Analyzing Operating Activities

Transcription

1 Analyzing Operating Activities REVIEW Income is the residual of revenues and gains less expenses and losses. Net income is measured using the accrual basis of accounting. Accrual accounting recognizes revenues and gains when earned, and recognizes expenses and losses when incurred. The income statement (also referred to as statement of operations or earnings) reports net income during a period of time. This statement also reports income components--revenues, expenses, gains, and losses. We analyze income and its components to evaluate company performance, assess risk exposures, and predict amounts, timing, and uncertainty of future cash flows. While "bottom line" net income frames our analysis, income components provide pieces of a mosaic revealing the economic portrait of a company. This chapter examines the analysis and interpretation of income components. We consider current reporting requirements and their implications for our analysis of income components. We describe how we might usefully apply analytical adjustments to income components and related disclosures to better our analysis. We direct special attention to revenue recognition and the recording of major expenses and costs. Further use and analysis is made of income components in Part Three of the book. 6-1

2 OUTLINE Income Measurement Concept of Income Measuring Accounting Income Alternative Classification and Income Measures Non-recurring items Extraordinary Items Discontinued Operations Accounting Changes Special Items Revenue and Gain Recognition Guidelines for Revenue Recognition Uncertainty in Revenue Collection Revenue When Right of Return Exists Franchise Revenues Product Financing Arrangements Revenue under Contracts Analysis Implications of Revenue Recognition Deferred Charges Research and Development Computer Software Expenses Exploration and Development Costs in Extractive Industries Supplementary Employee Benefits Employee Stock Options Interest Costs Income Taxes Appendix 6A Earnings per Share: Computation and Analysis Appendix 6B Economics of Employee Stock Options 6-2

3 ANALYSIS OBJECTIVES Explain the concepts of income measurement and their implications for analysis of operating activities. Describe and analyze the impact of non-recurring items - including extraordinary items, discontinued segments, accounting changes, and restructuring charges and write-offs. Analyze revenue and expense recognition and its risks for financial analysis. Analyze deferred charges, including expenditures for research, development, and exploration. Explain supplementary employee benefits and analyze disclosures for employee stock options (ESOs) Describe and interpret interest costs and the accounting for income taxes. Analyze and interpret earnings per share data (Appendix 6A). Understand the economics of employee stock options (appendix 6B). 6-3

4 QUESTIONS 1. The income statement portrays the net results of operations of an enterprise. Since results are what enterprises are established to achieve and since their value is, in large measure, determined by the size and quality of these results, it follows that the analyst attaches great importance to the income statement. 2. Income summarizes in financial terms the operating activities of a company. 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 income differs from cash flows because certain revenues and gains are recognized in periods before or after cash is received and certain expenses and losses are recognized in periods before or after cash is paid. 3. Economic income is net cash flows plus the change in the present value of future cash flows. Another similar concept, the Hicksian concept of income, considers income for the period to be the amount that can be withdrawn from the company in a period without changing the net wealth of the company. Hicksian income equals cash flow plus the change in the fair value of net assets. 4. Accounting income is the excess of revenues and gains over expenses and losses measured using accrual accounting. As such, revenues (and gains) are recognized when earned and expenses (losses) are matched against the revenues (and gains). 5. Net income is the excess of the revenues and gains of the company over the expenses and losses of the company. Net income often is called the bottom line, although that is a misnomer because certain unrealized holding gains and losses are charged directly to equity and bypass net income. Comprehensive income includes all changes in equity that result from non-owner transactions (excluding items such as dividends and stock issuances). Items creating differences between net income and comprehensive income include unrealized gains and losses on available for sale securities, foreign currency translation adjustments, minimum pension liability adjustments, and unrealized holding gains or losses on derivative instruments. Comprehensive income is the ultimate bottom line income number. Continuing income is a measure of net income earned by ongoing segments of the company. Continuing income differs from net income because continuing income excludes the income or loss of segments of the company that are to be discontinued or sold (it also excludes extraordinary items and effects from changes in accounting principles). 6. Details regarding comprehensive income are reported by the vast majority of companies in the statement of stockholders equity rather than the income statement. 7. Core income is a measure of income that excludes all non-recurring items that are reported as separate items on the income statement. 6-4

