Chapter Thirteen

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Prepared by: Stephen H. Penman – Columbia University
With contributions by
Nir Yehuda – Northwestern University
Mingcherng Deng – University of Minnesota
Peter D. Easton and Gregory A. Sommers – Notre Dame and Southern
Methodist Universities
Luis Palencia – University of Navarra, IESE Business School
13-2
What You Will Learn from this Chapter
•Why growth analysis focuses on residual earnings growth and
abnormal earnings growth, rather than earnings growth

•What a growth firm is

•What constitutes sustainable earnings

•What is meant by transitory earnings

•How to analyze sustainable profitability

•How sustainable earnings and growth analysis help answer the

question of whether a firm has durable competitive advantage

•What drives growth of the common shareholders’ investment

• How P/E and P/B ratios relate to each other

13-3
 The Big Picture for this Chapter

Valuation is based on forecasting residual earnings and residual

earnings growth

So, what drives growth?

 Understand what growth is, then identify the drivers of growth

 Understand that sustainable earnings is the base from which growth

can take place, so growth analysis starts with the identification of
sustainable earnings

13-4
What Is a Growth Company and How Is It Valued?

Growth in sales?

Growth is assets?

Growth in equity?

Growth in earnings?

Does a high P/E ratio indicate a growth company?

Does a high P/B ratio indicate a growth company?

13-5
 Remember the Caveat: Beware of Paying Too
Much for Growth
(Chapters 5, 6, and 7)

Firms can grow earnings, but not create value

Earnings growth generated by investment

Earnings growth generated by the accounting

Value-added growth:

Think of growth in residual earnings and abnormal earnings

growth

A reminder: abnormal earnings growth (AEG) is equal to

growth in residual earnings (ΔRE)

13-6
 A Growth Company?
General Electric Corp.: 1993-2000

13-7
 A Growth Company?
General Electric Again.: 2001-2010

13-8
Is Nike a Growth Firm?

13-9
 The Base for Growth:
Sustainable Earnings

Sustainable earnings are earnings that can be repeated

(sustained) in the future and which can grow.

Otherwise called
 Core Earnings
 Persistent Earnings

Unsustainable earnings are otherwise called

 Unusual Items
 Transitory Earnings

13-10
 Cutting to the Core:
Core Earnings (or Sustainable Earnings)

1. Distinguish core operating income from unusual (transitory)

income:

Operating Income = Core OI + Unusual items

2. Distinguish core income from sales from other core operating

income:

Operating Income = Core OI from Sales

+ Core Other OI
+ Unusual items

13-11
 Reformulating Income Statements to Identify Core and
Unusual Items
Reformulated Operating Income Statement: Core and Unusual Items
 Unusual Items
Core Operating Income
Core sales revenue
 Core cost of sales
= Core gross margin
 Core operating expenses
= Core operating income from sales before tax
 Tax on core operating income from sales
+ Tax as reported
+ Tax benefit from net financial expenses
 Tax allocated to core other operating income
 Tax allocated to unusual items
= Core operating income from sales
+ Core other operating income
+Equity income in subsidiaries
+Earnings on pension assets
+Other income not from sales
Tax on core other income
= Core operating income
 Special charges
 Special liability accruals
 Nonrecurring items
 Asset write-downs
 Changes in estimates
 Start-up costs expensed
 Profits and losses from asset sales
 Restructuring charges
 Profits and losses from discontinued operations
 Extraordinary operating items
 Accounting changes
 Unrealized gains and losses on equity investments
+ Gains from share issues in subsidiaries
 Currency gains and losses
 Derivative gains and losses (operations)
 Tax allocated to unusual items
= Comprehensive Operating Income
13-12
 Identifying Sustainable Earnings:
Items to Consider
1. Deferred (unearned) revenue
2. Restructuring charges, asset impairments, special charges
3. Research and development
4. Advertising and promotion
5. Pension expense
6. Changes in estimates
7. Realized gains and losses: Cherry Picking
8. Unrealized gains and losses on equity investments
9. Unrealized gains and losses from fair value accounting
10. Income taxes
11. “Other” income

13-13
 Watch Deferred Revenue

Firms may defer revenue into a “cookie jar” and then dip into
the cookie jar later

Microsoft, 2008-2010 (millions):

2010 2009 2008

Unearned revenue $29,374 $24,409 $24,532

Recognition of (28,813) (25,426) (21,944)

unearned revenue

13-14
Watch for Bleed Back of Restructuring and Merger Charges

Did IBM create earnings with restructuring charges?

