Financial

Statement
Analysis
K R Subramanyam
John J Wild

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

6-2

Analyzing Operating Activities

CHAPTER

6-3

Income Measurement
Concepts of Income
Economic
Economic Income
Income
Equals
Equalsnet
netcash
cashflows
flows++the
thechange
changein
inthe
thepresent
presentvalue
valueof
of
future
futurecash
cashflows
flows
Includes
Includesboth
bothrecurring
recurringand
andnonrecurring
nonrecurringcomponents
components
rendering
renderingititless
lessuseful
usefulfor
forforecasting
forecastingfuture
futureearnings
earningspotential
potential
Permanent
Permanent Income
Income
Also
Alsocalled
calledsustainable
sustainableearning
earningpower,
power,or
orsustainable
sustainableor
or
normalized
normalizedearnings
earnings
Estimate
Estimateof
ofstable
stableaverage
averageincome
incomethat
thataacompany
companyis
isexpected
expected
to
toearn
earnover
overits
itslife
life
Reflects
Reflectsaalong-term
long-termfocus
focus
Directly
Directlyproportional
proportionalto
tocompany
companyvalue
value

6-4

Income Measurement
Concepts
Based
Basedon
onaccrual
accrualaccounting
accounting

Suffers
Suffersfrom
frommeasurement
measurementerror,
error,arising
arisingbecause
becauseof
ofaccounting
accounting
distortions
distortions
Accounting
Accounting Income
Income consists
consists of:
of:

Permanent
PermanentComponent--the
Component--therecurring
recurringcomponent
component expected
expectedto
to
persist
persistindefinitely
indefinitely

Transitory
TransitoryComponent--the
Component--thetransitory
transitory(or
(ornon-recurring)
non-recurring)
component
componentnot
notexpected
expectedto
topersist
persist(Note:
(Note:The
Theconcept
conceptof
of
economic
economicincome
incomeincludes
includesboth
bothpermanent
permanentand
andtransitory
transitory
components.)
components.)

Value
ValueIrrelevant
IrrelevantComponent--value
Component--valueirrelevant
irrelevantcomponents
componentshave
have
no
noeconomic
economiccontent;
content;they
theyare
areaccounting
accountingdistortions
distortions

6-5

Income Measurement
Measurement
Two main components of accounting income:
Revenues (gains)
Expenses (losses)

6-6

Income Measurement
Measurement
Revenues and Gains
Revenues are earned inflows or prospective
inflows of cash from operations*
Gains are recognized inflows or prospective
inflows of cash from non-operations**
* Revenues are expected to
recur
**Gains are non-recurring

6-7

Income Measurement
Measurement
Expenses and Losses
Expenses are incurred outflows, prospective
outflows, or allocations of past outflows of cash
from operations
Losses are decreases in a companys
net assets arising from
non-operations
Expenses and losses are resources consumed, spent,
or lost in pursuing revenues and gains

6-8

Income Measurement
Alternatives
Two major income dimensions:
1. operating versus non-operating
2. recurring versus non-recurring*

*Motivated by need to separate permanent and

transitory components

6-9

Income Measurement
Alternatives
Alternative Income Statement Measures
Net incomewidely regarded as bottom line measure of
income
Comprehensive income--includes most changes to equity
that result from non-owner sources; it is actually the bottom line
measure of income; is the accountants proxy for economic income
Continuing income--excludes extraordinary items, cumulative
effects of accounting changes, and the effects of discontinued
operations from net income*
Core income--excludes all non-recurring items from net
income
*Often erroneously referred to as operating income

6-10

Income Measurement
Analysis
Operating
Operating versus
versus Non-Operating
Non-Operating Income
Income
Operating
Operating income--measure
income--measureof
ofcompany
companyincome
incomeas
asgenerated
generatedfrom
from
operating
operatingactivities
activities
Three
Threeimportant
importantaspects
aspectsof
ofoperating
operatingincome
income
Pertains
Pertainsonly
onlyto
toincome
incomegenerated
generatedfrom
fromoperations
operations
Focuses
Focuseson
onincome
incomefor
forthe
thecompany,
company,not
notsimply
simplyfor
forequity
equityholders
holders
(means
(meansfinancing
financingrevenues
revenuesand
andexpenses
expensesare
areexcluded)
excluded)
Pertains
only
to
ongoing
business
activities
(i.e.,
Pertains only to ongoing business activities (i.e.,results
resultsfrom
from
discontinued
discontinuedoperations
operationsisisexcluded)
excluded)
Non-operating
Non-operating income--includes
income--includesall
allcomponents
componentsof
ofnet
netincome
income
excluded
excludedfrom
fromoperating
operatingincome
income
Useful
Usefulto
toseparate
separatenon-operating
non-operatingcomponents
componentspertaining
pertainingto
tofinancing
financingand
and
investing
investing

