Privacy Policy. Industry Profiles. It is up to the analyst to average, smooth, or otherwise adjust reported earnings in accordance with specific analytical purposes. The accounting profession has earnestly tried to promulgate rules that discourage practices such as the smoothing of earnings. However, given the powerful propensities of companies and of their owners and managers to engage in such practices, analysts must realize that, where there is a will to smooth or even distort earnings, ways to do so are available and will be found.
Consequently, particularly in the case of companies where incentives to smooth are more likely to be present, analysts should analyze and scrutinize accounting practices to satisfy themselves regarding the integrity of the income-reporting process.
Managers are almost always concerned with the amount of net results of the company as well as with the manner in which these periodic results are reported. This concern is reinforced by a widespread belief that most investors accept the reported net income figures, as well as the modifying explanations that accompany them, as true indices of performance. Extraordinary gains and losses often become the means by which managers attempt to modify the reported operating results and the means by which they try to explain these results.
Quite often these explanations are subjective and are slanted in a way designed to achieve the impact and impression desired by management.
Nonrecurring Operating Gains or Losses. By "operating" we usually identify items connected with the normal and usual operations of the business. The concept of normal operations is more widely used than understood and is far from clear and well defined. Examples include: 1 foreign operations giving rise to exchange adjustments because of currency fluctuations or devaluations, and 2 an unusually severe decline in market prices requires a large write-down of inventory from cost to market.
The analyst in considering how to treat nonrecurring operating gains and losses would do best to recognize the fact of inherent abnormality in business and treat them as belonging to the results of the period in which they are reported. This category includes items of a non- operating nature that recur with some frequency. Examples include recurring exchange adjustments, gains and losses on sales of fixed assets, interest income, and the rental received from employees who rent company-owned houses.
While items in this category are often classified as "unusual" in published financial statements, the narrow definition of "non-operating" which they involve as well as their recurrent nature are good reasons why the analyst should not exclude them from current results.
Nonrecurring, Non-operating Gains or Losses. Of the three categories, this one possesses the greatest degree of "abnormality. In many cases these events are not unintended or unplanned. However, they can rarely be said to be totally unexpected. Business is ever subject to the risk of sudden adverse events and to random shocks, be they natural or man-made.
In the same manner, business transactions are also subject to unexpected windfalls. Examples in this category include substantial uninsured casualty losses unrelated to normal or expectable operating risks. It can be seen readily that while the above occurrences are, in most cases, of a nonrecurring nature, their relation to the operations of a business varies. All are occurrences in the regular course of business.
Even the assets destroyed by acts of nature were acquired for operating purposes and thus were subject to all possible risks. Of the three categories, this one comes closest to meeting the criterion of being "extraordinary. What looks at the time as unique may, in the light of experience, turn out to be the symptom of a new set of circumstances.
They are, nevertheless, part of the longer term record of results of the company. Thus, they enter the computation of average earnings, and the propensity of the company to incur such gains or losses must be considered in the projection of future average earnings. Whenever there is a gain whether it is recorded as extraordinary or not , there is an increase in resources. Similarly, a loss results in a reduction of resources.
In this sense, an extraordinary gain or loss is not different from a normal or ordinary gain or loss. Once an asset is written off as a result of extraordinary loss, that asset will not be available in the future to generate revenues. Conversely, an extraordinary gain will result in an addition of resources on which a future return can be expected. Therefore, the financial analyst should measure the potential effect of the extraordinary events on future earnings and evaluate the likelihood of the occurrence of events causing extraordinary items.
One implication frequently associated with the reporting of extraordinary gains and losses is that they have not resulted from a "normal" or "planned" activity of management and that, consequently, they should not be used in the evaluation of management performance.
The analyst should seriously question such a conclusion. What is "normal" activity in relation to management's deliberate actions? Whether we talk about the purchase or sale of securities, assets not used in operations, or divisions and subsidiaries that definitely relate to operations, we talk about actions deliberately taken by management with specific purposes in mind. The results of such activities always qualify or enhance the results of "normal" operations, thus yielding the final net results.
Most analysts probably would should disagree with this assertion. Management is entrusted with the control of all assets of an entity in every possible way, including extraordinary events. Their responsibility is not confined to "normal" operations, and we can generally assume that every action taken by the management has some specific purpose in mind, be it "normal operations" or "abnormal operations," to enhance company results. It is extremely rare to see a business event that can be termed completely unexpected or unforeseeable.
When it comes to the assessment of results that really count and those that build or destroy value, the distinction of what is normal and what is not fades.
From a strictly mathematical point of view, the accounting-based equity valuation model is impervious to accounting manipulations under the clean surplus relation. Firms that overstate net income will have higher book values, which will reduce future residual income. Firms with conservatively measured net income will report lower book values, which will increase future residual income.
On the other hand, projections of future profitability are based on current and past financial results. To the extent that accounting manipulations can affect net income forecasts by users, these manipulations will affect firm valuation. The major determinants of the PE ratio are 1 the level of current earnings, 2 trend in future residual income, and 3 risk. As illustrated in a chart in the chapter, the joint values of the PB and PE ratios give important insights into the market's expectations regarding earnings growth and future ROCE.
Forecasting must be differentiated from extrapolation. The latter is based on an assumption of the continuation of an existing trend and involves a mechanical extension of the trend into the uncharted territory of the future. Forecasting, on the other hand, is based on a careful analysis of as many individual components of income and expense as is possible and a considered estimate of future level taking into consideration interrelations among the components as well as probable future conditions.
Thus, forecasting requires as much detail as is possible to obtain. Consequently, the analyst will likely find much information in these analyses to aid in the forecasting process. Moreover, while not requiring it, the SEC encourages the inclusion in these discussions of forward-looking information. The best possible estimate of the average earnings of a company, which can be expected to be sustained and to repeat with some degree of regularity over a span of future years, is referred to as its earning power.
Except in specialized cases, earning power is universally recognized as the single most important factor in the valuation of a company. The importance of earning power in such that most analyses of income and related financial statements have as one of their ultimate objectives the determination of earnings. Earning power is a concept of financial analysis, not of accounting. It focuses on stable and recurring elements and aims to arrive at the best possible estimate of repeatable average earnings over a span of future years.
Accounting, as we have seen, can supply much of the essential information for the computation of earning power. However, the process is one involving knowledge, judgment, experience as well as a specialized investing or lending point of view. We know investors and lenders look ultimately to future cash flows as sources of rewards and safety.
Accrual accounting, which underlies income determination, aims to relate sacrifices and benefits to the periods in which they occur. In spite of its known shortcomings, this framework represents the most reliable and relevant indicator of longer-term future probabilities of average cash inflows and outflows presently known.
Interim financial statements, most frequently issued on a quarterly basis, are designed to fill the reporting gap between the year-end statements. They are used by decision makers as means of updating current results as well as in the prediction of future results. If a year is a relatively short period of time in which to account for results of operations for many analytical purposes, then trying to confine the measurement of results to a three-month period involves all the more problems and imperfections.
Generally, the estimating and adjustment procedures at interim financial statement dates are performed much more crudely than for year-end financial statements. The net result is that the interim reports are less accurate than year-end reports that are audited. The book also covers the various financial statements on company analysis and discounted cash flow valuation models. Sign in.
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