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Reporting & Earnings Qualityadvanced

Accruals and the Persistence of Earnings

Sloan (1996) showed that the accrual component of earnings is less persistent than the cash component. Earnings split into cash flow from operations plus accruals; profit driven by cash tends to recur, while profit driven by accruals tends to reverse. Firms with high accruals therefore see earnings fade, yet the market often fails to price this fully, the accrual anomaly. For a risk analyst the lesson is direct: a high ratio of accruals to earnings is a quantitative signal of lower earnings quality and a higher chance of disappointing results ahead.

Why it matters

Cash in the bank is hard to fake and tends to come back next year; an accrual is a promise or an estimate, and promises have a way of unwinding. Sloan's insight is that the two halves of profit have different shelf lives. A dollar of cash earnings is worth more, for forecasting, than a dollar of accrual earnings because the accrual dollar is more likely to reverse. So when you see profit leaning heavily on accruals, you should expect mean-reversion and mark down both the quality and the reliability of that earnings number.

Formulas

Earnings decomposition
Earnings=CFO+Accruals\text{Earnings} = \text{CFO} + \text{Accruals}
Accounting profit equals operating cash flow plus the accrual component. Accruals can be measured directly as net income minus CFO.
Earnings persistence regression
Et+1=α+β1 CFOt+β2 Accrualst+εt+1E_{t+1} = \alpha + \beta_1\,\text{CFO}_t + \beta_2\,\text{Accruals}_t + \varepsilon_{t+1}
Sloan finds β1>β2\beta_1 > \beta_2: the cash component predicts next-period earnings more strongly than the accrual component, so accrual-heavy earnings are less persistent.

Worked examples

Scenario

Two firms report the same US$100m earnings. Firm X has CFO of US$90m and accruals of US$10m; Firm Y has CFO of US$40m and accruals of US$60m. Using Sloan's finding, which firm's earnings are more likely to persist?

Solution

Firm X. Because the cash component is more persistent than the accrual component (β1>β2\beta_1 > \beta_2), X's mostly-cash profit is more likely to recur, while Y's accrual-heavy profit is more prone to reverse next period. Same reported earnings, but Y has lower earnings quality and a higher risk of a downward surprise. The accrual anomaly means the market may not have fully discounted Y's weaker outlook.

Common mistakes

  • ✗A dollar of accrual earnings is worth the same as a dollar of cash earnings. Sloan showed the cash component is more persistent, so for forecasting the two dollars are not equivalent.
  • ✗High accruals always mean fraud. High accruals lower earnings quality and predict reversal, but they can arise from legitimate growth and estimates; they are a quality signal, not proof of manipulation.
  • ✗Markets instantly price the lower persistence of accruals. The accrual anomaly is precisely the finding that prices often underweight this, so accrual-heavy firms can be systematically over-valued for a time.
  • ✗Accruals are just an abstract accounting artefact. Accruals equal the gap between reported profit and cash collected, a concrete and forecastable driver of future earnings.

Revision bullets

  • •Earnings = CFO + accruals; accruals = net income − CFO
  • •Sloan (1996): the cash component is more persistent than accruals
  • •Accrual-heavy earnings tend to reverse and fade
  • •Persistence regression finds β1>β2\beta_1 > \beta_2 (cash beats accruals)
  • •High accruals signal lower earnings quality (the accrual anomaly)

Quick check

Sloan (1996) found that, relative to the cash component of earnings, the accrual component is

Two firms report identical earnings, but one is mostly cash and the other mostly accruals. The accruals-heavy firm has

Connected topics

Reporting vs EarningsEarnings ManagementRed FlagsBeneish M-Score

Sources

  1. Sloan (1996)
    Sloan, R. G. "Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?" The Accounting Review 71, no. 3 (1996): 289-315.
    Establishes that accruals are less persistent than cash flows and documents the accrual anomaly.
  2. CFA Program, Financial Reporting Quality
    CFA Institute. "Financial Reporting Quality." CFA Program Curriculum, Financial Statement Analysis. CFA Institute.
    Discusses accruals quality and the cash-versus-accrual persistence of earnings.
How to cite this page
Dr. Phil's Quant Lab. (2026). Accruals and the Persistence of Earnings. Derivatives Atlas. https://phucnguyenvan.com/concept/frm-accruals-persistence
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