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Investors love strong earnings, and they love mergers and acquisitions. Tuesday, they got a dose of both.

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As we enter into the tsunami of earning' s reports for the first quarter of 2014, it will be important to look past the media driven headlines and do your homework.   The accounting mechanizations that have been implemented over the last five years, particularly due to the repeal of FASB Rule 157 which eliminated  " mark-to-market" accounting, have allowed an ever increasing number of firms to " game" earnings season for their own benefit.  

This was confirmed in a recent WSJ article  which stated:

" If you believe a recent academic study, one out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies' earnings. 

Not Enron-style, fraudulent fiddles, mind you. More like clever&mdash and legal&mdash exploitations of accounting standards that ' manage earnings to misrepresent [the company' s] economic performance,' according to the study' s authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like."

This should not come as a major surprise as it is a rather " open secret." Companies manipulate bottom line earnings by utilizing " cookie-jar" reserves, heavy use of accruals, and other accounting instruments to either flatter, or depress, earnings.

" The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big " restructuring charge" that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs' belief that these practices leave a significant mark on companies' reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study' s respondents said it was around 10% of earnings per share."

Of course, the reason that companies do this is simple: stock based compensation. Today, more than ever, many corporate executives have a large percentage of their compensation tied to company stock performance. A " miss" of Wall Street expectations can lead to a large penalty in the companies stock price. 

As shown in the table, it is not surprising to see that 93% of the respondents pointed to " influence on stock price" and " outside pressure" as the reason for manipulating earnings figures.

Note: For fundamental investors this manipulation of earnings skews valuation analysis particularly with respect to P/E' s, EV/EBITDA, PEG, etc. Revenues, which are harder to adjust, may provide truer measures of valuation such as P/SALES and EV/SALES.

So, as we head into earnings season, it is important to be aware of what is real, and what isn' t. Wade Slome brought this into focus recently  where he pointed out four things to look for

" Distorted Expenses: If a $10 million manufacturing plant is expected to last 10 years, then the depreciation expense should be $1 million per year. If for some reason the Chief Financial Officer (CFO) suddenly decided the building would last 40 years rather than 10 years, then the expense would only be $250,000 per year. Voila, an instant $750,000 annual gain was created out of thin air due to management&rsquo s change in estimates.

Magical Revenues:  Some companies have been known to do what&rsquo s called ' stuffing the channel.' Or in other words, companies sometimes will ship product to a distributor or customer even if there is no immediate demand for that product. This practice can potentially increase the revenue of the reporting company, while providing the customer with more inventory on-hand. The major problem with the strategy is cash collection, which can be pushed way off in the future or become uncollectible.

Accounting Shifts: Under certain circumstances, specific expenses can be converted to an asset on the balance sheet, leading to inflated EPS numbers. A common example of this phenomenon occurs in the software industry, where software engineering expenses on the income statement get converted to capitalized software assets on the balance sheet. Again, like other schemes, this practice delays the negative expense effects on reported earnings.

Artificial Income: Not only did many of the trouble banks make imprudent loans to borrowers that were unlikely to repay, but the loans were made based on assumptions that asset prices would go up indefinitely and credit costs would remain freakishly low. Based on the overly optimistic repayment and loss assumptions, banks recognized massive amounts of gains which propelled even more imprudent loans. Needless to say, investors are now more tightly questioning these assumptions. That said, recent relaxation of mark-to-market accounting makes it even more difficult to estimate the true values of assets on the bank&rsquo s balance sheets"

For really short term focused traders none of this really matters as price momentum trumps fundamentals. However, for longer term investors who are depending on their " hard earned" savings to generate a " living income" through retirement, understanding the " real" value will mean a great deal. Unfortunately, there are no easy solutions, online tips or media advice that will supplant rolling up your sleeves and doing your homework. 

As the WSJ article concludes

The CFOs in the study named and ranked several red flags.

  First and foremost, investors should keep an eye on cash flow:   Strong earnings when cash flow deteriorates may be a sign of trouble. The advantage of this approach is that, unlike some of the other warning signs, it is easily measurable, arming the investors and analysts who do their homework with strong ammunition against management.

  Secondly, stark deviations from the earnings recorded by the company' s peers should also set off alarm bells, as should weird jumps or falls in reserves.

The other potential problem areas are more subjective and more difficult to detect. When, for example, the chief financial officers urge stakeholders to be wary of ' too smooth or too consistent' profits or ' frequent changes in accounting policies,'   they are asking them to look at variables that don' t necessarily point at earnings (mis)management.

As the quarterly ritual of the earnings season approaches, executives and investors would do well to remember the words of the then-chairman of the Securities and Exchange Commission Arthur Levitt in a 1998 speech entitled " The Numbers Game."

' While the temptations are great, and the pressures strong, illusions in numbers are only that&mdash ephemeral, and ultimately self-destructive.' "

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