Four Tips for Understanding Earnings Reports

While the effect tax rate will vary by the location where the company is based and operates, in general, most companies will have an effective tax which will be fairly static from quarter-to-quarter and year-to-year. However, once in a while, there are two tax-related red flags that you should be aware of when companies report earnings:

If a company reports an EPS number that is much greater than expected, while the company's sales remain level or dropped and expenses remain level or increased, it may indicate that the company benefited from "one-time tax items."

For example, Ruby Tuesday RT reported EPS that was greater than expected by 5 cents, while revenues missed estimates by 4.5%. On closer inspection, Ruby Tuesday reported a "net tax benefit" of 24.6% versus a "real tax expense rate" of 30.9% in the prior year's quarter.

What looked like a "big beat" for Ruby Tuesday was, in fact, a miss.

A company that suddenly turns its history of generating "operating losses" to "operating gains" will report a low effective tax rate, generating earnings results that seem better than expected.

The reason for this anomaly is that accumulated prior years' losses (for which taxes were not due) can be carried forward as a deduction against current year's income for tax purposes. As a result, the EPS for the current year is deceptively higher than if the company were operating and paying taxes over longer periods of time.

For example, over many years Amazon.com AMZN generated and accumulated large operating losses that Amazon was not able to deduct. However, in future years, when the company began to generate profits, these old losses were used to offset current gains. Thus, lowering the effective tax rate and inflating EPS.

3. Make Sense of Managing Expenses

Expense accruals are defined as the recording of expenses incurred in the current period, which are not payable until future periods. While some expenses such as rent and utilities are straightforward, other expenses have more subjective criteria in determination of the accrual.

For example, in the financial services industry where bonuses are paid annually but are recorded quarterly, management has a great amount of discretion as the amount of bonus that will be accrued and paid.

Sometimes these expenses will be "managed" to help the company meet or exceed its earnings guidance or consensus estimates. What you should look for is consistency in such accruals and if necessary question why those accruals may vary from historical norms.

4. Keep an Eye on Calendar Shifts, Schedules and Deadlines

Notwithstanding what I previously covered about time frame comparisons, we need to be aware of the vagaries of the calendar.

There are several scenarios of how a company's income flows can be affected by calendar. Here are two:

In the retail sector there are shifts in financial data based on when certain holidays fall on the calendar. The most notorious shift is the one which is caused by Easter. Some years, Easter falls in March, while other years, it may fall in April.

Quite frequently, it seems that the Easter holiday flip-flops from one month to another in back to back years (though this is not always the case). Why is this important? Most stores are closed on Easter, so a day's worth of sales may be lost and hence shift from month-to-month.

New product introductions can cause blips in income flows. Often, this is most noticeable in the technology sector. For example, when Microsoft MSFT introduced its Vista operating system or when Apple AAPL was introducing a new version of the iPod.

Why this is important: consumers delayed purchases until the new products hit the shelves. This is often referred to as a "product upgrade cycle."

As you can see there are many aspects of a company's quarterly earnings press release or conference call that may give rise to inconsistent or confusing data and "stories."

As always, ignore the headlines and read the details before you draw any conclusions. You are likely to come across many of the situations above. The trick now is to be able to identify those issues when they first occur and incorporate them into your analysis.

Homework Time

To prepare yourself for the current earnings season or the next earnings season, look back at the prior quarter's earnings of your stock holdings, or refer to some of the earnings that I referred to in this lesson.

To stay up to date on earnings news, bookmark and visit TheStreet.com's Earnings section. And to listen to an upcoming (or archived) conference call for a specific company, check out TheStreet.com's Earnings Calendar: Conference Calls page.