LECTURE 4: INCOME AND CLASSIFICATION

Concept of Net Income

There is no definition of net income (or PoL) in the conceptual framework.

True (Ideal) Net Income

True net Income = Change in Wealth (Firm value) between t and t-1

Thus Income = change in the present-value of future receipts during the period
Similar to a return on a security which includes both dividends and capital appreciation

The non-existenxe of true net income

True NI = change in wealth (value) between t and t-1

Do we know the True wealth/value of firm at time t and t-1=> No

Why?
- PV estimates are subject to substantial error
- Markets are incomplete

Two conceptual approaches to measurement of income

1. BS (A/L) View of Income measuerment

- In which income is a measure of the increase in net resources of the enterprise during a period,
defined primarily in terms of increases in As and decreases in L
- BS has conceptual primacy

2. Revenue/Expenses and Matching View of income measurement

- the two major guiding principles in this proces are the revenue recognition principles and the
mathcing of expenses to revenue principlpe
- Income statement has conceptual primacy and the BS is a store of unallocated costs

THE REPORTING OF INCOME

Income concepts for valuation

Permanent income (also called sustainable or recurring income, maintainable, persistent, core
earnings) is the stable average income a business expect to earn over its life given the current states of
business condition

Operating income (NOPAT) which refers to income that arises from companies operating activities
- exclude all expenses and income that arises firm a firm's financing activities such as interest
expense and investment income

How is Income reported?

- requirements by Acct Std (GAAP income)
+ Statutory net profit
+ other comprehensive income
+ total comprehensive income
- EPS
 - iindustry presentation of pofits: Non-GAAP earnings measurese
+ underlying 9street) earnings
+ ebit and ebitda

AASB108 presentation of FS

the statement of PoL and OCI shall present

- POL
- total OCI
- CI for the period, being the total of profit or loss and OCI

Components of OCI

components of OCI are items of income and expensse that are specifically required or permitted by other
Australian Acct Std to be included in other comprehensive income and are not recognized in PoL. THey
currently include:
- revaluation GAINS relating to PPE or intangible assets
- remeasurement of defined benefit obligations
- gains nd losses arising from translating the financial statement of a foregin operation
- the effective portion of gains and losses on hedging instruments in a cashflow hedge

Motivation of reporting OCI

- items are included in OCI to enhance the relevance of the info in the statement of POL in the
period
- classifying items as income and expenses arising from transactions and events separately from
changes in value can provide useful information

Stret earings or non GAAP Earnings

Non-GAAP Earning smeasures

- recent years have seen an iincreased frequency with which firms prominently report alternative
financial performance metrics to GAAP earnings
- Such as ‘underlying earnings’, ‘cash earning’, recurring earing’ pro-forma earnig s, normalised
earnings and street earnings

What are non-GAAP earnings

In eneral it involves exclusion of items deemed to be non-recurring and one-off which inturn provide a
more representative measue of a firms underlng performance

However manages frequently exclude items that are not ‘once off’ in nature
-research and development expenses
depreciation and amortization
share-based compensation expenses

Reasons for reporting of non-GAAP earnings

- informative reasons
managers claim that the disclusre of non-GAAP earnings can provide a better measure of the company’s
underlying true perfomrnace

- Opportunistic Reasons
it is claimed managers maybe motivated to use non-GAAP earnings numbers to inflate and mislead
investors perceptions of underlying performance

Alternative measures of Operating Income: EBIT, EBITDA, EBITA

EBIT: arguments for excluding interest and tax

- earnings mxed both operating and financing activities of a firm giving a noisy measure of
operating income
- excludeing interest gives a more precise measure of operating income and oerformnace
+ Befroe financing costs and effects of leverage (as leverage can change from year to year,
abstracts from these efects
- Before taxes and thus provides a more precise measure of operating income

Arguments. made for excluding depreciation EBIITDA

- TO enhance earning comparability
+ assets are recorded at historical cost giving rise to a diferent from current costs resulting in
overstated earnings. This overstatement can vary between companies due to difference in timing
of asset purchases

- Earnings mgt
+ DEpreciation and impairment involves significant mgt discretion

- Deoreciation is a ‘non-cash’ expense

+ this argument is not true

Arguments for deducting depreeciation EBITDA

- deducting depreciation provides a more precise measure of operating income and thus improve
comparability
+ PPE are a cost of operation and thus these costs should be atched against reveue earned to
provide a measure of economic value aded
+ this improes comparability as companies vary substaintially in capital intensity

