6
CHAPTER
Analyzing Operating
Activities
Illustration Facts,
? Company with $100,000 in cash
? Buys condo for $100,000
? Rents condo for $12,000 per year
? End of the first year,Condo valued at $125,000
Income Measurement
Concepts
Illustration Facts,
? Net (free) cash flow = $(88,000)
? Operating cash flow = $12,000
? Economic income = $37,000
? ($12,000 rental income + $25,000 holding gain)
? Accounting income = $11,500 ($12,000 rental
income - $500 depreciation*)
*Condo’s useful life is 50 years and its salvage value is
$75,000—yearly straight-line depreciation is $500
Income Measurement
Concepts
Economic Income,
Two measures reflect
the economic concept
? economic income
? permanent income
Income Measurement
Concepts
Economic Income,
? Equals net cash flows + the change in the present value of
future cash flows
? Measures change in shareholder value—reflecting the
financial effects of all events in a comprehensive manner
? Includes both recurring and nonrecurring components—
rendering it less useful for forecasting future earnings
potential
? Related to Hicksian concept of
income—income includes both
realized (cash flow) and
unrealized (holding gain or
loss) components
Income Measurement
Concepts
Permanent Income*
? Equals stable average income that a company
is expected to earn over its life
? Reflects a long-term focus
? Directly proportional to company
value
? Often expressed by dividing
permanent income by
cost of capital
*Also called sustainable earning power,or sustainable or normalized
earnings
Income Measurement
Concepts
Economic Income and Permanent Income
Income Measurement
Concepts
0
1
2
3
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51
Ye a r s
$
M
i
l
l
i
o
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Pe rm a n e n t I n c o m e Ec o n o m i c I n c o m e
Accounting Concept of Income,
? Based on accrual accounting
? Capture aspects of both economic income and
permanent income
? Suffers from
measurement
problems—yields
accounting analysis
Income Measurement
Concepts
Revenue Recognition and Matching,
Revenue recognition
Revenues must be
(1) realized or realizable,and
(2) earned
Costs/Expenses matched with
recognized revenues
Product costs—recognized when product or
service sold
Period costs--recognized when incurred
Income Measurement
Concepts
Economic Income vs,Accounting Income,
Economic Income and Accounting
Income reflect similar concepts
BUT,
Accounting income is a product
of the financial reporting
environment—accounting
standards,enforcement
mechanisms,managers’ incentives,etc,
HENCE,
Accounting income can diverge from economic
income (yielding accounting distortions)
Income Measurement
Concepts
Accounting Income consists of,
? Permanent Component--the recurring component
expected to persist indefinitely
? Transitory Component--the transitory (or non-
recurring) component not expected to persist
(Note,The concept of economic income includes
both permanent and transitory components.)
? Value Irrelevant Component--value irrelevant
components have no economic content; they are
accounting distortions
Income Measurement
Concepts
Analysis Implications,
? Adjusting accounting income is
important task
? Necessary to specify analysis
objectives--e.g.,determining
economic income or permanent
income or sustainable earning power
? Adopt an inclusive approach—
including recurring and non-recurring
components
Income Measurement
Concepts
Income Measurement
Measurement
Two main components of accounting
income,
Revenues (gains)
Expenses (losses)
Sample Income Statement
Income Measurement
Measurement
Amber Corp,and Subsidiaries
2001
Sales
$14,314
$12,716
$13,033
Equity income 51
39
43
Interest income
12
74
15
Cost of goods sold (8,333)
(7,567)
(8,001)
Gross profit
$ 6,044
$5,262
$ 5,090
Expenses,
Selling and administrative
$(2,964)
$(2,478)
$(2,396)
Research and development
(1234)
(899)
(855)
Restructuring charge
--
(1016)
--
Interest expense
(725)
(715)
(654)
Income before taxes
$ 1,121
$ 154
$ 1,185
Income taxes
(336)
(351)
(356)
Income from continuing operations
$ 785
$ (197)
$ 830
Gain from extinguishment of debt
38
--
--
Loss from operating discontinued segment
--
0
(23)
Gain from sale of discontinued segment
--
--
66
Net income
$ 823
$ (197)
$ 873
Foreign currency translation adjustments
82
(54)
(31)
Unrealized holding gains on available-for-sale securities
24
22
6
Additional minimum pension liability adjustment
0
(4)
--
Comprehensive income
$ 929
$ (233)
$ 848
2000
1999
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
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 resource consumed,
spent,or lost in pursuing revenues and gains
Income Measurement
Measurement
Two major income dimensions,
1,operating versus non-operating
2,recurring versus non-recurring*
*Motivated by need to separate permanent and
transitory components
Income Measurement
Alternatives
Operating vs,Non-Operating and Recurring vs,Non-Recurring
Income Measurement
Alternatives
Operating Income
Non-Operating Income
Recurring
Income
Non-
Recurring
Income
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”
Income Measurement
Alternatives
Income Measurement
Analysis
What constitutes the ?correct? measure of
income for analysis purposes?