6-11

Income Measurement

Analysis
Determination
Determinationof
ofComprehensive
ComprehensiveIncomesample
Incomesamplecompany
company

Net income
Other comprehensive income:
+/- Unrealized holding gain or loss on marketable securities
+/- Foreign currency translation adjustment
+/- Postretirement benefits adjustment
+/- Unrealized holding gain or loss on derivative instruments
Comprehensive income

6-12

Non-Recurring Items

Extraordinary items
Discontinued segments
Accounting changes
Restructuring charges
Special items

6-13

Non-Recurring Items

Extraordinary Items
Criteria
Criteria
Unusual
Unusualin
innature
nature
Infrequent
Infrequentin
inoccurrence
occurrence
Examples
Examples
Uninsured
Uninsuredlosses
lossesfrom
fromaamajor
majorcasualty
casualty(earthquake,hurricane,
(earthquake,hurricane,
tornado),
tornado),losses
lossesfrom
fromexpropriation,
expropriation,and
andgains
gainsand
andlosses
lossesfrom
from
early
earlyretirement
retirementof
ofdebt
debt
Disclosure
Disclosure &
& Accounting
Accounting
Classified
Classifiedseparately
separatelyin
inincome
incomestatement
statement
Excluded
Excludedwhen
whencomputing
computingpermanent
permanentincome
income
Included
Includedwhen
whencomputing
computingeconomic
economicincome
income

6-14

Non-Recurring Items
Discontinued Operations
Accounting
Accounting is
is two-fold:
two-fold:
Income
Incomestatements
statementsfor
forthe
thecurrent
current and
andprior
priortwo
two
years
yearsare
arerestated
restatedafter
afterexcluding
excluding the
theeffects
effectsof
of
discontinued
discontinuedoperations
operations
Gains
Gainsor
orlosses
lossesfrom
from the
thediscontinued
discontinuedoperations
operationsare
are
reported
reportedseparately,
separately,net
net of
of tax*
tax*

*Reported
*Reportedin
intwo
two categories:
categories: (i)
(i) operating
operatingincome
incomeor
or
loss
lossfrom
fromdiscontinued
discontinuedoperations
operations until
until the
the
measurement
measurement date,
date,and
and (ii)
(ii)gains
gainsand
and losses
losseson
on
disposal
disposal

6-15

Non-Recurring Items

Discontinued Operations
For
For analysis
analysis of
of discontinued
discontinued operations:
operations:
Adjust
Adjustcurrent
currentand
andpast
pastincome
incometo
toremove
removeeffects
effectsof
of
discontinued
discontinuedoperations
operations
Companies
Companiesdisclose
disclosethis
thisinfo
infofor
forthe
thecurrent
currentand
andpast
pasttwo
two
years
years
For
Forearlier
earlieryears:
years:
Look
Lookfor
forrestated
restatedsummary
summaryinfo
infoor
orother
othervoluntary
voluntary
disclosures
disclosures
Take
Takecare
carewhen
whendoing
doinginter-temporal
inter-temporalanalysis
analysis
Adjust
Adjustassets
assetsand
andliabilities
liabilitiesto
toremove
removediscontinued
discontinuedoperations
operations
Retain
Retaincumulative
cumulativegain
gainor
orloss
lossfrom
fromdiscontinued
discontinuedoperations
operationsin
in
equity
equity

6-16

Non-Recurring Items
Accounting Changes
First Type of Accounting Change is
Accounting Principle Changeinvolves
Change
switch from one principle to another

Disclosure includes:
Nature of and justification for change
Effect of change on current income and
earnings per share
Cumulative effects of retroactive
application of change on income and EPS
for income statement years

6-17

Non-Recurring Items
Accounting Changes
Second Type of Accounting Change is
Accounting Estimate Change
Change
involves change in estimate
underlying accounting
Prospective applicationa change
is accounted for in current and
future periods
Disclose effects on current income
and EPS

6-18

Non-Recurring Items

Accounting Changes
Analyzing Accounting Changes
Are cosmetic and yield no cash flows
Can better reflect economic reality
Can reflect earnings management (or even
manipulation)
Impact comparative analysis (apples-to-apples)
Affect both economic and permanent income

