The Bottom Line on Income Statements

The documents not only highlight a company's performance, but can also provide clues to accounting concerns.
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Now that most companies have filed their

Form 10-Qs for the first quarter, it's time to keep working on the mini-audit of your favorite stock.

We

tackled the balance sheet a few weeks ago, so now we're ready to hit the income statement.

The income statement adds up all of the company's revenue, subtracts its expenses and gives you the bottom line -- a.k.a. net income. It helps you determine if your company is making money selling its products or services. You can use it to evaluate past performance and potentially predict its future.

At the same time, you'll find a lot of "creative accounting" on the income statement. Over the years, there have been two basic types of fraud, notes Ed Ketz, associate accounting professor at Penn State University. Fictitiously beefing up revenues and falsely decreasing expenses are the biggies. Either tactic increases the bottom line, so you can spot them on the income statement.

So we'll walk you through the hot spots. This is pretty dense stuff, so grab your coffee/Red Bull and let's get started!

Sell! Sell! Sell!

Start with the revenue number, the first line on the statement (hence why the figure is sometimes colloquially called the "top line"). Revenue represents the total money the company collected for any goods sold and/or services performed.

From there, if you subtract sales discounts, returned products and allowances for sales made on credit that aren't getting paid, you end up with the net revenue.

We mentioned above that beefing up revenue is a favorite tactic for crooked CEOs, and they do it in a few ways. It can be blatant, where the company just books fictitious sales in efforts to pump up revenue. Or it can be a bit more subtle by, say, recording sales too quickly. For instance, most companies consider an item a sale at the time of shipment. But some take a more assertive stance and claim the item is sold at the time of production. Their logic is that once the good is produced, it's sellable, so that should be revenue.

But just because a product is available for sale doesn't mean someone's actually going to buy it.

So how do you know if your company is being aggressive? Flip to the footnotes in the back of the report. The footnote titled "Summary of Accounting Policies," details the company's revenue-recognition policy and can help you determine at what point in the sales process the company considers the event to be a sale.

Granted, there are definitely some industry standards, but be concerned if the policy is overly aggressive. Look for fluctuations in the revenue number from this period to last. If the percentage difference is big, go back to the "Management Discussion & Analysis" section of the 10-Q and reread the revenue section. Management should've addressed it.

You can also use the revenue figure to easily calculate a gauge of a company's performance: the gross profit margin, or gross margin. That ratio is just gross profit (sales less the cost of the goods sold) divided by total revenue. For a manufacturer, gross margin is a measure of a company's efficiency in turning raw materials into income; for a retailer it measures its markup over wholesale.

The higher the number, the better, because that means the company able to get a high return on an item, or is selling it at a lower cost. But again, it depends on the industry. Discount retailers are going to keep their margins small because that's part of their game. But companies that don't sell products on a daily basis, like furniture or equipment companies, should have higher margins.

Expenses

Now move on to the expenses section. Expenses on the income statement can be anything from depreciation to salaries. Expenses are subtracted from total revenue, so they can easily bring a company's net income way down. And this is where the second-most-popular fraud occurs.

There are operating expenses associated with running the business, like sales and marketing costs, research and development, and general and administrative costs.

Things get hairy when a company decides to classify an expense cost as a long-term investment. So, instead of taking a one-time charge, the company elects to spread the charge out over a longer period of time. The bean counters call this "capitalizing the cost."

There are accounting rules that explain which expenses should be a one-time hit (like certain start-up costs) and which expenses can be capitalized over a longer period of time.

But, remember, taking an expense as a one-time hit can really bring net income way down. So, some companies attempt to capitalize certain expenses, or spread them out over a longer period of time to help to ease the pain. But it's cheating.

That's what AOL (now a part of

Time Warner

(TWX)

) tried to do back in the late '90s, reminds Ketz. AOL claimed that various marketing charges and other indirect costs associated with new subscribers should be capitalized over a five-year period because that's how long the average subscriber stays on as a member.

But those subscription costs should have been expensed as a one-time charge up front. So, AOL changed its policy. But like a guy with a speeding ticket who's still doing 90 miles per hour, it tried to get away with it again back in 2003. And no surprise, got caught.

Research and development has always been an expense associated with much debate. Should it be expensed in the year incurred, or capitalized over a few years because it can be a big asset to the company? The accounting higher-ups have said it needs to be expensed, and companies need to stay consistent. Again, read the MD&A for policies and procedures.

Operating Income vs. Net Income

Once you subtract operating expenses from gross profit, you have your company's operatingincome. This number is strictly based on the operations of the business. And many will argue thatthis provides the clearest look at a company's health.

That's because accounting expenses, like taxes, depreciation and amortization and other nonrecurring charges, are subtracted from operating income on the income statement. And some will dispute that these expenses have nothing to do with the company's actual performance. So those folks would just close the book at operating income.

But, regardless of the opinions, every company has to take these hits.

Still, be skeptical of nonrecurring costs and extraordinary items. "These are some of the most abused areas of the income statement," notes Ketz. That's because there's room for interpretation.

Theoretically, nonrecurring items are just that -- things that don't happen often. Common nonrecurring costs come from discontinued operations. So if a company closes a plant, costs like trying to sell unused assets or severance pay are incurred.

Extraordinary items are both unusual and infrequent. So frost damage in Canada would not qualify, whereas frost in the tropics would. But these expenses are a tough sell. Even expenses incurred with from the hurricanes in New Orleans didn't qualify as "extraordinary" because hurricanes are par for the course down there.

"I haven't seen a truly extraordinary event in a long time," says Ketz. So if your companyhas extraordinary expenses, make sure you read the MD&A and understand them.

Once those costs are subtracted out, you'll finally come down to net income -- sometimes called earnings, net profit, or the bottom line. This is truly what the company has left after subtracting

all

of its expenses from its total revenue.

Ideally, that number's not a loss. If it is, understand why. Are you looking at a start-up? Or is your company in dire straits?

Finally, look at the profit margin. That's the percentage of sales the company has left over as profit after paying all its expenses. While it varies from industry to industry, think of it as the interest rate you're getting on your investment. So you'd like to see this number increasing.

Next you'll find dividends and earnings per share. But we'll tackle those topics at another time. (Look for a dividend dissection in an upcoming

Booyah Breakdown.)

So how's your company doing? Making money, I hope.

And how's your head? Spinning, I'm sure. But you're learning -- and that just means you'resetting yourself up to make more money.

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;

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