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Earnings announcements make great headlines. The numbers are quick and simple, and give an immediate image of success or failure.

Large companies such as General Electric ( GE) and Caterpillar ( CAT), which posted second-quarter earnings in the past five days, can skyrocket or get hammered if results beat or miss analysts' expectations by only a few cents a share. But that can be largely irrational when the quality of earnings is assessed.

There are many ways management can play with numbers to shape results. So-called early-revenue recognition and capitalization of costs that should be expensed are two examples. On the whole, these manipulations stem from something called accrual accounting, in which firms shift costs and revenue to better reflect the actual performance in a particular quarter.

An example of this would be a company dealing in magazine subscriptions. While customers will pay for a year's worth of magazines up front, the company won't provide the magazines until sometime in the future. Without accrual accounting, the resulting financial statements would look odd. All of the revenue from the subscription would appear on the income statement in the first quarter, while only one quarter's worth of costs would be charged against this revenue.

In the following quarter there would be no revenue, since it had been realized in the first quarter, but there would be another quarter's worth of expenses being charged against no revenue. This would result in a huge amount of volatility in earnings from quarter to quarter. To fix that, accrual accounting allows the company to split payments into two categories, regular revenue and unearned revenue, which will be slowly drawn down each quarter to match the costs associated with producing the product.

The accruals ratio can be used to detect the changes in these deferred items and, therefore, the degree to which earnings are the result of accounting adjustments. The calculation is simple and intuitive. The main aim of the accruals ratio is to determine the increase in accruals during the period, which will only require a couple of adjustments.

On the balance sheet, most entries are subject to accruals, except for cash and debt. So, to determine the change in accruals, we will need to remove cash from total assets and debt from total liabilities. After this adjustment, subtracting total liabilities from total assets will result in net operating accruals (NOA).

NOA = (total assets - cash) - (total liabilities - debt).

Since what we are really concerned with is the change in this number from quarter to quarter, we need to find the percentage change in NOA. This calculation can be written as follows:

Accruals ratio = (NOA Q2 - NOA Q1) /((NOA Q2 + NOA Q1)/2)

The result of this formula will be the percentage change in net operating accruals during the quarter. This number will vary widely for different companies in different industries. The key for analyzing this metric is to compare the company against its past. The following table shows the trends in both Caterpillar's and GE's accruals ratio.

Net Accruals Ratios
Q2 '09
Q1 '09
Q4 '08
Q3 '08
Q2 '08

In the case of General Electric, we can see that since the first quarter of last year, the company has been slowly wearing down its accruals. While this has been aided by the deterioration of the economy and likely impairment charges to the carrying value of some assets, it's still a positive signal since economic downturns are times when there is earnings manipulation in the form of early-revenue recognition or capitalizing of expenses. This fairly substantial reduction in accruals seems to mean the latest earnings are of high quality.

General Electric beat analysts' estimates of $0.23 per share by 3 cents. Investors should feel comfortable that General Electric's reported results show an accurate depiction of the company's activities during the past quarter.

General Electric hasn't performed well since its earnings announcement. However, the quality of the earnings and the fact that its price-to-earnings ratio of 12.1 is far below industrial stocks' average of 18.6 suggests that GE is an attractive buy since it's valued at a discount based on high-quality earnings.

Caterpillar has had a similar trend in accruals. Monday's earnings announcement sent the stock soaring as it more than tripled analysts' expectations. These results appear to be the real deal too, as net accruals fell in the quarter.

While these two examples show negative accruals ratios, it's not a red flag if the ratio turns positive. Controlled accruals are to be expected, but watch for aberrations where accruals jump. This signals accounting manipulation and could lead to poor performance in the future as the adjustments reverse.
Prior to joining Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level II CFA candidate.