5 8. Operating income is a measure of firm performance from operating activities. Examples of operating income include product sales, cost of product sales, and selling, general, and administrative costs. Non-operating income includes all components of income not included in operating income. Examples of non-operating income include interest revenue and interest expense. 9. Operating versus non-operating and recurring versus non-recurring are distinct dimensions of classifying income. While there is overlap across selected items, these dimensions reflect different characteristics of business activities. For example, the interest income and interest expense of most companies recur in net income; hence, they are included in recurring income. However, these items are non-operating in nature. Similarly, non-recurring items such as restructuring charge are operating in nature. 10. Accounting standards (APB 30) restricted the use of the "extraordinary" category by requiring that an extraordinary item be both unusual in nature and infrequent in occurrence. These attributes are defined as follows: a. Unusual nature of the underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates. b. Infrequency of occurrence of the underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. Three examples of extraordinary items are: Major casualty losses from an event such as an earthquake, flood, or fire. A gain or loss from expropriation of property. A gain or loss from condemnation of land by eminent domain. 11. To qualify as discontinued operations, the assets and business activities of the divested segment must be clearly distinguishable from the assets and business activities of the remaining entity. Accounting and reporting for discontinued operations is two-fold. First, the income statement for the current and prior two years are restated after excluding the effects of the discontinued operations from the line items that determine continuing income. Second, gains or losses pertaining to the discontinued operations are reported separately, net of related tax effects. An analyst should separate and ignore discontinued operations in predicting future performance and financial condition. 12. To qualify as a prior period adjustment, an item must meet the following requirements: Material in amount. Specifically identifiable with the business activities of specific prior periods. Not attributable to economic events occurring subsequent to the prior period. Dependent primarily on determinations by persons other than management. Not reasonably estimable prior to such determination. 6-5

6 13. Distortions in revenues (gains) and expenses (losses) can arise from several accounting sources. These include choices in the timing of transactions (such as revenue recognition and expense matching), selections from the variety of generally accepted principles and methods available, the introduction of conservative or aggressive estimates and assumptions, and choices in how revenues, gains, expenses, and losses are classified and presented in financial statements. Generally, a company wishing to increase current income at the expense of future income will engage in one or more of the following practices: (a) It will choose inventory methods that allow for maximum inventory carrying values and minimum current charges to cost of goods or services sold. (b) It will choose depreciation methods and useful lives of property that will result in minimum current charges as depreciation expense. (c) It will defer all managed costs to the future such as, for example: pre-operating, moving, rearrangement and start-up costs, and marketing costs. Such costs would be carried as deferred charges or included with the costs of other assets such as property, plant, and equipment. (d) It will amortize assets and defer costs over the largest possible period. Such assets include goodwill, leasehold improvements, patents, and copyrights. (e) It will elect the method requiring the lowest possible pension and other employment compensation cost accruals. (f) It will inventory rather than expense administrative costs, taxes, and similar items. (g) It will choose the most accelerated methods of income recognition such as in the areas of leasing, franchising, real estate sales, and contracting. (h) It immediately will recognize as revenue, rather than defer the taking up of benefits, items such as investment tax credits. (i) Companies that wish to manage the size of accounting income can regulate the flow of income and expense by means of reserves for future costs and losses. 14. (1) Depreciation a. Straight Line: This is calculated by taking the salvage value (S) from the original cost (C) and dividing by the useful life of the asset in question; that is, (C- S)/(Useful life). Sum-of-Years'-Digits: This depreciation formula is: (C-S) x (X/Y); where C and S are the same as above, X is the remaining years (that is, if item is being depreciated over 5 years and this is the first year, then X=5), and Y equals the "sum-of-years'-digits" (that is, for a 5-year asset, Y= =15). b. Straight line is easily understood and provides level depreciation and earnings effects. The sum-of-the-years'-digits gives heavier weight to earlier years and causes higher depreciation and lower earnings in the early years and lower depreciation and higher earnings toward the end of the asset's life. (2) Inventory a. LIFO (last-in, first-out) method: The LIFO method assumes the inventory employed are those most recently acquired. FIFO (first-in, first-out) method: The FIFO method assumes the first inventory items acquired are used first. b. The effect on earnings depends on whether the economy is in an inflationary or deflationary period. In times of inflation (the more usual case), LIFO inventory accounting would result in lower earnings being reported than would be the case had FIFO been employed. 6-6

