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Analyzing Operating Activities

Financial
Statement
Analysis

K R Subramanyam
John J Wild
6
CHAPTER

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Income Measurement Income Measurement

Concepts of Income Concepts
Economic Income  Based on accrual accounting
 Equals net cash flows + the change in the present value of  Suffers from measurement error, arising because of accounting
future cash flows distortions
 Includes both recurring and nonrecurring components—
rendering it less useful for forecasting future earnings potential Accounting Income consists of:
Permanent Income  Permanent Component--the recurring component expected to
Also called sustainable earning power, or sustainable or persist indefinitely
 Transitory Component--the transitory (or non-recurring)
normalized earnings
Estimate of stable average income that a company is expected component not expected to persist (Note: The concept of
to earn over its life economic income includes both permanent and transitory
components.)
Reflects a long-term focus
Directly proportional to company value  Value Irrelevant Component--value
value irrelevant components have
no economic content; they are accounting distortions

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Income Measurement Income Measurement

Measurement Measurement
Two main components of accounting income: Revenues and Gains
Revenues (gains)
• Revenues are earned inflows or prospective
Expenses (losses)
inflows of cash from operations*
• Gains are recognized inflows or prospective
inflows of cash from non-operations**

* Revenues are expected to

recur
**Gains are non-recurring

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Income Measurement Income Measurement

Measurement Alternatives
Expenses and Losses
Two major income dimensions:
• Expenses are incurred outflows, prospective
1. operating versus non-operating
outflows, or allocations of past outflows of cash
2. recurring versus non-recurring*
from operations
• Losses are decreases in a company’s
net assets arising from
non-operations

Expenses and losses are resources consumed, spent,

*Motivated by need to separate permanent and
or lost in pursuing revenues and gains
transitory components

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Income Measurement Income Measurement

Alternatives
Alternative Income Statement Measures
• Net income—widely regarded as “bottom line” measure of
income
• Comprehensive income--includes most changes to equity that
result from non-owner sources; it is actually the bottom line
measure of income; is the accountant’s proxy for economic income
• Continuing income--excludes extraordinary items, cumulative
effects of accounting changes, and the effects of discontinued
operations from net income*
• Core income--excludes all non-recurring items from net income
*Often erroneously referred to as “operating income”
Analysis
Operating versus Non-Operating Income
Operating income--measure of company income as generated from
operating activities
Three important aspects of operating income
 Pertains only to income generated from operations
 Focuses on income for the company, not simply for equity holders
(means financing revenues and expenses are excluded)
 Pertains only to ongoing business activities (i.e., results from
discontinued operations is excluded)
Non-operating income--includes all components of net income
excluded from operating income
Useful to separate non-operating components pertaining to financing and
investing

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Income Measurement Non-Recurring Items

Analysis
 Extraordinary items
Determination of Comprehensive Income—sample company
 Discontinued segments
Net income
Other comprehensive income:  Accounting changes
+/- Unrealized holding gain or loss on marketable securities
+/- Foreign currency translation adjustment  Restructuring charges
+/- Postretirement benefits adjustment
+/- Unrealized holding gain or loss on derivative instruments
Comprehensive income  Special items

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Non-Recurring Items Non-Recurring Items

Extraordinary Items Discontinued Operations
Criteria Accounting is two-fold:
Unusual in nature
Infrequent in occurrence • Income statements for the current and prior two
years are restated after excluding the effects of
Examples
discontinued operations
Uninsured losses from a major casualty (earthquake,hurricane,
tornado), losses from expropriation, and gains and losses from • Gains or losses from the discontinued operations are
early retirement of debt reported separately, net of tax*

Disclosure & Accounting *Reported in two categories: (i) operating income or

Classified separately in income statement
Excluded when computing permanent income
Included when computing economic income
loss from discontinued operations until the
measurement date, and (ii) gains and losses on
disposal

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Non-Recurring Items Non-Recurring Items

Accounting Changes
Discontinued Operations
First Type of Accounting Change is
For analysis of discontinued operations: Accounting Principle Change—involves
• Adjust current and past income to remove effects of switch from one principle to another
discontinued operations
 Companies disclose this info for the current and past two
years Disclosure includes:
 For earlier years:
• Nature of and justification for change
 Look for restated summary info or other voluntary
disclosures • Effect of change on current income and
 Take care when doing inter-temporal analysis earnings per share
• Adjust assets and liabilities to remove discontinued operations
• Cumulative effects of retroactive
• Retain cumulative gain or loss from discontinued operations in
application of change on income and EPS
equity
for income statement years

