Investor, you haven't been told the whole story. For example, Applied Materials (NASDAQ:AMAT) didn't really make $1.4 billion last year, nor did CNET (NASDAQ:CNET) lose $26 million. American Pharmaceutical Partners (NASDAQ:APPX) didn't make $72 million, Adobe (NASDAQ:ADBE) didn't bring home exactly $266 million, and Stem Cells (NASDAQ:STEM) probably lost something other than $14 million. The list goes on.

And so does life. We, as a society, are used to so many things being in the "possibly real, but probably not" category -- breasts, real estate infomercials, sincerity -- that the thought of illusions, especially within the corporate world, doesn't really faze us.

The accrual anomaly
Way back in 1991, which, frighteningly, doesn't seem long ago to me, an academic named Richard Sloan stumbled on something he wasn't supposed to, at least in the eyes of the reigning elite: returns too good to be true -- graciously termed "abnormal" returns by said elite -- considering the risk involved.

How good? We're talking 10% too high, or 18% better than the market on a yearly basis -- mind-blowing in that few academic-derived trading strategies can be measured without a decimal point.

His reward? No surprise: years of scorn and rejection by academic journals. Abnormal returns meant academia didn't have it all figured out: It didn't like that. It wasn't until 1996 that he got published (Fool freelancers have waited almost as long), and even then by a somewhat off-topic journal. Now, a Web search for "Sloan accrual anomaly" reveals the legion of academic imitators, opiners, nitpickers, follow-up artists, and the occasional business writer who form the metaphorical palm fronds fanning his throne of fame.

I've been prohibited from disclosing Sloan's secret formula to the masses by a person -- we'll call him TMF Orangeblood -- who wished to exploit it for his own personal gain for just a little while longer. In the meantime, I'll give you the basic idea so you can set out to make your killing.

Earnings can be deceptive
Earnings for you and me mean cash. When I say I earned $11,000 after taxes last year (not entirely accurate, but I accept reader donations or even flowers -- better still, gifted 1-800-FLOWERS (NASDAQ:FLWS) stock -- in condolence), I had that money to spend. For companies, it's different. Accountants -- who, like everyone else, like to feel needed -- have well-meaningly plastered layers of complexity into what counts as "earnings": Companies can book revenue despite not having received a dime and, conversely, book expenses even when no cash left the door.

At times, this is a thing of beauty: A little agricultural corporation whose earnings would have otherwise been wiped out by a purchase of some pricey JohnDeere (NYSE:DE) tractors can instead "pretend" on its income statement to pay for the tractors over their life span via bite-sized installments.

But while other academics had been looking into the oasis and seeing only themselves, Sloan saw a little sewage in the water they'd all been drinking. Actually, others had seen it, too, but he showed that these accounting discrepancies (accruals) had a moral dimension: Good, conservative companies kept them to a minimum, whereas zealous stock pumpers maxed them out like credit cards. So, Sloan's dynamo portfolio would have you buying the good guys and short-selling the bad guys.

Amazingly -- and, speaking of sewage, I see that Orangeblood has left for the lavatory, so I'll say this quickly -- Sloan essentially compared two simple line items that anyone could find: net income, available at the bottom on the income statement, and... darn, here comes Orangeblood... back so fast, too.

All the better; I can lapse into my usual long-winded theoretical explanation, which will give you real understanding -- better for you in the long run than being spoon-fed a mindless formula.

The four horsemen of earnings
1. Net capital expenditures: The biggest reason earnings (the glamour shot) differ from cash flows (the naked photo) is that cash capital expenditures like the tractor purchase are broken into bite-sized fake "depreciation" expenses over many years on the income statement. Fresh capital expenditures happen every year, and any given year's depreciation would consist of a little bit (bite, really) of all the unused prior capital expenditures. Growing companies tend to spend increasing amounts on capital expenditures, so for a growing company, "real" earnings will be lower by the amount that capex exceeds depreciation.

Take it to the bank: Look for "Depreciation and Amortization" in the first (of three) sections of a company's statement of cash flows. That's the phony expense subtracted in reaching net income. Add it back in, then take out the real capital expenditures, which you can find on the second section of the statement of cash flows, typically masquerading as "Property, Plant, and Equipment."

