Earnings results can do one of three things every quarter: meet expectations, exceed expectations, or fail expectations. Meeting earnings expectations means the company has lived up to the analysts' predictions and earnings per share for the quarter are on target. A positive earnings surprise exceeds analysts' expectations, often driving the price up. A negative earnings surprise comes in below estimates, and the stock may sink following the announcement.

However, looking beyond this usually meaningless exercise in "meeting or beating estimates" can help you figure out exactly how well the company is performing. By the time a company reports a failure to meet earnings expectations, it may be too late to change your position on a stock. It is better to be forewarned. And the information that helps you predict the direction of a company's earnings is readily available in the financial statements and press releases from the company itself. Studying the income statement, the balance sheet, and the cash flow statement tells you volumes about the health of a company and whether its earnings are sustainable.

To simplify the search, focus on these common red flags: aggressive revenue recognition, manipulation of expenses downward, and changes in the business structure that may lead to unusual or extraordinary charges. Earnings releases are reported "pro forma," and that means there are no charges included in the figure. Charges can result in much lower earnings because they go to the bottom line -- net earnings. Understanding the quality of the company's business can help you predict if there will be charges and help you avoid losses.

Financial statements are a powerful ally in the hunt for earnings problems. What follows are three examples that can help you learn how to better interpret a company's true results.

Stuffing the channels
Bristol-Myers Squibb (NYSE:BMY) committed the classic example of a practice called "channel stuffing" to artificially inflate its quarterly and annual earnings. Bristol-Myers admitted to offering incentives to wholesalers and distributors to take on more drugs than needed for immediate sales. The incentives were generally offered towards the end of a quarter. Distributors were enticed to purchase products in an amount sufficient to meet quarterly sales projections from senior management at Bristol-Myers, but at quantities in excess of sales for the wholesalers. Distributors Cardinal Health (NYSE:CAH) and McKesson (NYSE:MCK) were saturated with Bristol-Myers' products.

In April 2002, the company disclosed the practice, and the price per share was cut in half. As a result of inappropriate revenue recognition, Bristol-Myers was forced to restate four years of earnings.

Was it possible to see beyond the rosy glow of the quarterly earnings reports? By comparing the balance sheet to the income statement, a diligent investor could have noticed some troubling trends.

The income statement and the balance sheet are joined at the hip, and manipulations in revenue most likely will show up in accounts receivables and inventory. While Bristol was booking revenue in advance of payment, accounts receivable and days sales outstanding were piling up. A look at the accounts receivable, days sales outstanding, and revenue by quarter in 2001 would have sent a clear message that something was wrong.

3/31/01 6/30/01 9/30/01 12/31/01
Accounts receivable (in billions) 3.4 3.6 3.8 3.7
Revenue (in billions) 5.3 5.3 4.6 3.0
Days sales outstanding 57.7 61.2 74.3 111.0
Growth revenue -- 0% -13.2% -34.8%
Growth in accounts receivable -- 5.9% 5.6% -2.6%
% Accounts receivable to revenue 64.1% 67.9% 82.6% 123.3%

With these simple calculations, it was easy to see the growth of revenue was out of sync with receivables and days sales outstanding. While revenue was actually declining from one quarter to the next, accounts receivable was increasing and uncollected accounts was becoming a larger percentage of booked revenue every month. Days sales outstanding increased dramatically from around two months to almost four. Bristol-Myers was not being paid for product that was going out the door, and distributors were stuffed with inventory. This is an example of aggressive revenue recognition.

AOL's sleight of hand
The flip side of the coin for maximizing revenue recognition is minimizing expenses. Time Warner's (NYSE:TWX) America Online division (prior to purchasing Time Warner) turned losses into gains by transforming operating expenses into capitalized expenses. Advertising costs associated with subscriber acquisition were converted to assets by classifying them as capital expenditures.

As with any capital expense, the full impact of the cost reflected on the income statement is postponed and a depreciation schedule is set up. The expense is taken incrementally against revenue over time. The huge outlay of cash AOL spent to recruit customers magically disappeared as the expense was turned into an asset on the balance sheet. If AOL had counted these costs as an expense, the 1995 pretax loss would have been $98 million instead of $21 million. The pretax income of $62 million reported for the year 1996 would have in reality been a loss of $62 million. AOL was able to report profits for six of eight quarters 1995 and 1996 by capitalizing its advertising costs. This accounting maneuver minimizes a company's expenses and can cause unwelcome earnings surprises in the form of restatements.

