Accounting Gimmicks will kill your investment. A company will have difficulty paying more taxes than it has actually earned. A quick check to see if the company is doing Accounting Gimmicks is to calculate the Income Taxes Paid and deduct that value to the Income Before Tax. If the difference between the Income Before Tax and the Income Taxes Paid does not match the Net Income in the company's Income Statement, that company could be in deep trouble.
However, nowadays some companies are getting very clever in making their financial statements look really good. They are able to hide large losses and still appear profitable. If you do not understand how the company is making tons of money, then it probably isn't a wise investment. Warren Buffet only invests in things he could understand and so should you.
Equations
Example 1
Date: Year 2010
Company: Coca-Cola
Income Before Tax: $14.243 Billion
Tax Rate: 16.7%
Net Income: $11.809 Billion
Example 2
Date: Year 2011
Company: IBM
Income Before Tax: $21.003 Billion
Tax Rate: 24.5%
Net Income: $15.855 Billion
Example 3
Enron was a company that did accounting gimmicks to make it appear they were making a lot of money. Their bankruptcy in December 2001 was the largest in history. A lot of investors lost their money.
Date: September 2000, Quarterly Statement
Company: Enron
Income Before Tax: $679 Million
Tax Rate: 30.7%
Net Income: $303 Million
Calculating the Income Taxes Paid:
Enron's Net Income should be:
| Income Statement | Calculated | |
Net Income | $303 Million | $471 Million |
There is a disparity with Enron's Net Income. Income Statement says it has $303 Million in Net Income but yet when we calculated the Net Income in regards to Income Taxes Paid, the calculated Net Income should have been $471 Million. This should have been one of the red flags that investors should have seen.