Year $billions
1991 3.7
1992 11.6
1993 8.9
1994 (2.8)
1995 (2.1)
1996 (1.5)
1997 (0.5)
1998 (0.4)

13-15
 Analyze R&D

THE ANALYSIS OF R&D: MERCK & CO.

(In billions of dollars) 2010 2009 2008

Sales 46.0 27.4 23.8

R&D 11.0 5.8 4.8
R&D-to-Sales 23.9% 21.2% 20.2%

13-16
 Analyze Marketing Expenditures

THE ANALYSIS OF ADVERTISING COSTS: COCA-COLA

(In billions of dollars) 2010 2009 2008

Revenues 35.1 31.0 31.9
Cost of goods sold 12.7 11.1 11.4
Gross profit 22.4 19.9 20.5
Selling, administrative and general 14.0 11.7 12.1
Operating income (before tax) 8.4 8.2 8.4

Advertising expenses 2.9 2.8 3.0

Advertising expenses/Sales 8.3% 9.0% 9.4%

13-17
 Analyze Pension Costs
_____________________________________________________________________
International Business Machines (IBM)
Components of pension expense, 2001-2004
(In millions of dollars)
2004 2003 2002 2001
Service cost 1,263 1,113 1,155 1,076
Interest cost 4,071 3,995 3,861 3,774
Expected return on plan assets (5,987) (5,931) (6,253) (6,264)
Amortization of transition asset (82) (159) (156) (153)
Amortization of prior service 66 78 89 80
cost
Actuarial losses (gains) 764 101 105 (24)
Net pension expense 95 (803) (1,199) (1,511)

Components of Pension Expense:

1. Service Cost
2. Interest Cost
3. Expected Return on Plan Assets
4. Amortization of Prior Service Cost
5. Amortization of Transition Asset or Liability
6. Changes in Actuarial Estimates (accrual gains and losses)

13-18
Watch the Expected Rate of Return on
Pension Plan Assets
In the 1980s, firms were using expected
rates of return of about 7%

In the 1990s, firms were using expected rates of

returns of 10-10½%

• Applying a high rate of return to bubble asset

prices produces bubble earnings

• Pricing on the basis of bubble prices perpetuates

the bubble

The Pension Pyramid Scheme

(Firms are now using more modest rate: 7½ - 8½%)

13-19
 Watch for Gains on Pension Fund Assets

• General Electric’s expected return on plan assets was

$4,327 million in 2001 (22.0% of earnings before tax)
against a service cost of $884 million. Its net pension
expense was a gain of $2,095 million.

• IBM reported an expected return on plan assets of

$6,264 million in 2001 (56.0% of operating income
before tax).

13-20
Watch Gains and Losses on Sales of Shares
Intel

In its report for its third quarter for 1999, Intel reported net
income of $1,458 million, with no indication of unusual items. Its
cash flow statement, however, reported $556 million in gains on
sales of investments, along with a $161 million loss on
retirements of plant, as add backs to net income to calculate cash
from operations.

Delta Air Lines

Delta reported operating income (before tax) of $350 million

for its September quarter in 1999. However, notes to the report
indicated that these earnings included pre-tax gains of $252
million from selling its interest in Singapore Airlines and
Priceline.com.

IBM

IBM reported before-tax operating income of $4,085 for its

June, 1999 quarter. However, footnotes revealed that this income
included a $3,430 million gain from the sale of IBM's Global
Network to AT&T. This gain reduced selling, general and
administrative expenses in the income statement!

