ch13-1 - CHAPTER 13 Financial Analysis The Big Picture...

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CHAPTER 13 Financial Analysis: The Big Picture Study Objectives 1. Understand the concept of sustainable income. 2. Indicate how irregular items are presented. 3. Explain the concept of comprehensive income. Study Objective 1 - Understand the Concept of Sustainable Income The value of a company is a function of its future cash flows. When analysts use this year's net income to estimate future cash flows, they must make sure that this year's net income does not include irregular revenues, expenses, gains or losses. Net income adjusted for irregular items is referred to as sustainable income. Sustainable income is the most likely level of income to be obtained in the future. Sustainable income differs from actual net income by the amount of irregular revenues, expenses, gains, and losses included in this year’s net income. Users are interested in sustainable income because it helps them derive an estimate of future earnings without the “noise” of irregular items. Study Objective 2 - Understand How Irregular Items are Presented Irregular items are identified by type on the income statement. Two types of irregular items are reported - discontinued operations and extraordinary items. Irregular items are reported net of taxes . Income tax expense is computed for the income before irregular items. Then, income tax expense is computed for each individual irregular item. 13-1
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Discontinued operations refers to the disposal of a significant component of a business, such as the elimination of a major class of customers or an entire activity. When the disposal of a significant component occurs, the income statement should report the gain (or loss) from discontinued operations, net of tax. To illustrate, assume that Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million from continuing operations in 2007. The company therefore has income before income taxes of $800,000. During 2007 the company discontinued and sold its unprofitable chemical division. The loss on disposal of the chemical operations (net of $90,000 taxes) was $210,000. Assuming a 30% tax rate on income before income taxes, the income statement presentation would be as follows: ROZEK INC.
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