The fewer accrual accounting adjustments that are made from operating cash flow, the higher the earnings quality will be. We can analyze the accrual levels by using the balance sheet or a cash flow statement to get an accrual to net operating assets ratio. The lower this ratio, the higher the earnings quality.
On the balance sheet, we can find NOA as:
NOA = operating assets – operating liabilities.
operating assets = total assets – cash – cash equivalents – marketable securities
operating liabilities = total liabilities – total debt
The amount of accruals on the balance sheet is the change in NOA in a period:
AccrualsBS = NOAend – NOAbeg
The accrual to ratio is the Accruals for a period derived by the average NOA for a period:
Using the cash flow statement we can find the accruals value by subtracting cash flow from operating activities and cash flow from investing activities from reported earnings:
accrualsCF = NI − CFO – CFI
The accruals ratio is similar to the balance sheet equation, we simply replace the source of accruals:
Wide fluctuations in the accruals ratio or large steady increase YOY may indicate earnings manipulation.