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Chapter 6
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.
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Chapter 06 - Analyzing Operating Activities
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
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ANALYSIS OBJECTIVES
Explain the concepts of income measurement and their implications for analysis of
operating activities.
Analyze revenue and expense recognition and its risks for financial analysis.
Describe and interpret interest costs and the accounting for income taxes.
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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.
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).
7. Core income is a measure of income that excludes all non-recurring items that are
reported as separate items on the income statement.
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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.
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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.
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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.
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.
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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.
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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.
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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.
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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.
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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
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(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.
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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.
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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
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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.
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EXERCISES
a. Cash xxx
Gain on disposition* xxx
Net assets of discontinued operations xxx
* (A loss on disposition would be recorded as a debit)
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Chapter 06 - Analyzing Operating Activities
Exercise 6-2—continued
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)
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Chapter 06 - Analyzing Operating Activities
Exercise 6-3—continued
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Chapter 06 - Analyzing Operating Activities
Exercise 6-3—concluded
* The unexpected return on pension fund assets ($40,000) does not affect net income or
stockholders’ equity in the current period.
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Chapter 06 - Analyzing Operating Activities
a. The point of sale is the most widely used basis for the timing of revenue
recognition because in most cases it provides the degree of objective
evidence many consider necessary to measure reliably periodic business
income. That is, sales transactions with outsiders represent the point in the
revenue generating process when most of the uncertainty about the final
outcome of business activity has been alleviated. It is also at the point of sale
in most cases that substantially all of the costs of generating revenues are
known, and they can at this point be matched with the revenues generated to
produce a reliable statement of a firm's effort and accomplishment for the
period. Any attempt to measure business income prior to the point of sale
would, in the vast majority of cases, introduce considerably more subjectivity
into financial reporting than most accountants are willing to accept.
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Chapter 06 - Analyzing Operating Activities
Exercise 6-5—concluded
of reported net income. Thus, in the vast majority of cases for which the
sales basis is used, estimating errors, though unavoidable, will be too
immaterial in amount to warrant deferring revenue recognition to a later
point in time.
2. When cash is received. The most common application of this basis for the
timing of revenue recognition is in connection with installment sales
contracts. Its use is justified on the grounds that, due to the length of the
collection period, increased risks of default, and higher collection costs,
there is too much uncertainty to warrant revenue recognition until cash is
received. The mere fact that sales are made on an installment contract
basis does not justify using the cash receipts basis of revenue recognition.
The justification for this departure from the sales depends essentially upon
an absence of a reasonably objective basis for estimating the amount of
collection costs and bad debts that will be incurred in later periods. If
these expenses can be estimated with reasonable accuracy, the sales
basis should be used.
(AICPA Adapted)
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Chapter 06 - Analyzing Operating Activities
c. The income recognized in the second year of the four-year contract would be
determined as follows:
First, the estimated total income from the contract would be determined by
deducting the estimated total costs of the contract (the actual costs to date
plus the estimated cost to complete) from the contract price.
Second, the actual costs to date would be divided by the estimated total
costs of the contract to arrive at a percentage completed, which would be
multiplied by the estimated total income from the contract to arrive at the
total income recognized to date.
Third, the total income recognized in the second year of the contract would
be determined by deducting the income recognized in the first year of the
contract from the total income recognized to date.
d. Earnings in the second year of the four-year contract would be higher using
the percentage-of-completion method instead of the completed-contract
method. This is because income would be recognized in the second year of
the contract using the percentage-of-completion method, whereas no income
would be recognized in the second year of the contract using the
completed-contract method.
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Chapter 06 - Analyzing Operating Activities
b. While the tax accounting does provide the company with significant funds
from tax postponement, it does not affect reported results because under
GAAP the company is required to provide for deferred taxes which it is
assumed will be payable in the future.
c. While it is true that the sale of the receivables without recourse would enable
the company to book profits in the year the lease originated, this practice
would at the same time substantially increase the company's tax bill.
c. An analyst should seek to determine the percent of revenues that come from
advertising in such barter transactions versus revenues from cash-paying (or
credit) customers. Some believe that barter-based revenues should be
segregated and viewed in a different light from that of more normal revenues.