7 c. (3) Installment sales a. Accrual method: Assumes income is recognized when the sale is made (earned). Installment method: Assumes income is recognized only when cash is received as the various installments come in. b. The installment method is commonly used for tax purposes while the accrual method is employed in financial statements. The accrual method would result in a higher earnings figure being reported than the installment method. 15. Three different types of accounting changes include: (a) Changes in accounting principle (b) Changes in accounting estimate (c) Changes in reporting entity 16. Special items refer to transactions and events that are unusual or infrequent, not both. These items are reported as separate line items on the income statement before continuing income. Examples of special items include restructuring charges, impairments of long-lived assets, and asset write-offs. 17. Special (one-time) charges usually receive less attention by investors because it often is believed that such charges will not recur in the future. As a result, companies often include as much operating expense and loss as possible in special charges hoping that investors will focus on income before special charges that excludes these expenses and losses. If investors do focus on income before these charges, company value may be erroneously perceived to be higher than is supported by the fundamentals. 18. Many special charges should be viewed as operating expenses that need to be reflected in permanent income. Essentially, many special charges are either corrections of understated past expenses or investments for improved future profitability. As such, analysts should adjust their income measurements to include special charges in operating income. 19. The following criteria exemplify the rules that have been established to prevent the premature anticipation of revenue. Realization is deemed to take place only after the following conditions have been met: (a) The earning activities undertaken to create revenue are substantially complete; for example, no significant effort is necessary to complete the transaction. (b) In the case of a sale, the risk of ownership has effectively passed to the buyer. (c) The revenue, as well as the associated expenses, can be measured or estimated with substantial accuracy. (d) The revenue recognized should normally result in an increase in cash, receivables, or marketable securities and, under certain conditions, in an increase in inventories or other assets, or a decrease in a liability. (e) The business transactions giving rise to the income should be at arm's-length with independent parties (that is, not with controlled parties). (f) The transactions should not be subject to revocation, for example, carrying the right of return of merchandise sold. 20. SFAS 48 ("Revenue Recognition When Right of Return Exists") specifies that revenue from sales transactions in which the buyer has a right to return the product should be recognized at the time of sale only if all of the following conditions are met: At the date of sale, the price is substantially fixed or determinable. 6-7

8 The buyer has paid the seller, or is obligated to pay the seller (not contingent on resale of the product). In the event of theft or physical damage to the product, the buyer's obligation to the seller would not be changed. The buyer acquiring the product for resale has economic substance apart from that provided by the seller. The seller does not have significant obligations for future performance to directly bring about resale of the product. Product returns can be reasonably estimated. If these conditions are not met, revenue recognition is postponed; if they are met, sales revenue and cost of sales should be reduced to reflect estimated returns and expected costs or losses should be accrued. Note: The Statement does not apply to accounting for revenue in (a) service industries if part or all of the service revenue may be returned under cancellation privileges granted to the buyer, (b) transactions involving real estate or leases, or (c) sales transactions in which a customer may return defective goods such as under warranty provisions. 21. Some of the factors that might impair the ability to predict returns (when right of return exists in transactions) are: (1) susceptibility to significant external factors, such as technological obsolescence or swings in market demand, (2) long return privilege periods, and (3) absence of appropriate historical return experience. 22. SFAS 49 ("Accounting for Product Financing Arrangements") is concerned with the issue of whether revenue has been earned. A product financing arrangement is an agreement involving the transfer or sponsored acquisition of inventory that, although it resembles a sale, is in substance a means of financing inventory through a second party. For example, if a company transfers inventory to another company in an apparent sale, and in a related transaction agrees to repurchase the inventory at a later date, the arrangement may be a product financing arrangement rather than a sale and subsequent purchase of inventory. If the party bearing the risks and rewards of ownership transfers inventory to a purchaser, and in a related transaction agrees to repurchase the product at a specified price, or guarantees some specified resale price for sales of the product to outside parties, the arrangement is a product financing arrangement and should be accounted for as such. 23. The percentage-of-completion method is preferred when estimates of costs to complete along with estimates of progress toward completion of the contract can be made with reasonable dependability. A common basis of profit estimation is to record that part of the estimated total profit that corresponds to the ratio that costs incurred to date bears to expected total costs. Other methods of estimation of completion can be based on units completed or on qualified engineering estimates or on units delivered. The completed-contract method of accounting is preferable where the conditions inherent in the contract present risks and uncertainties that result in an inability to make reasonable estimates of costs and completion time. Problems under this method concern the point at which completion of the contract is deemed to have occurred as well as the kind of expenses to be deferred. For example, some companies defer all costs to the completion date, including general and administrative overhead while others consider such costs as period costs to be expensed as they are incurred. Under either of the two contract accounting methods, losses (present or anticipated) must be fully provided for in the period in which the loss first becomes apparent. 6-8