For permanent income, use the new

method and ignore the cumulative effect

For economic income, evaluate the

change to assess whether it reflects
reality

6-19

Non-Recurring Items

Special Items
Special
Special Items--transactions
Items--transactionsand
andevents
eventsthat
thatare
areunusual
unusualor
or
infrequent
infrequent
Challenges
Challengesfor
foranalysis
analysis

Often
Oftenlittle
littleGAAP
GAAPguidance
guidance
Economic
Economicimplications
implicationsare
arecomplex
complex
Discretionary
Discretionarynature
natureserves
servesearnings
earningsmanagement
managementaims
aims

Two
Twomajor
majortypes
types

Asset
Assetimpairments
impairments(write-offs)
(write-offs)
Restructuring
Restructuringcharges
charges

6-20

Non-Recurring Items

Special Items
Asset
Asset Impairmentwhen
Impairmentwhenasset
assetfair
fairvalue
valueisisbelow
belowcarrying
carrying(book)
(book)value
value
Some
Somereasons
reasonsfor
forimpairments
impairments

Decline
Declinein
indemand
demandfor
forasset
assetoutput
output

Technological
Technologicalobsolescence
obsolescence

Changes
Changesin
incompany
companystrategy
strategy
Accounting
Accountingfor
forimpairments
impairments

Report
Reportat
atthe
thelower
lowerof
ofmarket
marketor
orcost
cost

No
Nodisclosure
disclosureabout
aboutdetermination
determinationof
ofamount
amount

No
Nodisclosure
disclosureabout
aboutprobable
probableimpairments
impairments

Flexibility
in
determining
when
Flexibility in determining whenand
andhow
howmuch
muchto
towrite-off
write-off

No
Noplan
planrequired
requiredfor
forasset
assetdisposal
disposal

Conservative
Conservativepresentation
presentationof
ofassets
assets

6-21

Non-Recurring Items

Special Items
Restructuring
Restructuring Chargescosts
Chargescostsusually
usuallyrelated
relatedto
tomajor
majorchanges
changesin
incompany
company
business
business
Examples
Examplesof
ofthese
thesemajor
majorchanges
changesinclude
include

Extensive
reorganization
Extensive reorganization

Divesting
Divestingbusiness
businessunits
units

Terminating
Terminatingcontracts
contractsand
andjoint
jointventures
ventures

Discontinuing
Discontinuingproduct
productlines
lines

Worker
Workerretrenchment
retrenchment

Management
Managementturnover
turnover

Write-offs
Write-offscombined
combinedwith
withinvestments
investmentsin
inassets,
assets,technology
technologyor
ormanpower
manpower
Accounting
Accountingfor
forestimated
estimatedcosts
costsof
ofrestructuring
restructuringprogram
program

Establish
Establishaaprovision
provision(liability)
(liability)for
forestimated
estimatedcosts
costs

Charge
Chargeestimated
estimatedcosts
coststo
tocurrent
currentincome
income

Actual
costs
involve
adjustments
against
Actual costs involve adjustments againstthe
theprovision
provisionwhen
whenincurred
incurred

6-22

Non-Recurring Items

Analyzing Special Items

Earnings Management with Special Charges
(1) Special charges often garner less investor
attention under an assumption they are non-recurring
and do not persist
(2) Managers motivated to re-classify operating
charges as special one-time charges
(3) When analysts ignore such re-classified charges
it leads to low operating expense estimates and
overestimates of company value

6-23

Non-Recurring Items

Analyzing Special Items

Income Statement Adjustments

(1) Permanent income reflect profitability of a company

under normal circumstances
Most special charges constitute operating expenses
that need to be reflected in permanent income
Special charges often reflect either understatements
of past expenses or investments for future profitability

(2) Economic income reflects the effects on equity of all

events that occur in the period
Entire amount of special charges is included

6-24

Non-Recurring Items
Analyzing Special Items
Balance Sheet Adjustments
Balance sheets after special charges often better reflect
business reality by reporting assets closer to net realizable
values

Two points of attention

(1) Retain provision or net against equity?
If a going-concern analysis, then retain
If a liquidating value analysis, then offset against equity

(2) Asset write-offs conservatively distort asset and liability

values

6-25

Revenue Recognition
Guidelines
Revenue
Revenue Recognition
Recognition Criteria
Criteria

Earning
Earningactivities
activitiesare
aresubstantially
substantiallycomplete
completeand
andno
nosignificant
significant
added
addedeffort
effortis
isnecessary
necessary

Risk
Riskof
ofownership
ownershipis
iseffectively
effectivelypassed
passedto
tothe
thebuyer
buyer

