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CFA Level I Exam · Financial Reporting Quality

Earnings Quality and Accrual Measures for CFA Level I

Updated 7 October 2026 · Fact-checked

Earnings quality is high when earnings are sustainable and adequate to cover the company's cost of capital. You assess it by comparing earnings with cash flow. The accruals ratio divides accruals by average net operating assets (balance sheet method) or uses net income minus CFO minus CFI (cash flow method). Lower accruals suggest higher quality.

Understand Earnings Quality and Accrual Measures

Start with a simple idea. Reported earnings are not cash. They include accruals: revenue booked before cash arrives, and expenses booked before or after cash leaves. Accruals are normal. But large or growing accruals can mean earnings are being pushed up by accounting choices rather than by real business performance.

The CFA curriculum treats earnings quality as having two parts. First, earnings must be sustainable: they are likely to recur in future periods. Second, they must provide an adequate return: the company earns more than its cost of capital. High-quality earnings are both. Earnings that come from one-off gains, or that fall short of the cost of capital, are lower quality even if GAAP-compliant or IFRS-compliant.

Keep two ideas apart. Reporting quality is about how decision-useful the reporting is (faithful, complete, neutral). Earnings quality is about the level and sustainability of results. High reporting quality is needed for high earnings quality, but you can have high reporting quality with low earnings quality, for example a firm that honestly reports poor, unsustainable earnings. Low reporting quality makes earnings quality hard or impossible to judge.

Accrual measures give a numerical check. The logic: net income = cash flow + accruals. If earnings rise because accruals rise, and cash flow does not follow, earnings are less likely to persist. A company whose net income is consistently above operating cash flow deserves scrutiny.

There are two ways to measure accruals. The balance sheet method uses the change in net operating assets (NOA). The cash flow method takes net income minus CFO minus CFI (using signed values). Both are then scaled by average NOA to give the accruals ratio. A high positive ratio is a warning sign; a ratio near zero or negative suggests higher quality. It is a signal, not proof of manipulation.

Key formulas to remember

Net operating assets (NOA)
NOA = Operating assets − Operating liabilities = (Total assets − Cash and marketable securities) − (Total liabilities − Total debt)
Operating assets exclude cash and marketable securities. Operating liabilities exclude financial debt.
Aggregate accruals (balance sheet method)
Aggregate accruals = NOA(end) − NOA(beginning)
A rise in NOA means that earnings were not matched by cash flows, i.e. a larger share of earnings is in the form of accruals.
Aggregate accruals (cash flow method)
Aggregate accruals = Net income − CFO − CFI
Use the cash flow statement. Outflows in CFI are negative numbers, so subtract the signed value.
Accruals ratio
Accruals ratio = Aggregate accruals ÷ Average NOA
Average NOA = (NOA beginning + NOA end) ÷ 2. Higher means lower earnings quality.
Cash flow to earnings comparison
Cash flow ratio = CFO ÷ Net income
A persistently low or falling ratio is a warning sign. Compare over several periods.
Earnings quality test
High quality = Sustainable earnings + Adequate return (above cost of capital)
Both conditions are needed.

How to solve Earnings Quality and Accrual Measures questions

Use this method for any question on earnings quality or accruals.

  1. 1Identify what is asked: a concept (sustainable, adequate, reporting vs earnings quality) or a calculation (accruals, accruals ratio).
  2. 2For concept questions, test the item against two tests: will it recur, and is the return above the cost of capital?
  3. 3For calculations, choose the method given. Balance sheet method: build NOA at both dates. Cash flow method: take net income − CFO − CFI.
  4. 4Compute aggregate accruals and keep the sign. Subtract signed CFI values carefully.
  5. 5Compute average NOA as the mean of beginning and end NOA, then divide accruals by it.
  6. 6Interpret: a higher ratio means lower quality; a low or negative ratio means higher quality.
  7. 7Check which answer option matches your number and your interpretation. Eliminate options with the wrong direction.

Quickest way: Direction-first elimination

When to use it: Use when a question asks which company or year has the highest earnings quality, or when the numbers are heavy.

  1. Decide the direction first: lower accruals ratio means higher earnings quality.
  2. For ranking questions, compute only the ratio, not extra detail, for each option.
  3. For cash flow method, do NI − CFO − CFI in one pass on the calculator.
  4. If two options remain, check the sign of CFI; sign errors are the usual trap.
  5. For concept items, pick the choice that mentions both sustainability and adequacy of return.

