History has a way of repeating itself in stock investing. When the dot com boom crashed, there was a lot of criticism leveled at the amount of financial slight of hand that occurred to pump up earnings; stock investors chased earnings. But, upon second and third looks, there was next to nothing behind those earnings reports due to some aggressive or unorthodox accounting methods. This all came to a head with Enron.

But, with companies struggling to meet earnings expectations, it appears that stock investors are in for a new cycle of financial slight of hand. For example, in its latest financial statements, BMO reported a $359 million “capital market environment change.” In reality, it really is a $359 million loan write-off.

Imagine telling the person reviewing your loan application that the reason why your income fell this year is because of a “capital market environment change.”

I suspect stock investors are going to begin to see some increasingly aggressive financial gymnastics in the next few quarters.  Here are a few things all investors should look out for:

1. Change in assumption. Wells Fargo pulled a nice little earnings trick last year. It traditionally recognizes a mortgage as a loan loss at 120 days but changed that assumption to 180 days and, shazam!, it deferred $265 million in loan losses, meeting earnings expectations (how convenient). Just be wary as soon as a company changes its financial assumptions (which are stated in the financial notes or in managements’ discussions).
2. Earnings goes up, cash and cash flow from operations goes down (or stays flat). Earnings is a measure of profitability but it does  not necessarily follow cash. You can book a sale into revenue but not get paid for a long time. Meanwhile, a company still has to pay the bills so even though your earnings go up, your cash is drying up. You can’t pay your vendors with an income statement.  You pay with cash. How do earnings and cash on hand head in different directions? It is the dot com special (aka the Nortel special). Offer extremely generous credit and payment terms to your clients. Book that as a sale in order to meet earnings but you have no cash standing behind that sale since your clients do not have to pay until next year but you still have to pay the bills (by borrowing against these same non-cash sales; neat trick that only lasts you so long).
3. Bad debt/accounts receivable (a/r) is not moving in tandem with revenue growth. You can find both on the balance sheet. If the allowance for bad a/r, or loan losses in financial institutions, are not moving in tandem with a/r (or loan) growth, the company may be artificially boosting results by not fully recognizing customers are not paying them (bad debt being an expense which reduces earnings so little recognized bad debt = higher earnings; see Wells Fargo example above).
4. Pension underfunding. These are usually found in the financial notes. Pension underfunding does not affect earnings directly but a large underfunding eventually means that there will be an earnings hit to reduce the short-fall (it is a question of when and not if). Focus on the absolute dollar figure of the pension underfunding and compare it against cash on hand. If the former is substantially larger than the latter, there is trouble coming. For example, even if GM survives, its pension underfunding may do it in anyways.
5. Continuous one-time charges. These are usually found in the management discussion. A one-time charge is supposedly just that- an out of the ordinary course transaction that should not affect the trend of the company. But if every quarter there is a one-time charge, what other accounting tricks are they playing?

Financial statements can be very confusing but stock investors should focus on the same things that we all focus on: how much cash is in the bank, what are our financial obligations in the future, do we have the cash to meet these obligations?

Focus on the simple things and cash, cash, cash (on hand and from operations) and do not get fooled by earnings trickery.