There is no answer for two reasons,
? Correct measurement depends on analysis
objectives
? Alternative accounting income measures
result from including or excluding line
items—still subject to accounting distortions
Income Measurement
Analysis
Operating versus Non-Operating Income
Operating income--measure of company income as generated from
operating activities
Three important aspects of operating income
? Pertains only to income generated from operations
? Focuses on income for the company,not simply for equity holders
(means financing revenues and expenses are excluded)
? Pertains only to ongoing business activities (i.e.,results from
discontinued operations is excluded)
Non-operating income--includes all components of net income excluded
from operating income
Useful to separate non-operating components pertaining to financing and
investing
Income Measurement
Analysis
Clean Surplus
Articulation of income with equity in successive balance
sheets--i.e.,income accounts for all changes in equity from
non-owner sources
Dirty Surplus
Accounting allows certain components of income to bypass
income as direct adjustments to equity
HENCE
Net income is generally a produce of
dirty surplus accounting
Comprehensive income is a product of
clean surplus accounting
Income Measurement
Analysis
Determination of Comprehensive Income—sample company
Net income
Other comprehensive income,
+/- Unrealized holding gain or loss on marketable securities
+/- Foreign currency translation adjustment
+/- Additional minimum pension liability adjustment
+/- Unrealized holding gain or loss on derivative instruments
Comprehensive income
Income Measurement
Analysis
Comprehensive Income
? Accountant?s proxy for economic income*
? Revenue and expense components must be adjusted in
estimating economic income (confine to the four usual
items),
? Include unrealized gains and losses from investment
securities
? Include foreign currency translation adjustments
? Exclude additional minimum pension liability adjustment
? Include change in pension funded status (pension
assets less pension obligations)
*Many components of comprehensive income are irrelevant
for determining permanent income
Non-Recurring Items
?Extraordinary items
?Discontinued
segments
?Accounting changes
?Restructuring
charges
?Special items
Non-Recurring Items
Extraordinary Items
Criteria
Unusual in nature
Infrequent in occurrence
Examples
Uninsured losses from a major casualty
(earthquake,hurricane,tornado),losses from
expropriation,and gains and losses from early retirement
of debt
Disclosure
Classified separately in income statement
Non-Recurring Items
Extraordinary Items
Frequency of Companies Reporting Extraordinary Items
Magnitude of Extraordinary Items
0%
5%
10%
15%
20%
25%
30%
78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Y e a r
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A l l P o s i t i v e N e g a t i v e
0%
10%
20%
30%
40%
78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Y e a r
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A l l P o si t i ve N e g a t i ve
Non-Recurring Items
Extraordinary Items
Extraordinary items,
? Are non-recurring
? Excluded when computing permanent income
? Included when computing economic income
? Can reveal risk exposures
? Can impact computation of sustainable earning
power
? Often Excluded when making comparisons over
time or across firms
Non-Recurring Items
Discontinued Operations
Panel A,Frequency of Reporting Discontinued Operations
Panel B,Magnitude of Discontinued Operations
0%
5%
10%
78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
P
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of
C
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A l l P o s i t i v e N e g a t i v e
0%
10%
20%
30%
78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Y e a r
A
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I
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A l l P o s i t i v e N e g a t i v e
Non-Recurring Items
Discontinued Operations
Accounting is two-fold,
? Income statements for the current and prior two
years are restated after excluding the effects of
discontinued operations
? Gains or losses from the discontinued operations
are reported separately,net of tax*
*Reported in two categories,(i) operating income or
loss from discontinued operations until the
measurement date,and (ii) gains and losses on
disposal
Non-Recurring Items
Discontinued Operations
For analysis of discontinued operations,
? Adjust current and past income to remove effects of
discontinued operations
? Companies disclose this info for the current and past
two years
? For earlier years,
? Look for restated summary info or other
voluntary disclosures
? Take care when doing inter-temporal analysis
? Adjust assets and liabilities to remove discontinued
operations
? Retain cumulative gain or loss from discontinued
operations in equity
Non-Recurring Items
Accounting Changes
Accounting changes are
of 3 types,
? Accounting principle
change
? Accounting estimate
change
? Reporting entity
change
Non-Recurring Items
Accounting Changes
Accounting Principle Change—
involves switch from one
principle to another
Disclosure includes,
? Nature of and justification for
change
? Effect of change on current
income and earnings per share
? Pro forma effects of retroactive
application of change on income
and EPS for income statement
years
Non-Recurring Items
Accounting Changes
Accounting Estimate 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
Non-Recurring Items
Accounting Changes
Reporting Entity Change—
involves initial publication
of consolidated statements,
or change in consolidation
policy,or a pooling of
interest
? Restate all prior periods’
financial statements and
disclosing the nature of
change
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)
? Effect 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
Non-Recurring Items
Special Items
Special Items--transactions and events that are unusual or infrequent
Challenges for analysis
? Often little GAAP guidance
? Economic implications are complex
? Discretionary nature serves earnings management aims
Two major types
? Asset impairments (write-offs)
? Restructuring charges
Non-Recurring Items
Special Items
Frequency of Reporting Special Items
0%
10%
20%
30%
40%
50%
78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Y e a r
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A l l P o si t i v e N e g a t i v e
Non-Recurring Items
Special Items
Magnitude of Special Items
0%
10%
20%
30%
40%
50%
60%
78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Ye a r
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A l l Po si t i ve N e g a t i ve
Non-Recurring Items
Special Items
Break-Up One-Time Charges (Special Items)
O n e - T i m e C h ar g e s b y F r e q u e n c y
G o o d w i l l
11%
PP&E
19%
I n v e n t o r
y
16%
U n i d e n t i f i
a b l e
27%
R e st r u ct
