A.

Income, Cash Flows and Assets: Definitions and Relationships

 The interrelationship among income, cash flow and assets is captured by the concept of
economic earnings = net cash flow + ∆ market value of firm's net assets

 However, future cash flow and interest rates are uncertain in the real world, and the
interrelationships are no as neat. Therefore, market price of assets are also uncertain, available
price may be difficult to relate to the present value of generally unknown, estimated future cash
flow, discounted at estimated interest rates. These estimates of future cash flows and interest
rates and their interrelationships depend on the expectations of different decision makers.
Moreover, the market value of an assets may be measured in various ways. In this world of
uncertainty, income (however measured) is, at best, only a proxy for economic income. Thus,
economists, analysts and other have developed a number of analytic and practical definition of
earning to serve as proxies of economic earnings.

Distributable earning are defined as the amount of earning that can be paid out as dividends
without changing the value of the firm. A related measure, sustainable income, refers to the
level of income that can be maintained in the future given the firm’s stock of capital
investement. Permanent earning, is used by analysts for valuation purposes. It is the amount
that can be normally earned given the firm’s assets and equal the market value of those assets
times the firm’s required rate of return. Accounting income is measured using the accrual
concept and provides information about the ability of the enterprise to generate future cash
flow.

B. The Accrual Concept of Income

 Accounting income represents a selective recognition of both current period actual cash flows
and changes in assets values. Reported income under the accrual concept provides a measure of
current operating performance “ not solely based on actual current period cash flows. Cash
inflows and outflows are recognized in income in the “appropriate” accounting periods, that is,
as goods and services are provided and used rather than as cash is collected and expenditures
incurred. The selected period “best” indicates the firm’s present and continuing ability to
generate future cash flows

 The accrual concept of accounting income assumes that forecast of future cash flows require
more than historical cash flow data; information about enterprise earning based on accrual
accounting generally provides a better indication of an enterprise’s present and continuing
ability to generate cash flow than information limited to the financial effects of cash receipts
and payment.

 Under accrual accounting, both the recognition and measurement of certain assets and
liabilities are results of the application of the accrual concept of income. The differentces
 between the income recognized and actual cash flow for period are accrued as assets or
liabilities.

Changes in market values of assets and liabilities may occur over a number of period. However,
they are either recognized in income in the period of disposal or when certain impairment
criteria are met. The result is current period income that may be distorted and may not be
indicative of normal earning power. As an initial step, one needs to understand the components
that make up the income statement.

1. Income Statement

 IAS 1:

 By Function

 Expenses based on their nature

 The excess revenues over costs and expenses = operating income from continuing operations

 Discontinued operations are segregated and reported net of income tax  not contribute to
future revenues and income

 Recurring income (pretax or post tax) form continuing operations should be the primary focus
of analysis

 Fairfield et. al (1996) found extraordinary items and discontinued operations were not useful in
predicting bottom-line ROE

2. Accounting Income: Revenue and Expense Recognition

 Issues must be addressed in recognition:

 Timing

There are two conditions that must be met for revenue recognition to take place. These
conditions are

a. Completion of the earning process

The firm must have provided all or virtually all the good or service for which it is to
be paid, and it must be posibble to measure the total expected cost of providing the
goods or services, that is, the seller must have no remaining significant contingent
obligation. If the seller is obligated to provide future services, but cannot estimate
the cost of doing so,, this condition is not statisfied.
b. Assurance of payment
The quantification of cash or assets expected to be received for the good or services
provided. Reliable measurement encompasses the realizability of proceeds of sale. If
 the seller cannot reasonably estimate the probability of nonpayment, realization is
not reasonably assured, and the second condition is not satisfied.

 Measurement

Revenue, measured as the amount expected to be collected, can be recognized when

good or service have been provided and their cost can be reliably determined.

The amount of revenue recognized at any given point in time is measured as

Good and service provided to date x total expected revenue

Total good and service to be provided

This equation measures the amount of revenue recognized cumulatively to date.

Revenue reported for the current period is the cumulative total less revenue recognized
in prior periods.

 In percentage of completion method recognizes revenues and costs in proportion to and as

work is completed

 It reports income earlier and is better indicator of trends in earning power

 Amounts billed to customers are recorded as liability (advance billings) and asset (accounts
receivable)

 Revenues should not be recognized at the time of sale or delivery when there is no reasonable
basis to estimate collectability of the sale proceeds. The installment method recognizes good
profit in proportion to cash collection, resulting in delayed recognition of revenues and expenses
as compared with full recognition at the time of sale.

 Cost Recovery Method . revenue recognition on sale or delivery is also precluded when the cost
to provide good or services cannot be reasonably determined, example, in the development or
raw land. In many cases, there is also substantial uncertainty about reveue realization since only
small downpayment may be required with nonrecourse financial provided by the seller. With
both future costs and collection uncertain, the cost recovery method requires that all cash
receipts be first accounted for as a recovery of cost. Only after all cost are recovered can profit
be recognized under this method.

 Issues in Revenue and Expense Recognition

 Revenue recognition: sales incentives, barter arrangements, recording license fees,

recording revenues, agents, contract, shipping and handling cost
  Expense recognition: deferral marketing expense, accrual deferral cost, bad debt
expense, warranty expense

 Classification: operating cost or COGS

 Software Revenue Recognition

 Persuasive evidence of an arrangement

 Delivery

 A fixed of determinable fee

 Assurance of collectability

 Other issues: broadcasting industry, mortgage issuers

C. Nonrecurring Items

When estimating a firm’s earning power, analysts should exclude items that are unusual or nonrecurring
in nature. However, this doesn’t mean that everything management labels nonrecurring should ignored.

a. Unusual or infrequent items (unusual in nature)

b. Extraordinary items (infrequent in occurrence and material in amount)

c. Discontinued operations

 Inadequate or uncertain markets or prospects

 Has an unsatisfactory contribution

 No longer considered by management

 Can be sold at significant profit

d. Accounting Changes

Accounting changes fall into two general categories; those undertaken voluntarily by the firm
and those mandated by new accounting standards. Generally, accounting change do not have
direct cash flow consequences. A change form incorrect to an acceptable accounting method is
treated as an error and its impact is reported as a prior period adjustment.

- Item requiring separate disclosure on the income statement may be discretionary with respect
to:

 Timing of the occurrence

 Classification of the item

- The discretionary nature of income recognition permits an examination of the degree of the
management manipulation of earning:

 Classification of good news/bad news

 Income smoothing

 Classificatory smoothing

 Big-Bath accounting

 Accounting changes

D. The Balance Sheet

 The current-non current distinction can be used to measure liquidity

 Contra account, a deduction from main account

 Adjunct account, changes in accumulated

 Balance sheet reports a firm's earning-generating ability

 Economic resources to provide future benefits

 Proper evaluation of a firm’s profitability

 Limitation of the Balance Sheet

 Selective reporting, off-balance sheet

 Measurement, at historical cost or market value

 Delayed recognition, permit to delay recognition

E. Statement of Stockholders’ Equity

 The statement must also report changes in comprehensive income:

 Minimum liability recognized for underfunded pension plans

 Market values of noncurrent investment

 Unrealized gains and losses on cash flow hedges

 Cumulative effect of exchange rate changes

 Unearned shares issued to employee stock ownership plans