Financial Education

Management may use discretion when selecting and applying accounting methods. This discretion reflects the fact that the economic impact of a given transaction will vary across firms as a function of their fundamental business characteristics. For example, companies that operate in distinct industries may use a specific machine, such as a generator, for two entirely different purposes. Additionally, firms within the same industry may use and wear out the same generator at dramatically different rates. Accordingly, it is appropriate to permit alternative depreciation methods and depreciable lives to reflect these inherent differences.

However, with this discretion comes the possibility for both honest mistakes (a poor estimation of product returns, for example) and intentional earnings manipulation (changing the estimate in order to “make the number.”) Therefore, the investor should separately assess the quality of the reported financial results.

Earnings quality is in the eye of the beholder. It has variously been defined as :

• Earnings that reflect underlying economic effects.
• Earnings that are better estimates of cash flows.
• Earnings that are more conservative (lower).
• Earnings that are predictable.

These definitions are often in conflict. Consider accelerated depreciation methods. They reduce earnings in the early years (are more conservative) but increase earnings in future years (at which point they are less conservative.) Straight line depreciation will more closely reflect cash flows and will be more predictable, but accelerated methods are probably more reflective of the underlying economic effects.

Many of these potential impacts on the income statement were discussed above in the context of the line item they affect. Analysts can estimate the effect of changing discretionary options by adjusting the reported financial statements.

Comprehensive income therefore includes sales and expenses incurred in the course of business appearing on the income statement, as well as many items that bypass the income statement such as gains and losses from currency translation (see Chapter 9) and changes in the value of certain securities. Comprehensive income reflects the change in the magnitude of the owners’ claim on the corporation resulting from all activities other than transactions with its shareholders, such as share issuance or repurchase, or dividend distributions. The term “other comprehensive income” refers to all of those items of comprehensive income that are not included on the income statement.

Companies that have other comprehensive income are required to disclose its composition in either the income statement, as part of the statement of changes in equity, or as a separate statement of comprehensive income.

Net income provides information on the overall profitability of a company. Since most investors are not interested in buying the entire company, just a piece of it, it is useful for the company to present its earnings on a per share basis. An investor who owns 100 shares can then easily determine his or her share of earnings. While computing earnings per share would seem to be an easy task, there is more to it than meets the eye. For example, the number of shares outstanding can vary throughout the year as the company issues new shares or repurchases shares. Further, companies often issue stock options or other securities (for example, bonds) that are convertible into common stock. As a result, companies are required to report earnings per share on a basic and diluted basis under both U.S. standards and IAS.

To compute basic earnings per share one divides the company’s net income by the weighted average number of common (U.S.) or ordinary (IAS) shares outstanding – that is, shares currently held by investors. The weighted average shares outstanding are computed by looking at the number of shares outstanding each day weighted by the number of days. For example, assume a company has 1,000 shares outstanding at the beginning of the year, January 1, and issues 500 additional shares on April 1. The weighted average number of shares outstanding is 1,377 (1,000 X 90/365 + 1,500 X 275/365). If you owned 100 shares at the beginning as well as at the end of the year, the resulting earnings per share is not necessarily your share of earnings for the past year but is an approximation based on the average number of shares outstanding. This measure also does not consider the potential impact of other securities that are convertible into common (or ordinary) shares.

Companies that have both stock and other securities, which can be converted into common stock, outstanding are considered to have a complex capital structure. Converting these other securities into shares would dilute (reduce) the percentage held by current shareholders. For example, investor A holds 100 shares of a company with 1,000 shares outstanding, which represents a 10% ownership interest. This same company has issued stock options for 250 shares to employees. If these options were exercised, investor A would then hold 100 shares out of 1,250, or an 8% interest. This represents a substantial dilution of investor A’s interest. Of course, if the employees were required to pay for their shares, the company would have more cash. Analysis of the company’s financial statements and notes would reveal the magnitude of potential dilution to the prospective investor.

Diluted earnings per share is computed by estimating the impact of potentially dilutive securities after determining how many shares would be outstanding if they were exercised. The resulting number therefore does not reflect a true historical number. Instead, it provides an estimate of the dilutive impact of these securities should they be exercised in the future.

Accounting standards generally require that a company choose and apply its methods consistently from year to year. Occasionally, new accounting standards or other circumstances (for example, a change in business processes such as the handling of inventory) necessitate that a company change its accounting policies. These changes are permitted and sometimes required. However, the effects of any such change must be disclosed to enable the reader to evaluate the impact on the financial statements.

Under U.S. GAAP, the cumulative effect of the change to the new accounting method as of the beginning of the current fiscal year is shown at the bottom of the income statement for that period, net of related income taxes. The new method is used in determining earnings for the current period. This does result in some incomparability for the current period.