This might affect revenue multiples in determining stock price or decisions in
other applications that rely on financial statements. Analysts should adjust
their models according to their beliefs about the relative merits of such
revenues.
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Chapter 06 - Analyzing Operating Activities
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Chapter 06 - Analyzing Operating Activities
Exercise 6-9—concluded
d. In the absence of a direct basis for associating asset cost with revenue, and if
the asset provides benefits for two or more accounting periods, its cost
should be allocated to these periods (as an expense) in a systematic and
rational manner. When it is impractical, or impossible, to find a close
cause-and-effect relationship between revenue and cost, this relationship is
often assumed to exist. Therefore, the asset cost is allocated to the
accounting periods by some method. The allocation method used should
appear reasonable to an unbiased observer and should be followed
consistently from period to period. Examples of systematic and rational
allocation of asset cost would include depreciation of fixed assets,
amortization of intangibles, and allocation of rent and insurance.
a. Research and development costs are expensed in the year that they are
incurred. This means R&D costs impact current income dollar for dollar. Also,
to the extent that research and development efforts lead to future revenues,
this is a violation of the matching principle in relating costs to revenues in
determining future income.
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Chapter 06 - Analyzing Operating Activities
b. Incent.Com would offer such a lucrative plan to its employees to attract and
retain a talented work force. Human capital is a key asset in technology
companies.
c. The grant date is January 1, 2004; Vesting date is January 1, 2009; First
exercise date is January 1, 2009.
d. No, the employee stock options are not “in-the-money” at the grant date. This
is because at the grant date the exercise price is greater than or equal to (not
less than) the market price of the stock.
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Chapter 06 - Analyzing Operating Activities
Exercise 6-12—concluded
g. Compensation cost should be allocated over the service period, years 2004
through 2008.
a. Managers often hold, or expect to hold, stock options. As a result, they will
increase their wealth when the market price of the stock increasing exceeds
the exercise price of stock options they hold. By withholding good news and
selectively releasing bad news before the date that the option’s exercise price
is established, the managers allegedly depress the price of the stock (at least
temporarily) until the exercise price is established.
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Chapter 06 - Analyzing Operating Activities
When rent revenues received in advance this year are included in this year's
taxable income but as unearned revenues (a current liability) for accounting
purposes, a timing difference arises. Because rent revenues are reported this
year for income tax purposes but not for accounting purposes, pretax
accounting income is less than taxable income. The difference creates a debit
to deferred income taxes equal to the difference in rent revenues multiplied by
the appropriate income tax rate.
On the income statement, the income tax effect of the depreciation (timing
difference) and the rent revenues received in advance (timing difference)
should be netted. This amount is classified as a deferred component of
income tax expense.
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Chapter 06 - Analyzing Operating Activities
There are at least two earnings targets that are typically relevant for managers
and investors. The first is the consensus earnings expectation of the analyst
community. The second is the earnings in the same quarter of the previous fiscal
year. (A third might be an earnings forecast previously released by management.)
Beating these targets by even a penny is typically viewed as a sign of sustained
profit growth and skilled leadership. This means that companies near these
targets will use earnings management to meet or exceed these targets, even if
only by a penny. Accordingly, earnings increases of $0.01 can be significant
when the change pushes earnings equal to or above relevant earnings targets.
Of course, a magnitude or scale issue can be relevant as well. A $0.01 change in
an earnings per share figure that is approximately $0.05 per share in total can be
quite relevant, whereas a $0.01 change for an earnings per share figure that is
approximately $10.00 per share can be substantially less relevant.
a. The effects of dilutive stock options and warrants are not included in the
computation of the number of shares for basic earnings per share. They are,
however, included in diluted earnings per share computations.
c. Antidilutive securities are excluded from both basic and diluted earnings per
share.
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Chapter 06 - Analyzing Operating Activities
b. Diluted earnings per share is the amount of current earnings per share that
reflects the maximum dilution that would result from the conversion of all
convertible securities and the exercise of all warrants and options. The
conversion of these securities individually would decrease earnings per share
and in the aggregate would have a dilutive effect. The computation of diluted
earnings per share should be based upon the assumption that all such issued
and issuable shares are outstanding from the beginning of the period, or from
their inception if after the beginning of the period. To summarize, whereas
basic earnings per share does not reflect any securities convertible or
exercisable into common shares, diluted earnings per share includes all such
securities and considers their dilutive effect upon earnings per share, taking
into account necessary adjustments to income resulting from the conversion
process.
