Financial Statement Analysis Blog #8 – accruals in reporting

“Truth searches for no one. It waits to be found.”

— Suzy Kassem, American writer, philosopher, author, filmmaker, and poet

So far in this series of financial statement analysis blogs we have discussed understanding the company, the profitability profiles, and managements’ decision making process when investing in operations that drive profits. In this blog post, we turn to the topic of assessing the accuracy of financial statements. While forensic accounting is beyond the scope of this post, it is worthwhile to note that some of the risks of fraudulent financial reporting are mitigated by the use of audited financial statements – preferably with auditors from the Big 4 accounting firms. Still, gray areas in financial reporting remains, and they can be used to “time” these earnings reports to make the company seems more profitable than it is.

A very common way companies “time” earnings is through the use of accruals in reporting. Accruals can significantly skewed the picture of consistency in the company’s earnings performance. In this blog post, we will review a technique to detect such use. We start with calculating balance sheet and cash flow statements accruals. With our example company Caterpillar (CAT), the picture looks like:

As we can see:

·       On the balance sheet ratio: the absolute level of accruals in the balance sheet is not high at all. CAT has done a good job bringing this accruals ratio down from the 15% 2012 level. There is a trend of its increasing in the most recent year (2015) compared to the previous year (2014), something that the company should monitor. There is no indication of the use of accruals to "time" earnings.

·       On the cash flow ratio: CAT has done a good job bringing this accruals ratio down from 13.8% in 2012. The 2013 to 2015 period saw a relatively steady level of cash flow accruals ratio. Given the significantly less ratios in recent years, there is no reason to conclude that there are accruals present in CAT 's earnings.

The Excel file that calculates the above figures and drives the conclusion is embedded.