u r i n g
22%
O t h e r
5%
O n e - T i m e C h ar g e s b y A m ou n t ( $ )
G o o d w i l l
8%
PP&E
32%
I n v e n t o r y
2%
U n i d e n t i f i a
b l e
19%
R e st r u ct u r i
ng
31%
O t h e r
8%
Non-Recurring Items
Special Items
Asset Impairment—when asset fair value is below carrying (book) value
Some reasons for impairments
?Decline in demand for asset output
?Technological obsolescence
?Changes in company strategy
Accounting for impairments
?Report at the lower of market or cost
?No disclosure about determination of amount
?No disclosure about probable impairments
?Flexibility in determining when and how much to write-off
?No plan required for asset disposal
Conservative presentation of assets
Non-Recurring Items
Special Items
Restructuring Charges—costs usually related to major changes in company business
Examples of these major changes include
? Extensive reorganization
? Divesting business units
? Terminating contracts and joint ventures
? Discontinuing product lines
? Worker retrenchment
? Management turnover
? Write-offs combined with investments in assets,technology or manpower
Accounting for estimated costs of restructuring program
? Establish a provision (liability) for estimated costs
? Charge estimated costs to current income
? Actual costs involve adjustments against the provision when incurred
Non-Recurring Items
Special Items
?Analyzing special items is
challenging and important
?Challenges arise from lack of
guidance in accounting
standards
?Challenges also arise in
understanding the economics
of special items
?Importance relates to the
frequency and impact on past,
present,and future income
Non-Recurring Items
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
Earnings Management with Special Charges—An Illustration
? Company earns $2 per share in perpetuity
? Cost of capital is 10%
? Company valuation is $20 ($2/0.10)
? Company overstates recurring earnings by $1 per share for 4 periods and then
reverses this with a single charge in the fourth year,
($ per share) Year 1 Year 2 Year 3 Year 4
Recurring earnings $2 + $1 $2 + $1 $2 + $1 $2 + $1
Special charge -- -- -- (4)
Net Income $3 $3 $3 $(1)
Analysis
(1) Suggests permanent component of $3 per share and a transitory component of
$(4) per share in Year 4
(2) Company stock is valued at $26 ([$3 / 0.10] - $4)
(3) Ignoring special charges (as some analysts advise) yields stock valued at $30 ($3
/0.10)
Non-Recurring Items
Special Items
Non-Recurring Items
Special Items
Earnings Management with Special Charges—Graphical Illustration
-2 0
-1 0
0
10
20
1 3 5 7 9
11 13 15 17 19
Y e a r
Ea
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n
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g
s
p
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r
Sh
a
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e
($
)
Se ri e s1
Se ri e s2
Se ri e s3
Se ri e s4
Non-Recurring Items
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
Non-Recurring Items
Special Items
Balance Sheet Adjustments
Balance sheets after special charges often better reflect
business reality by reporting assets closer to net realizable
values
Two additional points
(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
Revenue Recognition Criteria
? Earning activities are substantially complete and no
significant added effort is necessary
? Risk of ownership is effectively passed to the buyer
? Revenue,and related expense,are measured or
estimated with accuracy
? Revenue recognized normally
yields an increase in cash,
receivables or securities
? Revenue transactions are at arm’s
length with independent parties
? Transaction is not subject to revocation
Revenue Recognition
Guidelines
(1) A provision for doubtful (uncollectible) accounts reflects uncertainty in
collectibility of receivables from sales
(2) When collectibility is not reasonably assured,there exist three different
methods of recognizing revenue
? Installment Sales Method--used when there is no reasonable basis
for estimating doubtful accounts; company recognizes revenue and
expense from installment sales when sold,but defers income to future
periods when cash is collected and is recognized in proportion to the
total amount of cash received
? Cost Recovery Method--used when there is no reasonable basis for
estimating the degree of collectibility of receivables (a more
conservative version of installment sales method); company reports
revenue and expense from the sale in the income statement,but defers
the income and recognizes it only when the cost of the sale is fully
recovered
? Real Estate Method—used when there is the seller has significant
remaining construction or development obligations; company reports
a percentage of income earned according to the obligations fulfilled
Revenue Recognition
Uncertainty
Some special revenue recognition situations are
? Revenue When Right of Return Exists
? Franchise Revenues
? Product Financing Arrangements
? Transfers of Receivables with Recourse
? Recognition at Completion of Production
? Revenue under Contracts
? Percentage-of-completion method
? Completed-contract method
? Unearned Finance Charges
? Recognizing,Sales” to Leasing Subsidiaries
Revenue Recognition
Uncertainty
Revenue is important for
? Company valuation
? Accounting-based contractual agreements
? Management pressure to achieve income expectations
? Management compensation linked to income
? Valuation of stock options
Analysis must assess whether revenue reflects business reality
? Assess risk of transactions
? Assess risk of collectibility
Circumstances fueling questions about revenue recognition include
? Sale of assets or operations not producing cash flows to fund interest
or dividends
? Lack of equity capital
? Existence of contingent liabilities
Revenue Recognition
Analysis
Costs incurred but deferred because they are
expected to benefit future periods
Consider four categories of deferred costs
?Research and development
?Computer software costs
?Costs in extractive industries
?Miscellaneous (Other)
Deferred Charges
R&D costs include,
? Materials,equipment,and facilities acquired or constructed
for a R&D project
? Purchased intangibles with no alternative future uses
? Materials consumed in R&D activities
? Depreciation of equipment or facilities,and amortization of
intangible assets,used in R&D activities with alternative
future uses
? Salaries and other related costs of
personnel engaged in R&D
? Services performed by others in connection
with R&D
? Allocation of indirect costs,excluding general
and administrative
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
Deferred Charges
Research and Development
Analysis of R&D is challenging because,
? Future benefits are usually created from R&D
? Conceptually,R&D should not be expensed as incurred
? Expensing R&D impairs earnings usefulness
? Market often rewards a stock price for R&D
? Understates R&D assets
? Accounting ignores experiences
