Lecture 4 - Income Reporting and Classification Flashcards
Why can we not know the true value of income?
- PV estimates are subject to substantial error.
2. Markets are incomplete and not fully efficient.
What is the asset/liability way of viewing income?
- Increase in net resources of the enterprise.
- Balance sheet has conceptual primacy
What is the revenue/expense way of viewing income?
- Treat B/S as the way of storing unallocated cost (e.g. depreciation)
- Revenue recognition and matching expenses to revenue
What is permanent income?
Why is it important?
- Income that will persist into the future (be stable)
- Value expected cash flows into the future
In perpetuity
What is the income into perpetuity?
• Estimate persistent income
Share price (valuation) want to reflect the persistent economic value add.
What is operating income?
Why do we use it?
- Before financing costs (interest expense)
- Value the firm before deducting interest expense (if you remove the value of debt (liabilities)) you’re left with simply the value of equity (or income generated by equity)
- I.e. abstracting away from how the firm is leveraged and their capital structure.
What are 3 types of earning events?
- Permanent (or recurring)
- expected to persist indefinitely.
- e.g. operating sales. - Transitory (or non-recurring)
- affecting earnings in current year only.
e. g. income from sale of PPE - Price irrelevant
- no economic content (0 effect on company value)
- e.g. change in accounting policy.
Why do firms present non-GAAP earnings?
- Informative reasons:
a. Statutory includes bias and random error
b. Companies want to demonstrate underlying performance.
i. Signal their true performance. - Opportunistic reasons:
a. Make the company look better
b. Remove permanent losses – make the performance of the company look better than it actually or underlying should be.
EBIT
What is the rational?
Remove interest and tax:
Abstract away from financing activity.
Remove the financing cost and effects of leverage (leverage can change from year to year).
EBITDA
What is the rational?
Add back deprecation and amortisation.
Remove systemic bias and biased measurement error.
(intangibles, and management discretion)
Enhance comparability
- Historic cost account (cost is different)
Remove judgement and opportunity for earnings management.
Why should we deduct depreciation?
- Matching
- Enhance comparability
- (compare the actual resources)
- E.g. labour intensive or capital intensive model
- Creates more error when adding back depreciation. (miss out on capitalised in inventory)
Removal creates it own bias. (against labour intensive)
EBITA
What is the rational?
Removes amortisation
Account for bias against internally generated intangibles.
How to calculate EPS?
Earnings - perference share dividends
divided by
of shares - preference shares - non controlling interest.
Basic vs Diluted
Basic is normal
diluted takes into account the effect of options on diluting the number of shares and their price.
What are the issues with EPS?
- Does not consider the amount of asset or capital required to generate a particular level of earnings.
- E.g. just because a firm has the same level of EPS does not mean that they require the same level of assets to generate these earnings
How does the market use income information?
Assuming efficient market.
Market will only impound the difference tween actual and expected earnings (i.e. the unexpected component).
What were the 3 findings of ball and brown?
o The market is using some degree of economic value added to the underlying value of the firm
o Price lead earnings: The share market evokes the changes prior to the actual announcement
o Post Earnings Drift: At month 0, up to 2 months afterwards, it continues to impound of bad news, indicates that the market is not entirely efficient.