Common mistakes in Earnings Quality and Accrual Measures

  • Using total assets instead of net operating assets as the denominator.

    Students know the ratio idea but forget cash and debt are excluded.

    Fix: Remove cash and marketable securities from assets, and remove financial debt from liabilities, before using NOA.

  • Dividing by ending NOA rather than average NOA.

    It saves a step and looks similar.

    Fix: Always average beginning and ending NOA unless the question says otherwise.

  • Getting the sign of CFI wrong in the cash flow method.

    CFI is usually negative, and students subtract its absolute value.

    Fix: Subtract the signed number. If CFI is −50, then NI − CFO − CFI = NI − CFO − (−50) = NI − CFO + 50.

  • Treating a high accruals ratio as proof of manipulation.

    Students overread a warning sign.

    Fix: Say it signals lower earnings quality and calls for investigation, since growth also raises accruals.

  • Confusing reporting quality with earnings quality.

    The terms sound alike.

    Fix: Reporting quality is about the information; earnings quality is about sustainability and adequate return. Good reporting can show poor earnings.

Worked examples

Example 1

A company has net operating assets of $400 million at the start of the year and $460 million at the end. Net income is $90 million. Using the balance sheet method, what is the accruals ratio? Options: A) 7.0%, B) 14.0%, C) 15.0%

Show the solution
  1. Aggregate accruals = 460 − 400 = $60 million.
  2. Average NOA = (400 + 460) ÷ 2 = $430 million.
  3. Accruals ratio = 60 ÷ 430 = 0.1395, or about 14.0%.
  4. Net income of $90 million is not needed for the balance sheet method. It is extra information. Option A (7.0%) comes from dividing by the sum of the two NOA figures (400 + 460 = 860) without halving: 60 ÷ 860 = 6.98%, about 7.0%. Option C (15.0%) comes from dividing by beginning NOA: 60 ÷ 400 = 15.0%. Both are traps.

Answer: B) 14.0%. A higher ratio signals lower earnings quality.

Example 2

A firm reports net income of €120 million, cash flow from operations of €80 million and cash flow from investing of −€50 million. Average NOA is €500 million. Using the cash flow method, what is the accruals ratio? Options: A) −2.0%, B) 8.0%, C) 18.0%

Show the solution
  1. Aggregate accruals = NI − CFO − CFI = 120 − 80 − (−50).
  2. = 120 − 80 + 50 = €90 million.
  3. Accruals ratio = 90 ÷ 500 = 0.18, or 18.0%.
  4. Ignoring the CFI sign gives 120 − 80 − 50 = −10, so −10 ÷ 500 = −2.0%. That is option A. Ignoring CFI altogether gives 120 − 80 = 40, so 40 ÷ 500 = 8.0%. That is option B. Only 18.0% follows from the formula.

Answer: C) 18.0%. The ratio is high, so earnings quality is a concern and needs investigation.

Exam tips

  • Questions are often three-option conceptual items: pick the answer that links earnings quality to both sustainability and adequate return.
  • In calculations, the wrong options usually come from using beginning NOA or flipping the CFI sign. Check both before answering.
  • Remember the direction: higher accruals ratio means lower quality. Many items test only this.
  • Do not choose answers that say high accruals prove fraud or manipulation; the correct wording is a warning sign.
  • Be ready to separate reporting quality from earnings quality in a one-line definition.

Practice questions from Financial Reporting Quality

Earnings Quality and Accrual Measures in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Earnings Quality and Accrual Measures: frequently asked questions

What is the accruals ratio formula in the CFA Level I curriculum?

Accruals ratio = aggregate accruals ÷ average net operating assets. Aggregate accruals can come from the change in NOA (balance sheet method) or from net income − CFO − CFI (cash flow method). A higher ratio points to lower earnings quality.

What is the difference between sustainable and adequate earnings?

Sustainable earnings are likely to recur in future periods. Adequate earnings give a return above the company's cost of capital. High earnings quality needs both.

Do the balance sheet and cash flow methods give the same answer?

In theory they are linked, but in practice they can differ because of acquisitions, disposals and currency effects. In an exam, use the method the question names and the data it provides.

Is a high accruals ratio always a sign of earnings manipulation?

No. It is a warning sign that earnings are less backed by cash. Fast growth can also raise accruals, so an analyst investigates further before drawing a conclusion.