Analyzing Earnings Quality the Accruals Ratio

A companys accrual earnings has two components: cash earnings and aggregate
accruals

Accrual Basis Earnings = Cash Earnings + Aggregate Accruals

Aggregate Accruals = Accrual Basis Earnings Cash Earnings

When aggregate accruals are the dominant component of a companys earnings,

mean reversion tends to occur more quickly and so earnings with a high accrual component can
be considered lower quality.

Accruals Ratio the accruals ratio is a simple measure for analyzing earnings
quality. There are two approaches: the balance sheet approach and the cash flow statement
approach.

Balance Sheet Approach to the Accruals Ratio

Steps in evaluating aggregate accruals: the Balance Sheet Approach to the Accruals Ratio
Cash Flow Statement Approach to the Accruals
Ratio
NOTE: The two approaches to calculating a companys accruals ratio will not result in the
same value, but there is a high correlation between the methodologies.
Financial Reporting Problems and Warning Signs

FINANCIA REPORTING WARNING ANALYTICAL

L PROBLEM SIGN TOOL
STATEME
NT ITEM

Revenue Look for

increases in
days sales
Large outstanding
Overstated increases in (DSO) as this
revenue. accounts may indicate
receivable. questionable
credit sales
by the
company.

Revenue Misclassification The

of non- company
operating or changes
non-recurring items
revenue as included in
operating calculation of
revenue. earnings.

Expenses Analyze
Changing depreciation
depreciation ratios; review
method; footnotes to
Understating
increasing see if
expenses.
useful life or changes have
salvage been made to
values. companys
methodology.
Expenses Compare
growth of
sales to
growth of
Improper
non-current
capitalization of
Peculiar assets. If
items that
growth in sales growth
should be
non-current is low, but
expensed (done
assets. non-current
to defer
asset growth
expenses).
is abnormally
high, future
performance
may be poor.

Expenses Growth in
operating
Monitor
margin
Classifying company
accompanied
operating operating
by a growth
expenses as margin trends
in non-
non-recurring or and trends in
recurring or
non-operating. non-operating
non-
expenses.
operating
items.

Liabilities Monitor
operating
lease trends
in financial
Significant statement
Off balance amount of footnotes and
sheet financing. operating add operating
leases. leases to the
companys
reported
balance
sheet.
Goodwill Maintaining
a goodwill Monitor
balance on trends in
the balance goodwill,
Avoiding sheet when especially
goodwill the stocks during
impairment. market periods of
capitalization economic
exceeds the contraction
book value (recession).
of equity.

Cash Cash flow

Flows statement
excludes non-
Company Study both
cash investing
regularly the balance
and non-cash
acquires sheet method
financing
assets with and cash flow
activities, as
stock instead method of
cash flow based
of cash aggregate
aggregate
purchasing. accruals
accruals will
exclude these
items.