I understand what accruals are and that accruals reflected in earnings are not actual cash flow, but what does it mean that they are less persistent? Can’t they continue…
they can, but that’s less likely…the point is that accruals are more volatile so analysts shouldn’t ‘trust’ them as much as a real dollar of cash flow.
for example imagine a company that ends year 1 with $100 of receivables. then ends year 2 with $200 of receivables, $300 in year 3 and so on…does this reflect real earnings growth (which is how it would look on the income statement) or is it likely to reverse at some point? or be an indication of earnings manipulation? either way, you’d say it’s probably not a good sign for the company’s ability to keep growing earnings going forward.
The way I like to think about is that in the long run, earnings will revert to their mean level due to competitive forces.
So when you are analyzing a company with heavy use of accruals, for example deferring large amounts of revenue to manage a steady upward trend in profitability going forward, the current earnings level is relatively low compared to a similar company that correctly recognizes revenue (all else being equal).
Because the low earnings level is not representative of the future earnings capability of the company, it is said to be of lower quality or less persistent - because the deferred revenue balance will eventually be recognized as revenue, the low revenue will not “persist” in the future.
Thanks y’all. Couple other related questions: 1 ) to find accruals from the balance sheet, you do NOAend - NOA bgn. But what if gross fixed assets increase which is captured in NOA. I never thought of fixed assets/net fixed assets as an accrual but isn’t that what’s be included here? 2 ). Can you explain how earnings quality and comparability are examined by sector neutralizing (subtracting the mean/median sector group ratio from the subjects)? How are you analyzing earnings quality?
- The carrying value of fixed assets count as accruals because they are deferred expenses. You pay $1,000,000 for a factory but you don’t expense this all at once because according to accrual accounting the expenses should be recognized as incurred. So if you expect the factory to be of service for 15 years, you recognize the expense across these 15 years (using the relevant depreciation method). The undepreciated portion (Net PPE) is simply an expense waiting to be recognized in future periods.
Thats how fixed asset values relate to accruals (if that was your question?).
- Can’t really help with this, I dont’ recall the term “sector neutralizing”, been a while since I studied financial reporting. I’ll definitely come back to this later but studying the regression topics at the moment :D.
Maybe someone else can help?
sector neutralizing seems to be a way to benchmark your performance against the sector your firm is in.
(based on the definition above).
Thanks to you both!
Going_for_CFA_a, I think you hit the nail on number one. I guess i’ve just always thought of things like accounts receivables and prepaids as ACCRUALS, not fixed assets. I can see how fixed assets might fall into the deferrals bucket (as you explained).
Nevertheless, i guess they’re btoh treated as accruals in this case, right?