13-21
 Watch for Cherry Picking

Firms can choose which

securities to sell such that

realized gains are booked to the

income statement
unrealized losses are booked to
other comprehensive income

Watch banks and insurance

companies in particular

13-22
Watch for Changes in Estimates

Bad debt allowances

Deferred revenue
Warranty allowances
Residual values for leases

Beware of Cookie Jar Accounting

Look at Schedule II in 10-K

13-23
 Watch Income Taxes

One-time or expiring credits

Changes in valuation allowances for

deferred tax assets

Effective tax rates tend to move

towards the statutory rate overtime

13-24
A Reformulated Income Statement Showing Core Income:
General Mills

13-25
 Comprehensive Tax Allocation
GAAP Income Statement Reformulated Statement

Revenue $ 4,000 Core revenue $ 4,000

Operating expense (3,400) Core operating expense (3,400)
Restructuring charge (300) Core operating income before tax 600
Interest expense (100) Tax:
Income before tax 200 Tax reported $ 45
Income tax 45 Tax benefit of interest 35
Net earnings $ 155 Tax on unusual items 105 185
Core operating income after tax 415
Unusual Items:
Restructuring charge $ 300
Tax deduction 105 195
Operating income 220
Interest expense $ 100
Tax on interest (35) 65
Net earnings $ 155

13-26
 Analysis of Changes in ROCE

1. Analyze Changes in Profitability of Operations

2. Analyze the Effects of Changes in Financing

ROCE  RNOA  [FLEV x SPREAD]

(1) (2)

13-27
A Road Map

13-28
 Explaining the Changes in RNOA
Explaining RNOA

1. Distinguish core and transitory components

Core OI UI
RNOA  
NOA NOA

Core OI from Sales Core Other OI UI

  
NOA NOA NOA

Core OI is persistent income from core business

UI is unusual items that are non-recurring,
sometimes called transitory items.

All items are after tax

13-29
 Explaining Changes in RNOA (cont.)

2. Distinguish margin and turnover drivers of core income

RNOA  Core OI from Sales  Core Other OI  UI

NOA NOA NOA

 Core Sales PM x ATO  Core Other OI  UI

where NOA NOA

Core Sales PM  Core OI from Sales

Sales

13-30
 Explaining Changes in RNOA (cont.)

3. Explain changes in profit margins and asset turnovers

Explain changes in Core PM by looking at profit margin drivers
 GM (by segment)
 Selling Expenses / Sales
 Administrative Expenses / Sales
 R&D / Sales

Pay particular attention to GM: per unit sales prices, production costs…

Explain changes in ATO by looking at turnovers

 Accounts receivables turnover
 Inventory turnover
 PPE turnover
 Accounts payable turnover
 Operating liability turnover
Also
 Look at operating asset composition ratios
 Look at operating liabilities composition ratios
 Look at OLLEV

13-31
 Explaining Changes in RNOA:
the Calculations
The change in RNOA is explained as:

Change in RNOA Change in core sales profit Change due Change due to change in Change due
= + + +
margin at previous asset to change in other core income to change in unusual
turnover level asset turnover items

RNOA1  Core PM1 x ATO 0   ATO1 x Core PM1     UI 

 
 NOA 

(i) (ii) (iii)

Effect due to Effect due to Effect due to
change in change in Asset Unusual Items
Profit Margin Turnover this period

Note: (i) is usually more important that (ii)

13-32
Analyzing Changes in RNOA: Nike Inc.

1. Effect from changes in core profit margin 1.11%

2. Effect from changes in ATO 0.50
3. Effect from unusual items 0.59
ΔRNOA 2.20%

13-33
Analyzing Changes in RNOA: General Mills

1. Effect from changes in core profit margin 2.04%

2. Effect from changes in ATO 0.68
3. Effect of other operating income 0.33
4. Effect from unusual items 2.9
ΔRNOA 6.0%

13-34
 Analyzing Operating Leverage
Operating Leverage is the proportion of total costs that are fixed versus variable

Sales PM  Sales - Variable Cost - Fixed Costs

Sales
 Contribution Margin - Fixed Costs
Sales Sales
The first component here is called the contribution margin ratio

Contribution Margin
Contribution Margin Ratio  1 - Variable Costs 
Sales Sales

This ratio measures the change in income from a change in one dollar of sales

13-35
 Operating Leverage Measures

Operating Leverage is sometimes calculated as the ratio of fixed costs to variable

costs

Another measure is:

OLEV  Contribution Margin  Contribution Margin Ratio

Operating Income Profit Margin

Applying this measure to core operations:

% Change in Core OI  OLEV x % Change in Core Sales

13-36
 Analysis of Effect of Changes in Financing

ROCE  RNOA  [FLEV x SPREAD]

Effect of Financing

Change in ROCE = Change in RNOA + Change due to change in + Change due to

spread at previous level of change in financial
financial leverage leverage

ΔROCE1 = ΔRNOA 1 +  ΔSPREAD x FLEV0  + SPREAD 1x ΔFLEV1 

 