9 24. The recording of revenue is the first step in the process of income determination and is a step for which the recognition of any and all revenue depends. The analyst should be particularly inquisitive about revenue recognition policies and procedures. Some specific aspects include the following: (1) One element that casts doubt on the validity of revenue is uncertainty about the ability of the seller to collect the resulting receivable. Special collection problems exist with respect to installment sales, real estate sales, and franchise sales. Problems of collection exist, however, in the case of all sales and the analyst must be alert to them. (2) The analyst must also be alert to the problems related to the timing of revenue recognition. The present rules generally do not allow for recognition of profit in advance of sale such as with increases in market value of property such as land or equipment, the accretion of values in growing timber, or the increase in the value of inventories are not recognized in the accounts. As a consequence, income will not be recorded before sale and the timing of sales is a matter that lies within the discretion of management. That, in turn, gives management a certain degree of discretion in the timing of profit recognition. (3) In the area of contract accounting, the analyst should recognize that the use of the completed contract method is justified only in cases where reasonable estimates of costs and the degree of completion are not possible. Yet, some companies consider the choice of method a matter of discretion. (4) Other alternative methods of taking up revenue, as in the case of lessors or finance companies, must be fully understood by the analyst before an evaluation of a company's earnings or a comparison among companies in the same industry is undertaken. 25. SFAS 2 ("Accounting for Research and Development Costs") offers a simple solution to the complex problem of accounting for research and development costs. Namely, it requires that R&D costs be charged to expense when incurred. It defines research and development activities as follows: (a) Research activities are aimed at discovery of new knowledge for the development of a new product or process or in bringing about a significant improvement to an existing product or process. (b) Development activities translate the research findings into a plan or design for a new product or process or a significant improvement to an existing product or process. R&D specifically excludes routine or periodic alterations to ongoing operations and market research and testing activities. The Board recommended the following accounting treatment for R&D costs: (a) The majority of expenditures incurred in research and development activities as defined above constitutes the costs of that activity and should be charged to expense when incurred. (b) Costs of materials, equipment, and facilities that have alternative future uses (in research and development projects or otherwise) should be capitalized as tangible assets. (c) Intangibles purchased from an external party for R&D use that have alternative future uses should also be capitalized. (d) Indirect costs involved in acquiring patents should be capitalized as well. 6-9

10 Elements of costs that should be identified with R&D activities are: (a) Costs of materials, equipment, and facilities that are acquired or constructed for a particular research and development project and purchased intangibles, that have no alternative future uses (in research and development projects or otherwise). (b) Costs of materials consumed in research and development activities, the depreciation of equipment or facilities, and the amortization of intangible assets used in research and development activities that have alternative future uses. (c) Salaries and other related costs of personnel engaged in R&D activities. (d) Costs of services performed by others. (e) A reasonable allocation of indirect costs. General and administrative costs that are not clearly related to R&D activities should be excluded. The specific disclosure requirements as stipulated by SFAS 2 are: (1) for each income statement presented, the total R&D costs charged to expense is to be disclosed, and (2) government-regulated companies that defer R&D costs in accordance with the addendum to SFAS 2 must make certain additional disclosures to that effect. 26. For an analyst to form a reliable opinion on the quality and the future potential value of research outlays, the analyst needs to know a great deal more than the totals of periodic research and development outlays. The analyst needs information on (1) the types of research performed, (2) the outlays by category, (3) the technical feasibility, commercial viability, and future potential of each project assessed and reevaluated at the time of each periodic report, and (4) information on a company's success-failure experience in its several areas of research activity to date. Of course, present disclosure requirements will not give the analyst such information and it appears that, except in cases of voluntary disclosure, only the investor or the lender with the necessary clout will be able to obtain such information. In general, one can assume that the outright expensing of all research and development outlays will result in more conservative balance sheets and fewer bad-news surprises stemming from the wholesale write-offs of previously capitalized research and development outlays. However, the analyst must realize that along with a lack of knowledge about future potential s/he may also be unaware of the potential disasters that can befall an enterprise tempted or forced to sink ever greater amounts of funds into research and development projects whose promise was great but whose failure is nevertheless inevitable. 27. One of the most common solutions applied by analysts to the complex problem of the analysis of goodwill is to simply ignore it. That is, they ignore the asset shown on the balance sheet. Unfortunately, by ignoring goodwill, analysts ignore investments of very substantial resources in what may often be a company's most important asset. Ignoring the impact of goodwill impairment losses on reported periodic income is no solution to the analysis of this complex cost. Even considering the limited amount of information available to the analyst, it is far better that the analyst understand the effects of accounting practices in this area on accounting income rather than dismiss them altogether. 6-10