EBITDA is measured with error due to the error in estimation of the amount of D&A to addback

- ebitda is calculated by adding to ebit the total amount of D&A for the periiod
- howerver this may not the represent the deprecitaion expense in the P&L
- this is becaus part of this D&A is capitalized and included in inventory in BS

Earnings beforeinterest, taxes, and amortisation

- excludes amortization but include depreciation
- amoritzation is added back to increase comparability due to te differences in accounting between
acquired versus internally egnerated intangibles
- the recent focus on amortization is like due to the substantial increase in the significance of this
expens, which inturn is driven by increase in intangible intensity acroos time
EPS

EPS is widely used in analysis as a basic measure of profitability, primarily because it shares the same
denominator as price per share

EPS indicates the income earned by each ordinary share

can be used to value a share
the price earnings ratio is used worldwide as a std stock market indicator
ex: if the share price is 5$ per share, and the earnings per share is 0.5$, the PE ratio is 10

the PE ratio is often interpreted as a measure of the future earings prospects of a company

Basic EPS

basic EPS is determined by dividing ‘earnings’ for the financial year by the average ‘weighted number of
ordinary shares outstanding during the financial year

Definition of earnings for basic EPS

Profits after tax after deducting

- any portioin attributable to non-controlling (minority) interest
- any preference share dividends approached for the fiinancial year

Diluted EPS
- consider the effect of certain securites which can be converted to ordinary shares
eg convertible perference shares, convertible notes, convertible debentures, share options

- show how EPS would have been affected if the potential ordinary share in existence at balnce
date had actually been converted

Problem with using EPS for performance measurement

- doe not consider the amount of assets or capital required to generate a particular level of
earnings
- number of shares outstanding serves as a por measure of the amount of capital in use
+ twoo firms with the same earnings and EPS are not euallly profitable if one firm requires twice the
amount of assets or capital to generate those earnings

Any pressure of $100,000 divided by 20,000 shares equals any pressure of 56 be at the same
performance measure by return on performance as measured or proxy by Ernie’s pressure is
fundamentally different bus pay for some caution should be used in using any appreciate as a guide to
performance

EPS is a poor measure of changes in profitability over time because changes in shares outstanding over
can have a disproportionate eddect on the numerator and denominator

for example, a firm could experience a decline in earnings during a year but report higher EPS than it did
in the prior year if it purchaseed a sufficient number of shares early in the period

Use by capital markets

 - so we now turn to discussing the use of earnungs by capital markets
- as a not, when we dicuss this we really ae including all forms of earnings (GAAP, non-GAAP, eps,
ebit, ebitda,…

gather information => interpet information to forecast future CFs

=> discount CFs to dtermine valuation => transact on valuation => Asset price

So when should this news effect price or trading activiy

- when there is new news provided to an investor, and that news either
+ changes their expectations of future CFs OR
+ changes how those CFs are valued. (discount rate)
- that investor then enters into a transaction (create transaction volume)

- if those sum of those transactions across the market result in an increase in demand or supplyof
the shares to the market, then the price will move accordingly (create price change)

What if there is no new news - in earnings or otherwise? (earnings are not relevant, contain no news
investor werent already aware of,or are deemed to unreliable to not add value)

Investors do the following:

- gather the information
- do not change their expectations (no new news)
- do not change their valuation (no new news)
- thusm there valutation before earnings report is the same as the valuation after, wo why transact?
= no transaction
- there fore no change in price

So which part of the earnings news is the market responding to?

- Only the part of the news they were previously unaware of
- this means, only the part they had not previouly built into their expectations of future cashflows
- the part they had already

Unexpected earnings

= actual eanrings - expected eanrings

some possibe definitions and sources of expectation

UE = AE - last years earnings/analysis forecast/management guidance

Unexpected or Abnormal returns (AR)

ARit = realized returnit - expected return
ERit = f (Market return)

determine the stock’s markets response to the unexpected earnings which is the new info
- stock returns are affected by both form specific factors and market wide factors
- we want to isolate that part of the actual return that in unexpected over the event window for the
firm
- this measures the price someone response over the event window associated with unexpected
earnings

Example
So lets do a large sample study to investigate if the market reacts to earnings

