Most people judge companies as potential investments based on a few important criteria. Among these, revenue and net earnings are extremely important. However, how do you know a company’s reported income is accurate?
One troubling form of falsifying the income statement is inflating current revenue and earnings, a practice that has been given the decent-sounding name earnings management. Under the accounting rules, companies have discretion to make decisions that may increase net profits; this does not mean it is always accurate to use gimmicks that make performance look better than it is. By accruing revenues this year as an aggressive move, rather than spreading them over future years as a more conservative move, the current results are inflated — but future years’ income is going to be lower because this aggressive accounting decision has to be absorbed.
Many ways to tinker with the numbers
The flexibility in the accounting rules is a big part of the problem. A company does not have to commit outright fraud to inflate this year’s earnings. A rationale is easily found within the rules. These rules allow companies to use discretion in dozens of areas. For example:
- -The depreciation method is changed to report lower depreciation this year.
- -Reserves for bad debts is reduced to lower the current bad debts expense.
- -Methods for valuation of inventory are changed to reduce the cost of goods sold, which also increases net profits.
- -Reducing the estimate of write-off for obsolete or damaged inventory.
- -Adjusting pension account assumptions to increase estimated pension income or reduce pension expenses.
- -Adjusting the method and period for amortization of intangible assets in order to reduce amortization expenses.
- -Changing assumptions about investment income or valuation of investment assets.
- -Making liberal adjustments to currency exchange loss assumptions.
These are only a few of the possible ways that companies adjust what gets reported as net income this year. Given the range of allowed judgments, plus the possibility of outright misleading entries, there clearly is no one version of a company’s net income. The simple decision about when to recognize (place into the books) revenue or expenses gives a company broad discretion to tinker with reported income.
How to see through the manipulation
The solution cannot apply to a single year. Look at long-term trends. When you see a company’s reported revenue and net earnings performing erratically, it may be a sign that accounting decisions have been made to adjust what gets reported. When a company inflates one year’s results — even within the rules — that decision has to be taken up somewhere else. So one year’s profits may be impressive, only to be followed by a year with very dismal results or even a net loss.
There are legitimate reasons for some volatility. However, if a company’s 10-year trend is difficult to follow because profits rise and fall every year, it could be a danger signal. This does not mean a financial statement is fraudulent. A big part of the problem, everyone should remember, is the liberal accounting rules and the ability of companies to act within those rules to inflate income.
Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.
Tricks of Financial Reporting: Manipulating Earnings was provided by Minyanville.com.