If a company is playing games with its expenses, the most likely place financial report readers find evidence is in its capitalization or its amortization policies. You can find details about these policies in the notes to the financial statements.
Companies that want their bottom lines to look better may shift the way that they report depreciation and amortization, which are the tools they use to account for an asset's use and to show the decreasing value of that asset.
Advertising expenses
Companies report most advertising expenses in the accounting period when they're incurred. However, for some types of advertising, like direct-response advertising, companies can spread the expense over a number of quarters. Direct-response advertising is mailed directly to the consumer.
For example, when a business sends out an annual catalog, it can legitimately spread out the costs for that direct-mail piece over the year, as long as it can show that it receives orders from that catalog throughout the year. To find out a firm's policy on advertising expenses, look in the notes to the financial statements.
Research and development costs
Companies are supposed to report research and development (R&D) costs in the current period being reported on the financial statements, but some companies try to stretch out those expenses over a number of quarters so the reduction in net income isn't necessary all in the same year. If fewer expenses are subtracted from revenues, net income is higher, which makes the company look more profitable.
However, the SEC has ruled that because these expenditures are so high-risk and a company isn't certain when the R&D activities may benefit its revenue, the company must immediately report R&D expenses. One notable exception occurs when a company is developing new software, in which case it can spread its expenses over a number of periods until the software development is technically feasible.
To see how the company expenses its R&D, read the notes to the financial statements.
Patents and licenses
Most times, the expenses a company incurs during the research and development phase must be written off in the year when they occurred, and the expenses can't be capitalized. But the company can capitalize some expenses — for instance, those it incurs to register or defend a patent. The company can also list a patent or license it purchases as an asset at the purchase price and capitalize it.
All patents and licenses that a company purchases are listed as assets on the balance sheet. In addition, the balance sheet lists the costs of registering patents or licenses for products developed in-house. The value of these patents and licenses is amortized over the time period for which they're economically viable.
Companies can play games with the value of patents and licenses, as well as with the time periods for which they'll be considered economically viable. To see what a company says about its patent and license accounting policies, read the notes to the financial statements. Compare its policies with the policies of similar companies to see whether they appear reasonable.
Asset impairment
Tangible assets depreciate based on set schedules, but not all intangible assets face a rigid amortization schedule.
Any company that acquires another company can list goodwill on its balance sheet. A firm's value of goodwill is based on the amount of money or stock that it pays for the acquisition, over and above what the net tangible assets were worth.
In the past, companies amortized goodwill and wrote off its expenses each year. Today a company must prove that the value of its goodwill has been impaired before it can write it off. The SEC requires that companies test goodwill before they write off any value to see if any impairment to its value has occurred.
The value of goodwill is tested based on a number of factors, including
Competition and the ability of competitors to negatively affect the profitability of the business that a company acquires
The current or expected future levels of industry consolidation
The impact that potential or expected changes in technology may have on profitability
Legislative action that results in an uncertain or changing regulatory environment
Loss of future revenue if certain key employees of the acquisition company aren't retained
The rate of customer turnover, or how fast old customers leave and new customers arrive
The mobility of customers and employees
Restructuring charges
Restructuring charges is one of the primary ways companies can hide all sorts of accounting games. A company can restructure itself by combining divisions, having one division split off into two or more, or dismantling an entire division. Any major change in the way a company manufactures or sells its products usually entails restructuring.
Whenever a company indicates restructuring charges on its financial statements, scour the notes to the financial statements for reasons behind those charges and how the company determines how much it will write off. Carefully read the detail for costs allocated to the restructure. The restructuring method is a great way for a company to clean out the books. Luckily, this is a red flag that the SEC closely watches for.
In the notes to the financial statements, you usually find a note specifically detailing the restructuring. You may also find mentions of restructuring charges or plans in the management's discussion and analysis section. Usually when a company restructures, it incurs costs for asset impairment, lease termination, plant and other closures, severance pay, benefits, relocation, and retraining, giving creative accountants a lot of room to play the numbers.
The company must specify costs not only for the current period, but also costs for all future years in which the company anticipates additional costs and any related write-offs in periods prior to the one being reported. The SEC watches these charges very closely, too, and tries to close any loopholes that allow companies to charge recurring operating expenses to their restructuring.