Income Reporting

RCJ Chapters 2(53-73), 5(247-250), 6(282-288)

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Key Issues Income statement format

Special item: ex. restructuring charges Non-GAAP earnings reports

Companies’ pro-forma earnings Analysts’ operating earnings

Accounting changes

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Income Statement Format Purpose of multiple-step income

statement: separate permanent from transitory items.

enables a more accurate prediction of future earnings and future cash-flows.

Mythical Corporation

The items appearing below Income from continuing operations, called the non-recurring items (gains/losses), represent the transitory portion of earnings.

Income from continuing operations is intended to capture the sustainable part of income.

2001Net sales $3,957Cost of goods sold (1,364)Gross profit $2,593SG&A (1,093)Special or unusual charges (251)Income from continuing operations

before tax expense $1,249Income tax expense (406)Income from continuing operations $843Discontinued operations:

Income, net of tax 203Gain on disposal, net of tax 98

Income before extraordinary item andchange in accounting principle $1,144

Extraordinary loss, net of tax -----Cumulative effect of change in accounting

principle, net of tax (118)Net Income $1,026

“Above the line”

“Below the line”

RCJ page 54, Exhibit 2.1

Nonrecurring gains/losses include

discontinued operations

extraordinary losses/gains

cumulative effect of accounting changes

“Above the line”

“Below the line”

Before Tax

Net of Tax

Tax Expense

Mythical Corporation 2001Net sales $3,957Cost of goods sold (1,364)Gross profit $2,593SG&A (1,093)Special or unusual charges (251)Income from continuing operations

before tax expense $1,249Income tax expense (406)Income from continuing operations $843Discontinued operations:

Income, net of tax 203Gain on disposal, net of tax 98

Income before extraordinary item andchange in accounting principle $1,144

Extraordinary loss, net of tax -----Cumulative effect of change in accounting

principle, net of tax (118)Net Income $1,026

“Above the line”

“Below the line”

These items are reported below income from continuing operations net of income tax effects.

What are management incentives?

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Discontinued Operations Example of restated financial report due to Discontinued

Operations: (* assume that the discontinued operation constitutes 10% of the firm)

Restated OriginalRevenue(CGS)

9054

10060

GM(SGA)

369

4010

Income before taxTax exp. 40%

2710.8

3012

Inc from Cont. Op.Inc from Disc. Op.

16.21.8*

18-

NI 18 18Key point: NI is unchanged, but is allocated between income from continued operations and income from discontinued operations

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Comprehensive IncomeNI ± certain unrecognized gains/losses:

unrealized gains (losses) on “available-for-sale” marketable securities,

foreign currency translation gains (losses) unrealized losses resulting from minimum

pension obligations These are open transactions - balance

sheet carrying amounts are changed even though the transaction is not yet closed (i.e. asset is not yet sold).

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2001Net sales $3,957Cost of goods sold (1,364)Gross profit $2,593SG&A (1,093)Special or unusual charges (251)Income from continuing operations

before tax expense $1,249Income tax expense (406)Income from continuing operations $843Discontinued operations:

Income, net of tax 203Gain on disposal, net of tax 98

Income before extraordinary item andchange in accounting principle $1,144

Extraordinary loss, net of tax -----Cumulative effect of change in accounting

principle, net of tax (118)Net Income $1,026

income from continuing operations sometimes includes gains and losses that occur infrequently— called special or unusual items—but that arise from a firm’s ongoing, continuing operations.Example:Restructuring charges

“Above the line”

“Below the line”

Mythical Corporation

Special Items

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Example: IBM’s Restructuring Charges

-10,000

-5,000

0

5,000

10,000

15,000

20,000

86 88 90 92 94 96 98 2000

Year

Mill

ions

$

Net Income Operating Income Operating Income without unusual and special items

Which of the income numbers better reflect the sustainable level of earnings?

1. Net income2. Operating income3. Operating income without unusual and special items

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-14,000

-12,000

-10,000

-8,000

-6,000

-4,000

-2,000

0

2,000

4,000

86 88 90 92 94 96 98 2000

Year

Mill

ions

$

IBM'sSpecialItems

Was the occurrence of ‘special items’ really infrequent in IBM at the beginnings of the 1990?

Firms have an incentive to separately disclose and clearly label losses as unusual and non-recurring. Why?

If an analyst conjectured that the ‘special items’ are infrequent, how did it bias his earnings projections

IBM Example (cont’d)

2001Net sales $3,957Cost of goods sold (1,364)Gross profit $2,593SG&A (1,093)Special or unusual charges (251)Income from continuing operations

before tax expense $1,249Income tax expense (406)Income from continuing operations $843Discontinued operations:

Income, net of tax 203Gain on disposal, net of tax 98

Income before extraordinary item andchange in accounting principle $1,144

Extraordinary loss, net of tax -----Cumulative effect of change in accounting

principle, net of tax (118)Net Income $1,026

Mythical Corporation •Analyst Tip:  determine whether the “special or unusual items” are sustainable or transitory. If necessary addback losses or subtract gains (multiplied by 1-tax%, for after tax)

Ex. P.2-13

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EBITDA EBITDA: earnings before interest, taxes,

depreciation, and amortization. An estimate of cash available for distribution

to all claimants. Pervasively used in industries that heavily

invest in infrastructure (i.e. with high depreciation). # Telecommunication

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Non-GAAP Earnings Reports GAAP income from continuing operations includes

one-time items that are not indicative of future growth prospects.