● we get a large sample of firms

● we compute the unexpected earnings for those firms and form them into two portfolios of ‘good
earnings new’ and ‘bad earnings news’
● we compute the AR of the stocks in these portfolios across the 12m pre-earnings announcement
period, the announcement ‘the event’ month and the post-earnings announcement perios
● we compute the average AR of the stocks across all of these months

So, now we understand there is an association between earnings and returns

what determines the magnitude of the share price to unexpected earnings?
we can formalise this mathematically to describe the extent to which prices will move given the expected
future cash flows from an unexpected earning announcement

We can call an Earning response coefficient or ERC, which is essentially the change in stock price
even the unexpected earnings or

ERC = delta V / UE
Use by capital markets

what determines the magnitude of the response ERC?

1. the magnitude of the unexpected news
2. factors affecting the response to a $1 of unexpected news (eg holding magnitude constant):
a. the extent to which the news informs future CFs (persistance)
- economic fundamentals
- growth
- type of acct
- earnings quality (reliability)
b. risk

Determinants of Persistance: Economic fundamentals

Persistence: the extent to which earnings items are likely to repeat in future years, and therefore, are
highly relevant

Deifferent economic components of earngins can have different persistence

3 types of earnings events:

- permanent (or recurring0 - expected to persist indefinitely (ERC >1)
each dollar is with 1/r of firm value where r is cost of capital

- transitory (nonrecurring) - affecting earnings in current year only (ERC = 1)

it has a dollar for dollar effect on firm value

- price irrelevant - have no economic content and have zero effect on company value (ERC = 0)

Determinants of Persistence: Economic Fundamentals

ERCs are higher the more you expect a dollar of earnings to persist into the future

$1 of UE from a new product line will translate into more than $1 in AR if the new product is likely to
continue to generate future profits (ie persis)
- Price reaction = $1 + $1/r
- therefore ERC >1
Contrast with a $1 unexpected gain from the sale of a motor vehicle. it yielts a $1 UE for $1 AR now and
so has an ERC = 1

Earnings persistence: earnings growth

- in general growth firms may have a higher ERC than stable firms
- this is simply because an unexpected positive shick ti earnings (eg a $1 increase in sales) of a
growth firm in year t may imply future increasing earnings of $1.10 in year t+1, then $1.2 in year
t+2 and so on
- in contrast an unexpected positive shock to a stable firms earnings in year t (Eg of a $1) may
imply future earnings have increased at the constant amount of $1 in year t+1, then year $! in
year t+2 and so on

Type of accounting
What is persistence of various components of earrings based on how they are measured
- histriacal cost accounted items?
- FV accounted items??
So for the same $1 of new earnign information, the impact on stok price might be different

P&L vs OCI

In general P&L (HC) vd OCI (FV)

Historic Coat: recognise transactions and economic value-addded that is expecte to persist (ERC>1)
FV:; recognize the unrealized change invalue of the assets and liabilities (ERC = 1)
- assuming markets are efficient and prices follow a random walk
As a result we would expect a higher ERC with HC(P&L) vs FV (OCI)

Earnings Quality:

Earnings quality is the Precision (or error) with which reported earrings measures the u underlying teu
eRNINGS OF A FIRM

the greater the error in measuring true earnings the ower the ERC (the share price response to reported
earrings)

Factors that can affect earnings quality:

- fundamental uncertainty
- quality of Acct Std
- quality of CFO in apply Stds
- quality of Auditor and Corporate Gorvernance
TUTORIAL FOUR
Question 1
‘Underlying’ profit metrics are usually greater than statutory GAAP profits. Consider whether this
bias in the direction of adjustments is due to opportunistic or informative reporting on average
across all firms.
Assuming managers have a self-interested incentive to report higher than lower profits then it appears
prima facie that the bias in the direction of adjustments towards greater profit may be consistent with
opportunistic reporting. However there maybe an inherent bias towards adjusting for negative items, for
reasons that are not opportunistic, due to the nature of GAAP reporting for two reasons.
First, GAAP is conservative and therefore there is limited unrealized gains (which may be deemed
non-recurring) to adjust. For example, AASB 116 requires unrealized gains to be reported in OCI and
therefore there is no need to adjust for these items if they were deemed to be non-recurring as they are
never reported. As another example AASB 136 requires impairment write-downs but not write-up.
Therefore, management need to consider if the write-downs are transitory but there is no need to consider
or adjust for write-up because they are not reported in GAAP statutory profit. Second, there is simply a
greater variation in the type and function of firm expenses compared to firm revenues. In general a firm
may generate revenue from sale and of goods and services and interest revenue (e.g. two line items). In
contrast there is a substantially greater number of individual different types of costs (and thus expenses)
incurred by the firm in generating that revenue. Therefore the greater number of different types of costs
may give rise to a greater possibility that some of these are non-recurring.
Notwithstanding these fundamental reasons for a bias in the adjustments towards greater profits,
anecdotal evidence suggests there may also be in part an opportunistic explanation. An empirical fact is
that extreme profits and losses revert to the mean. This implies at least some extreme revenues are
non-recurring. However very rarely is it observed that firms deem some revenue transactions as
non-recurring. This in turn implies there may be some bias toward classifying expenses rather than
revenues as non-recurring.
Question 2
EBITDA is one of the most widely reported metrics in practice that is not required by accounting
standards. Both Qantas Ltd and Flight Centre Ltd report EBITDA. Flight Centre Ltd is a travel agency
company and Qantas is an airline. An extract from their 2022 balance sheets is reported below.
Required:
Will EBITDA increase or decrease the comparability of the true underlying economic operating
performance of Qantas and Flight Centre?
Solution
EBITDA is earnings before interest, taxes depreciation and amortisation.

The exclusion of depreciation could have a consequence of decreasing the comparability of operating
performance. However the exclusion of interest can have the benefit of improving the compatibility of
operating performance. The reasons for this are as follows.

Exclusion of Depreciation and Amortisation

The exclusion of depreciation and amortisation has a consequence that EBITDA will decrease the
comparability of the true underlying economic operating performance of Qantas and Flight Centre due to
the difference in capital (e.g PPE) and labour intensity between the two firms.

Accounting for the cost of fixed assets and thus depreciation is important because it improves
comparability of performance across companies and over time. EBITDA reflects the cost of labour but
excludes the cost of fixed assets. As is evident from the balance sheets Qantas and Flight Centre differ in
their capital (versus labour) intensity and thus the use of EBITDA will decrease comparability. For Flight
Centre the % of PPE of Total Assets is 6.8% versus 70% for Qantas. The primary resource that Flight
Centre uses to generate revenue is human labour (e.g travel agents) whereas the primary resource that
Qantas uses is the physical capital of planes. To compare the economic performance of the two entities
the expense associated with the use of both resources needs to be deducted from revenue.

Exclusion of Interest

The operating performance of a company is the performance solely due to operations and thus before
financing costs from funding sources such as interest. Companies can raise funds from either debt or
equity. The cost of debt is expensed in the P&L via interest expense however the cost of equity is not
included as an expense in the P&L. This if two companies have the same operating performance but have
different funding mixes from debt and equity then their net profit (after interest expense) will be different.

Thus the exclusion of interest can have a benefit of improving the comparision of the operating
performance of two companies. Flight Centre and Qantas have two different capital structures with
Qantas having a greater level of debt and in-turn a greater relative level of interest expense. Specifically,
[1]
Qantas (Flight Centre) has a debt-to-total assets of respectively 36% (17%) . Therefore the exclusion
of interest (effectively EBIT) will improve the comparison of operating performance.