(i) (ii) (iii)

Effect of change in Effect of change Effect of change
operating profitability in spread in leverage

13-37
 Effect of Changes in Financing: Reebok Stock Repurchase
In 1996, Reebok borrowed $600 million to repurchase stocks

Summary Reformulated Balance Sheets

(in millions of dollars)

1996 1995
Net operating assets 1135 1220
Net financial obligations 720 287
Common shareholders' equity 415 933
ROCE 18.90% 19.20%
RNOA 14.10% 16.90%
Net borrowing cost (NBC) 4.90% 4.80%
Financial leverage (FLEV) 0.515 0.187

If financial leverage had been maintained at 1995 level,

ROCE  RNOA  (FLEV x SPREAD)
ROCE 1996  14.1  0.187 x (14.1 - 4.9)   15.8%

Explaining ΔROCE
ROCE1996  - 0.3% - 2.8% - 2.9% x 0.187  0.328x 9.2%
 -2.8%- 0.54% 3.02%

13-38
 Explaining Changes in the SPREAD
SPREAD = RNOA – NBC

RNOA has been explained

Explain Change in NBC:

Distinguish core and unusual borrowing cost

NBC  Core financing exp.  Unusual financing exp.

NFO NFO
Core financing expenses
 Change in interest rates (risk free and risk premium)
 Change in tax rates (and shield)
 Substitution of preferred for debt financing

Unusual financing expenses

 Tax effect from unusually high or low taxes (operating losses)
 Interest income from tax refunds of prior years
 Gains and losses on financial items

13-39
 Analysis of Growth in Shareholders’ Equity:
Road Map

 CSE

 NOA  NFO

 Sales 
1
ATO

Changes in Sales for Changes in Individual Changes in NFO

Business Segments Asset Turnovers Components
Or Product Lines

13-40
 Analysis of Growth in Common Equity
ΔCSE = ΔNOA - ΔNFO

But, as ATO = Sales ,

NOA

NOA = Sales x 1
ATO
 1  - ΔNFO
ΔCSE= Δ  Sales x
 ATO 

These components of growth in equity investment:

1. Growth in sales
2. Change in net operating assets that support each dollar of sales
3. Change in the amount of net debt that is used to finance the change in net
operating assets rather than equity

13-41
 Preparing Financial Statements for Forecasting

1. Identify dirty surplus and calculate ROCE from statement of shareholders’

equity

2. Reformulate balance sheet

3. Reformulate income statement

4. Decompose ROCE: Profitability Analysis

5. Analyze ROCE: Sustainability of Earnings

6. Analyze Growth

Now you are ready to forecast future ROCE and growth and carry out
valuations

13-42
Using Growth Analysis to Understand P/B and P/E Ratios

• How does P/B relate to growth?

• How does P/E relate to growth?

• How does P/E relate to transitory earnings?

13-43
A Reminder: The Benchmark Case of Normal P/B and Normal P/E

Normal P/B Ratio Normal P/E Ratio

Book values expected to grow at equity cost of Earnings expected to grow at equity cost of capital
capital
Abnormal earnings growth expected to be zero
Residual earnings expected to be zero (Residual earnings expected to be unchanged)

Trailing normal P/E:

V  CSE0
0
E

V0E  d 0 E
  E 1
Earn0

Forward normal P/E:

V0E 1

Earn1  E  1

13-44
 A Normal P/E: Whirlpool Corporation
______________________________________________________________________________

Whirlpool Corp.: Analyst Forecast, December, 1994

1993A 1994A 1995E 1996E 1997E

Eps 4.43 4.75 5.08 5.45

Dps 1.22 1.28 1.34 1.41

Bps 22.85 25.83 29.30 33.04 37.07

RE (.10) 2.15 2.17 2.15 2.15

ΔRE 0.02 (0.02) 0.00

AEG 0.02 (0.02) 0.00

______________________________________________________________________________
Valuation:
2 . 15
V 0E  25 . 83   47 . 33
0 . 10
V 0E  d 0 47 . 33  1 . 22
  11 . 00
Earn 0 4 . 33 (approx)
V0E 47.33
  10.00
Earn1 4.75 (approx)

