Financial

Statement
Analysis

K R Subramanyam
John J Wild

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 6-2

Analyzing Operating Activities

6
CHAPTER
 6-3

Income Measurement
Concepts of Income
Economic
Economic Income
Income
 Equals
Equalsnet
netcash
cashflows
flows++the
thechange
changein
inthe
thepresent
presentvalue
valueof
of
future
futurecash
cashflows
flows
 Includes
Includesboth
bothrecurring
recurringand
andnonrecurring
nonrecurringcomponents—
components—
rendering
renderingititless
lessuseful
usefulfor
forforecasting
forecastingfuture
futureearnings
earnings
potential
potential
Permanent
Permanent Income
Income
 Also
Alsocalled
calledsustainable
sustainableearning
earningpower,
power,ororsustainable
sustainableor
or
normalized
normalizedearnings
earnings
 Estimate
Estimateofofstable
stableaverage
averageincome
incomethat
thataacompany
companyisisexpected
expected
to
toearn
earnover
overits
itslife
life
 Reflects
Reflectsaalong-term
long-termfocus
focus
 Directly
Directlyproportional
proportionalto tocompany
companyvalue
value
 6-4

Income Measurement
Concepts
 Based
Basedon
onaccrual
accrualaccounting
accounting
 Suffers
Suffersfrom
frommeasurement
measurementerror,
error,arising
arisingbecause
becauseof
of
accounting
accountingdistortions
distortions

Accounting
Accounting Income
Income consists
consists of:
of:

Permanent
PermanentComponent--the
Component--therecurring
recurringcomponent
component expected
expected
to
topersist
persistindefinitely
indefinitely

Transitory
TransitoryComponent--the
Component--thetransitory
transitory(or
(ornon-recurring)
non-recurring)
component
componentnot notexpected
expectedto
topersist
persist(Note:
(Note:The
Theconcept
conceptofof
economic
economicincome
incomeincludes
includesboth
bothpermanent
permanentandandtransitory
transitory
components.)
components.)

Value
ValueIrrelevant
IrrelevantComponent--value
Component--valueirrelevant
irrelevantcomponents
componentshavehave
no
noeconomic
economiccontent;
content;they
theyare
areaccounting
accountingdistortions
distortions
 6-5

Income Measurement
Measurement
Two main components of accounting income:
Revenues (gains)
Expenses (losses)
 6-6

Income Measurement
Measurement
Revenues and Gains

• Revenues are earned inflows or prospective

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
 6-7

Income Measurement
Measurement
Expenses and Losses

• Expenses are incurred outflows, prospective

outflows, or allocations of past outflows of cash
from operations
• Losses are decreases in a company’s
net assets arising from
non-operations 

Expenses and losses are resources consumed, spent,

or lost in pursuing revenues and gains
 6-8

Income Measurement
Alternatives
Two major income dimensions:

1. operating versus non-operating

2. recurring versus non-recurring*

 *Motivated by need to separate permanent and

transitory components
 6-9

Income Measurement
Alternatives

Operating vs. Non-Operating and Recurring vs. Non-Recurring

Operating Income

Non-
Recurring Recurring
Income Income

Non-Operating Income
 6-10

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”

 6-11

Income Measurement
Analysis
Operating
OperatingversusversusNon-Operating
Non-OperatingIncome
Income
  
Operating
Operatingincome--measure
income--measureof ofcompany
companyincome
incomeas asgenerated
generatedfrom
from
operating
operatingactivities
activities
  
Three
Threeimportant
importantaspects
aspectsof
ofoperating
operatingincome
income
 Pertains
Pertainsonly
onlytotoincome
incomegenerated
generatedfrom
fromoperations
operations
 Focuses
Focuseson onincome
incomeforforthe
thecompany,
company,notnotsimply
simplyforforequity
equityholders
holders
(means
(meansfinancing
financingrevenues
revenuesandandexpenses
expensesare areexcluded)
excluded)
 Pertains
Pertains only to ongoing business activities (i.e.,results
only to ongoing business activities (i.e., resultsfrom
from
discontinued
discontinuedoperations
operationsis isexcluded)
excluded)
  
Non-operating
Non-operatingincome--includes
income--includesall allcomponents
componentsof ofnet
netincome
income
excluded
excludedfromfromoperating
operatingincome
income
  
