Visit this link to learn more about this premium newsletter.

Published: June 14, 2005

Nearly all followers of the stock market, from the novice investor to the seasoned analyst, are well aware that earnings exert a major influence on share price movements. Arguably, no other single financial metric has such a direct impact on prices. Given that earnings are undoubtedly the most closely monitored financial statistic, financial news stories often lead with a discussion about a company’s earnings. Are they up, down, below expectations, above expectations, accelerating or decelerating? The media has falsely created the impression that this one figure alone should dictate our buy/sell decisions.

How often have you heard that investors should buy when P/E ratios are low and sell when they are high? Astute investors realize that this simplistic advice should be ignored, as it is superficial at best and can often be dangerous. Admittedly, a company’s profits are important, but they are only one component of the bigger picture.

It is interesting to note that several studies have proven that there is actually an inverse relationship between earnings growth and share price movements. One such study examined 65 years of earnings data for S&P companies and discovered that during 22 years of declining earnings, the market managed to gain an average of +14.2% annually. It may seem counterintuitive that the market can rally while earnings are falling, but clearly there are other factors involved. Consider also, that during the remaining 43 years, the S&P only managed to eke out a modest +4.9% annual return.

I believe that part of the inverse relationship between earnings and stock prices can be explained by the quality of reported earnings. Undoubtedly, some earnings are of higher quality than others (more on this topic later), and a firm with growth fueled by questionable earnings will inevitably falter. Initially, these types of firms may appear to be financially sound, but ultimately this illusion will quickly unwind, revealing the much bleaker condition that truly exists.

The purpose of today’s article is two-fold. First, I will shed some light on the income statement itself and will discuss why the numbers it contains should sometimes be viewed with skepticism. Also, I will outline several analytical techniques that you can use to spot accounting tricks and avoid potential investing mistakes.

Don’t believe everything you read:

The income statement, also called the profit and loss statement (P&L), is the financial statement that details a company’s sales and earnings. Although these financial measures are unquestionably the most widely reported of all figures, it is critical for investors to approach this particular report with a healthy degree of skepticism. The data reported on the income statement is the most closely scrutinized, and is thus subject to possible manipulation.

The majority of the investing public has little interest for financial results other than sales and earnings. Imagine how quickly many television viewers would change the channel if financial commentators went into a detailed discussion about operating margins, balance sheet data, or free cash flows!

This shortsightedness is good news for us, because the more diligent investor is willing to conduct the necessary analytical work that is typically neglected by the media and the casual investor. In other words, those willing to dig deeper can often capitalize on the public’s ignorance. By breaking down the income statement and discussing why it should be viewed with skepticism, I hope to provide you with a reliable means of distinguishing between profitable new investments and disasters waiting to happen.

Revenues:

The importance of revenue growth is well understood by everyone. The common business clich� take care of the top line and the bottom line will take care of itself sums up the critical role that healthy revenue growth plays. However, given its importance, it should come as no surprise that a company’s top line is often subject to manipulation.

There are several categories of misstated revenue figures. These range from revenue recorded in the wrong period to poor quality to outright fraud. According to GAAP (Generally Accepted Accounting Principles), revenue must first be earned before it can be recorded. The problem is that many sales are far from final, but are instead contingent on future actions, such as the delivery of equipment or the implementation of new software.

Out of desperation to meet Wall Street expectations, some companies will record certain sales as having been booked in the current period, even though the necessary work may not be completed until the next period. In fact, firms such as Sunbeam have even gone a step further and made side agreements with customers to accept product deliveries prematurely, whereby products are shipped out to a warehouse with the right to refuse the shipment. This questionable practice allowed Sunbeam to fool auditors and the public into believing that the sale was a legitimate transaction recorded in the current period. These side agreements and related party transactions are not financially substantive, but rather a method used to boost current sales and avoid having to report poor results.

Another similar tactic is for management to temporarily extend deep discounts to encourage customers to make early purchases of products that wouldn’t otherwise be needed until a later date. This can be used to help disguise a decline in demand and allow insiders sufficient time to unload their stock before the public is made aware of the sales slowdown.

Another deceptive move is for a company to relax its credit requirements to increase sales. This aggressive sales practice may lead to revenues that will eventually need to be written off as bad debt.

Finally, an unexpectedly large order or a temporary spike in demand may tempt some firms to hold back or increase reserves unnecessarily in an effort to give the appearance of steadily improving business conditions.

