INTRODUCTION TO ANALYZING BUSINESS EARNINGS




A special committee of the American Institute of Certified Public Accountants (AICPA) concluded the following about earnings and the needs of those who use financial statements:

Users want information about the portion of a company’s reported earnings that is stable or recurring and that provides a basis for estimating sustainable earnings.

While users may want information about the stable or recurring portion of a company’s earnings, firms are under no obligation to provide this earnings series. However, generally accepted accounting principles (GAAPs) require separate disclosure of selected nonrecurring revenues, gains, expenses, and losses on the face of the income statement or in notes to the financial statements. Further, the Securities and Exchange Commission (SEC) requires the disclosure of material nonrecurring items.

The prominence given the demand by users for information on nonrecurring items in the above AICPA report is, no doubt, driven in part by the explosive growth in nonrecurring items over the past decade. The acceleration of change together with a passion for downsizing, rightsizing, and reengineering have fueled this growth. The Financial Accounting Standards Board’s (FASB) issuance of a number of new accounting statements that require recognition of previously unrecorded expenses and more timely recognition of declines in asset values has also contributed to the increase in nonrecurring items.

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A limited number of firms do provide, on a voluntary basis, schedules that show their results with nonrecurring items removed. Mason Dixon Bancshares provides one such example. Exhibit 2.1 shows a Mason Dixon schedule that adjusts reported net income to a revised earnings measure from which nonrecurring revenues, gains, expenses, and losses have been removed. This is the type of information that the previously quoted statement of the AICPA’s Special Committee calls for.

Notice the substantial number of nonrecurring items that Mason Dixon removed from reported net income in order to arrive at a closer measure of core or sustainable earnings. In spite of the number of nonrecurring items removed from reported net income, the revised earnings differ by only about 6% from the original reported net income.

Firms that record either a large nonrecurring gain or loss frequently attempt to offset its effect on net income by recording a number of offsetting items. In the case of Mason Dixon, the large gain on the sale of branches if not offset may raise earnings expectations to levels that are unattainable. Alternatively, the recording of offsetting charges may be seen as a way to relieve future earnings of their burden. We do not claim that this was done in the case of Mason Dixon Bancshares, but its results are consistent with this practice.

Though exceptions like the Mason Dixon Bancshares example do occur, the task of developing information on a firm’s recurring or sustainable results normally falls to the statement user. Companies do provide, to varying degrees, the raw materials for this analysis; however, the formidable task of creating—an analysis comparable to that provided by Mason Dixon—is typically left to the user. The central goal of this chapter is to help users develop the background and skills to perform this critical aspect of earnings analysis. The chapter will discuss nonrecurring items and outline efficient approaches for locating them in financial statements and associated notes. As key background we will also discuss and illustrate income statement formats and other issues of classification. Throughout the chapter, we illustrate concepts using information drawn from

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INTRODUCTION TO ANALYZING BUSINESS EARNINGS

the financial statements of many companies. As a summary exercise, a comprehensive case is provided that removes all nonrecurring items from reported results to arrive at a sustainable earnings series.



