Income Reporting

1. Income Reporting RCJ Chapters 2(53-73), 5(247-250), 6(282-288)

2. Key Issues • Income statement format • Special item: ex. restructuring charges • Non-GAAP earnings reports • Companies’ pro-forma earnings • Analysts’ operating earnings • Accounting changes Paul Zarowin

3. 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. Paul Zarowin

4. 2001 Net sales $3,957 Cost of goods sold (1,364) Gross profit $2,593 SG&A (1,093) Special or unusual charges (251) Income from continuing operations before tax expense $1,249 Income tax expense (406) Income from continuing operations$843 Discontinued operations: Income, net of tax 203 Gain on disposal, net of tax 98 Income before extraordinary item and change 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” Mythical Corporation Income from continuing operations is intended to capture the sustainable part of income. The items appearing below Income from continuing operations, called the non-recurring items (gains/losses), represent the transitory portion of earnings. RCJ page 54, Exhibit 2.1

5. 2001 Net sales $3,957 Cost of goods sold (1,364) Gross profit $2,593 SG&A (1,093) Special or unusual charges (251) Income from continuing operations before tax expense $1,249 Income tax expense (406) Income from continuing operations$843 Discontinued operations: Income, net of tax 203 Gain on disposal, net of tax 98 Income before extraordinary item and change 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” Mythical Corporation Nonrecurring gains/lossesinclude • discontinued operations • extraordinary losses/gains • cumulative effect of accounting changes Before Tax “Above the line” Tax Expense These items are reported below income from continuing operations net of income tax effects. “Below the line” Net of Tax What are management incentives?

6. Discontinued Operations • Example of restated financial report due to Discontinued Operations: (* assume that the discontinued operation constitutes 10% of the firm) Key point: NI is unchanged, but is allocated between income from continued operations and income from discontinued operations

7. Comprehensive Income NI ± 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). Paul Zarowin

8. Special Items Mythical Corporation 2001 Net sales $3,957 Cost of goods sold (1,364) Gross profit $2,593 SG&A (1,093) Special or unusual charges (251) Income from continuing operations before tax expense $1,249 Income tax expense (406) Income from continuing operations$843 Discontinued operations: Income, net of tax 203 Gain on disposal, net of tax 98 Income before extraordinary item and change 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. “Above the line” “Below the line” Example: Restructuring charges

9. Example: IBM’s Restructuring Charges • Which of the income numbers better reflect the sustainable level of earnings? • Net income • Operating income • Operating income without unusual and special items Paul Zarowin

10. IBM Example (cont’d) • 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 Paul Zarowin

11. Mythical Corporation • Analyst Tip:  determine whether the “special or unusual items” are sustainable or transitory. 2001 Net sales $3,957 Cost of goods sold (1,364) Gross profit $2,593 SG&A (1,093) Special or unusual charges (251) Income from continuing operations before tax expense $1,249 Income tax expense (406) Income from continuing operations$843 Discontinued operations: Income, net of tax 203 Gain on disposal, net of tax 98 Income before extraordinary item and change 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 If necessary addback losses or subtract gains (multiplied by 1-tax%, for after tax) Ex. P.2-13

12. 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 Paul Zarowin

13. 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 Paul Zarowin

14. 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. Paul Zarowin

15. 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

16. Example 2: Marconi’s Pro-Forma • RCJ page 249, Exhibit 5.13 Paul Zarowin

17. Pro-Forma Adjustments

18. 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. Paul Zarowin

19. 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. Paul Zarowin

20. Valuation Under Different Earnings Measures Different 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: • Standard & Poor’s: P/E = 24.2 • First Call: P/E = 22.2 • GAAP: P/E = 36.8 According to which of the P/E ratios does the market seem more expensive? Paul Zarowin

21. 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. Paul Zarowin

22. Non-GAAP Earnings: Take Away Don’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! Paul Zarowin

23. Accounting Changes Types 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): DRCRDRCR asset or liability Gain ex. Accumulated dep’n Gain or  DRCRDRCR Loss asset or liability ex. Loss Accumulated dep’n *unless retroactive or cumulative effect indeterminable (e.g, FIFO  LIFO) Paul Zarowin

24. Accounting Changes (cont’d) #2: just go forward with new estimates ex. E2-13, 14; P10-14 Asset’s net book value Change of estimate: extends useful life Time Paul Zarowin