skills/full-company-analysis/references/modules/M022-accrual-and-cash-conversion-tests.md

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<!-- Module: 022 | Title: Accrual and Cash Conversion Tests -->

## PART V - FORENSIC ACCOUNTING | MODULE 022

# Accrual and Cash Conversion Tests

> Mission. Use accrual ratios, CFO versus net income, working-capital patterns, and multi-year normalization.

## Decision output

Objective: Use accrual ratios, CFO versus net income, working-capital patterns, and multi-year normalization. The completed work product must be reproducible from evidence, show the downstream financial or decision effect when material, state the strongest contrary case, and define a dated update rule.

## Explicit operating procedure

1. Calculate CFO/net income, accrual proxies, working-capital components, and multi-year cumulative earnings versus cash flow using consistent definitions.

1. Decompose CFO changes into underlying profit, receivables, inventory, payables, deferred revenue/customer advances, taxes, restructuring, and other operating balances.

1. Use average assets or another consistent scale when comparing accrual intensity and recognize that high-growth or subscription models can have structurally different working capital.

1. Test persistence across at least twelve quarters and a business cycle before labeling a divergence abnormal.

1. Investigate factoring, supplier finance, classification changes, acquisitions, and one-time working-capital releases that can mechanically improve cash conversion.

1. Normalize valuation cash flow only after explaining the causal source of the accrual/cash gap.

## Required evidence and model bridge

- Primary-source set: multi-year statements, auditor reports, non-GAAP reconciliations, reserve disclosures, filing changes. Preserve exact document/version, date, period, and source location for every material factual input used in accrual and cash conversion tests.

- For each key concept - total accruals, working-capital accruals, reversals, acquisitions, supplier finance, factoring - state whether it is a reported fact, analyst calculation, management claim, external estimate, or judgment. Quantitative concepts must retain raw components and units; qualitative concepts must retain the specific evidence and counterevidence.

- Map only economically relevant findings into the model or decision record. Process-control modules such as accrual and cash conversion tests may have no direct valuation line; in that case document the downstream error or governance risk the control prevents.

## Metrics and calculation controls

| Metric / concept | Construction | Required validation |
| --- | --- | --- |
| net income minus CFO scaled by assets | (Net income - cash flow from operations) divided by average total assets; positive values indicate accruals exceeding operating cash generation. | net income minus CFO scaled by assets: Tie the dollar measure to filed statements/footnotes; reconcile classification adjustments, one-time items, acquisitions/FX, and period consistency before using it analytically. |
| CFO/NI | Cash flow from operations divided by net income over the same period; evaluate over multiple years to reduce working-capital timing noise. | CFO/NI: Recalculate independently from cited source data; verify definition, period, units, scope, signs, and any reconciliation to reported financial or operating totals. |
| working-capital accrual ratios | Total accruals proxy = net income - cash flow from operations; scale consistently, commonly by average assets | working-capital accrual ratios: Recalculate working-capital accrual ratios from cited inputs; reconcile definition, period, units, signs, and source version; investigate and document any variance before use. |



## Accrual and cash-conversion laboratory

- Calculate multi-year CFO/net income, total accrual proxy, DSO, inventory days, DPO, and cash conversion cycle. Flag only persistent or causally unexplained divergences.

- When CFO improves, decompose the improvement into earnings, receivables, inventory, payables, deferred revenue, tax, and other working-capital movements. Supplier or customer financing can make CFO temporarily flattering.

- Compare the same analysis with at least two peers because business-model structure determines normal accrual intensity.

## Worked application

> Case: inventory builds before a launch and must be validated by later sell-through.

- Reconstruct the relevant reported fact from primary evidence before interpreting the case. For accrual and cash conversion tests, show the raw components rather than only the resulting ratio or narrative.

- Build the causal chain through total accruals, working-capital accruals, reversals, acquisitions, then identify which link is directly observed and which link remains an assumption.

- Calculate net income minus CFO scaled by assets, CFO/NI, working-capital accrual ratios from sourced components under the reported/base interpretation and at least one skeptical alternative interpretation.

- Translate the difference between cases into the variable that matters for accrual and cash conversion tests: evidence quality, revenue, operating profit/NOPAT, free cash flow, invested capital, financing/dilution, risk, or valuation. Mark non-applicable links instead of inventing them.

- Expert consistency test: use accrual screens as prompts for account-level investigation, never as standalone accusations.

- Precommit the specific future filing, KPI, customer/supplier observation, regulator action, or market input that would materially invalidate the accrual and cash conversion tests conclusion.

## Failure tests

- FAIL if total accruals cannot be defined and reproduced from the source pack.

- FAIL if an accrual signal is labeled aggressive or benign without identifying the balance-sheet accounts, economic driver, reversal pattern, and cash consequence.

- FAIL if the accrual and cash conversion tests conclusion depends on an unstated assumption, unreconciled definition, or evidence that cannot be traced to its source/version.

- FAIL if evidence materially inconsistent with the accrual and cash conversion tests conclusion is omitted, reclassified, or dismissed without a documented definition, materiality, causal, timing, and source-quality analysis.

## Completion test

A senior reviewer must be able to reproduce the accrual and cash conversion tests conclusion, vary the most sensitive assumption independently, trace the change through the model, understand the strongest opposing case, and identify the next evidence that would force an update. If any link is missing, the module remains open.