of many ongoing R&D activities
? Fails to serve needs and interests
of many analysts
Deferred Charges
Research and Development
Deferred Charges
Research and Development
Analysis needs/wants include
? Types of research
performed
? R&D outlays by category
? Technical feasibility
? Commercial viability
? Potential of R&D projects
? Prior success/failure with
R&D
[Note,Accounting for costs of computer software to
be sold,leased,or otherwise marketed identifies a
point referred to as technological feasibility]
Prior to technological
feasibility,costs
are expensed when
incurred
After technological feasibility,costs are capitalized
as an intangible asset
Deferred Charges
Computer Software Costs
Search and development costs for natural resources is
important to extractive industries including oil,gas,metals,
coal,and nonmetallic minerals
Two basic accounting viewpoints,
?,Full-cost” view—all costs,
productive and nonproductive,
incurred in the search for resources
are capitalized and amortized to
income as resources are produced
and sold
?,Successful efforts” view—all costs that do not result
directly in discovery of resources have no future benefit
and should be expensed as incurred
Deferred Charges
Costs in Extractive Industries
Deferred Charges
Other Deferred Costs
? Deferred charges are often substantial
? Validating many deferred charges depends on
estimates
? Assessing the benefit period to amortize deferred
charges is difficult
? Analysis must be alert to deferred charges that do
not carry future benefits
? Descriptions of deferred costs are useful in analysis
? Deferred charges are generally incapable of
satisfying creditors’ claims
? Assess propensity of management to defer costs
?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)
Employee Benefits
Overview
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
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
Employee Benefits
Employee Stock Options
Employee Benefits
Employee Stock Options
Illustration of an Option Granted to an Employee
Grant Vesting Exercise
Date Date Date
Vesting Period
|---------------------------------------------|--------------------------------------------------|
Stock Stock Stock
Price Price Price
$ 10 $ 15 $ 21
Two main accounting issues
? 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
? Cost recognition of ESO
?Determine cost of ESOs granted
?Amortize cost over vesting period
Employee Benefits
Employee Stock Options
Employee Benefits
Employee Stock Options
Factor Effect on fair value
Exercise price -
Stock price on date of grant +
Expected life of option +
Risk-free rate of interest +
Expected volatility of stock +
Expected dividends on stock -
Employee Benefits
Employee Stock Options
ESO Disclosures
? Pro forma income and EPS
? Note details on options
granted,outstanding,and
exercisable
? Assumptions for
computing fair value of
options granted
Employee Benefits
Employee Stock Options
Income from Continuing Operations after considering,Full” Effect of ESOs
Employee Benefits
Employee Stock Options
Income from Continuing Operations after considering,Full” Effect of ESOs
0% 20% 40% 60% 80% 100% 120%
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3 y r Av g
Interest and Taxes
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
Interest and Taxes
Interest Capitalization
Accounting requires
interest capitalization
when asset
? constructed or
produced for a
company’s own use
? constructed or
produced for a
company by others
where deposits or
progress payments
are made
Aims of interest
capitalization
(1) Better measure
asset acquisition
cost
(2) Better amortize
acquisition cost
against revenues
generated
Interest and Taxes
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
? FAF views interest as a period cost—not
capitalizable
? Changes in a company borrowing rate,not
explained by market trends,reveals changes
in risk
Interest and Taxes
Income Taxes
? Substantial cost of
business
? Important to analysis
of financial
statements
? Analysis focus on
periodic income tax
expense
Interest and Taxes
Income Tax Accounting
? Identify types and amounts of temporary differences
and the nature and amount of each type of operating
loss and tax credit carryforward
? Measure total deferred tax liability for taxable
temporary differences
? Compute total deferred tax asset for deductible
temporary differences and operating loss
carryforwards
? Measure deferred tax assets for each type of tax
credit carryforward
? Reduce deferred tax assets by a valuation allowance
Interest and Taxes
Permanent Income Tax Differences
Permanent differences result from tax regulations where,
? Items are nontaxable
? Deductions are not allowed
? Special deductions are granted
Effective tax rate can vary from statutory rate due to,
? Basis of property differs for financial and tax accounting
? Nonqualified and qualified stock option plans
? Special tax privileges
? Lower corporate income tax rate up to a certain level
? Tax credits
? Different tax rates on foreign income
? Tax expense includes both state and local income taxes
? Tax loss carryforward benefits
Interest and Taxes
Temporary Income Tax Differences
1) Revenue or gain recognized in financial reporting but deferred for
tax purposes
2) Expenses deducted for tax purposes exceed these expenses for
financial reporting
3) Revenue or gain recognized or tax but deferred for financial
reporting
4) Expenses deducted for financial reporting exceed these
expenses for tax,
? Financial
Statement Income Taxable Income
Initial Income Tax
Reported on Journal Entries
Balance Sheet
Category of Income Tax Income Tax Deferred Tax
Transaction Statement Return Expense Accounts*
1,Revenue or gain Earlier Later Debit Credit
2,Expenses or loss Later Earlier Debit Credit
3,Revenue or gain Later Earlier Credit Debit
4,Expenses or loss Earlier Later Credit Debit
2
Interest and Taxes
Temporary Income Tax Differences
Interest and Taxes
Income Tax Disclosures
? Total deferred tax liabilities
? Total deferred tax assets
? Total valuation allowance recognized for deferred tax assets
? Current tax expense or benefit,
? Deferred tax expense or benefit
? Investment tax credits,
? Government grants
? Benefits of operating loss carryforwards
? Tax expense resulting from allocating tax benefits
? Adjustments in deferred tax liability or asset
? Adjustments in beginning balance of valuation allowance
? Reconciliation between effective and statutory federal income
tax rate
Interest and Taxes
Income Tax Analysis
? Tax loss carrybacks yield tax refunds in the loss year and are an asset
? Tax loss carryforwards yield deferred assets
? Tax accounting ignores the time value of money
? Income tax disclosures explain why effective tax differs from statutory
tax
? Effective tax rate reconciliation is useful for forecasting
? Components of deferred income tax reveal future cash flow effects
Financial
Statement Income Taxable Income
?