The tremendous pressure to report solid sales figures may cause some companies to bend accounting standards. As a result, IBM, Informix, Sunbeam, Xerox and many others have been found guilty of one of the above practices. Note — In the analysis below, as well as in future educational articles, I will cover some specific analytical techniques designed to help investors spot these manipulative practices and uncover companies with poor earnings quality.

Expenses:

At times, companies will deliberately understate expenses on the income statement, thereby overstating net income. The reasons for this are obvious. For one thing, many executive bonus plans are tied to solid earnings growth.

So, how is this accomplished, and what should investors look for?

To begin, there is an important GAAP guideline — known as the matching principle — which requires companies to match expenses with the corresponding reported revenues. Many companies will ignore this requirement and will defer recording current expenses by capitalizing normal operating expenses as assets. This technique temporarily boosts current earnings. Recent examples of companies that have incorrectly recorded expenses as assets include WorldCom, Enron, AOL, and Cendant — all with disastrous results.

In some cases, companies will include soft assets in the current asset section of the balance sheet and will label them prepaid expenses. Other assets may hide expenses such as marketing, advertising, and other normal operating expenses. AOL was caught booking all of its marketing expenses as assets to be amortized over a period of time, which gave the false appearance of improved earnings.

R&D and software costs are also frequent favorites for companies to hide as assets on the balance sheet. For example, companies may sometimes implement large software packages and use the project to hide expenses by capitalizing them as assets. By doing this, the costs related to the project incorrectly remain on the balance sheet. Items such as training costs, consulting fees, and failed projects are often amortized beyond the useful life of the asset, even though GAAP requires the expensing of many of these related costs.

In other cases, impaired assets are kept on the balance sheet long beyond their useful life to avoid the charge to the bottom line. For example, inventory and receivables are subject to manipulation — companies often keep obsolete inventory on the balance sheet or over-inflate their receivables by not taking sufficient reserves for uncollectable accounts. Ultimately, these obsolete assets will be expensed at some point in the future and the stock will likely take a hit from the unexpected charges.

Another area of concern is one-time gains generated from the sale of a company’s indirect assets. For example, real estate sales can sometimes be used to hide deteriorating operating results. Often, gains from the sale of these non-core assets will find their way into normal operating income, misleading investors about the company’s true health.

Companies also often use one-time charges related to acquisition costs, goodwill write-offs or restructuring expenses in order to recognize future expenses in the current period. This technique allows companies to improve future earnings and give the appearance of improving business conditions and operating results. Investors often ignore these one-time events and management takes advantage of this opportunity to hide many of their current and future mistakes.

Finally, another technique used to improve earnings is to ignore normal month-end accruals for important expenses such as insurance, real estate taxes, interest or in some cases even advertising.

Analytical Techniques to Detect Trouble:

So, as you can see, there are many ways management can distort the earnings picture. The methods and tricks are too numerous and complex to list in this article. Of greater importance is learning how to spot poor earnings quality. Because every financial transaction eventually finds its way on to the balance sheet, I usually use this statement to verify the integrity of the data found on the income statement. If necessary, I will also occasionally turn to the cash flow statement.

There are several telltale signs that indicate potential future problems. One of the first things I look for is a disproportionate growth in receivables relative to sales. A pattern of receivables that rise significantly faster than sales may be indicative of aggressive revenue recognition. It might also reveal the implementation of lower credit standards as a ploy to capture less creditworthy customers.

In my regular analysis, I also keep an eye on bad debt reserves in relation to receivables. If they are not keeping pace, then investors should be concerned about a possible understatement of uncollectable accounts.

It is also critical that cash flow from operations not lag behind net income for an extended period of time. Whenever a company is not collecting the cash related to its reported earnings, then it calls into question the quality of those earnings.

Days sales outstanding (DSO) is a ratio used to measure the average length of time that a firm’s receivables are outstanding. To calculate this figure, simply take a company’s accounts receivable balance for the end of a certain time period and divide that figure by average sales per day during the same period. If DSOs are increasing, then in most cases the company should book a similar increase in bad debt reserves. If it doesn’t, then that could serve as an important warning sign.

Expenses related to depreciation are another variable that is very easy to manipulate. To do so, a company simply needs to extend the life of an asset or change the depreciation method it uses. If accumulated depreciation is declining as fixed assets are rising, then the corresponding depreciation expense for the fixed asset balance may be insufficient.

Likewise, amortization expenses are also easy to manipulate. Review the goodwill balance and check to make sure the company’s amortization expense is keeping pace with the increase in goodwill.

