Financial

Statement
Analysis
 
 
K.R. Subramanyam

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 6-2

Analyzing Operating Activities

6
CHAPTER
 6-3

Income Measurement
Concepts of Income
Economic
Economic Income
Income
Equals
Equalsnet
netcash
cashflows
flows++the
thechange
changeininthe
thepresent
presentvalue
valueofof
future
futurecash
cashflows
flows
Includes
Includesboth
bothrecurring
recurringandandnonrecurring
nonrecurringcomponents—
components—
rendering
renderingititless
lessuseful
usefulfor
forforecasting
forecastingfuture
futureearnings
earningspotential
potential
Permanent
Permanent IncomeIncome
Also
Alsocalled
calledsustainable
sustainableearning
earningpower,
power,or orsustainable
sustainableoror
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
expectedtotopersist
persist(Note:
(Note:The
Theconcept
conceptofof
economic
economicincome
incomeincludes
includesboth
bothpermanent
permanentandandtransitory
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 company’s
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 income—widely 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 accountant’s 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
Operatingversus
versusNon-Operating
Non-OperatingIncomeIncome
  
Operating
Operatingincome--measure
income--measureof ofcompany
companyincome
incomeas asgenerated
generatedfrom
from
operating
operatingactivities
activities
  
Three
Threeimportant
importantaspects
aspectsofofoperating
operatingincome
income
Pertains
Pertainsonly
onlytotoincome
incomegenerated
generatedfrom
fromoperations
operations
Focuses
Focuseson onincome
incomeforforthe
thecompany,
company,notnotsimply
simplyforforequity
equityholders
holders
(means
(meansfinancing
financingrevenues
revenuesand
andexpenses
expensesare areexcluded)
excluded)
Pertains
Pertainsonly
onlytotoongoing
ongoingbusiness
businessactivities
activities(i.e.,
(i.e.,results
resultsfrom
from
discontinued
discontinuedoperations
operationsisisexcluded)
excluded)
  
Non-operating
Non-operatingincome--includes
income--includesall allcomponents
componentsof ofnet
netincome
income
excluded
excludedfrom
fromoperating
operatingincome
income
  
Useful
Usefultotoseparate
separatenon-operating
non-operatingcomponents
componentspertaining
pertainingto tofinancing
financingand
and
investing
investing
 6-11

Income Measurement
 

Analysis
Determination
Determinationof
ofComprehensive
ComprehensiveIncome—sample
Income—samplecompany
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
Unusualininnature
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
retirementofofdebt
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
statementsforforthe
thecurrent
current and
andprior
priortwo
two
years
yearsare
arerestated
restatedafter
afterexcluding
excludingthetheeffects
effectsof
of
discontinued
discontinuedoperations
operations
•• Gains
Gainsororlosses
lossesfrom
fromthe
thediscontinued
discontinuedoperations
operationsare
are
reported
reportedseparately,
separately, net
net of
of tax*
tax*
  
*Reported
*Reportedin intwo
twocategories:
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
andlosses
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
gainororloss
lossfrom
fromdiscontinued
discontinuedoperations
operationsin
in
equity
equity
 6-16

Non-Recurring Items
Accounting Changes
First Type of Accounting Change is
Accounting Principle Change—involves
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 application—a 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
AssetImpairment—when
Impairment—whenasset assetfair
fairvalue
valueisisbelow
belowcarrying
carrying(book)
(book)value
value
  
Some
Somereasons
reasonsfor forimpairments
impairments
Decline
Declinein indemand
demandforforasset
assetoutput
output
Technological
Technologicalobsolescence
obsolescence
Changes
Changesin incompany
companystrategy
strategy
  
Accounting
Accountingfor forimpairments
impairments
Report
Reportatatthethelower
lowerof
ofmarket
marketor orcost
cost
No
No disclosure about determinationof
disclosure about determination ofamount
amount
No
Nodisclosure
disclosureaboutaboutprobable
probableimpairments
impairments
Flexibility
Flexibilityin indetermining
determiningwhen
whenandandhow
howmuch
muchtotowrite-off
write-off
No
Noplan
planrequired
requiredforforasset
assetdisposal
disposal
Conservative
Conservative presentation ofassets
presentation of assets
 6-21

Non-Recurring Items
 

Special Items
Restructuring
RestructuringCharges—costs
Charges—costsusually usuallyrelated
relatedto
tomajor
majorchanges
changesin
incompany
company
business
business
  