CHAPTER
Analyzing Operating
Activities
Illustration Facts,
? Company with $100,000 in cash
? Buys condo for $100,000
? Rents condo for $12,000 per year
? End of the first year,Condo valued at $125,000
Income Measurement
Concepts
Illustration Facts,
? Net (free) cash flow = $(88,000)
? Operating cash flow = $12,000
? Economic income = $37,000
? ($12,000 rental income + $25,000 holding gain)
? Accounting income = $11,500 ($12,000 rental
income - $500 depreciation*)
*Condo’s useful life is 50 years and its salvage value is
$75,000—yearly straight-line depreciation is $500
Income Measurement
Concepts
Economic Income,
Two measures reflect
the economic concept
? economic income
? permanent income
Income Measurement
Concepts
Economic Income,
? Equals net cash flows + the change in the present value of
future cash flows
? Measures change in shareholder value—reflecting the
financial effects of all events in a comprehensive manner
? Includes both recurring and nonrecurring components—
rendering it less useful for forecasting future earnings
potential
? Related to Hicksian concept of
income—income includes both
realized (cash flow) and
unrealized (holding gain or
loss) components
Income Measurement
Concepts
Permanent Income*
? Equals stable average income that a company
is expected to earn over its life
? Reflects a long-term focus
? Directly proportional to company
value
? Often expressed by dividing
permanent income by
cost of capital
*Also called sustainable earning power,or sustainable or normalized
earnings
Income Measurement
Concepts
Economic Income and Permanent Income
Income Measurement
Concepts
0
1
2
3
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51
Ye a r s
$
M
i
l
l
i
o
n
Pe rm a n e n t I n c o m e Ec o n o m i c I n c o m e
Accounting Concept of Income,
? Based on accrual accounting
? Capture aspects of both economic income and
permanent income
? Suffers from
measurement
problems—yields
accounting analysis
Income Measurement
Concepts
Revenue Recognition and Matching,
Revenue recognition
Revenues must be
(1) realized or realizable,and
(2) earned
Costs/Expenses matched with
recognized revenues
Product costs—recognized when product or
service sold
Period costs--recognized when incurred
Income Measurement
Concepts
Economic Income vs,Accounting Income,
Economic Income and Accounting
Income reflect similar concepts
BUT,
Accounting income is a product
of the financial reporting
environment—accounting
standards,enforcement
mechanisms,managers’ incentives,etc,
HENCE,
Accounting income can diverge from economic
income (yielding accounting distortions)
Income Measurement
Concepts
Accounting Income consists of,
? Permanent Component--the recurring component
expected to persist indefinitely
? Transitory Component--the transitory (or non-
recurring) component not expected to persist
(Note,The concept of economic income includes
both permanent and transitory components.)
? Value Irrelevant Component--value irrelevant
components have no economic content; they are
accounting distortions
Income Measurement
Concepts
Analysis Implications,
? Adjusting accounting income is
important task
? Necessary to specify analysis
objectives--e.g.,determining
economic income or permanent
income or sustainable earning power
? Adopt an inclusive approach—
including recurring and non-recurring
components
Income Measurement
Concepts
Income Measurement
Measurement
Two main components of accounting
income,
Revenues (gains)
Expenses (losses)
Sample Income Statement
Income Measurement
Measurement
Amber Corp,and Subsidiaries
2001
Sales
$14,314
$12,716
$13,033
Equity income 51
39
43
Interest income
12
74
15
Cost of goods sold (8,333)
(7,567)
(8,001)
Gross profit
$ 6,044
$5,262
$ 5,090
Expenses,
Selling and administrative
$(2,964)
$(2,478)
$(2,396)
Research and development
(1234)
(899)
(855)
Restructuring charge
--
(1016)
--
Interest expense
(725)
(715)
(654)
Income before taxes
$ 1,121
$ 154
$ 1,185
Income taxes
(336)
(351)
(356)
Income from continuing operations
$ 785
$ (197)
$ 830
Gain from extinguishment of debt
38
--
--
Loss from operating discontinued segment
--
0
(23)
Gain from sale of discontinued segment
--
--
66
Net income
$ 823
$ (197)
$ 873
Foreign currency translation adjustments
82
(54)
(31)
Unrealized holding gains on available-for-sale securities
24
22
6
Additional minimum pension liability adjustment
0
(4)
--
Comprehensive income
$ 929
$ (233)
$ 848
2000
1999
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
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 resource consumed,
spent,or lost in pursuing revenues and gains
Income Measurement
Measurement
Two major income dimensions,
1,operating versus non-operating
2,recurring versus non-recurring*
*Motivated by need to separate permanent and
transitory components
Income Measurement
Alternatives
Operating vs,Non-Operating and Recurring vs,Non-Recurring
Income Measurement
Alternatives
Operating Income
Non-Operating Income
Recurring
Income
Non-
Recurring
Income
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”
Income Measurement
Alternatives
Income Measurement
Analysis
What constitutes the ?correct? measure of
income for analysis purposes?
