Like all publicly distributed data, from government reports to corporate filings, a prudent investor evaluates it with a healthy dose of skepticism.
As we enter the season of quarterly releases, it’s important to remember you can’t trust an earnings report by its cover. Yes, it’s tempting to trade earnings reports, especially after witnessing Tuesday’s monster jump in NFLX.
The movie-streaming company posted earnings of 86 cents a share on sales of $1.27 billion. Analysts had expected the company to report earnings excluding items of 83 cents a share on $1.27 billion in revenue, according to a consensus estimate from Thomson Reuters.
Going forward, it’s important to know what to watch for. Here are a few ways companies can manipulate their EPS according to the investing caffeine blog.
Distorted Expenses: If a $10 million manufacturing plant is expected to last 10 years, then the depreciation expense should be $1 million per year. If for some reason the Chief Financial Officer (CFO) suddenly decided the building would last 40 years rather than 10 years, then the expense would only be $250,000 per year. Voila, an instant $750,000 annual gain was created out of thin air due to management’s change in estimates.
Magical Revenues: Some companies have been known to do what’s called “stuffing the channel.” Or in other words, companies sometimes will ship product to a distributor or customer even if there is no immediate demand for that product. This practice can potentially increase the revenue of the reporting company, while providing the customer with more inventory on-hand. The major problem with the strategy is cash collection, which can be pushed way off in the future or become uncollectible.
Accounting Shifts: Under certain circumstances, specific expenses can be converted to an asset on the balance sheet, leading to inflated EPS numbers. A common example of this phenomenon occurs in the software industry, where software engineering expenses on the income statement get converted to capitalized software assets on the balance sheet. Again, like other schemes, this practice delays the negative expense effects on reported earnings.
Artificial Income: Not only did many of the trouble banks make imprudent loans to borrowers that were unlikely to repay, but the loans were made based on assumptions that asset prices would go up indefinitely and credit costs would remain freakishly low. Based on the overly optimistic repayment and loss assumptions, banks recognized massive amounts of gains which propelled even more imprudent loans. Needless to say, investors are now more tightly questioning these assumptions. That said, recent relaxation of mark-to-market accounting makes it even more difficult to estimate the true values of assets on the bank’s balance sheets.