Frequently Asked Questions

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Ans: Financial ratios are useful not only to assess the past or present condition of an enterprise, but also to reliably predict its future solvency or bankruptcy. This type of information is of critical importance to present and potential creditors and investors. There are several different methods of analysis for obtaining this predictive information. view more..
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Ans: Up to this point we have considered financial ratios one at a time. However, there is a useful method for combining financial ratios known as Dupont1 analysis. To explain it, we first need to define some financial ratios, together with their abbreviations, as follows: view more..
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Ans: Some important points to keep in mind when using financial ratios are: • Whereas all balance sheet numbers are end-of-period numbers, all income statement numbers relate to the entire period. For example, when calculating the ratio for Accounts Receivable Turnover, we use a numerator of Credit Sales, which is an entire-period number from the income statement, and a denominator of Accounts Receivable, which is an end-ofperiod number from the balance sheet. view more..
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Ans: A special committee of the American Institute of Certified Public Accountants (AICPA) concluded the following about earnings and the needs of those who use financial statements: Users want information about the portion of a company’s reported earnings that is stable or recurring and that provides a basis for estimating sustainable earnings. view more..
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Ans: Defining nonrecurring items is difficult. Writers often begin with phrases like “unusual” or “infrequent in occurrence.” Donald Keiso and Jerry Weygandt in their popular intermediate accounting text use the term irregular to describe what most statement users would consider nonrecurring items. view more..
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Ans: Careful analysis of past financial performance aimed at removing the effects of nonrecurring items is a more formidable task than one might suspect. This task would be fairly simple if (1) there was general agreement on just what constitutes a nonrecurring item and (2) if most nonrecurring items were prominently displayed on the face of the income statement. view more..
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Ans: An examination of the income statement, the first step in the search sequence, requires an understanding of the design and content of contemporary income statements. This knowledge will aid in the location and analysis of nonrecurring view more..
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Ans: After the income statement, the operating activities section of the statement of cash flows is an excellent secondary source to use in locating nonrecurring items (step 2 in the search sequence in Exhibit 2.3). The diagnostic value of this section of the statement of cash flows results from two factors. First, gains and losses on the sale of investments and fixed assets must be removed from net income in arriving at cash flow from operating activities. Second, noncash items of revenue or gain and expense or loss must also be removed from net income. view more..
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Ans: The carrying values of inventories maintained under the LIFO method are sometimes significantly understated in relationship to their replacement cost. For public companies, the difference between the LIFO carrying value and replacement cost (frequently approximated by FIFO) is a required disclosure under SEC regulations. An example of a substantial difference between LIFO and current replacement value is found in a summary of the inventory disclosures of Handy and Harman Inc. in Exhibit 2.17. view more..
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Ans: Income tax notes are among the more challenging of the disclosures found in annual reports. They can, however, be a rich source of information on nonrecurring items. Fortunately, our emphasis on the persistence of earnings requires a focus on a single key schedule found in the standard income tax note. The goal is simply to identify nonrecurring tax increases and decreases in this schedule. view more..
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Ans: An “other income (expense), net,” or equivalent line item is commonly found in both the single- and multistep income statement. In the case of the multistep format, the composition of other income and expenses is sometimes detailed on the face of the income statement. In both the multi- and single-step formats, the most typical presentation is a single line item with a supporting note. Even though a note detailing the contents of other income and expense may exist, companies typically do not specify its location. Other income and expense notes tend to be listed close to the end of the notes to the financial statements view more..
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Ans: Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is an annual and a quarterly Securities and Exchange Commission reporting requirement. Provisions of this regulation have a direct bearing on the goal of locating nonrecurring items. As part of the MD&A, the SEC requires registrants to: view more..
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Ans: Typically, most material nonrecurring items will have been located by proceeding through the first six steps of the search sequence in Exhibit 2.3. However, some additional nonrecurring items may be located in other notes. Nonrecurring items can surface in virtually any note to the financial statements. We will now discuss three selected notes that frequently contain other nonrecurring items: notes on foreign exchange, restructuring, and quarterly and segment financial data. Recall that inventory, income tax, and other income and expense notes have already been discussed in steps 3 to 5. view more..
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Ans: The last section in the AK Steel Holdings income statement in Exhibit 2.9 is devoted to the reporting of other comprehensive income. This is a relatively new feature of the income statement and was introduced with the issuance by the FASB of SFAS No. 130, Reporting Comprehensive Income.44 The goal of the standard is to expand the concept of income to included selected items of nonrecurring revenue, gain, expense and loss. Under the new standard, traditional net income is combined with a new component, “other comprehensive income,” to produce a new bottom line, “comprehensive income.” view more..
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Ans: The work to this point has laid out important background but is not complete. Still required is a device to assist in summarizing information discovered on nonrecurring items so that new measures of sustainable earnings can be developed. We devote the balance of this chapter to introducing a worksheet specially designed to summarize nonrecurring items and illustrating its development and interpretation in a case study. view more..
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Ans: The sustainable earnings worksheet is shown in Exhibit 2.26. Detailed instructions on completing the worksheet follow: 1. Net income or loss is recorded on the top line of the worksheet. 2. All identified items of nonrecurring expense or loss, which were included in the income statement on a pretax basis, are recorded on the “add” lines provided. view more..
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Ans: The sustainable earnings base provides earnings information from which the distorting effects of nonrecurring items have been removed. Some analysts refer to such revised numbers as representing “core” or “underlying” earnings. Sustainable is used here in the sense that earnings devoid of nonrecurring items of revenue, gain, expense, and loss are much more likely to be maintained in the future, other things equal. Base implies that sustainable earnings provide the most reliable foundation or starting point for projections of future results. The more reliable such forecasts become, the less the likelihood that earnings surprises will result. Again, Phillips Petroleum captures the essence of nonrecurring items in the following: view more..
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Ans: This case example of using the SEB worksheet is based on the 1997 annual report of Baker Hughes Inc. and its results for 1995 to 1997. The income statement, statement of cash flows, management’s discussion and analysis of results of operations (MD&A), and selected notes are in Exhibits 2.27 through 2.34. Further, to reinforce the objective of efficiency in financial analysis, we adhere to the search sequence outlined in Exhibit 2.3. view more..




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