of goods on credit, the $100 is booked as revenue (which flows immediately into net income), even though no money has yet arrived. In the accounting view, the sale has been made. To reflect the delay in payment, accountants increase the accounts receivables by $100. (Sometimes, firms simultaneously establish an allowance for estimated non-payments [bad debts].)
Another short-term accrual is corporate income tax, which a financier considers to be an outflow only when it has to be paid—at least not until (the corporate equivalent of) April 15 of the following year. However, on the income statement, when a firm in the 40% corporate tax bracket makes $100 in profits, the income statement immediately subtracts the corporate income tax of $40 (which will eventually have to be paid on the $100 in profits) and therefore records net income of only $60. To reflect the fact that the full $100 cash is still around, $40 is recorded as tax payables.
In sum, for a financier, the machine costs a lot of cash today (so it is an immediate negative), theaccounts receivables are not yet cash inflows (so they are not yet positives), and the corporate income tax is not yet a cash outflow (so it is not yet a negative). For an accountant, the machine costs a prorated amount over a period of years, the accounts receivables are immediate positive earnings, and the corporate income tax is an immediate cost. There is definite sense in the approaches of both accounting and finance: the accounting approach is better in giving a snapshot impression of the firm’s value; the finance approach is better in measuring the timing of the cash inflows and cash outflows for valuation purposes. Note that valuation leans much more heavily on the assumption that all future cash flows are fully considered. Today’s cash flows alone would not usually make for a good snapshot of the firm’s situation.