11 28. Goodwill is measured by the excess of cost over the fair market value of tangible net assets acquired in a transaction accounted for as a purchase. That is the theory of it. The financial analyst must be alert to the makeup and the method of valuation of the Goodwill account as well as to the method of its ultimate disposition. One way of disposing of the Goodwill account, frequently chosen by management, is to write it off at a time when it would have the least serious impact on the market's judgment of the company's earnings, for example, at a time of loss or reduced earnings. Under normal circumstances, goodwill is not indestructible but is rather an asset with a limited useful life. Still, whatever the advantages of location, market dominance and competitive stance, sales skill, product acceptance, or other benefits are, they cannot be unaffected by the passing of time and by changes in the business environment. Thus, the analyst must assess the carrying amount of goodwill by reference to such evidence of continuing value as the profitability of units for which the goodwill consideration was originally paid. 29. The interest cost to a company is the nominal rate paid including, in the case of bonds, the amortization of any bond discount or premium. A complication arises when companies issue convertible debt or debt with warrants, thus achieving a nominal debt coupon cost that is below the cost of similar debt not carrying these features. After trial pronouncements on the subject and much controversy, APB 14 concluded in the case of convertible debt that the inseparability of the debt and equity features is such that no portion of the proceeds from the issuance should be accounted for as attributable to the conversion feature. In the case of debt issued with stock warrants attached, the proceeds of the debt attributable to the warrants should be accounted for as paid-in capital. The corresponding charge is to a debt discount account that must be amortized over the life of the debt issue thus increasing the effective interest cost. 30. a. SFAS 34 ("Capitalization of Interest Cost") requires capitalization of interest cost as part of the historical cost of "assets that are constructed or otherwise produced for an enterprise's own use (including assets constructed or produced for the enterprise by others for which deposits or progress payments have been made)." Inventory items that are routinely manufactured or produced in large quantities on a repetitive basis do not qualify for interest capitalization. The objectives of interest capitalization, according to the FASB, are (1) to measure more accurately the acquisition cost of an asset, and (2) to amortize that acquisition cost against revenues generated by the asset. b. The amount of interest to be capitalized is based on the entity's actual borrowings and interest payments. The rate to be used for capitalization may be ascertained in this order: (1) the rate of specific borrowings associated with the assets and (2) if borrowings are not specific for the asset, or the asset exceeds specific borrowings therefore, a weighted average of rates applicable to other appropriate borrowings may be used. Alternatively, a company may use a weighted average of rates of all appropriate borrowings regardless of specific borrowings incurred to finance the asset. 6-11

12 c. Interest capitalization is not permitted to exceed total interest costs for any period, nor is imputing interest cost to equity funds permitted. A company without debt will have no interest to capitalize. The capitalization period begins when three conditions are present: (1) expenditures for the asset have been made by the entity, (2) work on the asset is in progress, and (3) interest cost is being incurred. Interest capitalization ceases when the asset is ready for its intended use. 31. The intrinsic value of an option is the amount by which the market value of the underlying security exceeds the option exercise price at the time of measurement. The fair value of an option is the amount that market participants would be willing to pay today to purchase the option. 32. The fair value of an option is affected by the exercise price, the current market price, the risk-free rate of interest, the expected life of the option, the expected volatility of the stock price, and the expected dividend yield. 33. SFAS 123 requires that the company amortize the fair value of employee stock options (estimated using various option pricing models) at the grant date over the expected life of the option. The cumulative amortization of all employee stock options granted in the past is collectively called the option compensation expense. Until recently, option compensation expense was not charged to income. However, a recent revision of the standard, SFAS 123R, requires that the option compensation expense be charged to income. Compensation expense may be included in various expense categories such as cost of goods sold, SG&A, R&D etc. based on which area of the company the respective employee works for. 34. The economic cost of issuing options at the prevailing market price are: (1) the interest cost, which is that the employee is able to pay for the stock purchase many years later using the current stock price; and (2) cost of providing an option to exercise, which arises because the employee can share in the potential upside but is protected from sharing in the potential downside risk. 35. Option overhang refers to the intrinsic value of outstanding options (both exercisable and otherwise) as a proportion of the company s market value. It is a measure of the value of potential dilution that arises from option grants to employees. It measured by aggregating the intrinsic value of all outstanding employee stock options, using the current stock price, and dividing it by the current market capitalization of the company s equity. 35. The net income computed on the basis of generally accepted accounting principles (also known as "book income") is usually not identical to the "taxable income" computed on the entity's tax return. This is due to two types of difference. Permanent differences (discussed here) and temporary, or timing, differences. Permanent differences result from provisions of the tax law under which: (a) Certain items may be nontaxable for example, income on tax exempt obligations and proceeds of life insurance on an officer 6-12

