When you’re trying to value businesses then you’re primarily going to be trying to put a value on their earnings power or accrual earnings quality. We all like to see big earnings, but quantity is much less important than quality. Earnings can be considered high quality when they are both repeatable and accurately represent the company’s operations. This may not always be the case because of fraud, misreporting, and managerial accounting discretion. You can begin to determine whether or not a company has high quality earnings by checking on its accruals.
What could determine accrual earnings quality?
Net income is a product of accrual earnings quality accounting
Businesses make sales by either collecting cash or extending credit to their customers. Therefore, in the simplest terms, a company’s accounting earnings are equal to its cash earnings plus accruals. But, managers can manipulate accounting figures.
Executives decide how quickly to depreciate assets and how large the allowance for doubtful accounts should be (an estimate of how much customer credit is not likely to be repaid). They may also try to renegotiate terms with their suppliers to delay paying their bills, or try to recognize unearned revenue more quickly than would be considered appropriate. In the long-run these measures are not sustainable because accruals and deferrals are mean-reverting.
For example, if a large portion of unearned revenue is recognized as earnings today then there will be less revenue recognition remaining for the future. Likewise delaying bill payments today means that the company will show higher expenditures in the future.
When earnings are manipulated in these ways, then they are not representative of the company’s true earning power and are not repeatable. Research shows that companies with lower levels of accruals and deferrals have more persistent earnings. Moreover, “Earnings increases that are accompanied by high accruals, suggesting low-quality earnings, are associated with poor future [stock] returns .”
To monitor a company’s accruals, Scott Richardson of Barclays and Irem Tuna at London Business School developed the balance sheet aggregate accruals ratio and the cash aggregate accruals ratio .
These ratios can be used to view changes in a company’s accruals level over time and to make company-to-company comparisons. Historical averages and cross-industry comparisons will help you determine what an appropriate level is.
Note that the balance sheet aggregate accruals ratio and cash aggregate accruals ratio will not perfectly match because of noncash transactions and other classification differences, but the two are highly correlated (0.80)^2. Both should be used when making time-series and company comparisons.
Balance Sheet and Cash Aggregate Accrual Ratio
First calculate Net Operating Assets:
Next, subtract last period’s NOA from the current NOA figure to arrive at Balance Sheet Aggregate Accruals.
The Balance Sheet Aggregate Accruals Ratio is determined by dividing that number by the average accruals.
The procedure is similar when calculating Cash Flow Aggregate Accruals, as shown below.
Red Flags to Heed
Remember, a jump in earnings accompanied by a jump in the accruals ratio should raise a red flag; so too should a higher than industry-average growth rate with a higher than industry-average accruals ratio.
So, the next time you are looking at a stock then be sure to incorporate these ratios into your analysis. Doing so may just prevent you from being caught on your heels the next time a company admits to having some skeletons in its closet. Hopefully, you will have seen the signs and exited sooner than the general public.
About the Author
James DeMasi first became interested in the stock market at the age of thirteen and has pursued it as his career ever since. In that time he has worked as an investment consultant at EnnisKnupp, where his clients included some of the largest public pension funds in the United States, served a brief stint as a Wall Street trader, and is currently the founder of Seraphin Group LLC, a value-oriented Registered Investment Advisor.
 Chan, Konan, Louis K. C. Chan, Narsimhan Jegadeesh, and Josef Lakonishok. “Earnings Quality and Stock Returns.” Journal of Business 79, 3 (May 2006): 1041-82. Retrieved from http://www.nber.org/papers/w8308
 CFA Institute. Level II Financial Reporting and Analysis. 5th. 2. CFA Institute, 2011. Print.