Economic concepts of income

• Economic income
• Permanent income
• Operating income

Economic income

• Measures changes in Shareholders wealth.
• Cash flows + Present value of expected future cash flows.
• Useful when the objective of analysis is determining the exact return to the shareholder for the period.
• Less useful for forecasting future earnings potential.
• Based on the concept of accrual accounting
• Main purpose is income measurement
• Two main processes –
• Revenue recognition 
• Expense matching 

Accounting Vs Economic income

Reasons for difference

• Alternative income concepts
• Historical cost
• Transaction basis
• Conservatism
• Earnings management

Fair value accounting

Asset and liability values are determined on the basis of their fair values (typically market prices) on the measurement date (i.e., approximately the date of the financial statements).

Advantages & Disadvantages

Advantages

• Reflects current information.
• Consistent measurement criteria.
• Comparability
• No conservative bias
• More useful for equity analysis

Disadvantages

• Lower objectivity
• Susceptibility to manipulation. Use of Level 3 inputs.
• Lack of conservatism.
• Excessive income volatility.

Implications for Analysis

• Focus on the balance sheet.
• Restating income.
• Analyzing use of inputs.
• Analyzing financial liabilities.

Accounting Analysis

Demand for Accounting Analysis

Adjust for accounting distortions so financial reports better reflect economic reality

Adjust general-purpose financial statements to meet specific analysis objectives of a particular user

Sources of Accounting Distortions

• Accounting Standards – attributed to 

1. political process of standard-setting, 
2. accounting principles and assumptions, and 
3. conservatism

• Estimation Errors – attributed to estimation errors inherent in accrual accounting
• Reliability vs Relevance – attributed to over-emphasis on reliability at the loss of relevance
• Earnings Management – attributed to window-dressing of financial statements by managers to achieve personal benefits

Analysis Objectives

Comparatives Analysis – demand for financial comparisons across companies and/or across time

Income Measurement - demand for (1) equity wealth changes and (2) measure of earning power. These correspond to two alternative income concepts (1) Economic Income (or empirically, economic profit) (2) Permanent Income (or empirically, sustainable profit)

Earnings Management – Frequent Source of Distortion

Earning Management strategies:

Increasing Income – managers adjust accruals to increase reported income 

Big Bath – managers record huge write-offs in one period to relieve other periods of expenses 

Income Smoothing – managers decrease or increase reported income to reduce its volatility

Earnings Management – Motivations

• Contracting Incentives -  managers adjust numbers used in contracts that affect their wealth (e.g., compensation contracts)
• Stock Prices – managers adjust numbers to influence stock prices for personal benefits (e.g., mergers, option or stock offering)
• Other Reasons - managers adjust numbers to impact  

1. labor demands, 
2. management changes, and 
3. societal views

Earnings Management – Mechanics

Incoming Shifting:  Accelerate or delay recognition of revenues or expenses to shift income from one period to another 

Classificatory Earnings Management: Selectively classify revenues Earnings and expenses in certain parts Management of the income statement to affect analysis inferences regarding the recurring nature of these items

Process of Accounting Analysis

Accounting analysis involves several inter-related processes and tasks that can be grouped into two broad areas:

•  Evaluating Earning Quality: Steps

1. Identify and assess key accounting policies
2. Evaluate extent of accounting flexibility 
3. Determine the reporting strategy 
4. Identify and assess red flags

•  Adjusting Financial Statements:

Identify, measure, and make necessary adjustments to financial statements to better serve one’s analysis objectives; 

Auditing And Financial Statement Analysis

Auditing identifies errors and irregularities, which if undetected would materially affect these statements’ fairness of presentation or their conformity with GAAP. 

Types of Audit qualification

• “Except for” Qualification
• Adverse opinion
• Disclaimer of opinion