Amazon's Aggressive Income Statement

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Management at Amazon.com (AMZN Quote) has grown increasingly aggressive in setting key expense and revenue items -- giving the company's earnings a substantial, but possibly artificial, boost.

Last year's operating earnings of $180 million could have been reduced by more than a quarter if Seattle-based Amazon had merely maintained historical levels for income-statement items related to inventory, unpaid customer bills and advance payments to Amazon. To a large extent, these items, which exist at all retailers, are set according to management's own assumptions. Overly aggressive companies have been known to abuse them to make profits look stronger than they are.

One way to test if this is going on is to check whether ratios for these items are in line with historical levels -- and whether any change is justified by developments within the company's operations. At Amazon, there does not appear to be a strong case for assumptions becoming more aggressive. That means Amazon's true profitability could be weaker than it looks, casting doubt on whether the company can meet Wall Street's bullish earnings expectations for 2004.

Amazon spokesman Bill Curry responds: "We never manipulate numbers to influence results."

After a plunge into the single digits in 2001, Amazon's stock has rocketed higher as investors have begun to believe in the company again. But an unexpected earnings miss could, of course, force Amazon's highflying stock into another tailspin. On Monday, Amazon posted a late rally to finish 24 cents higher at $58.30.

Allowances

The numbers in question are arcane, and some of them get disclosed only once a year. But they could still be having a significant impact on earnings. The three items that warrant a closer look are:

• The inventory valuation allowance, which is the reserve the company keeps on its balance sheet to absorb losses from inventory. Amazon decides how much should be added to the reserve, and these additions are an expense item in the income statement.

• The accounts receivable reserve, which the company keeps on its balance sheet to absorb losses from customers who don't pay. At Amazon, the reserve for retail customers is not an issue, because buyers pay up front. Instead, the reserve that requires a closer look is the one that absorbs losses from third-party vendors that use Amazon's site. Additions to this reserve are also an expense item in the income statement.

• The amount of unearned revenue that is bled into earnings, which is in part an issue of timing. Unearned revenue is booked as a liability on the balance sheet. It represents advance payments for goods or services to which Amazon is contractually obligated but has yet to deliver. The company gets to choose how much of the unearned revenue gets fed, or amortized, into revenue each quarter.

When looking at these items, investors won't get a full picture by checking the dollar amount. Instead, they must assess their change in relation to other items. In each case, the relevant ratio has become substantially more aggressive.