Unfortunately for investors, by 1996, with capitalized advertising expenses at a staggering $314 million, AOL admitted defeat and expensed them. The company took a onetime charge of $385 million in the first quarter of 1997 and was fined $3.5 million by the SEC for inappropriately amortizing expenses. AOL also restated earnings for 1995 and 1996. By taking the onetime charge, it was off the hook for paying those amortized costs in the future. It was a win/win situation for AOL, but a lose/lose situation for investors.

Beware of companies trying to turn operating expenses into capital expenditures. When in doubt, consider whether the expense truly represents an asset that will provide revenue in future periods as buildings and equipment do.

Triad Hospitals and the world according to GAAP
Even when conducting business as usual in accordance with generally accepted accounting principles (GAAP), a company may report unexpected losses. Analysts base their published earnings forecasts on pro forma earnings that don't include adjustments for nonrecurring expenses or gains. This may lead to surprising earnings results.

Triad Hospital's (NYSE:TRI) pro forma earnings for fourth-quarter 2003 were expected to be $0.47 to $0.49 per share. On Feb. 23, 2004, it reported a loss of $0.01 after recording two nonrecurring expenses. Analysts had anticipated one charge, but not the second. That expense was the sale of Alice Regional Hospital for $18 million, representing a loss of $16 million. The discrepancy in value and the subsequent loss lies in understanding how GAAP directs businesses to account for assets and capital expenditures.

When a company makes an investment in property and equipment, it's a capital expenditure and is recorded at cost on the balance sheet (book value) as required by GAAP. Every year the value of the asset decreases (depreciates), which shows up as an expense on the income statement. GAAP allows "write-downs" of book value of assets, but never allows "write-ups." If a company has appreciating assets, onetime gains may show up, as will happen with Triad in 2004 when it sells some property to HCA (NYSE:HCA). When Triad sold Alice Regional Hospital, the sale price was lower than book value and a loss on sale was reported. Impairment (a nonrecurring charge) was recorded in the period in which the definitive agreement was reached -- the fourth quarter of 2003.

Could an investor have predicted this even when the analysts didn't mention it?

In this example, Triad warned investors that there was a possible future impairment, and investors had some idea of the magnitude of that potential impairment. The pending impairment and potential sale were alluded to in the second and third quarter 10-Qs:

One of Triad's hospitals had impairment indicators and was evaluated for potential impairment. Currently, the undiscounted future cash flows expected from the use of the assets and eventual disposition indicate that the recorded amounts are recoverable. The book value of this facility's long-lived assets was approximately $34 million at Sept. 30, 2003. If the projections of future cash flows deteriorate, then impairment of these assets may be required.

It was also hinted at in the earnings guidance released Jan. 12, 2004:

The expected gain on sale of the Kansas City assets could be offset partially by a much smaller potential loss on the possible sale of another facility that the Company is presently evaluating.

Another vital clue was found in four years' worth of history on the income statements. Nonrecurring charges in the form of impairments had been three years out of four. The diligent investor would have been justified in betting this would be likely to happen again, given the warnings. Coupled with the knowledge that Triad's business plan included strategic divestitures of unwanted properties, the fourth-quarter results shouldn't have been surprising.

Hunting for financial statement surprises
Is it worth all the trouble of digging through documents to uncover potential surprises? You bet. You will learn more about the company you're an owner of -- or a potential owner of -- and also learn about the ethics and the operations of a company from the inside out. That's not a bad investment of time.

As a recap, remember:

  • Look for improper revenue recognition
  • Make sure expenses are properly accounted for
  • Remember that quarterly earnings reports and guidance are reported pro forma and that when pro forma and GAAP collide, the real bottom line is according to GAAP
  • Use the financial statements and press releases from the company -- wring out every drop of information at your fingertips.

For more information, I highly recommend the following reading:

J. Graham owns shares of Bristol-Myers Squibb, Cardinal Health, and HCA. The Motley Fool strives to uphold the credo investors writing for investors.