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Non-Recurring Items Non-Recurring Items

Accounting Changes Accounting Changes
Analyzing Accounting Changes
Second Type of Accounting Change is
• Are cosmetic and yield no cash flows
Accounting Estimate Change—
• Can better reflect economic reality
involves change in estimate
• Can reflect earnings management (or even
underlying accounting manipulation)
• Impact comparative analysis (apples-to-apples)
• Affect both economic and permanent income
• Prospective application—a change
is accounted for in current and  For permanent income, use the new
method and ignore the cumulative effect
future periods
 For economic income, evaluate the
• Disclose effects on current income change to assess whether it reflects
reality
and EPS

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Non-Recurring Items Non-Recurring Items

Special Items Special Items
Special Items--transactions and events that are unusual or
infrequent Asset Impairment—when asset fair value is below carrying (book) value

Some reasons for impairments

Challenges for analysis  Decline in demand for asset output
 Technological obsolescence
 Often little GAAP guidance  Changes in company strategy
 Economic implications are complex
 Discretionary nature serves earnings management aims Accounting for impairments
 Report at the lower of market or cost
 No disclosure about determination of amount
Two major types
 No disclosure about probable impairments
 Flexibility in determining when and how much to write-off
 Asset impairments (write-offs)  No plan required for asset disposal
 Restructuring charges  Conservative presentation of assets

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Non-Recurring Items Non-Recurring Items

Special Items Analyzing Special Items
Restructuring Charges—costs usually related to major changes in company
business
Earnings Management with Special Charges
Examples of these major changes include
 Extensive reorganization (1) Special charges often garner less investor
 Divesting business units attention under an assumption they are non-recurring
 Terminating contracts and joint ventures and do not persist
 Discontinuing product lines
 Worker retrenchment
(2) Managers motivated to re-classify operating
 Management turnover
 Write-offs combined with investments in assets, technology or manpower charges as special one-time charges

Accounting for estimated costs of restructuring program (3) When analysts ignore such re-classified charges
 Establish a provision (liability) for estimated costs it leads to low operating expense estimates and
 Charge estimated costs to current income overestimates of company value
 Actual costs involve adjustments against the provision when incurred

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Non-Recurring Items Non-Recurring Items

Analyzing Special Items Analyzing Special Items

Income Statement Adjustments Balance Sheet Adjustments

(1) Permanent income reflect profitability of a company
under normal circumstances
• Most special charges constitute operating expenses
that need to be reflected in permanent income
• Special charges often reflect either understatements
of past expenses or investments for future profitability
(2) Economic income reflects the effects on equity of all
events that occur in the period
• Entire amount of special charges is included
Balance sheets after special charges often better reflect
business reality by reporting assets closer to net realizable
values
Two points of attention
(1) Retain provision or net against equity?
• If a going-concern analysis, then retain
• If a liquidating value analysis, then offset against equity
(2) Asset write-offs conservatively distort asset and liability
values

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Revenue Recognition Revenue Recognition

Guidelines Guidelines
Revenue Recognition Criteria
 Earning activities are substantially complete and no significant Some special revenue recognition situations are
added effort is necessary
 Risk of ownership is effectively passed to the buyer  Revenue When Right of Return Exists
 Revenue, and related expense, are measured or estimated with  Franchise Revenues
accuracy  Product Financing Arrangements
 Revenue recognized normally  Revenue under Contracts
yields an increase in cash,  Percentage-of-completion method
receivables or securities  Completed-contract method
 Revenue transactions are at arm’s  Unearned Revenue (amount of revenues that are still
length with independent parties unrecognized appear in the balance sheet as a liability)
 Transaction is not subject to revocation

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Revenue Recognition Deferred Charges

Analysis
Revenue is important for
 Company valuation
 Accounting-based contractual agreements Costs incurred but deferred because they are
 Management pressure to achieve income expectations expected to benefit future periods
 Management compensation linked to income
 Valuation of stock options
Consider four categories of deferred costs
Analysis must assess whether revenue reflects business reality
 Assess risk of transactions
 Assess risk of collectibility •Research and development
•Computer software costs
Circumstances fueling questions about revenue recognition include •Costs in extractive industries
 Sale of assets or operations not producing cash flows to fund interest
or dividends •Miscellaneous (Other)
 Lack of equity capital
 Existence of contingent liabilities

