6-1

Analysis of the Income Statement

4
CHAPTER
 6-2

Operating Activities

Revenue Deferred
Income Recognition Charge
Measurement
Guideline Employee
Concepts Uncertainty Benefit
Measurement Analysis
Alternative/Term
Analysis
Non
Recurring item

Extraordinary
Acc. Charge
Special Item
 6-3

Financial Statements Reflect Business Activities

 6-4

Operating Activities

Income
Measurement

Concepts
Measurement
Alternative/Term
Analysis
 6-5

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
componentnotnotexpected
expectedto
topersist
persist
 6-6

Income Measurement
Measurement
Two main components of accounting income:
Revenues (gains)
Expenses (losses)
 6-7

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
 6-8

Income Measurement
Measurement
Expenses and Losses

• Expenses are incurred outflows, prospective

cash outflows 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
 6-9

Income Measurement
Alternatives/Term
Two major income dimensions:

1. operating versus non-operating

2. recurring versus non-recurring*

*Motivated by need to separate permanent and

transitory components
 1-10
6-10

2017 2016 2015

 6-11

Income Measurement
Alternatives/Term
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
• Core income--excludes all non-recurring items from net income
 6-12

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
 6-13

Income Measurement
Analysis
Operating
Operatingversus
versusNon-Operating
Non-OperatingIncome
Income

Operating
Operatingincome--measure
income--measureof
ofcompany
companyincome
incomeas
asgenerated
generatedfrom
from
operating
operatingactivities
activities

Three
Threeimportant
importantaspects
aspectsofofoperating
operatingincome
income
Pertains
Pertainsonly
onlyto
toincome
incomegenerated
generatedfrom
fromoperations
operations
Focuses
Focuseson onincome
incomeforforthe
thecompany,
company,notnotsimply
simplyforforequity
equityholders
holders
(means
(meansfinancing
financingrevenues
revenuesand
andexpenses
expensesare areexcluded)
excluded)
Pertains
Pertains only to ongoing business activities (i.e.,results
only to ongoing business activities (i.e., resultsfrom
from
discontinued
discontinuedoperations
operationsis isexcluded)
excluded)

Non-operating
Non-operatingincome--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
 6-14

Operating Activities

Income
Measurement

Concepts
Measurement
Alternative/Term
Analysis
Non
Recurring item

Extraordinary
Acc. Charge
Special Item
 6-15

Non-Recurring Items

 Extraordinary items

 Accounting changes

 Restructuring charges

 Special items
 6-16

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)

Disclosure
Disclosure& & Accounting
Accounting
Classified
Classifiedseparately
separatelyin
inincome
incomestatement
statement
 6-17

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
 6-18

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
 6-19

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)
 6-20

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

 Discretionary
Discretionarynature
natureserves
servesearnings
earningsmanagement
managementaims
aims

Two
Twomajor
majortypes
types


 Asset
Assetimpairments
impairments(write-offs)
(write-offs)

 Restructuring
Restructuringcharges
charges
 6-21

Non-Recurring Items

Special Items
Asset
AssetImpairment—when
Impairment—whenasset
assetfair
fairvalue
valueisisbelow
belowcarrying
carrying(book)
(book)value
value

Some
Somereasons
reasonsforforimpairments
impairments
Decline
Declinein
indemand
demandforforasset
assetoutput
output
Technological
Technologicalobsolescence
obsolescence
Changes
Changesin incompany
companystrategy
strategy

Accounting
Accountingforforimpairments
impairments
Conservative
Conservativepresentation
presentationof
ofassets
assets
Report
Report at the lower of market orcost
at the lower of market or cost
No
Nodisclosure
disclosureabout
aboutdetermination
determinationof
ofamount
amount
No
Nodisclosure
disclosureabout
aboutprobable
probableimpairments
impairments
Flexibility
Flexibilityin
indetermining
determiningwhen
whenandandhow
howmuch
muchto
towrite-off
write-off
 6-22

Non-Recurring Items
Special Items
Restructuring
RestructuringCharges—costs
Charges—costsusually
usuallyrelated
relatedto
tomajor
majorchanges
changesin
incompany
company
business
business