Revenue,
Revenue,and
andrelated
relatedexpense,
expense,are
aremeasured
measuredor
orestimated
estimatedwith
with
accuracy
accuracy

Revenue
Revenuerecognized
recognizednormally
normally
yields
yieldsan
anincrease
increasein
incash,
cash,
receivables
receivablesor
orsecurities
securities

Revenue
Revenuetransactions
transactionsare
areat
atarms
arms
length
lengthwith
withindependent
independentparties
parties

Transaction
Transactionis
isnot
notsubject
subjectto
torevocation
revocation

6-26

Revenue Recognition
Guidelines
Some
Somespecial
specialrevenue
revenuerecognition
recognitionsituations
situationsare
are

Revenue
RevenueWhen
WhenRight
Rightof
ofReturn
ReturnExists
Exists

Franchise
FranchiseRevenues
Revenues

Product
ProductFinancing
FinancingArrangements
Arrangements

Revenue
Revenueunder
underContracts
Contracts
Percentage-of-completion
Percentage-of-completionmethod
method
Completed-contract
Completed-contractmethod
method

Unearned
UnearnedRevenue
Revenue(amount
(amountof
ofrevenues
revenuesthat
thatare
arestill
still
unrecognized
unrecognizedappear
appearin
inthe
thebalance
balancesheet
sheetas
asaaliability)
liability)

6-27

Revenue Recognition

Analysis
Revenue
Revenueisisimportant
importantfor
for

Company
Companyvaluation
valuation

Accounting-based
Accounting-basedcontractual
contractualagreements
agreements

Management
Managementpressure
pressureto
toachieve
achieveincome
incomeexpectations
expectations

Management
Managementcompensation
compensationlinked
linkedto
toincome
income

Valuation
Valuationof
ofstock
stockoptions
options

Analysis
Analysismust
mustassess
assesswhether
whetherrevenue
revenuereflects
reflectsbusiness
businessreality
reality

Assess
Assessrisk
riskof
oftransactions
transactions

Assess
Assessrisk
riskof
ofcollectibility
collectibility

Circumstances
Circumstancesfueling
fuelingquestions
questionsabout
aboutrevenue
revenuerecognition
recognitioninclude
include

Sale
Saleof
ofassets
assetsor
oroperations
operationsnot
notproducing
producingcash
cashflows
flowsto
tofund
fundinterest
interest
or
ordividends
dividends

Lack
Lackof
ofequity
equitycapital
capital

Existence
Existenceof
ofcontingent
contingentliabilities
liabilities

6-28

Deferred Charges
Costs
Costs incurred
incurred but
but deferred
deferred because
because they
they are
are
expected
expected to
to benefit
benefit future
future periods
periods
Consider
Consider four
four categories
categories of
of deferred
deferred costs
costs
Research
Research and
and development
development
Computer
Computer software
software costs
costs
Costs
Costs in
in extractive
extractive industries
industries
Miscellaneous
Miscellaneous (Other)
(Other)

6-29

Deferred Charges
Research and Development
Accounting for R&D is problematic due to:*

High uncertainty of any potential benefits

Time period between R&D activities and determination of success
Intangible nature of most R&D activities
Difficulty in estimating future benefit periods

Hence:
U.S. accounting requires expensing R&D when incurred
Only costs of materials, equipment, and facilities with alternative
future uses are capitalized as tangible assets
Intangibles purchased from others for R&D activities with alternative
future uses are capitalized
*These accounting problems are similar to those encountered with
employee training programs, product promotions, and advertising

6-30

Deferred Charges
Computer Software Costs
[Note:
[Note:Accounting
Accountingfor
forcosts
costsof
ofcomputer
computer software
softwareto
to be
be
sold,
sold, leased,
leased,or
or otherwise
otherwisemarketed
marketedidentifies
identifiesaapoint
point
referred
referredto
toas
astechnological
technologicalfeasibility]
feasibility]
Prior
Priorto
totechnological
technological
feasibility,
feasibility,costs
costs
are
areexpensed
expensedwhen
when
incurred
incurred
After
Aftertechnological
technologicalfeasibility,
feasibility,costs
costsare
arecapitalized
capitalizedas
as
an
anintangible
intangibleasset
asset

6-31

Deferred Charges
Costs in Extractive Industries
Search
Searchand
anddevelopment
developmentcosts
costsfor
fornatural
naturalresources
resourcesis
isimportant
importantto
to
extractive
extractiveindustries
industriesincluding
includingoil,
oil,gas,
gas,metals,
metals,coal,
coal,and
andnonmetallic
nonmetallic
minerals
minerals
Two
Twobasic
basicaccounting
accountingviewpoints:
viewpoints:
Full
Fullcost
costviewall
viewallcosts,
costs,
productive
productiveand
andnonproductive,
nonproductive,
incurred
incurredin
inthe
thesearch
searchfor
forresources
resources
are
arecapitalized
capitalizedand
andamortized
amortizedto
to
income
as
resources
are
produced
income as resources are produced
and
andsold
sold

