Measuring Profits & Losses (Income Statement)
So far we’ve conducted an introduction to financial statement analysis and a review of the balance sheet statement. Now we’re going to move onto the most popular and familiar financial statement and that is the income statement. One reason this particular financial statement is so popular is because it answers some of the most basic questions, such as, “How much stuff are you selling?” and “How much dough are you making?” With executive compensation incentives largely based off income statement profitability, it’s no surprise this statement is the one of choice. Unlike the balance sheet, which takes a snapshot picture of all your assets at a specific date in time, the income statement is like a scale, which measures gains or losses of a company over a specific period of time.
Like a wrestler or an overweight dieter, there can be an incentive to alter the calibration or lower the sensitivity of the financial weight scale. Fortunately for investors and other vested constituents, there are auditors (think of the Big 4 accounting firms) and regulators (such as the Securities and Exchange Commission) to verify the validity of the financial statement measurement systems in place. Sadly, due to organizational complexity, lack of resources, and lackadaisical oversight, the sanctity of the supervision process has been known to fail at times. One need not look any further than the now famous case of Enron. Not only did Enron eventually go bankrupt, but the dissolution of one of the most prestigious accounting firms in the world, Arthur Andersen, was also triggered by the accounting scandal.
Tearing Apart the Income Statement
Determining the profitability of a business through income statement analysis is generally not sufficient in coming to a decisive investment conclusion. Establishing the trend or the direction of profitability (or losses) can be even more important than the actual level of profits. The importance of profit trends requires adequate income statement history in order to ascertain a true direction. Comparability across time periods requires consistent application of rules going back in time. The “common form” income statement (or “percentage income statement”) is an excellent way to evaluate the levels of expenses and profits on an income statement across different periods. This particular format of historical income statement figures also provides a mode of comparing, contrasting, and benchmarking a company’s historical results with those of its peers (or the industry averages alone).
Shredding through the income statement, along with the other financial statements, often creates insufficient data necessary to make informed decisions. Other components of an annual report, such as the footnotes and Management Discussion and Analysis (MD&A) section, help paint a more complete picture. Interactions with company management teams and the investor relations departments can also be extremely influential forces. Regrettably, corporate viewpoints provided to investors are often skewed to an overly optimistic viewpoint. Management comments should be taken with a grain of salt, given the company’s inherent motivation to drive the stock price higher and portray the company in the most positive light.
Tricks of the Trade
One way to achieve profit goals is to improve revenues. If the traditional path to generating sales is unattainable, bending revenues in the desired direction can also be facilitated under the GAAP (Generally Accepted Accounting Principles) rules, or for those willing to risk times behind bars, criminals can attempt to bypass laws.
Due to the flexibility embedded within GAAP standards, corporate executives have a considerable amount of leeway in how the actual rules are implemented. Covering all the shenanigans surrounding income statement exploitation and distortion goes beyond the scope of this article, but nonetheless, here a few examples:
- Customer Credit: The relaxation of credit standards without increasing the associated credit loss reserves could have the effect of increasing short-term sales at the expense of future credit losses.
- Discounts: Offering discounts to accelerate sales is another accounting tactic. Offering price reductions may help sales now, but effectively this strategy merely brings future revenue into the current period at the expense of future sales..
- Adjusting Depreciation: Extending depreciation lives for the purpose of lowering expense and increasing profits may temporarily increase earnings but may distort the necessity of new capital equipment.
- Capitalization of Expenses: This practice essentially removes expenses from the income statement and buries them on the balance sheet.
- Merger Magic: Merger accounting can distort revenues and growth metrics in a manner that doesn’t accurately portray reality. Internally (or organic) growth typically earns a higher valuation relative to discretionary acquisition growth. Although mergers can optically accelerate revenue growth, acquirers usually overpay for deals and academic studies indicate the high failure rate among mergers.
Faux Earnings: Fix or Fraud?
The nature of financial reports has become more creative over time as new and innovative names for earnings have surfaced in press releases, which are not subject to GAAP guidelines. Reading terms such as “core earnings,” “non-GAAP earnings,” and “pro forma earnings” has become commonplace.
In addition, companies on occasion include GAAP approved “extraordinary” charges that are deemed rare and infrequent items. By doing so, income from continuing operations becomes inflated. More frequently, companies attempt to integrate less stringent, non-GAAP compliant, one-time so-called “nonrecurring,” “restructuring,” or “unusual” items. These “big-bath” expenses are designed to build a higher future earnings stream and divert investor attention to the earnings definition of choice. Unfortunately, for many companies, these nonrecurring items have a tendency of becoming recurring. Case in point is Procter & Gamble (PG), which in 2001 had recognized restructuring charges in seven consecutive quarters, totaling approximately $1.3 billion – recognizing these as part of ongoing earnings seems like a better choice. On the flip side, some companies want to include non-traditional gains into the main reported earnings. Take Coca-cola (KO) for example – in 1997 the Wall Street Journal highlighted Coke’s effort to include gains from the sales of bottler interests as part of normal operating earnings.
The review of the income statement plays a critical role in the overall health check of a company. From a stock analysis point, there tends to be an over-reliance on EPS (Earnings Per Share), which can be distorted by inflated revenues (“stuffing the channel”), deferral of expenses (extended depreciation), tax trickery, discretionary share buybacks, and other tactics discussed earlier. Generally speaking, the income statement is more easily manipulated than the cash flow statement, which will be discussed in a future post. Suffice it to say, it is in your best interest to make sure the income statement is properly calibrated when you perform your financial statement analysis.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in PG, KO or other securities referenced. References to content in Financial Statement Analysis (Martin Fridson and Fernando Alvarez) was used also. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.