Look For These Red Flags In The Income Statement

While Enron has become the poster child for blatant financial statement fraud, other companies have also been known to fudge their numbers. The income statement is one of a company’s major financial statements, along with its balance sheet and statement of cash flows, and it can be manipulated in a few common ways. Investors should watch for red flags related to revenue and expenses.

The income statement shows what a company’s earnings (or profits) are by showing all its revenues and expenses for a specific period. Income statement analysis is an integral aspect of fundamental analysis. The statement should capture an honest and accurate picture of a company’s financial situation so that investors can make informed decisions about buying or selling shares. Because these numbers are so important, they must be reviewed and approved by an independent auditor. Unfortunately, auditors can be fooled by fabricated numbers or even turn a blind eye to such happenings (see WorldCom and Global Crossing). That’s why investors should be vigilant and skeptical when studying a company’s income statements. (To read more see Understanding the Income Statement and Find Investment Quality In The Income Statement)

Beware of Revenue Manipulation

Revenues are vulnerable to misrepresentation. Common ways to manipulate revenues include recording revenue before it is actually earned or simply making up revenue that does not exist. Companies can do this by making fraudulent sales to complicit related parties (for example by selling to a sister company with immediate plans to cancel the sale), recording sales that are incomplete because they are tied to some condition (for example, recording the full value of an installment sale), recognizing consignment as completed sales, and altering contracts to boost sales. A company could also delay acknowledging customer returns to a later quarter, or perhaps ignore them altogether. But how can an investor know if a company is engaging in these income statement manipulations? Examine the company’s revenues over the last few periods. If it seems to be growing in an inconsistent way, that should be a red flag. Investors should look at the firm’s income statements for previous periods, including the last quarter and the last year, to see if there is a sudden and unexplained change in its revenues that isn’t accounted for by its cash flows. 

Misrepresenting Expenses

One common way of manipulating expenses is through inventory manipulation. For instance, a business could buy materials and then not record the full expense of the purchase or not record the purchase at all. Companies can also exaggerate vendor discounts to reduce costs or not write off inventory that is out of date and no longer saleable. Other schemes include overcounting or undercounting inventory to present whatever picture management wants to paint or creating phantom inventory. To catch a hint of these practices, examine the company's expenses. If expenses are changing in a way that is not consistent with previous periods, investors should investigate the variance. The company’s balance sheet and footnotes could also provide additional input. 

Cookie Jar Accounting

Many businesses operate in industries where the flow of revenue is not consistent and consequently income varies. Regardless of the natural rhythms of an industry, all publicly traded companies must report quarterly earnings and analysts and investors keep track of these earnings. Companies are under great pressure to meet targets and consistently beat their earnings from the previous quarter. Because of this, they might manipulate their revenues and expenses in different ways to paint a picture of stability and continuous growth when in reality the business may be less profitable, or even more profitable, than represented. For example, some businesses will keep reserves of revenue from past quarters, without explicitly stating this, or use other means to show profitability in future quarters. Other methods of such cookie jar accounting include shifting current expenses to a future period so as to boost current earnings. Future expenses can also be moved to an earlier period. Anything that looks like this sort of manipulation should also be a cause for further inquiry. Look for red flags in the earnings of past periods and management’s discussion of earnings. Also see if current earnings come from so-called “other income.” Other income can be a red flag for previous reserves being plugged in to boost current earnings. Companies that have been implicated in cookie jar accounting schemes include Dell and Fannie Mae.

Other Red Flags

Some transactions don’t occur regularly and are called nonrecurring transactions. Such a transaction could include the sale of the company’s headquarters. It is also worthwhile looking into these sorts of transactions to see if there is anything irregular. These sorts of items could show up as a “gain on disposal.". These sorts of one-time transactions could be a way for the company to manipulate its earnings and that’s why it merits investigation. 

The Bottom Line

An investor should be vigilant about investigating anything in a company’s income statement that raises a red flag. Both revenues and expenses are vulnerable to manipulation. Company management often has incentive to engage in manipulation and auditors do not always catch on. Reading the income statement and management’s discussion of its business (together with the balance sheet and footnotes, as well as the cash flow statement) provides clues for vigilant investors.