Question Two
Most companies now provide as part of their web-site an Investor Relations hub that reports a
large amount of voluntary information about their performance in addition to that mandated in
statutory financial statements by the accounting standards. This information will include webcast
discussion of their performance by the CEO and CFO, a presentation deck of power-point slide to
investors, a media release, announcements to the stock market etc. As an example review the
Results page on Investor Centre web page of Kogan.
https://www.kogancorporate.com/
Briefly review how Kogan reported its 2021 FY annual performance in its FY21 Results
Power-Point Presentation to Investors, in its Annual Report (page 1 and 2), the media release and
the statutory income statement (p 47 annual report). The investors presentation slides, annual
report and media release are an attachment on the LMS. Address the following questions:
 · What is the relative importance of statutory GAAP versus non-GAAP performance
metrics (see slide 4 and 5)?
· What do you observe about the disclosure of these adjusting items?
· Do you agree that the transactions removed from the statutory GAAP profit give rise to
an improved measure of the performance of Kogan?
· Should transactions reported in OCI be included in a measure of the performance of
Kogan?
For the purpose of answering this question assume a definition of income and performance as:
Revenue earned less (matched against) expenses incurred by the firm in that same period.
Assume we want the reported performance metric to be unbiased and free from ‘random error
and noise’ and thus precise. A random error is those economic events that have an expected
value of zero. These events simply add noise to the measure of performance.
Solution
The primary reporting measure used by Kogan is Adjusted NPAT (“Underlying Profit”) and Adjusted
EBITDA. The Adjusted NPAT of $m42.9 is > statutory profit after tax of $m3.5.
The Adjusted NPAT of $m42.9 in 2021 increased by 43% compared to last years adjusted profit of $m30.
In contrast statutory profit decreased by a substantial 87% (from $m26.8 in 2020 down to $m3.5 in
2021). In summary turning a $m3.5 statutory profit into $m42.9 underlying profit is quite an impressive
achievement.
Three main observations. First, substantially greater prominence and frequency is given to the underlying
profit measures (Adjusted NPAT and Adjusted EBITDA) compared to the statutory measure. For
example, all the key performance metrics are reported on an underlying basis (see on Page 5 of Results
Presentation and Page 11 of the Annual Report where Results Summary focuses on: Adjusted EBITDA,
Adjusted NPAT and Adjusted EPS).
Second, the underlying or adjusted profit is greater than the statutory profit which could be due to an
either an opportunistic bias in the direction of adjustments or simply adjustments to give rise to a more
informative measure of profit.
Third, in regard to the disclosure of the adjusting items while the ‘adjusted profit’ is given prominence it
is not until Page 21 of the Annual Report and the last Page of the Results Presentation (page 33) that a
reconciliation of ‘Adjusted NPAT’ to statutory profit is provided.

Do the adjustments to shift statutory profit of $m3.5 to an Adjusted NPAT of $m42.9 give rise to a more
informative or an opportunistic measure of performance?
The adjustments are in the copy of the reconciliation Table (page 21 of the Annual Report) in the
Appendix to these tutorial solutions. There are four main type of adjustments: Unrealised FX Loss
($m1.4); Equity-based compensation ($m15.6); Donations ($m2.5) and COVID-19 related stock
provision ($m2.2). Lets consider each in turn as to if they are driven by opportunistic motives or by
incentives to make the measurement of performance more informative.
How to assess if an adjustment is informative or opportunistic?
For an informative income metric we need a metric that measures past performance that is unbiased and
precise. By precise we mean free from random error and events that have an expected value of
zero……as these events are simply adding noise to the measure of performance.

Therefore for a more informative measure we may decide to adjust items that give rise to or reflect:
 – Bias (an example would be the adjusting for the immediate expensing of research expenditure
when in substance it is an asset)

– Random error or random events that in expectation have a value of zero and are simply adding
noise

In general there are two categories of events that have an expected value of zero:

1. Non-recurring events unrelated to the business such as a 1 in 100 years flood

2. Unrealised gains and losses on financial assets and instruments that are being held for the
long-run to fund the business. Assuming markets are efficient then in any given year the
market price of a financial asset could randomly increase or decrease. In the long-run the
expected value from these increases or decreases will average to zero. We will illustrate this
concept further using Kogan.

Unrealised FX Loss ($m1.4)

Kogan is in the business of importing goods for sale and therefore will incur FX gains and losses.
Assuming an efficient exchange rate market then these FX gains and losses in any given period will be
random and in expectation on average will be zero (assuming a random change in the exchange rate then
some years there will be FX gains and in other years FX losses). Therefore for purposes of valuation
which involves forecasting future cashflows the best estimate of FX gains/losses is zero and thus arguably
for the valuation objective FX gains/losses should be adjusted for to give rise to more informative
‘persistent’ profit figure. The same argument applies to the use of the financial reports for stewardship
and holding management to account for past performance. To the extent the FX loss (or a gain) is simply
[2]
due to luck then arguably it should be adjusted for.

