How to spot red flags in earnings

When investors are sizing up a company's earnings report, accounting experts say they should look for red flags that fall into several categories.

First, investors should pay close attention to whether a company is capitalizing its software development and technology. Capitalized development costs later show up on the balance sheet as an asset.

"Assets can turn into cash, which is a good thing, or they can turn into an expense, which reduces net income," said Roy Avondet, a partner with Deloitte & Touche.

If a company capitalizes its costs significantly, it is postponing expenses that will later affect profits instead of biting the bullet early on, Avondet said. "The risk in delaying it is that the value of technology may not last that long. Then there's a bigger write-off that will result later on," he said.

Investors can read the footnotes of a company's annual report to learn if a company plans to amortize the expense of an asset over time.

Fred Gill, a senior technician manager for accounting standards with American Institute of Certified Public Accountants, said the software industry has had guidelines since the 1970s to indicate when research and development costs should be accounted for as capitalized costs or when its a manufacturing expense.

That move was designed to put everyone on a level playing field when accounting for costs, Gill said, noting that it's usually more favorable to list development costs as part of the manufacturing process than R&D. Investors often question whether the financial benefit of that research and development will translate into revenues.

Accounting experts also say investors should examine a company's system and thresholds for recognizing. David Hickox, a partner with accounting firm Ernst & Young, said a conservative approach for marketing and licensing fees is to book the revenues over the life of the contract, rather than taking them up front.

Earlier this year, Gill said guidelines were drawn to indicate when software companies should account for revenues. But the industry's problems are far from solved.

The complex guidelines basically are designed to allow for consistent revenue reporting by all companies. Some accounting firms, however, said the guidelines are still open to interpretation and some confusion still exists.

"Delivering goods used to be assumed when a sale took place under traditional industries," Gill said. "When what constitutes when software is delivered? When a contract is signed, when the software is downloaded?" 

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