Amazon's Aggressive Income Statement

Steep Drop

First, the inventory valuation allowance. In 2000, Amazon's addition to the reserve was $31 million, compared to only $23 million in 2002. The drop was even steeper as a percentage of cost of inventory (which is cost of sales excluding cost of shipping). The inventory reserve addition in 2000 was equivalent to 1.81% of cost of inventory, compared to 0.9% for both 2001 and 2002.

If the reserve addition had been kept at the 2000 ratio of 1.81% in 2002, Amazon would have added an extra $23 million to costs in 2002. That is equivalent to 13% of the company's operating earnings.

Amazon's Curry responds that the inventory addition was at an "appropriate level." He says that inventory management has improved over the past few years. He illustrates this by pointing to an indicator called "inventory turns," which measures how many times a year a company sells its inventory. Amazon has increased that turn number to 19 in 2002, from 14 in 1999, Curry points out. Amazon bulls may also point out that the days' inventory outstanding measure (which compares inventory with cost of goods sold and expresses that relationship in days) fell between 2000 and 2002, which is a good thing. This indicator dropped to 17 days in the fourth quarter of 2002 from 21 days at the end of 2000.

Seeing as inventory management has clearly improved, why would it be wrong for Amazon to have let its inventory reserve drop? Simple answer: Amazon's product range has broadened and contains many items, such as consumer electronics, that carry far more inventory risk than books. In other words, it makes no sense that the reserve has slipped, and investors should be wary.

More of the Same

The accounts receivable allowance for vendors shows the same pattern. In 2000, the reserve for these receivables was 0.45% of net sales, compared to 0.2% in 2002. If the 2000 level had been maintained in 2002, Amazon's operating earnings would've been lower by $10 million, or 5.6%. Curry says of the most recent allowance: "That's the appropriate level." That seems particularly unwarranted, because Amazon's use of vendors has skyrocketed since 2000.

Unearned revenue's impact on earnings is slightly harder to track, because it is a revenue number. However, it is not hard to arrive at an estimated impact, by applying a very conservative 25% margin to the unearned revenue. The unearned revenue movements are particularly odd. In 2002, Amazon amortized $135 million of unearned revenue into revenue, but added only $95 million of unearned revenue to its balance sheet. How can it have added more to its earnings than it took in?