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Deferred Charges Deferred Charges

Research and Development Computer Software Costs
Accounting for R&D is problematic due to:* [Note: Accounting for costs of computer software to be
sold, leased, or otherwise marketed identifies a point
• High uncertainty of any potential benefits referred to as technological feasibility]
• Time period between R&D activities and determination of success
• Intangible nature of most R&D activities
• Difficulty in estimating future benefit periods Prior to technological
Hence: feasibility, costs
• U.S. accounting requires expensing R&D when incurred
• Only costs of materials, equipment, and facilities with alternative
are expensed when
future uses are capitalized as tangible assets incurred
• Intangibles purchased from others for R&D activities with alternative
future uses are capitalized
After technological feasibility, costs are capitalized as
*These accounting problems are similar to those encountered with
employee training programs, product promotions, and advertising
an intangible asset

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Deferred Charges Employee Benefits

Costs in Extractive Industries
Overview
Search and development costs for natural resources is important to
extractive industries including oil, gas, metals, coal, and nonmetallic
minerals  Increase in employee benefits supplementary to salaries and
wages
Two basic accounting viewpoints:
• “Full-cost” view—all costs,  Some supplementary benefits are not accorded full or timely
productive and nonproductive, recognition:
incurred in the search for resources
are capitalized and amortized to
income as resources are produced • Compensated absences
and sold • Deferred compensation contracts
• Stock appreciation rights (SARs)
• “Successful efforts” view—all costs that do not result directly in • Junior stock plans
discovery of resources have no future benefit and should be • Employee Stock Options (ESOs)
expensed as incurred. Prescribed for oil and gas producing
companies

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Employee Benefits Employee Benefits

Employee Stock Options
Employee Stock Options
Option Facts
ESOs are a popular form of • Option to purchase shares at a specific price on or after a future
date
incentive compensation • Exercise price is the price a holder has the right to purchase
—reasons include: shares at
• Exercise price often set equal to
stock price on grant date
 Enhanced employee performance • Vesting date is the earliest date
 Align employee and company incentives the employee can exercise
option
 Viewed as means to riches • In-the-Money: When stock
 Tool to attract talented and enterprising workers price is higher than exercise
price
 Do not have direct cash flow effects • Out-of-the-Money: When stock price
 Do not require the recording of costs is less than exercise price

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Employee Benefits Interest Costs

Employee Stock Options Interest Defined
Two main accounting issues
Interest
• Determining Dilution of earnings per share (EPS)
Compensation for use of money
 ESOs in-the-money are dilutive securities and affect diluted Excess cash paid beyond the money (principal)
EPS borrowed
 ESOs out-of-the-money are antidilutive securities and do not
Interest rate
affect diluted EPS
Determined by risk characteristics of borrower
• Determining Compensation expense
 Determine cost of ESOs granted Interest expense
 Amortize cost over vesting period Determined by interest rate, principal, and time

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Interest Costs Income Taxes


Interest Analysis Temporary Income Tax Differences

• Interest on convertible debt is controversial by

ignoring the cost of conversion privilege
• Diluted earnings per share uses number of shares
issuable in event of conversion of convertible debt Taxable Income
Financial
• Analysts view interest as a period cost—not Statement Income
capitalizable  Differences that are temporary in nature
• Changes in a company borrowing rate, not explained  expected to reverse in the future
by market trends, reveal changes in risk  mainly in the nature of timing differences between tax
and GAAP accounting
 accounted for using deferred tax adjustments

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Income Taxes Income Taxes

Income Tax Accounting Income Tax Analysis

• Identify types and amounts of temporary differences and the • Financial Statement Adjustments
nature and amount of each type of operating loss and tax credit • Present Valuing Deferred Tax Assets and
carryforward Liabilities
• Measure total deferred tax liability for taxable temporary
• Forecasting Future Income and Cash Flows
differences
• Compute total deferred tax asset for deductible temporary • Analyzing Permanent and Temporary
differences and operating loss carryforwards Differences
• Measure deferred tax assets for each type of tax credit • Earnings Management and Earnings Quality
carryforward
• Reduce deferred tax assets by a valuation allowance

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