Accruals are accounting adjustments for revenues that have been earned but are not yet recorded in the accounts and expenses that have been incurred but are not yet recorded in the accounts. While accruals are necessary to get an accurate reflection of the company's performance, they lend themselves to management discretion and possibly manipulation of earnings.

Management is under constant pressure to achieve targets and will try to speed up revenue recognition or delay expenses if it looks like results will come in below expectations. Conversely, management may slow down revenue recognition or pay for future expenses to smooth earnings into upcoming quarters.

If management is increasing the number of overall earnings, not by actual cash earnings, but by accrual accounting manipulation, then the possibility of a reduction in earnings or earnings growth is high. Conversely, a company with low or declining aggregate accruals should have more persistent earnings and higher quality.

Accrual manipulation leads to significant security mispricing, which is very likely to lead to a correction in the future. You can read more about this in the paper Accrual Reliability, Earnings Persistence and Stock Prices by Richardson, Sloan, Soliman and Tuna.

The authors recommend monitoring and comparing accruals levels and created two ratios for this: Balance Sheet Aggregated Accrual Ratio (BS Accrual Ratio) and Cash Flow Aggregated Accrual Ratio. (CF Accrual Ratio) The first calculates the increase of Net Operating Assets compared to the average of the last two years.

Formula:

An increase in earnings accompanied by an increase in the accruals ratios should raise a red flag. The same is true when the company posts above industry-average growth combined with above-average growth of the BS Accrual Ratio.