13 (b) (c) Certain deductions are not allowed for example, penalties for filing certain returns, government fines, and officer life insurance premiums. (d) Special deductions granted by law for example, dividend exclusion on dividends from unconsolidated subsidiaries and from dividends received from other domestic corporations. 36. The effective tax rate paid by a corporation on its income will vary from the statutory rate because: The basis of carrying property for accounting purposes may differ from that for tax purposes from reorganizations, business combinations, or other transactions. Nonqualified and qualified stock-option plans may result in book-tax differences. Certain industries, such as savings and loan associations, shipping lines, and insurance companies enjoy special tax privileges. Up to $100,000 of corporate income is taxed at lower tax rates. Certain credits may apply, such as R&D credits and foreign tax credits. State and local income taxes, net of federal tax benefit, are included in total tax expenses. What makes these differences and factors permanent is the fact that they do not have any future repercussions on a company's taxable income. Thus, they must be taken into account when reconciling a company's actual (effective) tax rate to the statutory rate. 37. SFAS 109 ("Accounting for Income Taxes") establishes financial accounting and reporting standards for the effects of income taxes that result from an enterprise's activities during the current and preceding years, and requires an asset and liability approach. SFAS 109 requires that deferred taxes should be determined separately for each tax-paying component (an individual entity or group of entities that is consolidated for tax purposes) in each tax jurisdiction. The determination includes the following procedures: Identify the types and amounts of existing temporary differences and the nature and amount of each type of operating loss and tax credit carry forward, plus the remaining length of the carry forward period. Measure the total deferred tax liability for taxable temporary differences, using the applicable tax rate. Measure the total deferred tax asset for deductible temporary differences and operating loss carry forwards, using the applicable tax rate. Measure deferred tax assets for each type of tax credit carry forward. Reduce deferred tax assets by a valuation allowance if based on the weight of available evidence. It is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized. Deferred tax assets and liabilities should be adjusted for the effect of a change in tax laws or rates. The effect should be included in income from continuing operations for the period that includes the enactment date. 6-13

14 38. (a) Revenues or gains are included in taxable income later than they are included in pretax accounting income. (b) Expenses or losses are deducted in determining taxable income later than they are deducted in determining pretax accounting income. (c) Revenues or gains are included in taxable income earlier than they are included in pretax accounting income. (d) Expenses or losses are deducted in determining taxable income earlier than they are deducted in determining pretax accounting income. 39. The components of the net deferred tax liability or net deferred tax asset recognized in a company's balance sheet should be disclosed. These include the: Total of all deferred tax liabilities. Total of all deferred tax assets. Total valuation allowance recognized for deferred tax assets. Additional disclosures include the significant components of income tax expense attributable to continuing operations for each year presented which include, for example: Current tax expense or benefit. Deferred tax expense or benefit (exclusive of the effects of other components). Investment tax credits. Government grants (to the extent recognized as a reduction of income tax expense). The benefits of operating loss carry forwards. Tax expense that results from allocating certain tax benefits either directly to contributed capital or to reduce goodwill or other noncurrent intangible assets of an acquired entity. Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in the tax status of the enterprise. Adjustments of the beginning-of-year balance of a valuation allowance because of a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years. Also to be disclosed is a reconciliation between the effective income tax rate and the statutory federal income tax rate. In addition, the amounts and expiration dates of operating loss and tax credit carry forwards for tax purposes must be disclosed. 40. (1) One of the flaws remaining in tax allocation procedures is that no recognition is given to the fact that a future obligation, or loss of benefits, should be discounted rather than shown at its entire amount as today's tax deferred accounts actually are. The FASB has reviewed the issue and decided not to address it because of the conceptual and implementation issues involved. (2) Another flaw is that the Board allowed parent companies to avoid providing taxes on unremitted earnings of subsidiaries and other specialized exceptions to the requirements of deferred tax accounting. 41. A The determination of the earnings level of an enterprise, which is relevant to the purpose of the analyst, is a complex analytical process. The earnings figure can be converted into a per-share amount that is useful in evaluating the price of the common stock, its dividend coverage, and the potential effects of dilution. As with any measure, there are strengths and weaknesses associated with its computation. Thus, the analyst must have a thorough understanding of the principles that govern the computation of earnings per share to effectively analyze it and use it in decision making. 6-14

