Why Not Just Cash Account?
- Kevin Carr
- Aug 26
- 4 min read
Updated: Sep 18
What do Enron, Carillion, and WeWork have in common? They were all profitable companies, but still collapsed due to unsustainably negative cash flows. When you look back in history, it’s littered examples of businesses that were, or at least appeared profitable, right up until the moment they collapsed.
Enron (2001): Once a US energy giant, but behind the scenes they used complex accounting tricks to hide debt and inflate profits. Reported earnings looked strong, but the business was bleeding cash. When the truth came out, Enron filed for bankruptcy, wiping out $74 billion in shareholder value and shaking trust in financial reporting.
Carillion (2018): A major UK construction and outsourcing group, it reported profits under long-term contract accounting, but in reality, cash flow was consistently negative. Mounting debt and delayed payments caught up with it, leading to a sudden collapse. The failure left thousands of employees jobless, projects abandoned, and raised questions about accounting transparency.
WeWork (2019–2023): Grew rapidly by leasing office space and subletting it to start-ups and corporates. Its “community-adjusted” earnings painted a picture of profitability, but the company burned billions in cash. A failed IPO in 2019 exposed its losses and governance issues. Despite bailouts, cash drain continued, and WeWork filed for bankruptcy in 2023, symbolising the dangers of hype-driven growth without cash discipline.
It’s tempting to therefore say that given cash flows are real, and profits can be manipulated, at least in the short term, then why not just cash account? Surely that would stop businesses from hiding behind “paper profits”?
The answer is more subtle. Cash is vital for survival, but it’s not always the best measure of performance. To see why, we need to explore the difference between cash and accrual accounting.
Cash vs Accrual Accounting: What’s the Difference?
Cash accounting: Record revenues and expenses only when money changes hands.
Accrual accounting: Record revenues when earned and expenses when incurred, regardless of cash timing.
Cash accounting can feel intuitive. If more money comes in than goes out, that looks healthy. But the catch is that cash timings don’t always align with business activity, for example;
Imagine winning a £1 million contract in December, but the customer doesn’t pay until January. Under cash accounting, December looks terrible and January looks brilliant, even though the business really performed in December. Accrual accounting fixes this by recognising revenues and expenses when they actually happen, not when cash changes hands
Why Earnings Matter More Than Cash Flows
So, are accrual-based earnings, or profits, a better measure of a company's performance than cash flows?
Patricia Dechow tested exactly this in her landmark 1994 study, “Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals.”
In the study, she asked: Which measure, earnings or cash flows, better reflects performance in a way that investors care about?
The results were clear, over a 15 year period on a sample size of 1,695 firm years;
Earnings explained 13.8% of variation in stock returns
Cash flows explained only 7.7%
So while both were statistically significant, earnings were nearly twice as informative. This is because accruals help earnings line up with real business activity better than raw cash flows alone. They act almost as a smoothing mechanism to adjust for factors such as the timing of cash payments and receipts, and non-cash expenses (e.g. depreciation).
Without these adjustments, financial statements would swing wildly with cash flows, often masking true performance.
This however only holds true if accruals are done properly and not abused.
The Risks of High Accruals: Lessons from Research
Despite Dechow's paper, accruals aren’t always good news. Richard Sloan’s 1996 study, "Do stock prices fully reflect information in accruals and cash flows about future earnings?" showed that companies with high accruals (earnings far above cash flows) tend to have lower future returns. This is because those accruals often aren’t usually sustainable. Investors tend to overreact to high reported earnings, and disappointment follows when accruals reverse.
When cash flows are higher than earnings (negative accruals), the picture is more mixed. Sometimes it’s a sign of conservative accounting, other times it’s a warning of underlying issues such as aggressive revenue deferral or early recognition of expenses to perhaps smooth out earnings.
When Profitable Companies Still Collapse: The Cash Flow Trap
Dechow showed that accruals accounting improves performance measurement, but cash still matters deeply. A business can look profitable and yet fail if it can’t generate or raise cash as per our examples above.
This is what happened with
Enron: Profits boosted by accounting gimmicks, but liquidity evaporated.
Carillion: Profits under contract accounting, but cash flow stayed negative until collapse.
WeWork: “Adjusted profits” hid enormous cash burn, leading to bankruptcy.
Therefore, we can conclude that while earnings, or profits, are a better indicator of performance, but cash flows are a better indicator of survival.
Why Not Just Cash Account? A Balanced View
If we relied only on cash accounting:
Performance would be distorted by payment timings.
It would be harder to compare firms across industries and years.
Managers and investors could miss when real value was being created.
If we relied only on earnings:
We might miss red flags in liquidity or overly aggressive use of accruals.
The best approach is balance:
Earnings give the best measure of economic performance.
Cash flows provide the reality check — is that performance sustainable?
This is why in all major accounting frameworks, a complete set of financial statements includes both and profit and loss or income, and cash flow statements.
As Dechow showed, accrual earnings tell us more about performance. As Sloan warned, too many accruals should raise eyebrows. And as business history shows, cash is still king when it comes to survival.
Bibliography
Dechow, P. M. (1994). Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals. Journal of Accounting and Economics, 18(1), 3–42.
Sloan, R. G. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, 71(3), 289–315.
Richardson, S. A., Sloan, R. G., Soliman, M. T., & Tuna, İ. (2005). Accrual reliability, earnings persistence and stock prices. Journal of Accounting and Economics, 39(3), 437–485.
Collins, D. W., Maydew, E. L., & Weiss, I. S. (1997). Changes in the value-relevance of earnings and book values over the past forty years. Journal of Accounting and Economics, 24(1), 39–67.
Found this useful?
Please share with your team or fellow accountants. Comment below with your thoughts or questions, and don't forget to log this read as 10 minutes of CPD!
Comments