Successful
Successfulefforts
effortsviewall
viewallcosts
coststhat
thatdo
donot
notresult
resultdirectly
directlyin
in
discovery
discoveryof
ofresources
resourceshave
haveno
nofuture
futurebenefit
benefitand
andshould
shouldbe
be
expensed
expensedas
asincurred.
incurred.Prescribed
Prescribedfor
foroil
oiland
andgas
gasproducing
producing
companies
companies

6-32

Employee Benefits
Overview
Increase in employee benefits supplementary to salaries and
wages
Some supplementary benefits are not accorded full or timely
recognition:
Compensated absences
Deferred compensation
contracts
Stock appreciation rights (SARs)
Junior stock plans
Employee Stock Options (ESOs)

6-33

Employee Benefits
Employee Stock Options
ESOs are a popular form of
incentive compensation
reasons include:
Enhanced employee performance
Align employee and company incentives
Viewed as means to riches
Tool to attract talented and enterprising workers
Do not have direct cash flow effects
Do not require the recording of costs

6-34

Employee Benefits
Employee Stock Options
Option Facts
Option to purchase shares at a specific price on or after a future
date
Exercise price is the price a holder has the right to purchase
shares at
Exercise price often set equal to
stock price on grant date
Vesting date is the earliest date
the employee can exercise
option
In-the-Money: When stock
price is higher than exercise
price
Out-of-the-Money: When stock price
is less than exercise price

6-35

Employee Benefits
Employee Stock Options
Two main accounting issues
Determining Dilution of earnings per share (EPS)
ESOs in-the-money are dilutive securities and affect diluted
EPS
ESOs out-of-the-money are antidilutive securities and do not
affect diluted EPS
Determining Compensation expense
Determine cost of ESOs granted
Amortize cost over vesting period

6-36

Interest Costs
Interest Defined
Interest
Compensation for use of money
Excess cash paid beyond the money (principal)
borrowed

Interest rate
Determined by risk characteristics of borrower

Interest expense
Determined by interest rate, principal, and time

6-37

Interest Costs
Interest Analysis
Interest on convertible debt is controversial by
ignoring the cost of conversion privilege
Diluted earnings per share uses number of shares
issuable in event of conversion of convertible debt
Analysts view interest as a period costnot
capitalizable
Changes in a company borrowing rate, not explained
by market trends, reveal changes in risk

6-38

Income Taxes

Taxable Income

GAAP

GAAP

GAAP

GAAP

Temporary Income Tax Differences

Financial
Statement Income

Differences
Differencesthat
that are
aretemporary
temporaryin
innature
nature
expected
expectedto
toreverse
reversein
inthe
thefuture
future
mainly
mainlyin
inthe
thenature
natureof
oftiming
timingdifferences
differencesbetween
betweentax
tax
and
andGAAP
GAAPaccounting
accounting
accounted
accountedfor
for using
usingdeferred
deferred tax
taxadjustments
adjustments

6-39

Income Taxes
Income Tax Accounting
Identify
Identifytypes
typesand
andamounts
amountsof
oftemporary
temporarydifferences
differencesand
andthe
the

nature
natureand
andamount
amountof
ofeach
eachtype
typeof
ofoperating
operatingloss
lossand
andtax
taxcredit
credit
carryforward
carryforward
Measure
Measuretotal
totaldeferred
deferredtax
taxliability
liabilityfor
fortaxable
taxabletemporary
temporary
differences
differences
Compute
Computetotal
totaldeferred
deferredtax
taxasset
assetfor
fordeductible
deductibletemporary
temporary
differences
differencesand
andoperating
operatingloss
losscarryforwards
carryforwards
Measure
Measuredeferred
deferredtax
taxassets
assetsfor
foreach
eachtype
typeof
oftax
taxcredit
credit
carryforward
carryforward
Reduce
Reducedeferred
deferredtax
taxassets
assetsby
byaavaluation
valuationallowance
allowance

6-40

Income Taxes
Income Tax Analysis
Financial Statement Adjustments
Present Valuing Deferred Tax Assets and
Liabilities
Forecasting Future Income and Cash Flows
Analyzing Permanent and Temporary
Differences
Earnings Management and Earnings Quality