Useful
Usefulto toseparate
separatenon-operating
non-operatingcomponents
componentspertaining
pertainingto tofinancing
financingand
and
investing
investing
 6-12

Income Measurement
 

Analysis
Determination
Determinationof
ofComprehensive
ComprehensiveIncome—sample
Income—samplecompany
company

Net income
Other comprehensive income:
+/- Unrealized holding gain or loss on marketable securities
+/- Foreign currency translation adjustment
+/- Postretirement benefits adjustment
+/- Unrealized holding gain or loss on derivative instruments
Comprehensive income
 6-13

Income Measurement
Analysis

What
What constitutes
constitutesthe
the‘correct’
‘correct’measure
measureof
of income
incomefor
for
analysis
analysispurposes?
purposes?
  
There
Thereisisno
no answer
answer for
for two
two reasons:
reasons:

•• Correct
Correct measurement
measurement depends
dependson onanalysis
analysis objectives
objectives
•• Alternative
Alternativeaccounting
accountingincome
income measures
measuresresult
resultfrom
from
including
includingor
or excluding
excludingline
line items—still
items—stillsubject
subject to
to
accounting
accountingdistortions
distortions
 6-14

Non-Recurring Items
 

 Extraordinary items

 Discontinued segments

 Accounting changes

 Restructuring charges

 Special items
 6-15

Non-Recurring Items
 

Extraordinary Items
Criteria
Criteria
Unusual
Unusualininnature
nature
Infrequent
Infrequentin
inoccurrence
occurrence

Examples
Examples
Uninsured
Uninsuredlosses
lossesfrom
fromaamajor
majorcasualty
casualty(earthquake,hurricane,
(earthquake,hurricane,
tornado),
tornado),losses
lossesfrom
fromexpropriation,
expropriation,and
andgains
gainsand
andlosses
lossesfrom
from
early
earlyretirement
retirementofofdebt
debt

Disclosure
Disclosure & & Accounting
Accounting
Classified
Classifiedseparately
separatelyin
inincome
incomestatement
statement
Excluded
Excludedwhen
whencomputing
computingpermanent
permanentincome
income
Included
Includedwhen
whencomputing
computingeconomic
economicincome
income
 6-16

Non-Recurring Items
Discontinued Operations
Accounting
Accounting is
is two-fold:
two-fold:

•• Income
Incomestatements
statementsfor forthe
thecurrent
current and
andprior
priortwo
two
years
yearsare
arerestated
restatedafter
afterexcluding
excludingthe theeffects
effectsof
of
discontinued
discontinuedoperations
operations
•• Gains
Gains or
or losses
losses from
from the
thediscontinued
discontinuedoperations
operations are
are
reported
reportedseparately,
separately,netnet of
oftax*
tax*
  
*Reported
*Reportedin in two
twocategories:
categories: (i) (i)operating
operating income
incomeoror
loss
lossfrom
fromdiscontinued
discontinued operations
operations until
untilthe
the
measurement
measurement date, date,and
and(ii)
(ii) gains
gainsand
andlosses
losseson on
disposal
disposal
 6-17

Non-Recurring Items
 

Discontinued Operations

For
For analysis
analysis of of discontinued
discontinued operations:
operations:
•• Adjust
Adjustcurrent
currentand
andpast
pastincome
incometo toremove
removeeffects
effectsof
of
discontinued
discontinuedoperations
operations
 Companies
Companiesdisclose
disclosethis
thisinfo
infofor
forthe
thecurrent
currentand
andpast
pasttwo
two
years
years
 For
Forearlier
earlieryears:
years:
 Look
Lookfor
forrestated
restatedsummary
summaryinfo infoor
orother
othervoluntary
voluntary
disclosures
disclosures
 Take
Takecare
carewhen
whendoing
doinginter-temporal
inter-temporalanalysis
analysis
•• Adjust
Adjustassets
assetsand
andliabilities
liabilitiesto
toremove
removediscontinued
discontinuedoperations
operations
•• Retain
Retaincumulative
cumulativegain
gainororloss
lossfrom
fromdiscontinued
discontinuedoperations
operationsin
in
equity
equity
 6-18

Non-Recurring Items
Accounting Changes
First Type of Accounting Change is
Accounting Principle Change—involves
switch from one principle to another