15 42. A Earnings per share data are used in making investment decisions. They are used in evaluating the past operating performance of a company and in forming an opinion as to its future potential. They are commonly presented in prospectuses, proxy material, and reports to stockholders, and is the only financial statement ratio that is audited. They are used in the compilation of business earnings data for the press, statistical services, and other publications. When presented with formal financial statements, they assist the investor in weighing the significance of a corporation's current net income and of changes in its net income from period to period in relation to the shares an analyst holds or may acquire. Current GAAP regarding EPS conforms to international standards. The analyst must be aware that basic EPS does not take into account securities that, although not common stock, are in substance equivalent to common stock. The analyst must take care to focus on diluted EPS, which intends to show the maximum extent of potential dilution of current earnings that conversions of securities could create. 43. A Diluted earnings per share is the amount of current earnings per share reflecting the maximum dilution that would result from conversions, exercises, and other contingent issuances that individually would decreased earnings per share and in the aggregate yield a dilutive effect. All such issuances are assumed to have taken place at the beginning of the period (or at the time the contingency arose, if later). 44. A The amount of any dividends on preferred stock that have been paid (declared) for the year should be deducted from net income before computing earnings per share. 45. A Yes, if warrants or options are present, an increase in the market price of the common stock can increase the number of common equivalent shares by decreasing the number of shares repurchasable under the treasury stock method. 46. A SFAS 128 has a number of flaws and inconsistencies that the analyst must consider in interpreting EPS data: (a) The computation of basic EPS completely ignores the potentially dilutive effects of options and warrants. (b) There is a basic inconsistency in treating certain securities as the equivalent of common stock for purposes of computing EPS while not considering them as part of the stockholders' equity in the balance sheet. Consequently, the analyst will have difficulty in interrelating reported EPS with the debt-leverage position pertaining to the same earnings. (c) Generally, EPS are considered to be a factor influencing stock prices. Whether options and warrants are dilutive or not depends on the price of the common stock. Thus we can get a circular effect in that the reporting of EPS may influence the market price which, in turn, influences EPS. Under these rules earnings may depend on market prices of the stock rather than only on economic factors within the enterprise. In the extreme, this suggests that the projection of future EPS requires not only the projection of earnings levels but also the projection of future market prices. 47. A (a) Earnings per share data are used in making investment decisions. They are used in evaluating the past operating performance of a company and in forming an opinion as to its future potential. They are commonly presented in prospectuses, proxy material, and reports to stockholders. They are used in the compilation of business earnings data for the press, statistical services, and other publications. When 6-15

16 presented with formal financial statements, they assist the investor in weighing the significance of a corporation's current net income and of changes in its net income from period to period in relation to the shares an analyst holds or may acquire. (b) Earnings per common share are not fully relevant to the valuation of preferred stock. For purposes of preferred stock evaluation, the earnings coverage ratio of preferred stock is among the most relevant. It measures the number of times preferred dividends have been earned and, thus, is a measure of the safety of the dividend as well as the safety of the preferred issue. 6-16

17 EXERCISES Exercise 6-1 (25 minutes) a. Cash xxx Gain on disposition* Net assets of discontinued operations * (A loss on disposition would be recorded as a debit) xxx xxx b. Income (expense) related to discontinued operations include the operating profit (loss) recorded prior to sale and the gain (loss) on sale. These are reported net of applicable tax. c. When estimating future earning power, the results from discontinued operations should not be treated as recurring. This is important for an assessment of the permanent income of a company. d. Separately reporting discontinued operations allows the analyst to view the results of operations without the segment that will not be ongoing. As a result, the analyst can better assess the permanent component of income, for which results of discontinuing operations will be excluded. Exercise 6-2 (30 minutes) a. By the use of reserves, a company can allocate costs in excess of actual experience in the current period, based on estimates of additional costs in the future, or even based on the simple possibility of further costs in the future. Then, in later periods, actual costs can be written off against the reserve rather than reported as expenses in the company's income statement for those periods. The advantage to the company is that earnings trends can be "smoothed," and a cushion for future earnings can be built up during good economic years for use during leaner periods. To the extent that stability and predictability of earnings are market virtues, the company's common stock might be accorded a higher multiple for these efforts, in effect lowering the cost of capital to the company. The use of reserves both poses problems for the analyst and conflicts with some basic accounting principles. These include: (1) Use of reserves contradicts the matching principle, by which revenues and related costs should be recognized in the same period. (2) Reserving for future events (especially contingencies) is obviously subject to estimate, and accounting should attempt to record quantifiable value as much as possible. 6-17