Investors should also carefully monitor changes in inventory balances, as they can yield important clues. If inventory is growing relative to other items — such as sales, cost of sales or accounts payable — then this is a good indication that the firm’s inventory may be obsolete. Inventory reserves should keep pace with the growing inventory balance. If you see a significant drop in inventory reserves, then this is likely an attempt to artificially increase earnings by reversing the previously recognized inventory related expense.

Finally, you’ll want to take a close look at prepaid expenses and other assets and make sure these account balances are not increasing substantially with respect to total assets. These accounts have notorious served as hiding places for normal operating expenses like maintenance, marketing or insurance costs. Unstable cost of goods sold percentages should raise concerns about the correct accounting for this critical line item. When you see a sharp decline in operating expenses or selling, general and administrative (SG&A) expenses, you should cross-check this against the balance sheet in search of an unusually sharp spike in soft assets like prepaid or other assets. This is where improper capitalizing of normal operating costs is often captured.

Common Size Analysis:

Common size analysis is another important tool that investors can use to spot problems in a firm’s income statement. This technique can be broken down into two distinct methods: vertical and horizontal.

With vertical analysis, all line items on the income statement are expressed as a percentage of net sales and balance sheet accounts are represented as a percentage of total assets or liabilities. A close examination will allow someone to quickly find problematic component changes in a firm’s income statement or balance sheet over a period of time. For example, if cost of goods sold was 50% of sales over a given period and this number suddenly dropped to 30%, then the change should raise concerns. As another example, if inventory that historically represented 15% of total assets unexpectedly jumped to 25%, then investors should start asking management some tough questions. Has obsolete inventory been correctly recognized and written off as an expense? Is cost of goods sold being correctly valued, or has it been understated by an artificially high inventory balance? In general, the percentages for most of the accounts should remain stable over time. Sudden shifts should raise warning flags, or at least be investigated further.

Horizontal analysis looks at trends over time. A specific year is designated the base year, and percentage changes in later years are then calculated. For example, if sales are growing at 25%, yet selling expenses have remained stable along with cost of sales, then you may want to review the firm’s balance sheet to see if expenses are being hidden.

This technique has many useful applications. For example, when receivables start to represent a much larger percentage of total assets, this could raise concerns over earnings quality. Quality could also be called into question if cash suddenly became a smaller percentage of total assets while earnings were on the rise. Significant improvements in SG&A relative to sales may be due to the recording of normal operating expenses as assets.

You can also use horizontal analysis to review the growth of inventory versus sales or cost of sales growth. The relationship between these accounts should be directly correlated. A substantial increase in soft assets relative to sales is a strong indication of an incorrectly capitalized expense. Finally, if SG&A expenses are growing more slowly than sales, then this could be attributable to management artificially extending the life of assets or goodwill.

Lastly, investors should always read the Management Discussion and Analysis and footnote section of each firm’s 10Q filing. It contains important data about segmented sales, references to accounting method changes, and discussions about costs. This is where management is often forced to reveal some of its accounting tricks.

Conclusion:

On a final note, I understand that these analytical techniques take quite a bit of time and knowledge to put into practice. Although I strongly encourage you to use these various methods when doing your own research, you can also rest assured that I do this type of thorough analysis before I cover any stock in my Undiscovered Micro-Cap Gems newsletter. As a result, the companies I profile in my newsletter should in most cases benefit from having superior earnings quality and above-board accounting practices.

To learn more about my Undiscovered Micro-Cap Gems newsletter or to sign up for a risk-free subscription, please visit the following link:

Thanks for reading!

John DiStanislao

Editor

Undiscovered Micro-Cap Gems

P.S. — To receive in-depth guidance on today’s leading micro-cap opportunities every single weekend, plus educational guidance similar to that shown above, please subscribe to John DiStanislao’s premium investment newsletter — Undiscovered Micro-Cap Gems .

J ohn DiStanislao has developed a long and successful track record over the years by investing primarily in deeply discounted micro-cap securities. His academic training includes degrees in both Investment Finance and Accounting from one of New York City’s most prestigious business schools. In addition to years of successful micro-cap stock investing, he has also excelled at financial systems development and consulting positions for several Fortune 500 companies.

John has managed to separate himself from other investment professionals by designing a variety of custom computer programs and data mining tools. He uses these advanced computer models, along with a host of fundamental research, to uncover quality stocks for readers interested in explosive micro-cap investing. Over the years, John’s insight and counsel has been sought and used by dozens of well-known and highly acclaimed hedge funds, mutual funds and Ivy League academics, as well as thousands of individual investors.