Other Comprehensive Income (OCI): Exchange gain on translation of foreign operations $272,000
The above intuition also explains why the accounting standards require certain transaction to be booked
through Other Comprehensive Income (OPI). For your information the appendix to has a list of
transactions that are required by accounting standards to be included in OCI. These can be summarized
as:
· Unrealized gains or losses on available for sale-securities
· Exchange differences on translation of foreign operations*
· Unrealized gains and losses on derivatives and cash flow hedges
· Revaluation of land and buildings
These transactions are usually unrealised gains /losses on financial instruments. Assuming an efficient
market for these financial instruments then gains or losses are equally likely in any given period and thus
will be random and therefore on average in expectation will be zero (alternatively expressed they have a
persistence factor of zero). 3
Therefore, these unrealized gains/losses are booked though OCI, by accounting standards, as they are
deemed as not being relevant for either assessing the past permanent performance of a firm or for
forecasting future permanent income. Consistent with this in practice, analysts do not include OCI items
in their forecasts of future earnings and OCI items are not included in adjusted performance metrics used
to assess and reward management.
*Exchange differences on translation of foreign operations arise if a company has a subsidiary in a
foreign country then each year for purposes of consolidation the company has to translate the financial
statements of the subsidiary into Australian dollars giving rise to an unrealized exchange difference each
year if the exchange rate has changed from prior years (see AASB 121). Assuming an efficient
exchange rate market then then FX gains and losses in any given period are equally likely and will be
random and therefore on average in expectation will be zero. Therefore these exchange differences
should not be used for either forecasting future cashflows for valuation or assessing the past performance
of management.
Equity-Based Compensation ($m15.6)
Kogan like most corporates rewards its employees using equity-based compensation through the use of
employee share option schemes. These schemes reward employees with share options which they are
allowed to exercise subject to certain conditions (for example the performance of the firm reaches a
certain level). These employee options are clearly an expense of the firm as when the options are
exercised they result in the dilution of wealth of current shareholders.
The intuition for this is that employees will only exercise the options if the exercise price is lower than the
current share price. The new share price after issue will be lower as there will be more shares on issue and
thus the pre-existing shareholders are worse off (there wealth has been diluted). Assume a firm with a
single-shareholder and single share currently worth $10. Assume an option is issued to an employee with
an exercise price of $5. Assume the employee exercises the option and pays $5 to the firm. The firm now
has total aggregate wealth of $15 ($10 + the inflow of $5). There are now 2 share on issue. So the price of
each share is $7.50.
Therefore given that equity-based compensation is a cost of doing business that is no different from
salaries and wages it should not be adjusted for. Kogan’s generated revenue from these employees
working hard and therefore to determine the profit we need to match against this revenue the cost of the
employees which includes equity-based compensation (employee stock options).
Employee Options are required to be expenses under Accounting Standard AASB2 Share-Based
Payments. While employee options are clearly an expense it is worthwhile noting this it is difficult to
estimate the true value of these options and in-turn the recorded value in the P&L will contain a degree of
measurement error.
Donations ($m2.5)
Kogan made donations of $m2.5 which they removed from reported Adjusted NPAT.
Firms as part of the ESG (Environmental, Social, and Governance) movement are increasingly making
donations and incurring other forms of expenditures on ‘social good’ activities. For example community
contributions. Should they adjust for these donations and other forms of social expenditure in measuring
firm performance? There are two main arguments made for why corporations are making donations and
other forms of expenditure on social activities.
First, to benefit from a “halo” effect. By making a donation the company may appear to be a good
[3]
corporate citizen and this in-turn may generate sales revenue from ESG conscious consumers. If this is
the motive then clearly the donations are a cost of doing business that was incurred to generate revenue
and thus they should be matched against revenue to provide a more precise measure of the true profit that
was made. Thus it should NOT be adjusted for. This is both for predicting future profits and assessing
past performance of management.
The second motive is that firms may invest in ESG due to insider-initiated “self-interested’ corporate
philanthropy - e.g., corporations giving to charities on the boards of which their executives or own board
members sit in order that they appear like heros’. However, they are using shareholder’s funds to make
themselves look good. If this is the motivate then firm management needs to be monitored and held to
account in order to limit insider-initiated ESG activities. Therefore the donations should be expensed and
NOT adjusted for.
COVID-19 related stock provision ($m2.2).
Kogan in anticipation of many sales from the COVID lockdown ordered a large volume of stock which
in turn it was unable to sell and thus was forced to write-down stock under the ‘lower of cost and NRV
rule’. Kogan then argued that COVID was a once-off transitory event (non-recurring) which did not
reflect normal operating conditions. Thus it is argued thus the write-down of $m2.2 should be adjusted for
to provide a measure of more ‘normal’ or ‘permanent’ performance both for the purposes of assessment
of past performance of management (the stewardship objective) and also predicting future ‘permanent’
earnings (the valuation objective).
However KOGAN is in the business of ordering stock in anticipation of consumer demand in response to
a wide variety of economic events of which COVID is just one of many different types of shocks to the
economy. Therefore a performance measure should reflect the skill of the firm and management in
managing stock in response to these shocks.

