In October 2001, Computer Associates, one of the world's largest software companies, reported pro-forma income of $359M for its fiscal 2nd quarter, nearly a 60% increase over the previous year. The impressive numbers were the result of a new business model, which stretched software revenues over the entire year. At the same time, the company reported to the SEC a loss of $291M for the quarter using GAAP. This story underscores the importance of always relying on GAAP-based SEC filings and also illustrates one of the most common genres of creative accounting - revenue recognition.

Revenue recognition is simply when a company books its sales. Most companies book their sales when delivery has occurred or services have been rendered, while others do it when the company receives payment. Some companies, however, book sales more creatively or outright fraudulently. Although Computer Associates technically did nothing illegal, but their new results were misleading to some investors. Some more fraudulent companies might go the extra mile and actually book future sales as current revenue. This happened at Xerox in the late 1990s and into 2000 when they accelerated the revenue recognition of leasing equipment over four years. This time, even the GAAP financial statements showed a higher net income. So, how can investors see through this smoke screen?

The key is looking at the one thing that most accounting tricks cannot change - cash. The simple check is this: Compare net income from the balance sheet to cash from operations on the statement of cash flows. If these two numbers do not correlate, then something is amiss. When Xerox showed a net income of over $100M and operating cash flow was -$8M, clearly something was wrong! By using this simple five-minute check, investors can avoid many of the most common types of accounting fraud.

Where do you find this information? A company's financial statements can be found quarterly in form 10Q and yearly in form 10k, usually under Section 1. A company's net income can be found towards the bottom of the Income Statement, and indicates how much the company "made" - that is, all revenues minus all operating expenses. The company's cash from operations can be found in the statement of cash flows, in the first section "cash flow from operating activities". The number we are looking for is "net cash provided by operating activities" or simply "net operating cash". This number takes all cash receives and subtracts all cash expenditures. Even if a company claims a future sale on net income, they could not have possibly received cash for it - and that's how we can tell! For an example of a 10Q statement, check out Microsoft's latest filing.

You can find all of the SEC filings filed by a company, including their annual report and financial statements at SECFilings.com.