Accruals Ratio

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Dreary

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The ratio is used to estimate the amount of accruals there is, since high accruals mean less persistent earnings, i.e., low quality earnings.
When calculating the ratio based on CF statement, it is equal to NI minus CFO minus CFI, all divided by average Net Operating Assets (NOA).
Question: Why not also take out CFF?
 
What accruals can you think of that sit in cash flow from financing? Isnt most of that truly cash with no estimation or asusmptions required?
 
I don’t know.
Don’t we take out CFO because it is cash? So, if we pay dividends (CFF), shouldn’t we take that out too?
When we get cash though bank overdrafts (that’s CFF), shouldn’t we take that out too?
 
Yeah, I looked it up in CFAI (237-238), and really dont see a good explanation of why only CFO and CFI factor into aggregate accruals (NI - CFO - CFI) or the accruals ratio.
I think in the most basic form, the accruals ratio is separating the cash from cash that is expected (the accrual piece) and dividing it by a total asset number. So basically you start with Net income (which includes accruals and actual cash flow) and then you back out CFO and CFI (the actual cash that came in) and that leaves you with just the accrual amount.
So you have just what is an accrual (an unpaid so uncertain cash amount) divided by total assets.
Im not 100% sure why CFF isnt accounted for here, but most CFF items i can think of are truly cash in and cash out items. So there arent many accruals there. I could be wrong. Anyone?
 
I thought i knew this better and clearly dont. The book does say that we exclude debt from the original NOA formula because it is generally discretion free. (It does say this isnt entirely true because there are certain things, but for the purpose here we assume debt is discretion free)
so i guess my next question as would you consider most items in CFF cash flows from debt?
 
I just find it odd that they (CFAI and Stalla) don’t mention it…no, it isn’t obvious either way.
 
CFAdreams
“Im not 100% sure why CFF isnt accounted for here, but most CFF items i can think of are truly cash in and cash out items. So there arent many accruals there. I could be wrong. Anyone?”
I would agree with this, as from a purely accounting, one would not find any accruals under the cash flow from financing activites. Also CFF items, e.g. rasing of debt, issuing of shares, are items that would not contain any area of uncertainty as there tend to be legal requirements which are in place, placing a higher level of certainty on those items.
Dreary
“When we get cash though bank overdrafts (that’s CFF), shouldn’t we take that out too?”
When dealing with overdrafts i think one needs to assess if the overdraft, expected to reverse out in the future, or is expected to be a long term effect, one would not usually classify bank overdrafts as CFF, unless there is no indication that that the entity would turn to a cash positive balance.
 
The goal is to determine the reliability and persistence of earning, using accrual% of Net income as an indicator that negatively correlates with reliability.
Whether or not CFF has accruals in it is not the point- the point is that Cash flow from financing doesnt correspond with net income the same as CFO and CFI.
For instance, selling shares or taking debt to raise money isn’t revenue, so it isn’t in net income. The money raised may then be used in cfo or cfi. ie issue $1M debt [CFF] purchase $1M Land [CFI]
 
th123 is on the market. Net Income arrives from things associated with CFI and CFO.
CFO in the case of normal operating business profit, and CFI from unrealized/realized income from investments in other businesses (not all the time, but you include CFI to account for it)
 
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