- A company’s accrual earnings has two components: cash earnings and aggregate accruals
- 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
Aggregate Accruals = Accrual Basis Earnings – Cash Earnings
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.