What is the Sloan accrual ratio, and how does it help analysts assess earnings quality?

The Sloan accrual ratio (named after Professor Richard Sloan's 1996 research) measures the proportion of a company's earnings that comes from accruals rather than cash. Higher accrual ratios indicate potentially lower earnings quality because accruals involve more estimation, judgment, and potential for manipulation.

The Core Insight:

Earnings = Cash component + Accrual component

Cash-based earnings tend to persist into future periods (recurring, reliable). Accrual-based earnings tend to reverse (they represent timing differences that eventually unwind). Companies with high accrual ratios often see future earnings declines.

Calculation — Two Approaches:

Balance Sheet Approach:

Accruals = (ΔNon-Cash Current Assets − ΔCurrent Liabilities excl. short-term debt − Depreciation)

Or more simply:

Accruals = Net Income − Cash Flow from Operations − Cash Flow from Investing

Then:

Sloan Accrual Ratio = Accruals / Average Total Assets

Cash Flow Statement Approach (simpler):

Accrual Ratio (CF) = (Net Income − CFO) / Average Total Assets

Worked Example — Pineridge Corp:

Method 1: Simple accrual ratio (using CFO)

Accruals = $18,500,000 − $9,200,000 = $9,300,000

Average total assets = ($142M + $128M) / 2 = $135,000,000

Accrual ratio = $9,300,000 / $135,000,000 = 6.89%

Method 2: Aggregate accruals (using CFO + CFI)

Accruals = $18,500,000 − $9,200,000 − (−$7,800,000) = $18,500,000 − $1,400,000 = $17,100,000

Accrual ratio = $17,100,000 / $135,000,000 = 12.67%

Interpretation Guidelines:

Pineridge's 6.89% (simple) is moderate, but the 12.67% aggregate ratio warrants investigation — it could indicate large capitalized costs or aggressive revenue recognition.

What Drives High Accrual Ratios?

1. Revenue recognition — recognizing revenue before cash is collected
2. Capitalization policies — capitalizing costs that should be expensed
3. Working capital management — building inventory, stretching payables
4. Provision reversals — releasing previously accrued liabilities
5. Fair value gains — unrealized gains on financial instruments

Key Exam Points:

1. Lower accrual ratio = higher earnings quality.
2. The ratio measures the divergence between reported income and cash generation.
3. Sloan's research showed high-accrual companies underperform low-accrual companies over subsequent periods (accrual anomaly).
4. Best used in cross-sectional comparison (vs. industry peers) and time-series analysis (vs. company's own history).

Explore earnings quality metrics in our CFA Level II FRA course.