18 Exercise 6-2 continued (3) The reserving technique makes reported earnings less indicative of fundamental trends in the company. The effects of the economic cycle are reduced, making correlation techniques (such as GNP growth vs. EPS growth) invalid. These reported numbers might mislead the uninformed investor. In contrast to the artificial smoothing referred to earlier, the company's growth rate may be exaggerated, by over-reserving for losses in a bad year, and subsequent writing off of the reserve. It should be noted that a reserve can be properly taken such as when it recognizes a liability that (1) likely exists in the relatively near future such as costs of winding up a plant shutdown with the next year or (2) is subject to quantification such as the outright expropriation of net assets in a foreign country. b. If the analyst is able to discern the impact of reserves, s/he should exclude the reserves' impact from accounting income when assessing past trends. Only operating or normal earnings should be compared over the short-term. However, over a longer period of time, the losses against which reserves have been taken should be included. In estimating future earnings, the analyst must carefully consider the impact of reserves and exclude the impact when forecasting normal earnings. By doing this, the analyst will have a better understanding of the true operations of the company. In the valuation of common stock, the analyst must focus on the sustainable earning power of the company. Thus, earnings may have to be adjusted upward or downward depending on the degree of abuse of reserves. c. Several examples of reserves are cited in the chapter. Also, students often benefit from a review of business magazines in attempting to identify such reserves. (CFA Adapted) Exercise 6-3 (35 minutes) a. A change from the sum-of-the-years'-digits method of depreciation to the straight-line method for previously recorded assets is a change in accounting principle. Both the sum-of-the-years'-digits method and the straight-line method are generally accepted. A change in accounting principle results from adoption of a generally accepted accounting principle different from the generally accepted accounting principle used previously for reporting purposes. 6-18

19 Exercise 6-3 continued b. A change in the expected service life of an asset arising because of more experience with the asset is a change in accounting estimate. A change in accounting estimate occurs because future events and their effects cannot be perceived with certainty. Estimates are an inherent part of the accounting process. Therefore, accounting and reporting for certain financial statement elements requires the exercise of judgment, subject to revision based on experience. c. 1. The cumulative effect of a change in accounting principle is the difference between: (1) the amount of retained earnings at the beginning of the period of change and (2) the amount of retained earnings that would have been reported at that date if the new accounting principle had been used in prior periods. 2. FASB 2005 Statement Accounting Changes and Error Corrections requires that effective in 2005, companies should apply the retrospective approach to changes in accounting principle. Thus, all presented periods must be restated as if the change were in effect during those periods, and any cumulative effect from periods before those presented is an adjustment to beginning retained earnings of the earliest period presented. d. Consistent use of accounting principles from one accounting period to another enhances the usefulness of financial statements in comparative analysis of accounting data across time. e. If a change in accounting principle occurs, the nature and effect of a change in accounting principle should be disclosed to avoid misleading financial statement users. There is a presumption that an accounting principle, once adopted, should not be changed in accounting for events and transactions of a similar type. f. Mandatory accounting changes are largely non-discretionary. Thus, managerial discretion is not present, or at least is to a lesser degree. One should examine the motivations for voluntary accounting changes and assess any earnings quality impact. g. Mandatory accounting changes are largely non-discretionary. However, there is often a window of time for a company to adopt a mandatory accounting change. If a window exists, management has discretion as to the timing of the adoption. Thus, the timing of adoption and any accounting ramifications should be considered. For example, if a manager is going to adopt an accounting change that includes a large charge, the manager might choose to adopt in a relatively poor quarter to attempt to potentially conceal or downplay the poor operating performance. 6-19

20 Exercise 6-3 concluded h. Mandatory accounting changes often include the recognition of retroactive earnings affects. For example, the rules in accounting for other post-employment benefits require that companies establish a liability for the accrued benefits to date. This results in a large charge for many companies. Of course, the market potentially views the charge as largely the fault of accounting rule makers. Thus, managers have incentive to increase the amount of the charge and use the bloated liability to increase future earnings. Exercise 6-4 (20 minutes) Comprehensive income computation:* a. Computation: b. Balance sheet accounts affected: $1,000,000 Net income (closed to equity) - 100,000 Unrealized holding loss on available for sale securities + 50,000 Foreign currency translation gain - 25,000 Additional minimum pension liability adjustment - 12,000 Unrealized holding losses on derivative instruments $ 913,000 Comprehensive income (component of equity) * The unexpected return on pension fund assets ($40,000) does not affect net income or stockholders equity in the current period. 6-20