A objective of a performance metric is stewardship and to make management accountable, then

effectively by excluding the stock loss provision, we are not reporting on management failures. This in
turn could create significant incentives problems. Furthermore, in regard to the valuation objective and
predicting the future then ‘write-downs’ (and impairments) provide a measure of managers “skill” and
thus may be an input into determining future payoffs.
Question 3
The Investor Presentation (page 8) and Annual Report (page 7) of Wesfarmers reports the
Divisional Return on Capital (ROC) for Bunnings, Kmart and Officeworks for 2021. These are
attached on the LMS. Review the reported ROC. Do you consider that the accounting reported
ROC reflects the true underlying economic ROC (and if so what is the source of competitive
advantage)? If you believe the reported ROC is biased due to measurement error what is the main
adjustment that has been used to achieve this? Do you agree with this adjustment: is it informative
or opportunistic?
Extract from Wesfarmers Annual Report (page 7). Key Financial Indicators for Bunnings
Wesfarmers of which Bunnings is a division is in the GICS Consumer Discretionary sector. The reported
Return on Capital (ROC) for the Bunnings Division in the Annual report of 82.5% (2021) is simply
incredibly abnormally large. The typical ROC in the Consumer Discretionary sector is 17%.
Is this ROC 82% due to abnormal economic performance attributable to a competitive advantage or an
accounting adjustment giving rise to a bias? There are no accounting standards over how ROC should be
computed. It is possible that a partial explanation for the large ROC is due to the competitive advantage
that Bunnings may have due to its dominance of the home hardware and renovation market (we will
discuss more about competitive advantage in following weeks). Bunnings may have also benefited from
COVID. However the sheer magnitude is unlikely to be completely explained by economic
fundamentals.
The accounting adjustment that explains the high ROC is that Bunnings have excluded right-of-use assets
and lease liabilities in computing the capital in the denominator of ROC. See Footnote 1 from footnotes
of reporting ROC performance on Page 7 of Annual Report (extract below)
To compute ROC we want to divide the net operating profit by the total capital or resources that
Bunnings. This total capital pool is the sum of capital from both debt and equity (we will be discussing
the computation of ROIC more next week). Lease liabilities (as you learned in IFA2) are simply a form
of debt. Therefore lease liabilities should be included in the denominator as it is a source of debt capital
that Bunnings has used to generate profit.

How significant is lease liabilities as a source of capital? Inspection of the balance sheet of Wesfarmers
(see below) shows that lease liabilities are a very, very significant source of capital being 34% of total
capital ($m6,136/$m17,923). Total lease liabilities are $m6,136. Total capital is the sum debt which
includes leases and equity which is $m17,923 ($m6,136 +$m2,072+ $m9,715). These lease liabilities are
the source of capital to fund the large warehouse shopping outlets that are a significant feature of the
Bunnings business model. ROC when based on true total capital = $m2,185/$m17,923 = 12.19%

Thereby by omitting leases as a source of capital from the denominator of the computation of ROC the
ROC is biased upward significantly.

Question 4
Nanosonics is a large ASX listed company in the healthcare industry which manufactures and
distributes ultrasound probe disinfectors and other related technologies. The company reported its
earnings results for the year ended 30 June 2021 to the market on 25th August 2021. As can be see
below the reported earnings decreased from $m10.1 in 2020 to $m8.6 in 2021. However on the days
of the earnings announcement the share price increased by 21.9%. See the attached media
coverage of the announcement. Answer the following questions:

Required
a. Provide two explanations for why Nanosonics share price increased even though the earnings
decreased?

Solutions
a.
Explanation One
Nanosonics share price increased because the reported earnings of $m8.6 million was lower than the
market’s expected earnings. An efficient market will only react to and price the direction of “news” if the
reported information is different from expectations. While last years (2020) earnings was $m10.1
throughout the 2021FY both Nanosoics and for example analysts would have updated markets
expectations which would have included for example media press releases regarding the bad news
associated with the decline in earnings from$m10.1 to $m8.6. Therefore when the actual earnings of
$m8.6 was announced this may have been greater than the markets expectations. This is consistent with
the attached AFR article which described the announcement of $m8.6 as being greater than the analyst
guidance “ meaning net profit ….. beating consensus estimates”.
Explanation Two
If economy-wide events were such that the whole market rose strongly on 25th August, 2021, this would
reduce the decline in the Nanosonics share value attributed to the firm-specific bad news. If the rise in the
market index was large enough to overwhelm the bad firm-specific information, Nanosonics share price
would rise.

