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Unformatted text preview: 1 Chapter 6 – Analyzing Operating Ac- tivities Income measurement Concept of income Income (also referred to as earnings or profits ) summarizes in financial terms the operating activities of a business. It is the most demanded piece of company information in the financial markets. Income is the amount of revenues and gains for the period in excess of expenses and losses, all computed under accrual accounting. Income provides a measure of the change in shareholder wealth for a period and an indication of a company’s future earning power. Accounting in- come differs from cash flows because certain revenues and gains are recognized in periods before or after cash is received and cer- tain expenses and losses are recognized in periods before or after cash is paid. Determining and explaining a business’s income for the period is the main purpose of the income statement . Accounting , or reported , income is different from eco- nomic income. The illustration shows that economic income dif- fers from accounting income, and both differ from the cash flow measures. We might also notice that the $37,000 economic in- come is probably not sustainable in that we certainly can’t count on a 25 % annual appreciation in the condominium’s value year after year. This implies the economic income of $37,000 is less useful for forecasting future earnings. If accounting income of $11,500 is probably closer to permanent income—at least in this case. Economic concept of income Economic income Economic income is net cash flows plus the change in the present value of future cash flows. Economic in- come for a period is the total amount by which the company increased or decreased in value. Under this definition, income in- cludes both realized (cash flow) an unrea- lized (holding gain or loss) components. This concept of income is similar to how we measure the return on a security or a portfo- lio of securities—that is, return includes both the dividends and capital appreciation. In other words, economic income measures change in shareholder value. It does thus exhibits the exact return to the shareholder for the period, and as such, economic in- come is the bottom line indicator of compa- Illustration Facts: 1. Company with $100,000 in cash 2. Buys condo for $100,000 3. Rents condo for $12,000 per year 4. End of the first year: Condo valued at $125,000 1. Net (free) cash flow = $(88,000) 2. Operating cash flow = $12,000 3. Economic income = $37,000 ($12,000 rental income + $25,000 holding gain) 4. 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 deprecia- tion is $500 2 ny performance—measuring the financial efforts of all events of the period in a comprehensive manner. However, because of its comprehensive nature, economic income includes both recurring and nonrecurring components and is therefore less useful for forecasting future earnings potential. Indeed, economic income computations can yield un-therefore less useful for forecasting future earnings potential....
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This note was uploaded on 06/11/2011 for the course ACCT 3607 taught by Professor Mike during the Spring '11 term at Assumption College.
- Spring '11