Chapter6 - Analyzing Operating Activities CHAPTER 6 Income...

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6 CHAPTER Analyzing Operating Activities
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Illustration Facts: • Company with $100,000 in cash • Buys condo for $100,000 • Rents condo for $12,000 per year • End of the first year: Condo valued at $125,000 Income Measurement Concepts
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Illustration Facts: • Net (free) cash flow = $(88,000) • Operating cash flow = $12,000 • Economic income = $37,000 • ($12,000 rental income + $25,000 holding gain) • Accounting income = $11,500 ($12,000 rental income - $500 depreciation*) *Condo’s useful life is 50 years and its salvage value is $75,000—yearly straight-line depreciation is $500 Income Measurement Concepts
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Economic Income: Two measures reflect the economic concept • economic income • permanent income Income Measurement Concepts
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Economic Income: • Equals net cash flows + the change in the present value of future cash flows • Measures change in shareholder value—reflecting the financial effects of all events in a comprehensive manner • Includes both recurring and nonrecurring components— rendering it less useful for forecasting future earnings potential • Related to Hicksian concept of income—income includes both realized (cash flow) and unrealized (holding gain or loss) components Income Measurement Concepts
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Permanent Income* • Equals stable average income that a company is expected to earn over its life • Reflects a long-term focus • Directly proportional to company value • Often expressed by dividing permanent income by cost of capital *Also called sustainable earning power, or sustainable or normalized earnings Income Measurement Concepts
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Economic Income and Permanent Income Income Measurement Concepts 0 1 2 3 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 Years $ Million Permanent Income Economic Income
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Accounting Concept of Income: • Based on accrual accounting • Capture aspects of both economic income and permanent income • Suffers from measurement problems—yields accounting analysis Income Measurement Concepts
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Revenue Recognition and Matching : Revenue recognition Revenues must be (1) realized or realizable, and (2) earned Costs/Expenses matched with recognized revenues Product costs—recognized when product or service sold Period costs--recognized when incurred Income Measurement Concepts
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Economic Income vs. Accounting Income: Economic Income and Accounting Income reflect similar concepts BUT: Accounting income is a product of the financial reporting environment—accounting standards, enforcement mechanisms, managers’ incentives, etc. HENCE: Accounting income can diverge from economic income (yielding accounting distortions) Income Measurement Concepts
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Accounting Income consists of: • Permanent Component--the recurring component expected to persist indefinitely • Transitory Component--the transitory (or non- recurring) component not expected to persist (Note: The concept of economic income includes both permanent and transitory components.) • Value Irrelevant Component--value irrelevant components have no economic content; they are accounting distortions Income Measurement Concepts
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This note was uploaded on 08/06/2010 for the course FI575 FI575 taught by Professor Srinivasan during the Spring '08 term at Keller Graduate School of Management.

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Chapter6 - Analyzing Operating Activities CHAPTER 6 Income...

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