Gain an Edge by Reading Financial Statements

As of late, accounting “errors” seem to be frequently occurring in some companies. First, Research In Motion had trouble accounting for its employee options. Now Imax Corp. is reviewing how it accounted for some of its operating costs. According to the company, it might be necessary to restate six years’ worth of financial statements because some of the costs were capitalized when they perhaps should have been expensed.

You see, costs can be capitalized on a company’s balance sheet as an asset and expensed on the income statement for as long as an asset has a useful shelf life. This is a more aggressive accounting method for dealing with costs because, in effect, it increases a company’s current earnings.

Of course, this is also a legal strategy when, for example, an airline is capitalizing its costs for purchasing new airplanes. These planes are not simply an expense just because they generate revenues. It only makes sense to capitalize them and treat them as assets on the balance sheet and expense only a portion of the initial costs on the income statement.

Capitalizing versus expensing doesn’t always make sense. Companies generally don’t like to expense their costs because the full expenditure immediately goes on the current income statement. While this accounting method is more conservative, it also has the effect of reducing a company’s current earnings.

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So, what happened at Imax? Was it an honest mistake or another case of accounting fraud? Right now, the company’s auditors are still analyzing the financial statements in order to determine the nature of the “errors.” However, I can tell you that this is not the first time Imax has been under the scrutiny of regulators. Plus, where there is smoke, there’s usually fire.

While some analysts argue that accounting errors of $2.5 million versus $708.2 million of total expenses reported for the past six years is far too small a percentage to cause grief, they seem to have forgotten that once forensic accountants start digging, who knows what else they might find.

Management bias is at the heart of the problem. CFOs often make all the final decisions when it comes to how certain items are accounted for on financial statements. Out of the four basic financial statements, balance sheets and income statements are the most prone to manipulation. Analysts and investors also look at these two statements the most.

This is why I believe it’s of paramount importance for any prudent investor to learn how these statements can be manipulated and how to use the statement of cash flow to determine the true state of a company’s financials. Trust me, it’s not that difficult to learn and it could save you a bundle in the process.