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American Express Co. (NYSE:AXP): Possible understatement of net income?

Next week American Express Company (NYSE:AXP) will be announcing its Q3 earnings. What should investors expect with regards to AXP accounting practices and reserves? Ahead of the American Express Company (NYSE:AXP) earnings announcement,CapitalCube assesses the Earnings Quality for the company based on data over the last five years.

Today’s blog wraps up our focus on American Express Company (NYSE:AXP) for this week. Our earlier articles on the subject included: American Express (NYSE:AXP): Playing cards with Wal-Mart (NYSE:WMT)American Express Co. (NYSE: AXP): M&A and Dividend assessmentAmerican Express (NYSE:AXP): Two star dividend?.

Our company analysis are always peer-based. We compare American Express Company (NYSE:AXP) stock to its peers in the Financial Conglomerates sector, namely:  JPMorgan Chase & Co. (NYSE:JPM), Visa Inc (NYSE:V), Citigroup Inc. (NYSE:C), Bank of America Corp (NYSE:BAC), Mastercard Inc (NYSE:MA), Capital One Financial Corp. (NYSE:COF), Discover Financial Services (NYSE:DFS), and Cielo S/A (CIEL3).

Earnings Quality

Accounting Quality

AXP-US’s net income margin for the last twelve months is around the peer median, which combined with a relatively conservative accrual policy suggests possible understatement of its reported net income.

Management of Reserves

Strong Buildup
The company’s accrual levels over the last twelve months are both positive and greater than the peer median suggesting the company is not only building reserves but is doing so in a relatively strong manner compared to its peers.

Material Categories

Excluding the effects of change in revenue, the accounting categories causing the most impact on the movement of net income from the prior period to the current period are SG&A, Accounts Receivable and Intangible Assets.

Earnings: From Accounting or Cash Flow?

Net Income = Net Operating Cash Flow – “Accruals”

Accruals are estimates by company management of non-cash expenses, assets and liabilities that are recognized before they are paid. They are calculated as net operating cash flow less net income.
The analysis of accruals can help signal possible earnings management of reported net income and EPS results. For example, ‘Over-Accrued’ can signal under reported net income and/or the building of balance sheet reserve accounts, while ‘Under-Accrued’ can signal inflated Net Income results and/or release of balance sheet reserves to aid reported earnings.

Recent trend for AXP-US’s accruals

The annual trend suggests that AXP-US’s accruals to revenue ratio continues to trend upward and is above (but within one standard deviation of) its four-year average accruals to revenue ratio of 16.5%. Though its accruals to revenue ratio has remained relatively stable at 17.3% compared to 2010, its peer median has increased to 17.3% from 16.7% during this period. Relative to peers, accruals to revenue ratio fell 0.6 percentage points.
On a quarterly basis, AXP-US’s accruals to revenue ratio continues to trend downward and is below (but within one standard deviation of) its four-quarter average accruals to revenue ratio of 24.9%. While its accruals to revenue ratio decreased to 23.2% from 26.6%, its peer median increased during this period to 21.3% from -7.5%. Relative to peers, accruals to revenue ratio fell 32.2 percentage points.
Graph of Annual Accruals (TTM) showing Peer Median for American Express Co. (NYSE:AXP)
Graph of Quarterly Accruals (TTM) showing Peer Median for American Express Co. (NYSE:AXP)

Accounting Quality

Financials suggest possible understatement of net income.

AXP-US’s net income margin for the last twelve months is around the peer median (15.0% vs. peer median of 16.4%). This average margin and relatively conservative accrual policy (23.7% vs. peer median of 18.3%) suggests possible understatement of its reported net income.
Accounting Quality or Net Margin vs. Accruals charted with respect to Peers for American Express Co. (NYSE:AXP)

Management of Reserves

AXP-US’s accounting suggests a relatively strong buildup in its reserves.

AXP-US’s accruals over the last twelve months are positive suggesting a buildup of reserves. In addition, the level of accrual is greater than the peer median — which suggests a relatively strong buildup in reserves compared to its peers.
Management of Reserves, Buildup or Drain? Charted with respect to Peers for American Express Co. (NYSE:AXP)

Key Items Impacting Cash Flow

Accounts Receivable, Intangible Assets and PP&E have the most material impact on the movement of net income.

We assess the impact of various categories on the cash flow of the company by performing a variance analysis. For each category, this variance analysis measures the movement between the current and previous periods, normalized for the size of the company (e.g. days outstanding or percentage of revenues). This normalization eliminates any movement attributable to period-by-period growth and helps isolate the impact of any accounting policy changes the company might have made in recording the values in each category.
The chart below shows the impact of the top accounting categories on American Express Co.’s cash flow for the current quarter. We consider both positive and negative impacts on the cash flow since the categories could have either decreased or increased the reported net income.
% Impact on Cash Flow for American Express Co. (NYSE:AXP)
The table below details the impact of the major accounting categories on American Express Co.’s net operating cash flow for the current quarter. While we have identified the major accrual categories, and conduct several tests on this standardized set, it should be noted that companies can sometimes have a non-standard accrual item that has a higher impact on the difference between net operating cash flow and net income.
American Express Co. (NYSE:AXP): Possible understatement of net income?

Supporting Tests and Analytics

Company Profile

American Express Co. is a global payments and travel company. The company, through its subsidiaries, offers products and services including charge and credit payment card products and travel-related services to consumers and businesses around the world. It focuses on generating alternative sources of revenue on a global basis in areas such as online and mobile payments and fee-based services. The various products and services are sold globally to diverse customer groups, including consumers, small businesses, mid-sized companies and large corporations through various channels, including direct mail, online applications, targeted direct and third-party sales forces and direct response advertising. American Express operates through four reportable segments: U.S. Card Services, International Card Services, Global Commercial Services and Global Network & Merchant Services. The U.S. Card Services segment offers a wide range of card products and services to consumers and small businesses in the United States and provides travel services to card members and other customers. The International Card Services segment offers proprietary consumer and small business cards outside the United States. The Global Commercial Services segment provides expense management services to companies and organizations worldwide through its Global Corporate Payments and Global Business Travel businesses. Global Corporate Payments offers a range of expense management solutions to companies worldwide through its Corporate Card Programs and Business-to-Business Payment Solutions. Global Business Travel provides globally integrated solutions, both online and offline, as well as through mobile applications, to help organizations manage and optimize their travel investments and service their traveling employees. The Global Network & Merchant services segment operates a global payments network that processes and settles proprietary and non-proprietary card transactions. It also provides point-of-sale products, multi-channel marketing programs and capabilities, services and data, leveraging the global closed-loop network. The company was founded by Henry Wells, William G. Fargo and John Warren Butterfield on March 28, 1850 and is headquartered in New York, NY.

Disclaimer

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This article was originally written by abha.dawesar, and posted on CapitalCube.
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