With tax-day just one month away, it seems appropriate to talk about earnings today. To add to the serendipity, we're just two weeks away from the anniversary of the capitulation of the Financial Accounting Standards Board (FASB), which ultimately changed how companies are allowed to report earnings.

That might not sound like too much of a big deal, but at the time, accountants were at least mildly concerned about changes to Generally Accepted Accounting Principles (GAAP) - a huge document of over 12,000 pages that had been codified and drafted since 1973. It was essentially the bible and rulebook of financial accounting for two generations of American accountants.

According to Mara Bruce, audit manager at Schneider Downs, a CPA firm based in Pittsburgh, PA it was the biggest change to GAAP "in over 50 years."

At the very least, it made valuations a bit uncertain for professional analysts and regular investors alike. And at the time, it was viewed as acquiescence to corporate interests. If you remember, March 30th of last year was a terrifying time to be a shareholder or a CEO.

Bank CEOs especially found themselves on the ropes. Angry politicians and CEOs alike called for changes to the rules, and they eventually got them. What did these new rules mean?

To quote an article on Bloomberg.com from late March, 2009:

By letting banks use internal models instead of market prices and allowing them to take into account the cash flow of securities, FASB's change could boost bank industry earnings by 20 percent, {{Robert}} Willens [a former managing director at Lehman Brothers Holdings Inc] said. Companies weighed down by mortgage- backed securities, such as New York-based Citigroup, could cut their losses by 50 percent to 70 percent, said Richard Dietrich, an accounting professor at Ohio State University in Columbus.

'This could turn net losses into significant net gains,' Dietrich said. 'It may well swing the difference as to whether bank earnings are strong this quarter, or flat to negative.'

The whole situation smacks of the typical spoiled neighborhood kid who changes the rules of the game so that he always wins. If he steps out of boundaries, the boundaries change. If he starts losing, it's because someone else is cheating. If he doesn't win he calls foul. Heads I win, tails you lose.

Were GAAP rules unfair when banks were piling up record earnings? Maybe, but we didn't hear a peep of complaint until banks were in danger of becoming insolvent. It seems unfair, but that doesn't mean we should take our ball and go home, either.

We just have to be that much more diligent. That's why I'm going to quickly discuss some of the warning signs to look out for, no matter whose rules we're playing by.

We can still win, but we can't give an inch when it comes to one of the most important factors in choosing a good investment: earnings.

The forecasting of earnings and setting of price targets often is a self-defining game on Wall Street. While many analysts are skilled in corporate forecasting, many others simply ask a company's management for their estimates and then conform to these as forecasts. One danger to forecasting is that executives are capable of manufacturing the desired outcome to meet or exceed guidance and analyst expectations.

For example, let's say a company has estimated that it is going to earn 53 cents per share over the next quarter and analysts all agree with this number. At the end of the quarter, actual reported earnings are 54 cents per share. This one-cent surprise causes the stock's price to rise the day of the earnings announcement. However, the company may have created this suspiciously close outcome with a simple journal entry. It may have consisted of any number of adjustments:

  • Booking earned revenue early based on volume of current orders (actual and promised or verbally committed), but without booking the corresponding direct costs.
  • Reducing the reserve for bad debts with the explanation that future bad debts are expected to be lower than previously estimated.
  • Accelerating the positive write-off of reserves based on acquisition profits from a previous year's activity.
  • Deferred expense payments and accruals, based on the false rationale that these expenses are not yet accrued.

All of these explanations sound good because they mimic legitimate and similar adjustments made by way of quarter-end accruals. But there is a problem with this kind of adjustment. The real intention is to meet earnings estimates or surpass them, to ensure investors and analysts that management is in control of growth, and also to make the case that its forecasting ability is quite good. The problems are even more serious. Consider, for example, the following:

  • Auditors may look at the books at the end of the quarter, but do not perform an in-depth analysis of transactions. The quarterly review is very preliminary and does not require the auditing firm to state specifically that the books look right. Only a glaring error is going to be revealed in this process.
  • The final accounting of the quarter often does not occur for several weeks after the end of the quarter itself. Thus, the earnings report is preliminary and can easily change later. But once the final accounting has been done and earnings are adjusted, investors have moved on, focused on the next quarter's estimate.
  • Even when last quarter's earnings are later changed, explanations are likely to be vague or nonexistent. They usually consist of downplaying the manipulation. But if investors do not pay attention to the interim quarter shenanigans, they may miss an important truth: Many companies do not meet their quarter earnings estimates, even though their news releases say they do.

Even if a company is otherwise solvent, profitable and healthy, I don't like to invest with anyone who has a tendency to fib. Small lies tend to turn into big ones as any investor in Enron or WorldCom will remember.

So, how can you figure out if a company has been fibbing with its earnings?

Tomorrow, I'll discuss some simple ways to find out if a company is reporting accurate earnings or just blowing smoke.