 Disclosure includes:
• Nature of and justification for change
• Effect of change on current income and
earnings per share
• Cumulative effects of retroactive
application of change on income and EPS
for income statement years
 6-19

Non-Recurring Items
Accounting Changes
Second Type of Accounting Change is
Accounting Estimate Change—
involves change in estimate
underlying accounting
 
• Prospective application—a change
is accounted for in current and
future periods
• Disclose effects on current income
and EPS
 6-20

Non-Recurring Items
 

Accounting Changes
Analyzing Accounting Changes
• Are cosmetic and yield no cash flows
• Can better reflect economic reality
• Can reflect earnings management (or even
manipulation)
• Impact comparative analysis (apples-to-apples)
• Affect both economic and permanent income
 For permanent income, use the new
method and ignore the cumulative effect
 For economic income, evaluate the
change to assess whether it reflects
reality
 6-21

Non-Recurring Items
 

Special Items
Special
Special Items--transactions
Items--transactionsand
andevents
eventsthat
thatare
areunusual
unusualor
or
infrequent
infrequent
  
Challenges
Challengesfor
foranalysis
analysis


 Often
Oftenlittle
littleGAAP
GAAPguidance
guidance

 Economic
Economicimplications
implicationsare
arecomplex
complex

 Discretionary
Discretionarynature
natureserves
servesearnings
earningsmanagement
managementaims
aims
  
Two
Twomajor
majortypes
types


 Asset
Assetimpairments
impairments(write-offs)
(write-offs)

 Restructuring
Restructuringcharges
charges
 6-22

Non-Recurring Items
 

Special Items
Asset
AssetImpairment—when
Impairment—whenasset assetfair
fairvalue
valueisisbelow
belowcarrying
carrying(book)
(book)value
value
  
Some
Somereasons
reasonsfor forimpairments
impairments
Decline
Declinein indemand
demandforforasset
assetoutput
output
Technological
Technologicalobsolescence
obsolescence
Changes
Changesin incompany
companystrategy
strategy
  
Accounting
Accountingfor forimpairments
impairments
Report
Reportatatthethelower
lowerof
ofmarket
marketor orcost
cost
No
No disclosure about determinationof
disclosure about determination ofamount
amount
No
Nodisclosure
disclosureaboutaboutprobable
probableimpairments
impairments
Flexibility
Flexibilityin indetermining
determiningwhen
whenandandhow
howmuch
muchtotowrite-off
write-off
No
Noplan
planrequired
requiredforforasset
assetdisposal
disposal
Conservative
Conservative presentation ofassets
presentation of assets
 6-23

Non-Recurring Items
 

Special Items
Restructuring
RestructuringCharges—costs
Charges—costsusually usuallyrelated
relatedto
tomajor
majorchanges
changesin
incompany
company
business
business
  
Examples
Examplesof ofthese
thesemajor
majorchanges
changesinclude
include
 Extensive
Extensivereorganization
reorganization
 Divesting
Divestingbusiness
businessunits
units
 Terminating
Terminating contractsand
contracts andjoint
jointventures
ventures
 Discontinuing
Discontinuingproduct
productlines
lines
 Worker
Workerretrenchment
retrenchment
 Management
Managementturnover
turnover
 Write-offs
Write-offs combinedwith
combined withinvestments
investmentsin inassets,
assets,technology
technologyor
ormanpower
manpower
  
Accounting
Accountingfor forestimated
estimatedcosts
costsof ofrestructuring
restructuringprogram
program
 Establish a provision (liability) for estimated costs
Establish a provision (liability) for estimated costs
 Charge
Chargeestimated
estimatedcosts
coststotocurrent
currentincome
income
 Actual
Actualcosts
costsinvolve
involveadjustments
adjustmentsagainst
againstthe
theprovision
provisionwhen
whenincurred
incurred
 6-24

Non-Recurring Items
 

Analyzing Special Items

Earnings Management with Special Charges

(1)  Special charges often garner less investor

attention under an assumption they are non-recurring
and do not persist

(2)  Managers motivated to re-classify operating

charges as special one-time charges

(3) When analysts ignore such re-classified charges

it leads to low operating expense estimates and
overestimates of company value
 6-25

Non-Recurring Items
 

Analyzing Special Items

Income Statement 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
 6-26

Non-Recurring Items
Analyzing Special Items

Balance Sheet Adjustments

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