The Corporate Income Statement and the
Statement of Stockholders’ Equity
0REVIEWING THE CHAPTER
Objective 1: Define
quality of earnings
, and identify the components of a corporate income
The most commonly used predictors of a company’s performance are expected changes in
earnings per share and expected return on equity. Net income is a key component of both
Because net income is so important in measuring a company’s prospects, it is equally
important to evaluate the quality of the net income figure, or the
quality of earnings.
quality of earnings refers to the substance of earnings and their sustainability into future
accounting periods. It is affected by the accounting methods and estimates that management
chooses and by the gains and losses, write-downs and restructurings, and nature of the
nonoperating items reported on the income statement. Management also has choices about
the content and positioning of these income-statement categories.
Net income or loss for a period includes all revenues, expenses, gains, and losses. A
corporate income statement may therefore contain many line items and subtotals. On the
income statement of a corporation that has both continuing and discontinued operations, the
operating income section is called
income from continuing operations.
which includes revenues, costs and expenses, gains and losses on the sale of assets, write-
downs of assets, and restructurings, is followed by a section on income taxes. Appearing
below that are nonoperating items, such as discontinued operations, extraordinary gains and
losses, and the write-off of goodwill that has been impaired. Earnings per share data appear
at the bottom of the statement.
The different estimates and methods that management can choose for dealing with such
matters as uncollectible accounts, inventory, and depreciation produce different net income
figures. In general, an accounting method or estimate that produces a lower, or more
conservative, figure produces a more reliable quality of earnings. Management’s choices
about how nonoperating and nonrecurring items are reported on the income statement also
affect the “bottom line.” Financial analysts should therefore look beyond the net income
figure to the notes to the financial statements, where generally accepted accounting
principles require full disclosure of the significant accounting methods used in preparing the
statements and any changes in those methods.
Although gains or losses on the sale of assets appear in the operating section of the income
statement, they usually represent one-time events. They are not sustainable, ongoing
operations, and management often has some choice as to their timing. Analysts should
therefore ignore them when considering operating income.