Power-point slides for chapter 4.ppt - INCOME INCOME...

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4-1 Evaluate past performance. Help assess the risk or uncertainty of achieving future cash flows. Predicting future performance. Usefulness INCOME STATEMENT INCOME STATEMENT LO 1
4-2 Limitations Companies omit items that cannot be measured reliably. Income is affected by the accounting methods employed. Income measurement involves judgment. INCOME STATEMENT INCOME STATEMENT LO 1
4-3 Companies have incentives to manage income to meet or beat Wall Street expectations, so that market price of stock increases and value of stock options increase. Quality of earnings is reduced if earnings management results in information that is less useful for predicting future earnings and cash flows. Quality of Earnings INCOME STATEMENT INCOME STATEMENT LO 1
4-4 findings indicate that companies tend to nudge their earnings numbers up by a 10th of a cent or two. That lets them round results up to the highest cent, as illustrated in the following chart. What the research shows is that the number Managing earnings up or down adversely affects the quality of earnings. Why do companies engage in such practices? Some recent research concludes that many companies tweak quarterly earnings to meet investor expectations. How do they do it? Research WHAT’S YOUR PRINCIPLE WHAT DO THE NUMBERS MEAN? FOUR: THE LONELIEST NUMBER continued LO 1
4-5 “4” appeared less often in the 10th’s place than any other digit and significantly less often than would be expected by chance. This effect is called “quadrophobia.” For the typical company in the study, an increase of $31,000 in quarterly net income would boost earnings per share by a 10th of a cent. A more recent analysis of quarterly results for more than 2,600 companies found that rounding up remains more common than rounding down. Another recent study reinforces the concerns about earnings management. Based on a survey of 169 public- company chief financial officers (and with in-depth interviews of 12), the study concludes that high-quality earnings are sustainable when backed by actual cash flows and “avoiding unreliable long-term estimates.” However, about 20 percent of firms manage earnings to misrepresent their economic performance. And when they do manage earnings, it could move EPS by an average of 10 percent. Is such earnings management a problem for investors? It is if they cannot determine the impact on earnings quality. Indeed, the surveyed CFOs “believe that it is difficult for outside observers to unravel earnings management, especially when such earnings are managed using WHAT’S YOUR PRINCIPLE WHAT DO THE NUMBERS MEAN? FOUR: THE LONELIEST NUMBER (continued) LO 1
4-6 survey authors say the CFOs “advocate paying close attention to the key managers running the firm, the lack of correlation between earnings and cash flows, significant deviations between firm and peer experience, and unusual behavior in accruals.” Sources: S. Thurm, “For Some Firms, a Case of ‘Quadrophobia’,” Wall Street Journal (February 14, 2010); and H. Greenberg, “CFOs Concede Earnings Are ‘Managed’,”

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