13 Chapter The Corporate Income Statement and the Statement of Stockholders Equity Performance Measurement: Quality of Earnings Issues Objective 1: Define quality of earnings, and identify the components of a corporate income statement. Quality of earnings refers to the substance of earnings and their sustainability into future accounting periods. Because of the importance of the bottom line (net income) there is a significant interest in evaluating quality of earnings. (Basically this data is useful for investors to see if the stock is over or undervalued). Quality of earnings is affected by these items: Accounting methods and estimates Gains and losses on transactions Write-downs and restructurings Nonoperating items The corporate income statement includes: Revenues Expenses Gains and losses Income tax expense Discontinued operations Extraordinary gains and losses Earnings per share When a company has BOTH __________________ and continuing operations, the operating income section is called income from continuing operations.
The Effect of Accounting Methods and Estimates A firms operating income is affected by ____________ and ________________ Accounting estimates should be based on realistic _______________ but there is considerable latitude in making the estimate The importance of accounting estimates depends on the industry in which the firm operates Accounting Estimates Uncollectible accounts receivable Sales returns Useful life of an asset Residual value of an asset Total units of production Total recoverable units of natural resource Amortization period Warranty claims Environmental cleanup costs Accounting Methods
1. 2. 3. 4.
Percentage of net sales or aging to estimate uncollectible accounts receivable LIFO, FIFO, or average cost to value inventory Accelerated, production, or straight-line depreciation Revenue recognition methods
Effect of Accounting Methods and Estimates Some methods and estimates are more ________________ than others The existence of alternatives can cause problems in the interpretation of financial statements Conventions that help overcome this problem include: o Full disclosure (Explain significant accounting policies used in preparing the financial statements in a note to the financial o statements) Consistency (Requires that the same accounting procedures be followed from year to year) Gains and Losses Result from the sale or disposal of operating assets or marketable securities (one time events BUT they appear in the ________________ section of the income statement. Write-Downs and Restructurings Write-down - The recording of a decrease in the value of an asset below the carrying value on the __________________, and The reduction of operating _____________ in the current period by the amount of the decrease. Also called a write-off Restructuring - The estimated cost associated with a change in a companys operations Usually involving the closing of facilities and lay off of personnel Write-Downs and Restructurings (contd) Reduce current operating income o Boost future income by shifting future costs to the current period Are often an indication of bad management decisions o Paying too much for the assets of another company o Making operational changes that do not work out Big bath o Taking all possible losses in current year so that future years will be clean of these costs o Often occurs when a company is having a bad year or a change of management takes place, so that the company can show improved results in future years
Nonoperating Items Discontinued operations Extraordinary gains and losses o Can significantly effect net income o Analysts consider nonoperating items when reviewing a companys because these are nonrecurring items (what happens if they keep reoccurring? Something is wrong.)
Quality of Earnings and Cash Flows Items that have no affect on cash flows (except possible income tax effects) since cash expenditures were previously made:
o Gains and losses o Asset write-downs and restructurings o Nonoperating items Therefore, the focus of analysis is on sustainable earnings o Which generally have a relationship to future cash flows Managements performance and compensation often linked to profit margin, return on assets, or return on equity Stop & Review Q. What is quality of earnings? The substance of earnings and their sustainability into future years. (After all an investment in the end is ONLY worth the amount of cash it will bring to you.) END OF OBJECTIVE 1