FOOL PLATE SPECIAL: An Investment Opinion
Watch for Earnings Tricks

Now that warning season is over, we can get underway with actual earnings reports. Trouble is, too many investors look only at the end result -- the net income number -- to make their investment decisions. But that number, as an accounting construct, has a bunch of elements that go into it, so much so that there is plenty of room for companies to do things to ensure they hit their numbers. Below are some of the usual suspects: accounts receivable, research and development, and taxes.

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By Bill Mann (TMF Otter)
October 9, 2000

OK, so it hasn't exactly been a stellar warning season. September extracted a pound of flesh from several influential companies. After such a parade of pre-announcements, investors may be right in looking at the upcoming earnings reports with a little dread. But the pre-warners -- Dell (Nasdaq: DELL), Apple (Nasdaq: AAPL), J.C. Penney (NYSE: JCP), Intel (Nasdaq: INTC), and others -- aren't necessarily the places to look for more trouble.

Most companies, magically, hit or exceed their expected earnings levels. It may seem magical, but it's really sleight of hand: Analysts get significant guidance from companies to push their numbers higher or lower in advance of the announcement.

But there's still a ton of pressure on companies to both beat numbers and show sufficient earnings growth over previous quarters, since they know most investors fail to look beyond the earnings number. So companies sometimes fudge elsewhere. If that "elsewhere" is in general and administrative costs (G&A), congratulations -- you've got a company that is trimming its overhead. But watch out for these situations.

1. Packing the sales channels
Since quarterly earnings are done on an accrual basis, sometimes companies will offer "fire sales" or other incentives to its customers in order to book revenue. This is not good, but it shows up in the balance sheet, under accounts receivable. Xerox (NYSE: XRX), for example, had its receivables increase by $300 million between December and June, on declining sales.

2. Cutting research and development
Companies have to continually invest money in themselves in order to bring out new products. This money, which goes under the account of research and development, is not generally capitalized, and is subtracted as a current expense. This makes it an easy target for a company in trouble.

3. Lowering tax levels
Companies have a bewildering array of tax credits and other incentives that they call upon to keep a few extra dollars in their pockets. In particular, newer companies that have recently become profitable have tax credits from the losses they incurred previously. If a company has beaten earnings numbers but its tax rate is lower, then it actually has not done as well as it seems. To calculate the tax rate, simply take the amount paid in taxes and divide it by the net income. For mature companies, it should be within one or two percentage points of 34%.

Investors who look only at the earnings number are at a distinct disadvantage, as some signs of fiscal health are only found in working through the financial statements. If you wouldn't buy a car based on its paint job, then you shouldn't just count on "earnings" for your investment guidance either.

Your Turn:
Check out our earnings calendar to find out when all your favorite companies are due to report. Then load them into our Portfolio Tracker.