(CFA Adapted)
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Chapter 06 - Analyzing Operating Activities
PROBLEMS
Net Income................................................................... $ 50 $ 20
[a] Represents net income (loss) from operations for Year 7 and for Year 8 until
August 15.
[b] Represents:
Loss from operations August 15 to December 31....................... $ (1)
Loss on sale of assets (after $5 tax)............................................. (5)
Total................................................................................................. $ (6)
The $10 loss and related tax benefit of $5 would still be recorded (anticipated) at
December 31, Year 8 (the asset would be reduced by $10 to market value).
1. a
2 b (40% of revenues and costs are recognized)
3. a
4. d
5 a
6. c
7. d [($120,000/30%) + ($440,000/40%)]
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Chapter 06 - Analyzing Operating Activities
a. (1) Failing to timely record returned credit card purchases and membership
cancellations: An accounts receivable analysis would be the focal point to
identifying this problem. We would examine for either continual growth in
accounts receivable or unusual (unexplained) write-offs of receivables.
Ratios or techniques that compare cash collections to accounts receivable
also could potentially identify a problem area or fraudulent behavior.
b. The external auditor must conduct the audit according to generally accepted
auditing standards. The culpability of auditors in a fraud situation varies on a
case by case basis. It is often difficult to detect a fraud if key client personnel
are colluding and conspiring to cover up. However, in this case the fraud was
so widespread that auditor negligence is part of the problem. From an
economic perspective, this question will ultimately be answered via litigation.
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Chapter 06 - Analyzing Operating Activities
b. Identification of Amounts & Sources (combining federal, state and foreign taxes):
11 10 9
1. Earnings before income taxes [26].......................... $667.4 $179.4 $106.5
2. Expected income tax @ 34% (confirmed by [134]).... 226.9 61.0 36.2
3. Total income tax expense [27].................................. 265.9 175.0 93.4
4. Total income tax due *............................................... 230.4 171.1 161.2
5. Total income tax due and not yet paid [44]............. 67.7 46.4 30.1
d. Campbell can probably deduct for tax purposes only cash actually spent in
Year 10 for these charges. If this is so, an estimate of cash spent is (see item
[105]):
$339.1 - $301.6 = $37.5; $37.5 / 34% = $110 million
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Chapter 06 - Analyzing Operating Activities
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Chapter 06 - Analyzing Operating Activities
STEAD CORPORATION
($ in thousands) Year 4 Year 5 Year 6
a. Income Statement
Sales................................................................ $10,000 $10,000 $10,000
Expenses *...................................................... 9,000 9,000 10,400
Income before tax.......................................... $ 1,000 $ 1,000 $ (400)
Tax expense:
Current **.................................................... — 300 500
Deferred..................................................... 500 200 (700)
Total tax expense....................................... $ 500 $ 500 $ (200)
Net income (loss)........................................... $ 500 $ 500 $ (200)
b. Balance Sheet
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Chapter 06 - Analyzing Operating Activities
Income Statement
Years 1 2 3 4 5 6 7 8
Net income (**).............................. $10 $17.5 $25 $(247.5) $130 $157.5 $130 $150
* Taxable income.................................... $20 $35 $50 $(300) $(65)b $185c $260 $300
Tax due at 50% rate.............................. 10 17.5 25 (52.5)a 0 92.5 130 150
a
Operating loss of $300 carried back to eliminate all taxable income for Year 1, Year 2 and Year
3 and secure refund of $52.5 for total taxes paid during those years.
b
Income for Year 5 of $130 less loss carryforward of $195.
c
Income for Year 6 of $250 less loss carryforward of $65.