(b) Now assume that $m10.1 is the markets best forecast of the actuals earnings that will
be announced of $m8.6 and the decrease of $m1.5 is news to the market. Consider the
two situations below:
i. The deviation of forecasted earnings from actual earnings of $1.5
million is completely accounted for by the emergence of a new competitor
with a new ultrasound product that has captured a share of the market.
 ii. The deviation of the forecasted earnings from actual earnings of $1.5
million is completely accounted for by a fire in Nanosonics's largest
distribution outlet, which had caused the outlet to be closed temporarily for
six months.

In which of these two scenarios would you expect the price change of Nanosonics.'s common
stock to be greater? Explain.
Under these assumptions the earnings announcement is bad news and there will be a negative share price
reaction as the reported earnings of $m10.1 is lower than the markets expectations immediately preceding
the announcement of $m8.6 (an assumption we have made).
The share price decrease should be greater for scenario (i) because that situation reflects a persistent
decline in earnings arising from a permanent loss of customers to a competitor. In scenario (ii), the
earnings decrease is transitory. Hence, Nanosonics’s common stock price change should be greater in
scenario (i).
As a general principle the market prices “information” or “news” in the same way it determines the value
of an asset = the expected future cashflows as a result of the information discounted at the cost of equity.
Question 5
Attached is a list of the top 100 accounting firms in Australia as at 2021 ranked by size of fee
revenue. There is a clear two-tier market structure with 4 very large accounting firms (KPMG,
PwC, EY and Deloitte) known as the Big4 and then many smaller accounting firms known as the
non-Big4. Does the size of the accounting firm matter?
Integrated Media Technology Limited (IMT) is audited by Moore Australia (ranked #18) and
Linius Technologies Limited (ASX:LNU) is audited by KPMG (ranked #4). Assume both
companies are involved in the same industry, have the same risk and both announce a $1 of
unexpected good earning news.
(a) Which company would you expected to have the greater security price reaction to the $1
of unexpected good news.
(b) Now assume that Integrated Media Technology Limited has much higher debt-equity
ratio and thus beta than Linius Technologies Limited. Would your answer to part (a)
change.
Integrated Media Technology Limited (IMT) develops and distributes visual technology solutions. The Company focuses
on autostereoscopic 3D display technology and virtual realty solutions for advertising, education, retail, medical, and
entertainment sectors. IMT markets its products in Australia, Hong Kong, and China.
Linius Technologies Limited (ASX:LNU) makes hyper-personalized video experiences possible with its globally
patented Video Virtualization Engine (VVE).

a. The greater the perceived random error in earnings the lower the market reaction as the
random error will not persist into the future.

If auditors vary in quality and this affects the reliability of earnings (the degree of error) then this
in turn may affect the market reaction assuming the market knows that audit quality varies. The
market reaction to a $1 of unexpected earnings will be lower if the market believes that the
earnings contains a greater amount of random error due to a poor quality audit and thus less likely
to persist.
 Is the quality of the Big 4 auditors greater than non-Big 4 auditors? Some argue that because of
their size and scope that Big 4 auditors are able to invest in the capabilities, including both human
resources such as highly skilled staff and technology, necessary to provide a higher quality audit.
Others such as regulators have argued that the quality of Big4 audits could be negatively affected
due to both the magnitude of non-audit fees which may impair their independence and
concentration which may give rise lack of competition.

b. The market prices information based on the expected future cashflows associated with the
information discounted for the firm’s systematic risk associated with the cash flows. The answer could
change, because firms with higher leverage in their capital structure, and in turn higher beta have
greater systematic risk (i.e their cost of capital is higher). Therefore firms with high beta will tend to
have lower share price reaction to a dollar of news. Therefore if this effect is strong enough then
Integrated Media Technology Limited may have a lower share price reaction than Linius Technologies
Limited.

Adjustments made by KOGAN in the presentation slide deck to investors

Example of Transactions Typically Included in OCI

[1]
Q = $7,232/$19,653 = 36% Flight = $660,289/$3,732,087 =17%