Analyzing Earnings Quality - the Accruals Ratio
- A company's 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 company's 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.
Two approaches to the Accruals Ratio:
Balance sheet approach
Cash flow statement approach
Balance Sheet Approach to the Accruals Ratio
Steps in evaluating aggregate accruals: the Balance Sheet Approach to the Accruals Ratio
Steps in evaluating aggregate accruals: the Cash Flow Statement Approach to the Accruals Ratio.
NOTE: The two approaches to calculating a company's accruals ratio will not result in the same value, but there is a high correlation between the methodologies.
- CFA Level 2: Financial Reporting Part 3 – Introduction
- Various Definitions of Earnings
- Total Comprehensive Income
- Earnings and Cash Flows
- Derivatives Hedging and Financial Reporting
- Cash Basis Accounting vs. Accrual Basis Accounting
- Management Motivations for Financial Statement Manipulation
- Measures of Earnings Quality
- Analyzing Earnings Quality - the Accruals Ratio
- Financial Reporting Problems and Warning Signs
- Financial Statement Analysis - Ratio Analysis
- Adjusting a Company's Reported Financial Statements