Don't Be Fooled By Misleading Company Earnings

Many investors look at company earnings when evaluating a stock's potential. However, in recent years it has become more apparent that earnings reports can be misleading. Here are a few things to consider about why you cannot based financial decisions on earnings that are reported by corporations.

Manipulating Earnings

In today's business world, it is more apparent than ever that company earnings can be manipulated. When a company reports a certain amount for earnings, it is because that is what they want you to believe the earnings were. However, there are many different ways that earnings reports can be manipulated. Here are a few ways that a company might try to manipulate their earnings report.

Operating Earnings Reporting Discrepancies

Originally, operating earnings was meant to be a uniform way for companies to report their earnings to investors. It is meant to exclude one-time gains and expenses from the bottom line. In theory, this sounds like a very straightforward way of reporting your earnings. However, each financial analyst uses different criteria on what should be excluded from a company's operating earnings. Therefore, you have one company excluding one type of expense and another company excluding another. Therefore, you are not truly comparing apples to apples when you look at operating earnings.

Off-Balance Sheet Financing

Another problem with using earnings to evaluate a company is when off-balance sheet financing is used. This is when a company manages to keep large expenditures off of the balance sheet by classifying them as something else. For example, instead of a company making a large capital expenditure, they can simply choose to set up a lease agreement instead. Therefore, the asset is kept on the balance sheet of the leasing company instead. The company that leases the asset only reports the rental expense on their books. This allows companies to take on larger amounts of debt whenever they have exceeded the ratios set forth in the company bylaws. If a company does not want to lower their earnings, they can simply choose to finance a purchase of your off-balance sheet methods and avoid any attention. This was a major problem during the Enron fiasco. They use a large number of off-balance sheet financing methods in order to acquire assets.

Accelerated Revenue Recognition

With different accounting strategies, companies can choose to recognize revenue that different points. Some companies recognize revenue over a longer period of time and therefore, this can lower earnings reported. However, if you choose to accelerate the period in which you recognize revenue, this will bump up a company's earnings. Nothing really changed except the way the revenue was reported. This can provide a large increase in reported earnings for companies that choose to use this method of accounting.

Depreciation

The depreciation of assets can play a large role in the financial members represented for a company. There are several different ways to depreciate an asset. If a company chooses to take the bulk of the depreciation on the front end, this can skew earnings reports.

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