2. Changes in non-cash, non-debt working capital: After revenues and expenses net out, what's left is net income. But not all revenues were actual cash in, and not all expenses were actual cash out. Cash seekers like to strip out these non-cash accruals to ascertain a better picture of the cash that came in.

Take it to the bank: Flip to the balance sheet and subtract cash from current assets -- we'll call the result Subtotal 1. Then, subtract anything that looks like debt (line items vary) from current liabilities. Now you've got Subtotal 2. Subtract 2 from 1 to get non-cash, non-debt working capital. Now do the same for the year-ago (or quarter-ago, as applicable) balance sheet and note the year-to-year change. This confusing amount, usually a positive number given that working capital tends to increase, represents another major segment of accrual income. In other words, if a company had net income of $100 but increased working capital by $20 in the process, it really took in only $80 in cash.

One warning: This amount can be jumpy from year to year, so look more at long-term trends.

3. One-time items: Weird little things crop up from time to time -- hurricanes, meteors, CEO farewell parties -- that aren't representative of the ongoing business. Is it fair to strip them out? Generally, yes. But remember to be fair and strip both one-time expenses and gains. Also, watch for repeat "one-time charge" offenders -- the corporate equivalent of a kid who's late to class every day, but with a different excuse each time.

Take it to the bank: The company will list the most obvious adjustments at the bottom of the income statement. As you progress, you can dig for more bounty in the footnotes and text of the financial statements; for such homegrown adjustments, think through whether their (prior) inclusion raised or lowered taxes, and remove that tax effect as well.

4. Debt: Debt's not just for the balance sheet anymore. Net capital expenditures and increases in working capital count as "investments." Companies issue debt to help make, among other things, investments. So it's safe to assume that these two "hidden" investments aren't entirely paid for out of equity holders' pockets. If a company issued $100 in new debt one year, while repaying $80, you could reduce its net investment -- the sum total of the net capex plus the non-cash/non-debt working capital increase -- by $20 when determining "cash" net income applicable to shareholders.

Take it to the bank: Skip the number theory above; debt issuance doesn't necessarily match debt usage and is a jumpy, once-every-few-years thing -- meaning the above will give too-wild fluctuations. Instead, figure a relevant time-frame average for the book values of the debt divided by the debt plus equity, then multiply that number by the net investment, as defined above, to get the portion financed by debt. Subtract that from the total to get the portion that's safe to subtract from net income. (This is an approach championed by Aswath Damodaran, reigning czar of cash flow. I am forever indebted to Prof. Damodaran for making his materials available to ignoramuses like myself.)

Sloan's simplicity
Sloan's paper didn't quite go through all this. He basically -- I say basically because the available line items were a little different back then -- compared net income, available on the income statement, to operating cash flow, which is simply the first subtotal on the statement of cash flows. Roughly speaking, when accrual-based net income exceeded cash-based (duh) operating cash flow, it was bad news to Sloan, whereas the reverse was good news. Easy enough.

Or is it? Because he had to study thousands of stocks, Sloan wasn't able to get quite as detailed as we've gotten in this article. And believe me, I'm 100% aware that most of you will like the sound of the Sloan two-step better than the complex melody above. But there's a catch: Sloan's portfolios held thousands of stocks. Try doing that yourself.

Most investors need to look at stocks individually because they can't afford the risk of purchasing a statistical anomaly -- e.g., a stock that passes the bare-bones test but looks bad upon closer inspection. That's why understanding the difference between earnings and cash flows is paramount to serious investors.

The Fool's own Tom Gardner, a serious investor if there ever was one, pierces the veil of accruals in his Hidden Gems newsletter. Like Sloan, his results have clobbered the market -- up 43.69% since his newsletter's July 2003 inception, compared with a measly 7.94% gain for the S&P 500. Check it out via a free 30-day trial.

James Early has been tempted by the occasional real estate infomercial. He can't speak for Orangeblood, but James owns none of the stocks mentioned in this article. The Motley Fool has a disclosure policy.