Normal P/E for a 10% cost of capital

13-45
 P/E Ratios Different from Normal

• If earnings are expected to grow faster than the cost of capital (cum-dividend),
P/E > Normal
• If earnings are expected to grow slower than the cost of capital (cum-dividend),
P/E < Normal

OR

• If AEG is forecasted to be positive, P/E > Normal

• If AEG is forecasted to be negative, P/E < Normal

OR

• If RE is forecasted to increase, P/E > Normal

• If RE is forecasted to decrease, P/E <Normal

13-46
 The P/E Ratio and the P/B Ratio

• P/B indicates expected growth in book value

• P/E indicates expected growth in earnings

OR

• P/B indicates future RE

• P/E indicates future changes in RE from current RE

13-47
 How do P/E and P/B Articulate?

P/B Ratio
High High Low

23,146 10,848
P/E Ratio
Low

10,849 23,147

Joint Values of P/E and P/B Ratios; 1963-2001

13-48
Median P/B for E/P Portfolios: 1968-85
_______________________________________________________
E/P Median Median
Portfolio E/P P/B
_______________________________________________________

1 (High) .255 .645

2 .193 .806
3 .169 .889
4 .154 .938
5 .142 .988
6 .133 1.038
7 .124 1.107
8 .116 1.162
9 .109 1.251
10 .102 1.350
11 .094 1.460
12 .087 1.545
13 .080 1.744
14 .072 1.902
15 .063 2.081
16 .052 2.254
17 .039 2.473
18 .017 2.304
19 -.046 1.428
20 (Low) -.417 .833
______________________________________________________

13-49
Median E/P for P/B Portfolios: 1968-85
_______________________________________________________
P/B Median Median
Portfolio P/B E/P
_______________________________________________________

1 (High) 6.20 .040

2 3.66 .055
3 2.82 .067
4 2.33 .077
5 2.00 .085
6 1.76 .091
7 1.58 .097
8 1.43 .102
9 1.31 .105
10 1.22 .110
11 1.13 .115
12 1.05 .121
13 .98 .126
14 .92 .130
15 .85 .130
16 .79 .129
17 .72 .129
18 .64 .127
19 .54 .113
20 (Low) .39 .084
______________________________________________________

13-50
 Fill Out the Cells
(this is not TIC-TAC-TOE)
P/B
High High Normal Low

A B C
Normal
P/E

D E F
Low

G H I
Which cell do growth firms fall in ?

