Ch2 Trade-off: CF vs Accounting

[reiss1]

Hi all,

In Ch2 notes p. 4 it states "There is a classic trade-off between economics (aka, cash flow) and accounting: to reduce cash flow volatility might increase earnings (accounting volatility)!"

I am a bit puzzled on the trade-off between CF volatility and accounting volatility.

I am unsure why higher CF volatility may translate to lower accounting volatility, and vice-versa.

Reiss

 

[Lu Shu Kai FRM]

Hi @reiss1 ,

I looked at the notes. It states that the trade-off exists as a disadvantage of hedging risk, which is the decrease in cashflow volatility for an increase in accounting volatility. Off the top of my head, one of the disadvantages of high accounting volatility is that investors may not see the company as stable, which results in less funds for the company to invest in projects, infrastructure etc.

This is just one of the possibilities I am thinking of, but it may or may not be the meaning that was intended by David.

Hope this helps!

 

[David Harper CFA FRM]

Thank you @lushukai for taking the time to observe that the context is hedging. This is a point (for example) articulated by FRM author Crouhy, see https://forum.bionicturtle.com/threads/economic-earning-accounting-earning.10625 i.e.,

@Nicole Seaman Thanks for looking. The relevant LO is "Evaluate some advantages and disadvantages of hedging risk exposures." under the R2 reading (Crouhy Chapter 2. Corporate Risk Management) where the source text reads as below (emphasis mine, I haven't checked our study note):

"As a final point, even a well-developed risk management strategy has compliance costs, including disclosure, accounting, and management requirements. Firms may avoid trading in derivatives in order to reduce such costs or to protect the confidential information that might be revealed by their forward transactions (for example, the scale of sales they envisage in certain currencies). In some cases, hedging that reduces volatility in the true economic value of the firm could increase the firm’s earnings variability as transmitted to the equity markets through the firm’s accounting disclosures, due to the gap between accounting earnings and economic cash flows." -- Crouhy, Michel. The Essentials of Risk Management, Second Edition (Kindle Locations 1089-1094). McGraw-Hill Education. Kindle Edition.

@Anuja Please see this recent thread at https://forum.bionicturtle.com/thre...-by-reducing-true-economic-value-which.10388/

... Accounting earnings are also called "reported earnings" and these would be the numbers reported by public companies that are closely followed; for example, earnings per share, is reported earnings per share (EPS). These do matter, but they are determined for the most part by accounting principles and their interpretation. The income statement is mostly a function of such rules, including revenue recognition, matching costs during the period, allocating capital investments, and accrual, just to name a few ideas. The accounting principles are terrifically evolved and logical but the net earnings number will not equal the cash flow during the period. In general, while economic earnings can mean different things (for example, economic value added, EVA, is a specific methodology for "un-raveling" the accounting earnings into a cash-flow based earnings), in general it implies a cash-flow based earnings base; i.e., how much normalized cash flow did the company earn in the period. Or even, what is the sustainable (adjusted) cash flow earned in the period. So, it could start with the accounting pre-tax earnings number and, just for example, it could add back depreciation and amortization which are non-cash charges (expenses during the period that reduce reported pretax income but which were not actually cash spent). There are many of examples of both (i) income statement expenses which do not match the current period cash expense, and (ii) conversely, cash investments or dilution that do not get fully deducted in the current period; e.g., investments are capitalized over multiple periods, so maybe only 10% of an cash investment is deducted in the current period expense; or in technology companies, a big issue is stock option dilution which has an accounting treatment that is very different from its potential economic implication (it is hard to expense derivatives!). So, i would say really simply that accounting earnings are the GAAP/IASB rule-based earnings that, while some discretion is given, are mostly forced while economic earnings is the "priestly art and science" of adjusting those numbers into a more genuine cash-flow based perspective.

Although, Crouhy's point is a narrow subset of this overall general trade-off (between conservative accounting and realistic economics) where he is pointing to the issue in hedging, where hopefully i've setup that thorny problem in the link. Mainly the issue is that a successful hedge is likely to minimize the net volatility (aka, minimum variance hedge in Hull) of two positions combined (the "net portfolio" of 1. the exposure + 2. the hedge instrument) yet the accounting rules (being conservative) might force the recognition of a loss immediately. So maybe the "exposure is profitable" during a period such that the hedge instrument (performing its duty) produces a loss. But maybe the profitable side is unrealized (i.e., unreported on the current income statement) but the hedge loss must be realized/reported currently. In this case, maybe the net contribution to economic earnings is roughly zero (low volatility!) but the reported, current period earnings (accounting) contribution only sees the loss (higher volatility). I hope that's helpful musing! Thanks,

.... and notice in the thread where contemporaneously I shared an article on the topic at https://forum.bionicturtle.com/threads/economic-earning-accounting-earning.10625/post-51756. The actual article (Earnings shenanigans underpin Wall Street record) can still be retrieved for concrete color. Thanks,

 

[Lu Shu Kai FRM]

Thank you David, it is a really helpful reference!