** Disclosure: Tax loss carryforwards are $195 at end of Year 4 and $65 at end of Year 5.
Accounting effects [journal entries Dr. (Cr.)]:
Tax expense..................................... 10 17.5 25 (52.5) 65 125 130 150
FIT Receivable................................. 52.5
FIT Payable...................................... (10) (17.5) (25) (92.5) (130) (150)
Extraordinary gains......................... (65) (32.5)
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Chapter 06 - Analyzing Operating Activities
Are the convertible bonds dilutive? No. Assuming conversion of bonds, 100,000
additional shares would be issued. The net income adjustment would be:
Interest expense related to bonds........................... $500,000
Less taxes.................................................................. (200,000)
Increase in net income............................................. $300,000
Consequently:
EPS = ($6,500,000+$300,000)/(2,500,000+100,000) = $2.62
Diluted EPS = $6,500,000/(2,500,000+50,000) = $2.55
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Chapter 06 - Analyzing Operating Activities
CASES
Case 6-1 (50 minutes)
Income Statement
Sales............................................$9,900 $8,100 $10,800 $9,900
Costs and expenses:
Cost of goods sold............................ 7,700 6,300 8,400 7,610d
Selling expense................................. 990 810 1,080 990
Shipping expense.............................. 220 180 240 220
Net income............................................. $ 990 $ 810 $ 1,080 $1,080
Notes:
a. Deferred income: Sales is $1,800 less costs of ($1,400 + $180 + $40) = $180.
b. Time of production: Figures can be reflected gross as in left column or net as in right
column.
c. Inventory, at net realizable value $790 = $900 less $20 less $90.
d. Cost of goods sold is a "to-balance" figure based on inventory (for example, Beg. $0 plus
purchases $8,400 less End. $790 = COGS $7,610).
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Chapter 06 - Analyzing Operating Activities
Case 6-1—continued
b. The installment method delays the reporting of revenues and thereby delays
the time for payment of taxes. The time value of money is a major motivation
for delaying cash payments for taxes.
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Chapter 06 - Analyzing Operating Activities
b. Sales and cost of goods sold are typically the most highly persistent, and
reductions on COGS as a percentage of sales such as we see in this example
are rare. SG&A costs are also typically highly persistent. However, the
company may be able to find ways to cut some of these through operating
efficiencies. The R&D costs are also reasonably persistent. Again, the
company can choose to increase or decrease these, but such a decision can
have severe ramifications for future profitability. Restructuring costs are
generally viewed as transitory.
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Chapter 06 - Analyzing Operating Activities
Case 6-2—concluded
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Chapter 06 - Analyzing Operating Activities
1.
BREAK-DOWN OF RESTRUCTURING AND OTHER CHARGES
Charge
Classific Pre- Post- Utilized Balance
Description ation Tax Tax Pre-Tax Pre-Tax
Lease Commitments.............................
Restruc. 81 0 81
Severance/Closing Costs.....................
Restruc. 29 4 25
PP&E Write-Down..................................
Restruc. 155 155 0
Other.......................................................
Restruc. 29 5 24
Markdown-Store Closedowns..............
CGS 29 2 27
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Chapter 06 - Analyzing Operating Activities
Case 6-3—continued
2.
Gross Profit..................................................................
2979 26.7% 3324 29.8% 3328 30.2%
Depreciation.................................................................
255 2.3% 255 2.3% 253 2.3%
Restructuring Charge.................................................
294 2.6% 0 0.0% 0 0.0%
Tax Provision...............................................................
26 0.2% 216 1.9% 282 2.6%
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Chapter 06 - Analyzing Operating Activities
Case 6-3—continued
3.
Elements of Restructuring Plan and Expected Economic Effects
Expected Economic
Element Description Cost Effects
Store - Close 50 Leases 81 Sales reduction $ 322
Closing international and Severance etc 29 MM, operating loss
9 Toys “R” Us PPE Write down 155 saving $ 5 MM pa
stores that do Markdown 29 2600 employees
not meet Acctg change & terminated ($ 100-150
strategic legal settlements 39 MM pa saving)
Total 333
profitability Closings: Eliminate
objectives loss making
- Close 31 US stores/focus on more
Kids “R” Us profitable opportunities
stores and Combo Stores: Release
convert 28 working capital, lower
nearby Toys “R” operating costs,
Us stores into increase productivity
combo stores
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Chapter 06 - Analyzing Operating Activities
Case 6-3—continued
6-47
Chapter 06 - Analyzing Operating Activities
b. Diluted EPS:
Are the convertible bonds dilutive? Yes. Assuming conversion, the net
income adjustment would be:
6-48