Generally Accepted Accounting Principles, or GAAP as they are often called, give management a lot of leeway in determining how to report earnings to shareholders. At times, a company may opt to change the way it has accounted for a particular item in the past, which may result in increasing or decreasing the reported profits despite the company actually being in the identical economic position.
Think back to our depreciation discussion. You saw that the same $5,000 computer could cause drastically different reported profit figures in each of the three years depending upon which method management chose. An aggressive manager could take over a company that had been using the sum of the years digits depreciation method and order the accountants to switch to the straight line depreciation method. With a waive of the pen, profits appear to go through the roof, especially if the business is asset intensive. In reality, you and the other shareholders aren't any richer. In fact, it's likely you are poorer because the manager probably got paid a bonus for his new, record breaking profits.
Management is required to disclose accounting changes in the 10K filings. It is tremendously important that you determine if the change was necessary or simply a maneuver to inflate the amount of profit reported to shareholders. If you suspect there are a lot of games going on with the accounting choices, just walk down the road. There are tens of thousands of companies in which you can buy stock, not to mention all of the small businesses you can acquire or start. It's not worth it to be in a partnership with dishonest people.
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This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.