There is no answer for two reasons,
? Correct measurement depends on analysis
objectives
? Alternative accounting income measures
result from including or excluding line
items—still subject to accounting distortions
Income Measurement
Analysis
Operating versus Non-Operating Income
Operating income--measure of company income as generated from
operating activities
Three important aspects of operating income
? Pertains only to income generated from operations
? Focuses on income for the company,not simply for equity holders
(means financing revenues and expenses are excluded)
? Pertains only to ongoing business activities (i.e.,results from
discontinued operations is excluded)
Non-operating income--includes all components of net income excluded
from operating income
Useful to separate non-operating components pertaining to financing and
investing
Income Measurement
Analysis
Clean Surplus
Articulation of income with equity in successive balance
sheets--i.e.,income accounts for all changes in equity from
non-owner sources
Dirty Surplus
Accounting allows certain components of income to bypass
income as direct adjustments to equity
HENCE
Net income is generally a produce of
dirty surplus accounting
Comprehensive income is a product of
clean surplus accounting
Income Measurement
Analysis
Determination of Comprehensive Income—sample company
Net income
Other comprehensive income,
+/- Unrealized holding gain or loss on marketable securities
+/- Foreign currency translation adjustment
+/- Additional minimum pension liability adjustment
+/- Unrealized holding gain or loss on derivative instruments
Comprehensive income
Income Measurement
Analysis
Comprehensive Income
? Accountant?s proxy for economic income*
? Revenue and expense components must be adjusted in
estimating economic income (confine to the four usual
items),
? Include unrealized gains and losses from investment
securities
? Include foreign currency translation adjustments
? Exclude additional minimum pension liability adjustment
? Include change in pension funded status (pension
assets less pension obligations)
*Many components of comprehensive income are irrelevant
for determining permanent income
Non-Recurring Items
?Extraordinary items
?Discontinued
segments
?Accounting changes
?Restructuring
charges
?Special items
Non-Recurring Items
Extraordinary Items
Criteria
Unusual in nature
Infrequent in occurrence
Examples
Uninsured losses from a major casualty
(earthquake,hurricane,tornado),losses from
expropriation,and gains and losses from early retirement
of debt
Disclosure
Classified separately in income statement
Non-Recurring Items
Extraordinary Items
Frequency of Companies Reporting Extraordinary Items
Magnitude of Extraordinary Items
0%
5%
10%
15%
20%
25%
30%
78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Y e a r
P
r
o
p
o
r
ti
o
n
o
f
C
o
m
p
a
n
ie
s
R
e
p
o
r
ti
n
g
A l l P o s i t i v e N e g a t i v e
0%
10%
20%
30%
40%
78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Y e a r
A
b
s
o
lu
te
M
a
g
n
it
u
d
e
a
s
%
o
f
C
o
n
ti
n
u
in
g
I
n
c
o
m
e
A l l P o si t i ve N e g a t i ve
Non-Recurring Items
Extraordinary Items
Extraordinary items,
? Are non-recurring
? Excluded when computing permanent income
? Included when computing economic income
? Can reveal risk exposures
? Can impact computation of sustainable earning
power
? Often Excluded when making comparisons over
time or across firms
Non-Recurring Items
Discontinued Operations
Panel A,Frequency of Reporting Discontinued Operations
Panel B,Magnitude of Discontinued Operations
0%
5%
10%
78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
P
rop
or
ti
on
of
C
om
pa
ni
e
s
R
e
po
rt
ing
A l l P o s i t i v e N e g a t i v e
0%
10%
20%
30%
78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Y e a r
A
bs
ol
ut
e
M
a
gn
it
ud
e
a
s
%
of
C
on
ti
nu
ing
I
nc
om
e
A l l P o s i t i v e N e g a t i v e
Non-Recurring Items
Discontinued Operations
Accounting is two-fold,
? Income statements for the current and prior two
years are restated after excluding the effects of
discontinued operations
? Gains or losses from the discontinued operations
are reported separately,net of tax*
*Reported in two categories,(i) operating income or
loss from discontinued operations until the
measurement date,and (ii) gains and losses on
disposal
Non-Recurring Items
Discontinued Operations
For analysis of discontinued operations,
? Adjust current and past income to remove effects of
discontinued operations
? Companies disclose this info for the current and past
two years
? For earlier years,
? Look for restated summary info or other
voluntary disclosures
? Take care when doing inter-temporal analysis
? Adjust assets and liabilities to remove discontinued
operations
? Retain cumulative gain or loss from discontinued
operations in equity
Non-Recurring Items
Accounting Changes
Accounting changes are
of 3 types,
? Accounting principle
change
? Accounting estimate
change
? Reporting entity
change
Non-Recurring Items
Accounting Changes
Accounting Principle Change—
involves switch from one
principle to another
Disclosure includes,
? Nature of and justification for
change
? Effect of change on current
income and earnings per share
? Pro forma effects of retroactive
application of change on income
and EPS for income statement
years
Non-Recurring Items
Accounting Changes
Accounting Estimate 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
Non-Recurring Items
Accounting Changes
Reporting Entity Change—
involves initial publication
of consolidated statements,
or change in consolidation
policy,or a pooling of
interest
? Restate all prior periods’
financial statements and
disclosing the nature of
change
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)
? Effect 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
Non-Recurring Items
Special Items
Special Items--transactions and events that are unusual or infrequent
Challenges for analysis
? Often little GAAP guidance
? Economic implications are complex
? Discretionary nature serves earnings management aims
Two major types
? Asset impairments (write-offs)
? Restructuring charges
Non-Recurring Items
Special Items
Frequency of Reporting Special Items
0%
10%
20%
30%
40%
50%
78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Y e a r
P
r
o
p
o
r
t
i
o
n
o
f
C
o
m
p
a
n
i
e
s
R
e
p
o
r
t
i
n
g
A l l P o si t i v e N e g a t i v e
Non-Recurring Items
Special Items
Magnitude of Special Items
0%
10%
20%
30%
40%
50%
60%
78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Ye a r
A
b
s
o
l
u
te
Ma
g
n
i
tu
d
e
a
s
%
o
f
C
o
n
ti
n
u
i
n
g
I
n
c
o
m
e
A l l Po si t i ve N e g a t i ve
Non-Recurring Items
Special Items
Break-Up One-Time Charges (Special Items)
O n e - T i m e C h ar g e s b y F r e q u e n c y
G o o d w i l l
11%
PP&E
19%
I n v e n t o r
y
16%
U n i d e n t i f i
