Accounting treatment changes almost always change comparisons of apples to apples to comparisons of apples to kiwi fruit, obscuring reality and earnings quality.
Lengthening of depreciation period boosts EPS in the short term and hurts it in the long term. Track D&A as a percentage of fixed assets. If the percentage declines, the company may have extended the D&A period.
In mergers, the reporting entity changes. This offers management a way to consign all sorts of expenses and charges to the past. Acquisitions are tougher because the reporting entity doesn't change.
Manipulating the allowance for doubtful debts affects receivables, and it carries across the financial statements. If the percentage of allowance for doubtful accounts drops sharply relative to gross AR, it may indicate an artificial boost to revenues and therefore earnings.
Note: businesses just don't see their customers' payment quality increase faster than the rate of new receivables.
When a company makes an acquisition, it is allowed up to 12 mos to adjust the purchase price for the acquired company's carrying value of assets and liabilities. As a result of the purchase price reallocation within a year, expenses are kept off the income statement, artificially boosting earnings in the period of adjustment.
The most conservative treatment (of intangibles) is to immediately expense acquired in-process research and development, patents and licences, direct response marketing, and other R&D.
Software companies may capitalize software development (at their discretion) once technological feasibility is reached (whatever that means).
The frequence of capitalization, the items capitalized, and the relative size of those items tells investors whether capitalization is a serious concern or not.
Deferred revenue - revenue a company receives before it delivers the product or service.
Days in Deferred Revenues (DDR) = (91.25 x deferred revenue)/quarterly revenue.
Reducing reserves for warranties boosts EPS.
Know your company's debt intimately:
- Avoid all companies whose business models depend on securitizations or consistent access to credit markets.
- Debt used to fund dividends and/or stock buybacks must pass the most stringent of tests - and usually fails.
- Carefully monitor the uses of debt to determine adequate returns on capital raised.
- Only buy companies with large debt to assets where you can model interest coverage, maturity dates and other terms.
Assuming too high returns on pension investments understates pension liabilities and overstates tangible book value.
Remember. It is normal for gross margins to vary. Be suspicious of any that were unchanging.
Price changes in cost of goods sold inputs are not sustainable as a source of earnings quality, but a dramatic increase in consumer demand and increased volume could make up for it.
To detect problems in input costs requires industry and company specific knowledge.
Recurring one time charges are a bright red flag wrt earnings quality. Serial one time charges may allow a company to establish reserves or bundle normal operating costs, making future results look better than they are.
The long investor should run from those companies with serial restructuring charges. They are not worth the effort to figure out.
Another way for management to manipulate earnings unsustainably is through taxes. The value of net operating loss carryforwards (NOL - a deferred tax asset) depends on what profits and tax rates management estimate it will have in the future. Investors should compare the expected tax rate indicated by management and forecast by Wall St with what is actually reported in the quarter. An artificially low tax rate may indicate that the tax allowance was reversed, benefitting current EPS.
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