Financial Reporting Quality: Aggregate Accruals
Earnings can be decomposed into cash and accrual components. The accrual component (aggregate accruals) has been found to have less persistence than the cash component, and therefore (1) earnings with higher accrual component are less persistent than earnings with smaller accrual component, all else equal; and (2) the cash component of earnings should receive a higher weighting evaluating company performance.
Balance-Sheet-Based Accruals Ratio
Waste Management Inc., balance sheet computation of aggregate accruals
US$ in millions
Based on: 10-K (reporting date: 2021-12-31), 10-K (reporting date: 2020-12-31), 10-K (reporting date: 2019-12-31), 10-K (reporting date: 2018-12-31), 10-K (reporting date: 2017-12-31).
1 2021 Calculation
Net operating assets = Operating assets – Operating liabilities
= 28,979 – 8,566 = 20,413
2 2021 Calculation
Balance-sheet-based aggregate accruals = Net operating assets2021 – Net operating assets2020
= 20,413 – 20,711 = -298
3 2021 Calculation
Balance-sheet-based accruals ratio = 100 × Balance-sheet-based aggregate accruals ÷ Avg. net operating assets
= 100 × -298 ÷ [(20,413 + 20,711) ÷ 2] = -1.45%
The analysis of the balance-sheet-based accruals ratio reveals a period of stability followed by significant volatility between 2018 and 2021. The ratio serves as a proxy for earnings quality, where higher positive accruals typically indicate a greater divergence between reported earnings and actual cash flows.
- Net Operating Assets Trend
- Net operating assets exhibited a gradual increase from 16,241 million US dollars in 2018 to 17,007 million US dollars in 2019. A substantial expansion occurred in 2020, with assets rising to 20,711 million US dollars, before slightly contracting to 20,413 million US dollars by the end of 2021.
- Aggregate Accruals Performance
- Balance-sheet-based aggregate accruals remained relatively flat between 2018 and 2019, moving from 730 million to 766 million US dollars. However, 2020 experienced a sharp spike to 3,704 million US dollars. This trend reversed abruptly in 2021, as aggregate accruals shifted to a negative value of -298 million US dollars.
- Accruals Ratio Interpretation
- The accruals ratio remained consistent at approximately 4.6% during 2018 and 2019, suggesting a stable relationship between cash flows and accrual-based accounting. The ratio surged to 19.64% in 2020, indicating a significant increase in non-cash earnings relative to the asset base, which often suggests a decline in the immediate quality of earnings. By 2021, the ratio dropped to -1.45%, signaling that cash flows exceeded accrual-based earnings, effectively reversing the previous year's trend and indicating a high degree of cash-backed reporting for that period.
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Cash-Flow-Statement-Based Accruals Ratio
Waste Management Inc., cash flow statement computation of aggregate accruals
US$ in millions
Based on: 10-K (reporting date: 2021-12-31), 10-K (reporting date: 2020-12-31), 10-K (reporting date: 2019-12-31), 10-K (reporting date: 2018-12-31), 10-K (reporting date: 2017-12-31).
1 2021 Calculation
Cash-flow-statement-based accruals ratio = 100 × Cash-flow-statement-based aggregate accruals ÷ Avg. net operating assets
= 100 × -628 ÷ [(20,413 + 20,711) ÷ 2] = -3.05%
The analysis of aggregate accruals from 2018 to 2021 reveals significant volatility in the relationship between reported earnings and cash flow, characterized by a dramatic spike in 2020 followed by a reversal in 2021.
- Net Operating Assets Trend
- Net operating assets demonstrated a general upward trajectory over the period, increasing from US$ 16,241 million in 2018 to US$ 20,413 million in 2021. A notable expansion occurred in 2020, with assets rising to US$ 20,711 million, indicating a substantial growth in the operating asset base that remained largely stable into the following year.
- Aggregate Accruals Performance
- Cash-flow-statement-based aggregate accruals exhibited extreme fluctuations. Values remained relatively modest in 2018 (US$ 524 million) and 2019 (US$ 172 million), but surged to US$ 2,940 million in 2020. This trend reversed sharply in 2021, with aggregate accruals falling to negative US$ 628 million, signaling a fundamental shift in the composition of earnings relative to cash flow.
- Accruals Ratio and Reporting Quality
- The cash-flow-statement-based accruals ratio reflects a period of instability in earnings quality. The ratio was low and stable between 2018 and 2019, at 3.30% and 1.03% respectively, suggesting a close alignment between cash flow and reported profits. The sharp increase to 15.59% in 2020 indicates a significant divergence where accounting earnings far exceeded cash flows. The subsequent decline to -3.05% in 2021 indicates a transition to a state where cash flow exceeded reported earnings, often associated with a reversal of prior accruals or conservative accounting adjustments.
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