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CFA Level II Exam · Integration of Financial Statement Analysis Techniques

Evaluating Earnings Quality and Accruals for CFA Level II

Updated 7 October 2026 · Fact-checked

Earnings quality is how well reported earnings reflect sustainable, repeatable performance backed by cash. To assess it, compare net income with operating cash flow, compute accrual ratios, check persistence, and scan for aggressive or conservative accounting. High accruals and weak cash conversion signal lower quality.

Understand Evaluating Earnings Quality and Accruals

Earnings are an accrual number. Revenue is recognised when earned, and expenses when incurred, not when cash moves. That is useful, but it gives managers room for judgement. Cash flow is harder to shape, so the gap between the two is informative.

Earnings quality has two sides. First, the reporting must be faithful: the numbers reflect real economics, with no aggressive choices. Second, the earnings must be sustainable: they come from the core business and are likely to recur. High-quality earnings are both. Low-quality earnings may be accurate but one-off, or recurring but overstated.

Accruals are the non-cash part of earnings. Total accruals = net income − cash flow from operations. A company with large positive accruals relative to its size is booking profit that has not yet turned into cash. That can be innocent, such as fast growth in receivables. It can also signal early revenue recognition, deferred expenses, or understated reserves. Accruals tend to reverse, so earnings built on them are usually less persistent.

Persistence means current earnings are a good predictor of future earnings. Cash-based earnings are generally more persistent than accrual-based ones. Analysts also separate operating from non-operating items and recurring from non-recurring ones.

Watch the direction of bias. Aggressive accounting increases reported earnings or the balance sheet position (higher assets, lower liabilities), for example through longer asset lives, lower reserves, or capitalising costs. It lowers quality and borrows from the future. Conservative accounting lowers current earnings, but it can also create low quality if it builds hidden reserves to release later, a practice called cookie jar reserves, which smooths income. Either direction can distort. Exam questions usually ask you to read the data and name the concern.

Key formulas to remember

Total accruals
Total accruals = Net income − Cash flow from operations (CFO)
The cash flow accrual ratio goes one step further and also subtracts cash flow from investing (NI − CFO − CFI). Use the version the question asks for.
Balance sheet accrual ratio
Accrual ratio (BS) = (NOAend − NOAbeg) ÷ Average NOA
NOA = operating assets − operating liabilities, where operating assets = total assets − cash and marketable securities, and operating liabilities = total liabilities − total debt. Average NOA = (NOAbeg + NOAend) ÷ 2. A rising ratio suggests lower quality.
Cash flow accrual ratio
Accrual ratio (CF) = (NI − CFO − CFI) ÷ Average NOA
CFI = cash flow from investing. It measures earnings not backed by operating or investing cash flow, so higher values mean more of earnings lacks cash support. Compare across years and peers.
Cash flow to income conversion
CFO ÷ Net income
A ratio persistently below 1 or falling suggests earnings may be overstated. Judge the trend and the cause.
Net operating assets
NOA = Operating assets − Operating liabilities
Same NOA as in the balance sheet ratio: operating assets are total assets less cash and marketable securities, and operating liabilities are total liabilities less total debt. It is the scaling base for both accrual ratios.

How to solve Evaluating Earnings Quality and Accruals questions

Use this sequence on any earnings quality item in a vignette.

  1. 1Read the question first, then find the income statement, balance sheet and cash flow data in the exhibits.
  2. 2Identify which measure is asked for: total accruals, balance sheet accrual ratio, cash flow accrual ratio, or CFO to net income.
  3. 3Compute NOA for each year-end if needed. Then take the average NOA for the cash flow ratio, or the change in NOA for the balance sheet ratio.
  4. 4Calculate the ratio carefully, with attention to sign. Positive accruals mean earnings exceed cash.
  5. 5Compare against prior years, the peer group, or any benchmark given. Trend and relative level matter more than one number.
  6. 6Look for the cause in the notes: receivables growth, inventory build-up, capitalised costs, changed estimates, or reserve releases.
  7. 7Conclude on direction: higher accruals and weak cash conversion point to lower quality and lower persistence.
  8. 8Check that your answer matches the option wording, such as aggressive versus conservative.

Quickest way: Three-check scan for earnings quality

When to use it: Use when the question asks which company has lower earnings quality or what the data suggest, and the time is short.

  1. Check CFO against net income: is CFO well below earnings, and is the gap widening?
  2. Check whether NOA is growing faster than sales or earnings, which raises the balance sheet accrual ratio.
  3. Check for a cause: receivables or inventory outpacing sales, lengthening asset lives, falling reserves, or one-off gains in income.
  4. Pick the option that matches the worse of the signals, and confirm that the sign and direction are right.

Common mistakes in Evaluating Earnings Quality and Accruals

  • Treating a low accrual ratio as always good or a high one as proof of manipulation.

    Students want a one-way rule.