Examples
Examplesofofthese
thesemajor
majorchanges
changesinclude
include
Extensive
Extensivereorganization
reorganization
Divesting
Divestingbusiness
businessunits
units
Terminating
Terminating contractsand
contracts andjoint
jointventures
ventures
Discontinuing
Discontinuingproduct
productlines
lines

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
 6-23

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
 6-24

Operating Activities

Revenue
Income Recognition
Measurement
Guideline
Concepts Uncertainty
Measurement Analysis
Alternative/Term
Analysis
Non
Recurring item

Extraordinary
Acc. Charge
Special Item
 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(Example
(Example::Ship
Ship
builder, Highway builder, deposit vs delivery? )
 6-26

Revenue Recognition

Guidelines
Some
Somespecial
specialrevenue
revenuerecognition
recognitionsituations
situationsare
are

 Revenue
RevenueWhen
WhenRight
Rightof
ofReturn
ReturnExists
Exists
 Franchise
FranchiseRevenues
Revenues
 Revenue
Revenueunder
underContracts
Contracts
 Percentage-of-completion
Percentage-of-completionmethod
method
 Completed-contract
Completed-contractmethod
method
 6-27

Revenue Recognition
Analysis
Revenue
Revenueis isimportant
importantfor
for
 Company
Companyvaluation
valuation
 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
assetsororoperations
operationsnot
notproducing
producingcash
cashflows
flowsto
tofund
fundinterest
interest
or
ordividends
dividends
 Lack
Lackofofequity
equitycapital
capital
 6-28

Operating Activities

Revenue Deferred
Income Recognition
Measurement Charge

Guideline
Concepts Uncertainty
Measurement Analysis
Alternative/Term
Analysis
Non
Recurring item

Extraordinary
Acc. Charge
Special Item
 6-29

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)
 6-30

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
 6-31

Deferred Charges
Computer Software Costs
[Note:
[Note:Accounting
Accountingforforcosts
costsof
ofcomputer
computersoftware
softwareto
tobe
be
sold,
sold,leased,
leased,or
orotherwise
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
capitalizedasasan
an
intangible
intangibleasset
asset(how
(howmany
manysuccess
success??In
InSilicon
SiliconValley?)
Valley?)
 6-32

Deferred Charges
Costs in Extractive Industries
Search
Searchand
anddevelopment
developmentcosts
costsfor
fornatural
naturalresources
resourcesisisimportant
importantto
to
extractive industries including oil, gas, metals, coal, and nonmetallic
extractive industries including oil, gas, metals, coal, and nonmetallic
minerals
minerals

Two
Twobasic
basicaccounting
accountingviewpoints:
viewpoints:
•• “Full
“Full‑cost”
‑cost”view—all
view—allcosts,
costs,
productive and nonproductive,
productive and nonproductive,
incurred
incurredininthe
thesearch
searchfor
forresources
resources
are
arecapitalized
capitalizedand
andamortized
amortizedtoto
income
incomeas asresources
resourcesare
areproduced
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 (Recent
(RecentOil
Oilprice
priceplunge
plunge?)?)
 6-33

Operating Activities

Revenue Deferred
Income Recognition Charge
Measurement
Guideline Employee
Concepts Uncertainty Benefit
Measurement Analysis
Alternative/Term
Analysis
Non
Recurring item

Extraordinary
Acc. Charge
Special Item
 6-34

Employee Benefits

Overview

 Increase in employee benefits supplementary to salaries and

wages
 Some supplementary benefits are not accorded full or timely
recognition:

• Employee Stock Options (ESOs)

 6-35

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
 Apple Inc, Alibaba, Inc ?
 6-36

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
 6-37

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
 6-38

Question
• Explain why an analyst attaches great importance to evaluation of the income
statement.
• Define income. Distinguish income from cash flow
• Distinguish between operating and nonoperating income. Cite examples of items that
are typically included in each category
• Operating vs. nonoperating and recurring vs. nonrecurring are two distinct
dimensions of classifying income. Explain this statement and discuss whether or not
you agree with it.
• Accounting practice distinguishes among different types of accounting changes.
Identify two different types of accounting changes.
• How do companies use special charges to influence investors’ perceptions regarding
company value?
• Describe aspects of revenue recognition that an analyst must be especially alert to
 6-39

Exercise