You Need to Determine Earnings Quality Through Accruals

December 12th, 2011

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.

Guest post byJames DeMasi

Seraphin Group

Table of Contents

What could determine accrual earnings quality?

Net income is a product of accrual earnings quality accounting

Balance Sheet and Cash Aggregate Accrual Ratio

Red Flags to Heed

About the Author

References

About OSV Guest Author

When youre trying to value businesses then youre 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 companys
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?

TOP QUALITY 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 companys 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
companys 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 [1].

To monitor a companys 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 [2].

These ratios can be used to view changes in a companys 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 periods 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.

Follow James on Twitter @SeraphinGroup, on Facebook as well as Seraphin Group

LLC.