    Fix: Say a high ratio is a warning to investigate. Growth businesses can have legitimate accruals.

  • Using ending NOA instead of average NOA in the cash flow accrual ratio.

    The two ratios have different numerators (the change in NOA for the balance sheet ratio, NI − CFO − CFI for the cash flow ratio), which makes students mix up the denominators. Both ratios use average NOA as the denominator.

    Fix: Follow the formula given in the vignette. Scale by average NOA unless told otherwise.

  • Getting the sign wrong when CFO exceeds net income.

    Students memorise NI − CFO without thinking about meaning.

    Fix: Negative accruals mean cash earnings exceed reported earnings. That is usually a positive sign, but check for conservatism or reserve building.

  • Assuming conservative accounting always means high quality.

    Conservative sounds safe.

    Fix: Understatement distorts too. Reserves built now and released later can smooth income and hide the true trend.

  • Forgetting sustainability when earnings are accurate.

    Students focus only on accounting choices.

    Fix: Ask whether the earnings come from core operations and will recur. One-off gains lower quality even if correctly reported.

Worked examples

Example 1

Vignette: Altara Corp reports net income of 180 million and cash flow from operations of 120 million for the year. Cash flow from investing is −90 million. Net operating assets were 900 million at the start of the year and 1,100 million at the end. Q1: What is the balance sheet accrual ratio? Q2: What is the cash flow accrual ratio? Q3: What does the pattern suggest?

Show the solution
  1. Q1: Change in NOA = 1,100 − 900 = 200. Average NOA = (900 + 1,100) ÷ 2 = 1,000.
  2. Balance sheet accrual ratio = 200 ÷ 1,000 = 20%.
  3. Q2: NI − CFO − CFI = 180 − 120 − (−90) = 150. Divide by average NOA 1,000: 150 ÷ 1,000 = 15%.
  4. Q3: NI − CFO = 180 − 120 = 60 million, so net income exceeds operating cash flow. The cash flow accrual measure equals NI minus cash from operating and investing activities. The 90 million of investing outflow is reinvestment into NOA, so it increases accruals to 150 million. The balance sheet ratio of 20% also shows NOA growing quickly. Both measures show positive accruals alongside fast NOA growth, so the pattern calls for investigation of the causes.

Answer: Q1: 20%. Q2: 15%. Q3: NI exceeds CFO by 60 million. The cash flow accrual measure subtracts both CFO and CFI, so the 90 million investing outflow (reinvestment into NOA) lifts accruals to 150 million. Positive accruals on both measures with fast NOA growth are a warning to investigate receivables, inventory, and capitalised costs, since earnings built on accruals tend to be less persistent.

Example 2

Vignette: Two peers, Brenner and Calder, have the same revenue growth. Brenner's CFO is 0.95 times net income, and the ratio is stable over three years. Calder's CFO fell from 1.0 times to 0.6 times net income over three years while receivables rose much faster than sales. Q1: Which company shows lower earnings quality? Q2: What is the likely accounting concern at Calder?

Show the solution
  1. Q1: Brenner's cash conversion is near 1 and stable, so earnings are backed by cash.
  2. Calder's conversion is falling from 1.0 to 0.6, so a growing share of earnings is non-cash.
  3. Q2: Receivables rising faster than sales suggests revenue may be recognised too early, sales may be on lenient credit terms, or collectability is overstated, such as an inadequate allowance.

Answer: Q1: Calder. Q2: Aggressive revenue recognition or an understated allowance for doubtful accounts, which would inflate current earnings.

Exam tips

  • Read the cash flow statement and the notes in every earnings quality item. The cause of the accrual gap is often there.
  • Know both accrual ratio formulas and their denominators. Questions often give NOA components and ask you to build NOA first.
  • Answer on direction. Many options differ only on aggressive versus conservative or higher versus lower quality.
  • Watch for non-recurring items in income. They affect sustainability even when the accounting is correct.
  • Show your arithmetic in the margin of your rough work and double-check signs, especially CFI.

Evaluating Earnings Quality and Accruals in other exams

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

Evaluating Earnings Quality and Accruals: frequently asked questions

What is a good accrual ratio?

There is no single cut-off. Lower and stable ratios generally indicate better quality. Compare to prior years and peers in the same industry, because growth firms naturally carry more accruals.

What is the difference between the balance sheet and cash flow accrual ratios?

The balance sheet ratio uses the change in net operating assets. The cash flow ratio uses net income minus CFO and CFI. Both are scaled by average NOA, and both signal how much of earnings is not backed by cash.

Does low earnings quality mean fraud?

No. It means reported earnings are less reliable or less sustainable. Causes include aggressive judgement, one-off gains, or real business changes. Fraud is only one possible explanation.

What are examples of indicators of low earnings quality?

Examples include CFO persistently below net income, receivables or inventory growing faster than sales, longer useful lives, shrinking reserves, frequent one-off gains, and large capitalised costs.