Ch11S - Chapter 11: The Income Statement & Statement of...

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Analysis of the Corporate Income Statement 1. Chapters 5 through 8 and Chapter 10 discussed GAAP for various assets and liabilities. Changes in these assets and liabilities often cause changes in stockholders’ equity. These changes in stockholders’ equity result from two types of transactions: 1. Capital Transactions : arise when the company issues stock, repurchase stock, and declare and pay dividends, as discussed in Chapter 9. 2. Operating Transactions : arise when companies use assets to generate earnings (net income). Prior chapters discussed how to measure the results of operating transactions. In this chapter the focus is on how to report operating transactions on the company’s income statement. This is important because financial analysts and other users use the information in the income statement to predict future earnings which, in turn, are used to assess what the company is worth (i.e., its stock price). The financial analyst is likely to ask 2 questions regarding the company’s income statement when using it to predict future earnings: (1) Does the earnings item result from an activity in which the company will continue its involvement, or is it from an unusual event that is unlikely to recur regularly? (2) Does the earnings item result from the company’s primary (core) operating activity (producing & selling goods to customers) or is it from an activity that is peripheral (incidental) to the company’s primary operating activity? The figure below depicts these distinctions with examples: Recurring Nonrecurring Primary Activity Producing and Selling Products Income from Products to be Discontinued Peripheral Activity Gain on Sale of Equipment Interest Revenue Interest Expense Extraordinary Items Cumulative Effect of a Change in Accounting Principle
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3. Quality of Earnings For the financial analyst this term refers to the characteristics of the earnings number that makes it useful for predicting future earnings and hence, what the company’s stock is worth. Accordingly, financial analysts are more confident in estimating what the company’s stock is worth using income items from recurring activities rather than using income items from nonrecurring activities. However, the company’s management often characterizes income-increasing earnings items so as to make them appear to be primary and recurring, and characterizes income-decreasing items as peripheral and nonrecurring. Thus the analyst must sort through the various components of earnings to identify those most useful for predicting future earnings. GAAP aids the financial analyst in this endeavor by requiring companies to
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This note was uploaded on 09/26/2011 for the course 06A 001 taught by Professor Stuff during the Fall '10 term at University of Iowa.

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Ch11S - Chapter 11: The Income Statement & Statement of...

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