a b l e
27%
R e st r u ct
u r i n g
22%
O t h e r
5%
O n e - T i m e C h ar g e s b y A m ou n t ( $ )
G o o d w i l l
8%
PP&E
32%
I n v e n t o r y
2%
U n i d e n t i f i a
b l e
19%
R e st r u ct u r i
ng
31%
O t h e r
8%
Non-Recurring Items
Special Items
Asset Impairment—when asset fair value is below carrying (book) value
Some reasons for impairments
?Decline in demand for asset output
?Technological obsolescence
?Changes in company strategy
Accounting for impairments
?Report at the lower of market or cost
?No disclosure about determination of amount
?No disclosure about probable impairments
?Flexibility in determining when and how much to write-off
?No plan required for asset disposal
Conservative presentation of assets
Non-Recurring Items
Special Items
Restructuring Charges—costs usually related to major changes in company business
Examples of these major changes include
? Extensive reorganization
? Divesting business units
? Terminating contracts and joint ventures
? Discontinuing product lines
? Worker retrenchment
? Management turnover
? Write-offs combined with investments in assets,technology or manpower
Accounting for estimated costs of restructuring program
? Establish a provision (liability) for estimated costs
? Charge estimated costs to current income
? Actual costs involve adjustments against the provision when incurred
Non-Recurring Items
Special Items
?Analyzing special items is
challenging and important
?Challenges arise from lack of
guidance in accounting
standards
?Challenges also arise in
understanding the economics
of special items
?Importance relates to the
frequency and impact on past,
present,and future income
Non-Recurring Items
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
Earnings Management with Special Charges—An Illustration
? Company earns $2 per share in perpetuity
? Cost of capital is 10%
? Company valuation is $20 ($2/0.10)
? Company overstates recurring earnings by $1 per share for 4 periods and then
reverses this with a single charge in the fourth year,
($ per share) Year 1 Year 2 Year 3 Year 4
Recurring earnings $2 + $1 $2 + $1 $2 + $1 $2 + $1
Special charge -- -- -- (4)
Net Income $3 $3 $3 $(1)
Analysis
(1) Suggests permanent component of $3 per share and a transitory component of
$(4) per share in Year 4
(2) Company stock is valued at $26 ([$3 / 0.10] - $4)
(3) Ignoring special charges (as some analysts advise) yields stock valued at $30 ($3
/0.10)
Non-Recurring Items
Special Items
Non-Recurring Items
Special Items
Earnings Management with Special Charges—Graphical Illustration
-2 0
-1 0
0
10
20
1 3 5 7 9
11 13 15 17 19
Y e a r
Ea
r
n
i
n
g
s
p
e
r
Sh
a
r
e
($
)
Se ri e s1
Se ri e s2
Se ri e s3
Se ri e s4
Non-Recurring Items
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
Non-Recurring Items
Special Items
Balance Sheet Adjustments
Balance sheets after special charges often better reflect
business reality by reporting assets closer to net realizable
values
Two additional points
(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
Revenue Recognition Criteria
? Earning activities are substantially complete and no
significant added effort is necessary
? Risk of ownership is effectively passed to the buyer
? Revenue,and related expense,are measured or
estimated with accuracy
? Revenue recognized normally
yields an increase in cash,
receivables or securities
? Revenue transactions are at arm’s
length with independent parties
? Transaction is not subject to revocation
Revenue Recognition
Guidelines
(1) A provision for doubtful (uncollectible) accounts reflects uncertainty in
collectibility of receivables from sales
(2) When collectibility is not reasonably assured,there exist three different
methods of recognizing revenue
? Installment Sales Method--used when there is no reasonable basis
for estimating doubtful accounts; company recognizes revenue and
expense from installment sales when sold,but defers income to future
periods when cash is collected and is recognized in proportion to the
total amount of cash received
? Cost Recovery Method--used when there is no reasonable basis for
estimating the degree of collectibility of receivables (a more
conservative version of installment sales method); company reports
revenue and expense from the sale in the income statement,but defers
the income and recognizes it only when the cost of the sale is fully
recovered
? Real Estate Method—used when there is the seller has significant
remaining construction or development obligations; company reports
a percentage of income earned according to the obligations fulfilled
Revenue Recognition
Uncertainty
Some special revenue recognition situations are
? Revenue When Right of Return Exists
? Franchise Revenues
? Product Financing Arrangements
? Transfers of Receivables with Recourse
? Recognition at Completion of Production
? Revenue under Contracts
? Percentage-of-completion method
? Completed-contract method
? Unearned Finance Charges
? Recognizing,Sales” to Leasing Subsidiaries
Revenue Recognition
Uncertainty
Revenue is important for
? Company valuation
? Accounting-based contractual agreements
? Management pressure to achieve income expectations
? Management compensation linked to income
? Valuation of stock options
Analysis must assess whether revenue reflects business reality
? Assess risk of transactions
? Assess risk of collectibility
Circumstances fueling questions about revenue recognition include
? Sale of assets or operations not producing cash flows to fund interest
or dividends
? Lack of equity capital
? Existence of contingent liabilities
Revenue Recognition
Analysis
Costs incurred but deferred because they are
expected to benefit future periods
Consider four categories of deferred costs
?Research and development
?Computer software costs
?Costs in extractive industries
?Miscellaneous (Other)
Deferred Charges
R&D costs include,
? Materials,equipment,and facilities acquired or constructed
for a R&D project
? Purchased intangibles with no alternative future uses
? Materials consumed in R&D activities
? Depreciation of equipment or facilities,and amortization of
intangible assets,used in R&D activities with alternative
future uses
? Salaries and other related costs of
personnel engaged in R&D
? Services performed by others in connection
with R&D
? Allocation of indirect costs,excluding general
and administrative
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
Deferred Charges
Research and Development
Analysis of R&D is challenging because,
? Future benefits are usually created from R&D
? Conceptually,R&D should not be expensed as incurred
? Expensing R&D impairs earnings usefulness
? Market often rewards a stock price for R&D
? Understates R&D assets
? Accounting ignores experiences
of many ongoing R&D activities
? Fails to serve needs and interests
of many analysts
