Lesson A2.2 · 2 of 5 · Creative accounting
What are accruals and how do estimates shift reported profit
Accruals are the part of profit that has not turned into cash yet: sales not collected, costs paid in a different year, and estimates such as depreciation or provisions. Richard Sloan showed in 1996 that profit built mostly on accruals holds up less well than profit backed by cash, and that share prices did not fully allow for it.
Terms in this lesson
- Sloan ratio
- How much of profit is only on paper and has not arrived as cash yet.
- Cash conversion
- How much of the accounting profit actually lands in the bank as cash.
- Net income
- What is left for shareholders after all costs, interest and tax.
- Cash flow statement
- The money that actually came into and went out of the bank account over a period.
What are accruals in accounting
Definition
Why is profit not the same as cash?
Accruals = net profit - operating cash flow
Accounts record revenue when it is earned and costs when they are incurred, not when money changes hands. Say a company delivers $10m of goods in December on 60-day terms. December’s profit includes the sale; the cash arrives in February. The gap between profit and cash is the accruals. Sloan measured them from the balance sheet: the change in non-cash current assets, less the change in current liabilities (excluding short-term debt and tax payable), less depreciation, all divided by average total assets.
Profit rises now, the cash comes later. If it comes.
The longer a company reckons a machine will last, the lower the yearly charge.
Warranties, lawsuits, restructuring: the amount set aside is management’s estimate.
The rest of this lesson is in the subscription
The subscription unlocks every chapter of Intermediate, Trading school, Investor psychology and Advanced, with their exercises and unlimited reviews.
Create a free accountWhat Sloan (1996) found about accruals
Richard Sloan published his study in July 1996 in The Accounting Review. He used 40,679 firm-year observations from the NYSE and AMEX between 1962 and 1991, leaving out banks and insurers. Two findings. First, profit that comes from accruals persists less in later years than profit that comes from cash. Second, share prices behave as if investors “fixate” on total profit without seeing what it is made of.
Size-adjusted annual return of the portfolio buying the lowest-accrual companies and shorting the highest-accrual ones in Sloan (1996): 10.4% in year one, 4.8% in year two and 2.9% in year three, the last not statistically significant.
Sloan ranked companies into ten groups by accruals. A portfolio buying the lowest-accrual group and shorting the highest earned, over and above companies of the same size, 10.4% in the first year, 4.8% in the second and 2.9% in the third, the last not statistically significant. More than 40% of these returns came in the days around the following quarterly earnings announcements. These are historical results on US shares, not a promise.
The estimates that move profit: depreciation, provisions, revenue
Real case
How much can one estimate be worth?
Alphabet stretched the useful life of its servers from 4 to 6 years: 2023 depreciation fell by $3.9bn and net income rose by $3.0bn.
The company set this out in its results release of 30 January 2024: in January 2023 it reassessed the useful lives of its servers (from four years to six) and some network equipment (from five to six), effective from 2023. Net income for 2023 was $73,795m, so the change supplied about 4% of it. Depreciation of property and equipment fell from $13,475m to $11,946m even though capital spending went up. It is a permitted, disclosed change, not fraud: it simply shows how much rides on an assumption you only see in the notes.
Provisions work the same way: the company estimates what warranties, lawsuits or a restructuring will cost. A smaller provision today means higher profit today. A very large provision in an already weak year, released later in good years, shifts profit from one year to another. Impairments (writing down assets such as goodwill) also rest on management’s assumptions about the future.
Definition
When is revenue recognised?
IFRS 15, issued in May 2014 and applied from 1 January 2018, has five steps. In the US the matching rules sit in ASC 606.
The steps: identify the contract with the customer; identify the performance obligations in it; determine the transaction price; allocate the price to each obligation; recognise revenue when an obligation is satisfied. Estimates come in mainly at step 3 (discounts, returns, variable bonuses) and step 5 (revenue at a point in time or as the work progresses). Two companies with the same contracts can show different revenue in a quarter depending on those estimates.
How to compare profit with cash: the accruals ratio
Definition
How do you measure how much of profit is estimates?
Accruals ratio = (net profit - operating cash flow) ÷ average total assets × 100
Dividing by assets lets you compare large and small companies. Large and positive means profit with little cash behind it. Negative is normal for asset-heavy businesses: depreciation reduces profit but takes no cash out. A common variant, the Sloan ratio, also takes investing cash flow away from profit. Watch the trend over several years, not a single year.
Lessons are educational. They are not a recommendation to buy or sell. Investing involves risk and you can lose money. Sources: R. G. Sloan, “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?”, The Accounting Review, vol. 71, no. 3, July 1996, pp. 289-315 (sample, accruals definition, persistence, table 6); IFRS Foundation, IFRS 15 summary (the five steps, issued May 2014, effective 1 January 2018, Topic 606); Alphabet, results release of 30 January 2024 (Form 8-K, SEC EDGAR); Boeing, 2025 10-K annual report (SEC EDGAR); our calculations.