AT&T reported a net gain from the cumulative effect of accounting changes in 2003. Its footnote explains:

2003 includes cumulative effect of accounting changes of $2,541: a $3,677 benefit related to the adoption of Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (FAS 143); and a $1,136 charge related to the January 1, 2003 change in the method in which we recognize revenues and expenses related to publishing directories from the “issue basis” method to the “amortization” method.

In years past, AT&T would recognize all of the revenue and expenses associated with directory publications at the time of publication. However, it changed its accounting practice to reflect the fact that the directories are used for a period of time. It now amortizes both the revenue and the expense over the expected time the directory will be in use.

The analyst can also evaluate the impact on prior earnings by examining the cumulative impact of the change. In the case of AT&T, the after-tax cumulative impact on net income was $2.5 billion. Net earnings for previous years would have been $2.5 billion higher on a cumulative basis if the new standards had always been used.

Occasionally, a company will encounter an item that is so extraordinary that it merits special display on the income statement. Under IAS 8, extraordinary items are:

Income or expenses that arise from events or transactions that are clearly distinct from the ordinary activities of the enterprise and therefore are not expected to recur frequently or regularly.

Companies must consider their particular facts and circumstances to determine whether an item is extraordinary, as an item could be extraordinary for some companies but not others. IAS 8 notes that events such as the expropriation of assets or natural disasters such as earthquakes would normally qualify as extraordinary items for most companies. However, an earthquake might be extraordinary for a company whose factory is destroyed but not for the property and casualty insurance company that insured the loss.

Under U.S. GAAP, Accounting Principles Board (APB) 30 provides that:

Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Thus, both of the following criteria should be met to classify an event or transaction as an extraordinary item:

a. Unusual nature—the underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates.
b. Infrequency of occurrence—the underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates.

AT&T’s footnote disclosure states that (amounts in millions):

2003 includes an extraordinary loss on our real estate leases related to the adoption of Financial Accounting Standards Board (FASB) Interpretation No. 46 “Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51” (FIN 46).

Certain items are excluded from the definition of an extraordinary item, such as strikes, write-downs of assets including inventory, sales or other dispositions of assets, and litigation settlements. If companies were given too much latitude in classifying items as extraordinary, they might be tempted to report all losses as extraordinary items and all gains as continuing operations. Similar to the impact of discontinued operations, the separate disclosure of extraordinary items enables investors to evaluate continuing operations and the extraordinary item individually.

Both U.S. and international standards provide that if an item does not meet the definition of extraordinary but is of sufficient magnitude or nature that its disclosure would be relevant to financial statement users, such items should be disclosed separately on the face of the financial statements or footnotes. Such items are commonly referred to as unusual items.

Discontinued operations occur when a company disposes of, or plans to dispose of, a relatively large component of its business, such as an operating unit or geographical segment. Including these segments with continuing operations would mislead investors about the sustainability of earnings.

IAS 35, Discontinuing Operations, is similar to the requirement under U.S. GAAP. Both require extensive disclosures once a company has entered into an agreement to sell a segment or the board of directors has approved and announced the planned discontinuance. This could entail a sale, disposal, or phasing out of a major business segment, but the elimination of individual products, services, or locations does not qualify. For example, a company that operates restaurants and manufactures golf clubs decides to sell the golf club operations and close several restaurants in its largest territory. Only the sale of the golf club business would be considered a discontinued operation.

Under IAS 35, the following activities would generally not be classified as discontinued operations:

• Gradual or evolutionary phasing out of a product line or class of service.
• Discontinuance, even if relatively abruptly, of several products within an ongoing line of business.
• Shifting of some production or marketing activities for a particular line of business from one location to another.
• Closing of a facility to achieve productivity improvements or other cost savings.
• Selling a subsidiary whose activities are similar to those of the parent or other subsidiaries.

The IAS regulation requires that the revenue, expenses, pretax income, and related income taxes of the discontinued operations be displayed separately on the face of the income statement. This can be shown in a separate column or section of the income statement. U.S. standards require presentation at the bottom of the income statement on a net of tax basis with related footnote disclosures.

When a company has majority-owned subsidiaries in which it owns less than 100% the full amount of the subsidiaries’ revenues and expenses are presented on the income statement. The minority interest represents the portion of the subsidiaries’ net income to which someone other than the parent company is entitled.

When a company owns part but not all of another company, there are different ways to account for the investment. In the case of a significant ownership, but not enough to justify considering the investee a subsidiary, the company will report a separate line – equity in income of affiliates – representing the proportionate share of the investee’s profits. The revenue, expenses, assets and liabilities of the investee will not appear on the investor’s financial statements.