13-51
 The Solution
P/B
High Normal Low
FRE>0 FRE=0 FRE<0
FRE>CRE
High

A B C
FRE>0 CRE<0 FRE<0
A
CRE<FRE
B
FRE=0
C
CRE<FRE
Normal
FRE=CRE

D E F
P/E

CRE>0 CRE=FRE=0 CRE<0

D
CRE=FRE E F
CRE=FRE

G H I
FRE<CRE
Low

FRE>0 CRE>0 FRE<0

G
CRE>CRE
H
FRE=0
I
CRE>FRE

FRE = Expected future residual earnings CRE = Current residual earnings

13-52
A High P/B; High P/E
Nike, Inc.
The market gave Nike a P/B of 4.1
and a P/E of 21 in 2005, both high
relative to normal ratios. Current
residual earnings were $642 million
and analysts were forecasting
earnings that indicated higher residual
earnings in the future.
D High P/B; Normal P/E
Whirlpool Corp.
Whirlpool, with a positive but
constant RE was a cell D firm in
1994. Whirlpool was priced at 11
times earnings (cum-dividend), as we
saw, and at 1.8 times book value.
G High P/B; Low P/E
US Airways Group
US Airways reported an ROCE of
81% in 1998. Analysts deemed 1998
to be a particularly good year and
forecast ROCE for 1999 and 2000
down to 29% and 33%. The stock
traded at 12.6 times book value,
consistent with high ROCE in the
future, but at a P/E of only 4.
B Normal P/B; High P/E
Westcorp
Westcorp, a financial services holding
company, reported earnings for 1998 of
0.65 per share and an ROCE of 5.4%.
Analysts in 1999 forecasted earnings of
$1.72 for 1999 and $2.00 for 2000,
which translate into an ROCE of 13.6%
and 14.1% respectively. With a
forecasted ROCE at about the
(presumed) cost of capital but increasing
from the current level this is a cell B
firm. The market gave the firm a P/B of
1.10 and a P/E of 24.
E Normal P/B, Normal P/E
Horizon Financial Corp.
Horizon Financial Corp., a bank holding
company, reported an ROCE of 10.3%
for fiscal 1999. Analysts forecasted that
ROCE would be 10.6% for 2000 and
after, roughly at the same level. If the
equity cost of capital is 10%, this firm
should have a normal P/B and a normal
P/E. The stock traded at 11 times
earnings and 1.0 times book value.
H Normal P/B; Low P/E
America West Holdings
America West Holdings, the holding
company for America West Airlines had
an ROCE of 15.0% in 1998. Analysts
forecasted in 1999 that the ROCE would
decline to 11.7% by 2000. The market
gave the stock a P/B of 1.0 in 1999, in
line with the forecasted ROCE equaling
the cost of capital. But the P/E was 7,
consistent with the expected drop in the
ROCE.
C Low P/B; High P/E
Rocky Shoes & Boots, Inc.
Like Nike, a footwear manufacturer, Rocky
Shoes reported an ROCE of 1.8% for 1998
with earnings of 0.21 per share. Analysts
forecast an ROCE of 6.2% for 1999 and
7.8% for 2000, on earnings of 0.72 and 0.95
respectively. The market gave the firm a
P/B of 0.6 and a P/E of 33, appropriate for a
firm with forecasted ROCE less than the
(presumed) cost of capital but with
increasing ROCE.
F Low P/B; Normal P/E
Rainforest Cafe Inc.
In 1999, analysts covering Rainforest Cafe,
the theme restaurant (“a wild place to eat”),
forecasted earnings of $0.62 per share for
1999 and $0.71 for 2000, or an ROCE of
6.8% and 7.2%. The stock traded at a P/B
of 0.6, reflecting the low anticipated ROCE.
The ROCE for 1998 was 6.5%. With 1998
profitability similar to forecasted
profitability, the stock should sell at a
normal P/E ratio. And indeed it did: the
P/E at the time of the forecasts was 11.
I Low P/B; Low P/E
UAL Corporation
United Airlines’ holding company traded at
a P/B of 0.7 in mid-1999 and a P/E of 6. It
reported an ROCE of 29.2% for 1998, but
its ROCE was expected by analysts to drop
to 10.6% (before a special gain) in 1999 and
to 9.1% in 2000.
13-53
 What is a Growth Stock?

• P/E indicates growth in RE but this could be from a very low

base: Firms in cell C can be high P/E firms

• Trailing P/E reflects growth and transitory earnings. If earnings

are temporarily low, P/E will be high

The Molodovsky Effect:

Cells B and H are pure Molodovsky effects
Cells A, C, G and I are mixed growth and Molodovsky
effects

13-54
 P/B is not Growth

P/B is often said to indicate a growth stock

But…..

• A firm can have a high P/B but zero growth (Cell D)

• A firm can have a high P/B and negative growth (Cell G)

• A firm can have a low P/B and positive growth (Cell C)

There is much confusion around the notions of value vs. growth in

investing

13-55
 Accounting Quality Watch
• Deferred revenue Firms can defer too much earnings to the future and thus create too
much earnings growth. Conversely, firms can defer too little earnings
and so report unsustainable earnings currently.

• Restructuring charges Firms can make excessive restructuring charges in one year and bleed
them back to earnings in future years, giving the appearance of
growth. FASB Statement 146 now limits the practice.

• Selling, general and SG&A is a large, aggregated number that covers a multiple of sins.
administrate expense Penetrate its composition.

• Gains and losses on These are often hidden in SG&A expense, but are not a part of the
asset sales core business.

• R&D and advertising Firms can increase earnings by temporarily reducing R&D and
advertising expenditures. This not only inflates current earnings but
damages future earnings that the expenditures would otherwise
produce.

(continued)

13-56
 Accounting Quality Watch (cont.)

• Pension accounting Pension accounting brings prices into the income statement with
the danger that earnings can reflect price bubbles. Returns on
pension plan assets are commingled with core operating income
from the business, contaminating profit margins. Expected
returns on plan assets can be overestimated.

• Cherry picking Firms can cherry pick realized gains on investments into the
income statement and report unrealized losses in the equity
statement. Restate the income statement of a comprehensive
income basis.

• Changes in estimates Firms can affect earnings by changes in estimates (of bad debts,
warranty liabilities, and accrued expenses, (for example).

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