Deferred Charges
Research and Development
Deferred Charges
Research and Development
Analysis needs/wants include
? Types of research
performed
? R&D outlays by category
? Technical feasibility
? Commercial viability
? Potential of R&D projects
? Prior success/failure with
R&D
[Note,Accounting for costs of computer software to
be sold,leased,or otherwise marketed identifies a
point referred to as technological feasibility]
Prior to technological
feasibility,costs
are expensed when
incurred
After technological feasibility,costs are capitalized
as an intangible asset
Deferred Charges
Computer Software Costs
Search and development costs for natural resources is
important to extractive industries including oil,gas,metals,
coal,and nonmetallic minerals
Two basic accounting viewpoints,
?,Full-cost” view—all costs,
productive and nonproductive,
incurred in the search for resources
are capitalized and amortized to
income as resources are produced
and sold
?,Successful efforts” view—all costs that do not result
directly in discovery of resources have no future benefit
and should be expensed as incurred
Deferred Charges
Costs in Extractive Industries
Deferred Charges
Other Deferred Costs
? Deferred charges are often substantial
? Validating many deferred charges depends on
estimates
? Assessing the benefit period to amortize deferred
charges is difficult
? Analysis must be alert to deferred charges that do
not carry future benefits
? Descriptions of deferred costs are useful in analysis
? Deferred charges are generally incapable of
satisfying creditors’ claims
? Assess propensity of management to defer costs
?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)
Employee Benefits
Overview
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
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
Employee Benefits
Employee Stock Options
Employee Benefits
Employee Stock Options
Illustration of an Option Granted to an Employee
Grant Vesting Exercise
Date Date Date
Vesting Period
|---------------------------------------------|--------------------------------------------------|
Stock Stock Stock
Price Price Price
$ 10 $ 15 $ 21
Two main accounting issues
? 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
? Cost recognition of ESO
?Determine cost of ESOs granted
?Amortize cost over vesting period
Employee Benefits
Employee Stock Options
Employee Benefits
Employee Stock Options
Factor Effect on fair value
Exercise price -
Stock price on date of grant +
Expected life of option +
Risk-free rate of interest +
Expected volatility of stock +
Expected dividends on stock -
Employee Benefits
Employee Stock Options
ESO Disclosures
? Pro forma income and EPS
? Note details on options
granted,outstanding,and
exercisable
? Assumptions for
computing fair value of
options granted
Employee Benefits
Employee Stock Options
Income from Continuing Operations after considering,Full” Effect of ESOs
Employee Benefits
Employee Stock Options
Income from Continuing Operations after considering,Full” Effect of ESOs
0% 20% 40% 60% 80% 100% 120%
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3 y r Av g
Interest and Taxes
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
Interest and Taxes
Interest Capitalization
Accounting requires
interest capitalization
when asset
? constructed or
produced for a
company’s own use
? constructed or
produced for a
company by others
where deposits or
progress payments
are made
Aims of interest
capitalization
(1) Better measure
asset acquisition
cost
(2) Better amortize
acquisition cost
against revenues
generated
Interest and Taxes
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
? FAF views interest as a period cost—not
capitalizable
? Changes in a company borrowing rate,not
explained by market trends,reveals changes
in risk
Interest and Taxes
Income Taxes
? Substantial cost of
business
? Important to analysis
of financial
statements
? Analysis focus on
periodic income tax
expense
Interest and Taxes
Income Tax Accounting
? Identify types and amounts of temporary differences
and the nature and amount of each type of operating
loss and tax credit carryforward
? Measure total deferred tax liability for taxable
temporary differences
? Compute total deferred tax asset for deductible
temporary differences and operating loss
carryforwards
? Measure deferred tax assets for each type of tax
credit carryforward
? Reduce deferred tax assets by a valuation allowance
Interest and Taxes
Permanent Income Tax Differences
Permanent differences result from tax regulations where,
? Items are nontaxable
? Deductions are not allowed
? Special deductions are granted
Effective tax rate can vary from statutory rate due to,
? Basis of property differs for financial and tax accounting
? Nonqualified and qualified stock option plans
? Special tax privileges
? Lower corporate income tax rate up to a certain level
? Tax credits
? Different tax rates on foreign income
? Tax expense includes both state and local income taxes
? Tax loss carryforward benefits
Interest and Taxes
Temporary Income Tax Differences
1) Revenue or gain recognized in financial reporting but deferred for
tax purposes
2) Expenses deducted for tax purposes exceed these expenses for
financial reporting
3) Revenue or gain recognized or tax but deferred for financial
reporting
4) Expenses deducted for financial reporting exceed these
expenses for tax,
? Financial
Statement Income Taxable Income
Initial Income Tax
Reported on Journal Entries
Balance Sheet
Category of Income Tax Income Tax Deferred Tax
Transaction Statement Return Expense Accounts*
1,Revenue or gain Earlier Later Debit Credit
2,Expenses or loss Later Earlier Debit Credit
3,Revenue or gain Later Earlier Credit Debit
4,Expenses or loss Earlier Later Credit Debit
2
Interest and Taxes
Temporary Income Tax Differences
Interest and Taxes
Income Tax Disclosures
? Total deferred tax liabilities
? Total deferred tax assets
? Total valuation allowance recognized for deferred tax assets
? Current tax expense or benefit,
? Deferred tax expense or benefit
? Investment tax credits,
? Government grants
? Benefits of operating loss carryforwards
? Tax expense resulting from allocating tax benefits
? Adjustments in deferred tax liability or asset
? Adjustments in beginning balance of valuation allowance
? Reconciliation between effective and statutory federal income
tax rate
Interest and Taxes
Income Tax Analysis
? Tax loss carrybacks yield tax refunds in the loss year and are an asset
? Tax loss carryforwards yield deferred assets
? Tax accounting ignores the time value of money
? Income tax disclosures explain why effective tax differs from statutory
tax
? Effective tax rate reconciliation is useful for forecasting
? Components of deferred income tax reveal future cash flow effects
Financial
Statement Income Taxable Income
?
