Post copied from a textbook in management accouning (Damodaran)
The most troubling thing about earnings reports is that we are often blindsided not by the items that get reported (such as extraordinary charges) but by the items that are hidden in other categories. We would suggest the following checklist that should be reviewed about any earnings report to gauge the possibility of such shocks.
· Is earnings growth outstripping revenue growth by a large magnitude year after year?
This may well be a sign of increased efficiency, but when the differences are large and continue year after year, you should wonder about the source of these efficiencies.
· Do one-time or non-operating charges to earnings occur frequently? The charge itself might be categorized differently each year – an inventory charge one year, a restructuring charge the next and so on. While this may be just bad luck, it may also reflect a conscious effort by a company to move regular operating expenses into these non-operating items.
· Do any of the operating expenses, as a percent of revenues, swing wildly from year to year? This may suggest that the expense item (say SG&A) includes non-operating expenses that should really be stripped out and reported separately.
· Does the company manage to beat analyst estimates quarter after quarter by a cent or two? Not every company is a Microsoft. Companies that beat estimates year after year are involved in earnings management and are moving earnings across time periods. As growth levels off, this practice can catch up with them.
· Does a substantial proportion of the revenues come from subsidiaries or related holdings? While the sales may be legitimate, the prices set may allow the firm to move earnings from unit to the other and give a misleading view of true earnings at the firm.
· Are accounting rules for valuing inventory or depreciation changed frequently?
· Are acquisitions followed by miraculous increases in earnings? An acquisition strategy is difficult to make successful in the long term. A firm that claims instant success from such as strategy requires scrutiny.
· Is working capital ballooning out as revenues and earning surge? This can sometimes let us pinpoint those firms that generate revenues by lending to their own customers. None of these factors, by themselves, suggest that we lower earnings for these firms but combinations of the factors can be viewed as a warning signal that the earnings statement needs to be held up to higher scrutiny.