Examples
Examplesof ofthese
thesemajor
majorchanges
changesinclude
include
 Extensive
Extensivereorganization
reorganization
 Divesting
Divestingbusiness
businessunits
units
 Terminating
Terminating contractsand
contracts andjoint
jointventures
ventures
 Discontinuing
Discontinuingproduct
productlines
lines
 Worker
Workerretrenchment
retrenchment
 Management
Managementturnover
turnover
 Write-offs
Write-offs combinedwith
combined withinvestments
investmentsin inassets,
assets,technology
technologyor
ormanpower
manpower
  
Accounting
Accountingfor forestimated
estimatedcosts
costsof ofrestructuring
restructuringprogram
program
 Establish a provision (liability) for estimated costs
Establish a provision (liability) for estimated costs
 Charge
Chargeestimated
estimatedcosts
coststotocurrent
currentincome
income
 Actual
Actualcosts
costsinvolve
involveadjustments
adjustmentsagainst
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
andnonosignificant
significant
added
addedeffort
effortisisnecessary
necessary
 Risk
Riskof
ofownership
ownershipis iseffectively
effectivelypassed
passedto
tothe
thebuyer
buyer
 Revenue,
Revenue,andandrelated
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
atarm’s
arm’s
length
lengthwith
withindependent
independentparties
parties
 Transaction
Transactionis isnot
notsubject
subjecttotorevocation
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
(amountofofrevenues
revenuesthat
thatare
arestill
still
unrecognized
unrecognizedappear
appearin
inthe
thebalance
balancesheet
sheetas
asaaliability)
liability)
 6-27

Revenue Recognition
 
Analysis
Revenue
Revenueis isimportant
importantforfor
 Company
Companyvaluation
valuation
 Accounting-based
Accounting-basedcontractual
contractualagreements
agreements
 Management
Managementpressure
pressuretotoachieve
achieveincome
incomeexpectations
expectations
 Management
Managementcompensation
compensationlinked
linkedtotoincome
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
questionsaboutaboutrevenue
revenuerecognition
recognitioninclude
include
 Sale
Saleof
ofassets
assetsor oroperations
operationsnot notproducing
producingcash
cashflows
flowstotofund
fundinterest
interest
or
ordividends
dividends
 Lack
Lackofofequity
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 for costs
costsofofcomputer
computer software
software to
to be
be
sold,
sold, leased,
leased,oror otherwise
otherwisemarketed
marketed identifies
identifies aapoint
point
referred
referredto
toas
astechnological
technologicalfeasibility]
feasibility]
  
Prior
Priortototechnological
technological
feasibility,
feasibility,costs
costs
are
areexpensed
expensedwhen when
incurred
incurred
  
After
Aftertechnological
technological feasibility,
feasibility, costs
costsare
arecapitalized
capitalizedasas
an
anintangible
intangibleasset
asset
 6-31

Deferred Charges
Costs in Extractive Industries
Search
Searchand
anddevelopment
developmentcosts
costsfor
fornatural
naturalresources
resourcesisisimportant
importantto
to
extractive
extractiveindustries
industriesincluding
includingoil,
oil,gas,
gas,metals,
metals,coal,
coal,and
andnonmetallic
nonmetallic
minerals
minerals
  
Two
Twobasic
basicaccounting
accountingviewpoints:
viewpoints:
•• “Full
“Full‑cost”
‑cost”view—all
view—allcosts,
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”
efforts”view—all
view—allcosts
coststhat
thatdo
donot
notresult
resultdirectly
directlyin
in
discovery
discoveryof
ofresources
resourceshave
havenonofuture
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 cost—not
capitalizable
• Changes in a company borrowing rate, not explained
by market trends, reveal changes in risk
 6-38

Income Taxes


Temporary Income Tax Differences

GAAP

GAAP
GAAP
GAAP
Financial
Taxable Income
Statement Income
 Differences
Differencesthat
that are
aretemporary
temporaryin innature
nature
 expected
expectedto toreverse
reverseininthe
thefuture
future
 mainly
mainlyininthe
thenature
natureofoftiming
timingdifferences
differencesbetween
betweentax
tax
and
andGAAP
GAAPaccounting
accounting
 accounted
accountedfor for using
usingdeferred
deferredtax
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
typeofofoperating
operatingloss
lossand
andtax
taxcredit
credit
carryforward
carryforward
•• Measure
Measuretotal
totaldeferred
deferredtax
taxliability
liabilityfor
fortaxable
taxabletemporary
temporary
differences
differences
•• Compute
Computetotal
totaldeferred
deferredtaxtaxasset
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