Examples: Merger and acquisition transaction costs amortization of goodwill (changed after SFAS 142) Asset write-offs Gain from sale of assets

Reports that correct for that: Companies’ pro-forma earnings Analysts’ adjusted earnings

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Companies’ Pro-Forma Earnings In their earnings press-releases most(1)

companies also provide ‘pro-forma’ earnings that adjust for non-recurring items.

These pro-forma earnings have become the main focus of investors, analysts and companies since the end of 1990s.

(1) At the end of 2001 more than 300 companies in the S&P 500 excluded some ordinary expenses, as defined by GAAP, from the pro-forma earnings numbers they feed to investors and analysts.

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Example 1: JDS Uniphase’s Pro-Forma

Pro forma results for the quarter ended June 30, 2001 exclude the $6,087.7 million reduction of goodwill and purchased intangibles, $11.4 million effect on gross profit related to purchase accounting adjustments of the value of inventory; $1,143.3 million of purchased intangibles amortization and inprocess R&D (IPR&D) charges; $12.5 million refund of payroll taxes on stock option exercises; $562.0 million of realized and unrealized losses on equity investments; $30.4 million of non-cash stock compensation; and $30.6 million in activity related to investments accounted for under the equity method of accounting…

The GAAP net loss for the first 3 quarters of 2001 was $7.889 billions, and for the equivalent period in 2000 net loss was $401.6 million

The following table summarizes JDS Uniphase pro forma results for the quarter:(in millions, except per share amounts)

2001 2000Net sales $601 $641Gross profit $(234) $324Income (loss) from operations $(734) $200Income (loss) before income taxes $(723) $210Net income (loss) $(477) $137

Three months ended June 30, 2001

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Example 2: Marconi’s Pro-Forma RCJ page 249, Exhibit 5.13

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Pro-Forma AdjustmentsProForma GAAP PFADJ PFADJ %

Type Number Units Mean Mean Mean PositiveAll 479 $M $40.60 $12.80 $27.80 88%

Merger and acquisition costs 189 $M $25.20 ($10.40) $35.60 94%Unspecified nonrecurring charges 171 $M $22.20 $2.50 $19.80 86%

In-process R&D 73 $M $74.50 $19.80 $54.70 99%Restructuring charges 67 $M $32.98 $1.70 $31.20 93%Amortization charges 55 $M $45.20 $16.10 $29.10 95%

Gain/losses on asset sales 52 $M $35.00 $13.30 $21.70 48%Compensation charges 49 $M $71.50 $44.20 $27.30 84%

Extraordinary items 41 $M $27.80 ($11.30) $39.10 85%Asset impairments/ write-offs 37 $M $10.90 ($39.60) $50.50 94%

Startup/Closing costs 23 $M $9.40 ($27.80) $37.20 91%Litigation costs 19 $M $20.70 $7.10 $13.60 84%Tax adjustments 18 $M $21.70 $16.90 $4.80 83%

Other 91 $M $39.30 $15.40 $24.00 77%

Descriptive Statistics: Pro Forma Earnings Releases 1997-1999

Source: Lougee and Marquardt (2002), w orking paper New York University

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Pro-Forma Adjustments (cont’d) Most of the adjustment in companies’ pro-forma

reports are income increasing (see above table). Companies strategically use pro-forma to show

their income in a better light. Companies that miss an earnings benchmark are more

likely to report pro-forma earnings (Lougee and Marquardt 2002).

Skeptics argue that pro-forma earnings are nothing than EEBS – Earnings Excluding Bad Stuff.

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Analysts’ Adjusted Earnings Analysts use adjusted earnings measures that

exclude some transitory components included in GAAP earnings.

Such adjusted earnings calculated by First Call and S&P are widely used by investors for valuation and analysis purposes.

The discrepancy between the different earnings measures can be substantial.

Example: at the end of 2001 the average GAAP earnings for the S&P500 firms was $28 a share, while the average ‘operating earnings’ calculated by First Call totaled $45 a share.

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Valuation Under Different Earnings MeasuresDifferent pro-forma earnings provide different perspective on how expensive the market is. Here is the price-to-earnings ratio of the S&P500 at the end of August 2001 based on the pro-forma earnings of:

1. Standard & Poor’s: P/E = 24.22. First Call: P/E = 22.23. GAAP: P/E = 36.8

According to which of the P/E ratios does the market seem more expensive?

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Standards for Analysts’ Adjustments? The very influential Standard & Poor’s

company releases their new standards of pro-forma adjustments in hope to create an industry standard among analysts.

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Non-GAAP Earnings: Take AwayDon’t get confused by non-GAAP income measures: When an earnings number is provided outside the

financial reports, it is important to understand whether it is GAAP earnings, pro-forma earnings or other kind of adjusted earnings measure.

Note which items were excluded from the GAAP number in the calculation of the pro-forma/adjusted number.

Consider the reason for exclusion/inclusion of each item Sophisticated investors can find useful information in

pro-forma/adjusted earnings!

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Accounting ChangesTypes of accounting changes:1. Changes in accounting principle (ex. Straight line to/from accel. Dep’n)2. Changes in accounting estimates (ex. Useful lives of PPE, bad debts %) #1 is Cumulative Effect Accounting Change* (see I/S): DR CR DR CRasset or liability Gain ex. Accumulated dep’n Gainor  DR CR DR CR Loss asset or liability ex. Loss Accumulated dep’n *unless retroactive or cumulative effect indeterminable (e.g, FIFO LIFO) 

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Accounting Changes (cont’d)#2: just go forward with new estimates 

ex. E2-13, 14; P10-14

Asset’s net book value

Time

Change of estimate: extends useful life