The
Little Book of Valuation
Measuring Earnings and Profitability
How profitable is a firm? What did it earn on the assets in which it
invested? These are the fundamental questions we would like financial
statements to answer. Accountants use the income statement to provide
information about a firmÕs operating activities over a specific time period. In
terms of our description of the firm, the income statement is designed to
measure the earnings from assets in place.
Accounting Principles Underlying Measurement of Earnings and Profitability
Two
primary principles underlie the measurement of accounting earnings and
profitability. The first is the principle of accrual accounting. In accrual
accounting, the revenue from selling a good or service is recognized in the
period in which the good is sold or the service is performed (in whole or
substantially). A corresponding effort is made on the expense side to match
expenses to revenues.[1]
This is in contrast to cash accounting, wherein revenues are recognized when
payment is received and expenses are recorded when they are paid.
The
second principle is the categorization of expenses into operating, financing,
and capital expenses. Operating expenses are expenses that at least in theory
provide benefits only for the current period; the cost of labor and materials
expended to create products that are sold in the current period is a good
example. Financing expenses are expenses arising from the nonequity
financing used to raise capital for the business; the most common example is
interest expenses. Capital expenses are expected to generate benefits over
multiple periods; for instance, the cost of buying land and buildings is
treated as a capital expense.
Operating expenses
are subtracted from revenues in the current period to arrive at a measure of
operating earnings from the firm. Financing expenses are subtracted from
operating earnings to estimate earnings to equity investors or net income.
Capital expenses are written off over their useful life (in terms of generating
benefits) as depreciation or amortization.
Measuring Accounting Earnings and Profitability
Because
income can be generated from a number of different sources, accounting
principles require that income statements be classified into four sections:
income from continuing operations, income from discontinued operations,
extraordinary gains or losses, and adjustments for changes in accounting
principles.
Accounting
principles require publicly traded companies to use accrual accounting to
record earnings from continuing operations. Although accrual accounting is
straightforward in firms that produce goods and sell them, there are special
cases in which accrual accounting can be complicated by the nature of the
product or service being offered. For instance, firms that enter into long-term
contracts with their customers, for instance, are allowed to recognize revenue
on the basis of the percentage of the contract that is completed. As the
revenue is recognized on a percentage of completion basis,
a corresponding proportion of the expense is also recognized. When there is
considerable uncertainty about the capacity of the buyer of a good or service
to pay for a service, the firm providing the good or service may recognize the
income only when it collects portions of the selling price under the
installment method.
Operating
expenses should reflect only those expenses that create revenues in the current
period. In practice, however, a number of expenses are classified as operating
expenses that do not meet this test. The first is depreciation and
amortization. Although the notion that capital expenditures should be written
off over multiple periods is reasonable, the accounting depreciation that is
computed on the original historical cost often bears little resemblance to the
actual economic depreciation. The second expense is research and development
expenses, which accounting standards in the United States classify as operating
expenses but which clearly provide benefits over multiple periods. The rationale
used for this classification is that the benefits cannot be counted on or
easily quantified. The third is operating lease expenses, which are closer to
being financial than operating expenses.
Much of financial
analysis is built around the expected future earnings of a firm, and many of
these forecasts start with the current earnings. It is therefore important that
we know how much of these earnings come from the ongoing operations of the firm
and how much can be attributed to unusual or extraordinary events that are
unlikely to recur on a regular basis. Nonrecurring items include the following:
1.
Unusual or
infrequent items, such as gains or losses from the divestiture of an asset
or division and write-offs or restructuring costs. Companies sometimes include
such items as part of operating expenses. As an example, in 1997 Boeing took a
write-off of $1,400 million to adjust the value of assets it acquired in its
acquisition of McDonnell Douglas, and it showed this as part of operating
expenses.
2.
Extraordinary
items, which are defined as events that are unusual in nature, infrequent
in occurrence, and material in impact. Examples include the accounting gain
associated with refinancing high-coupon debt with lower-coupon debt and gains
or losses from marketable securities that are held by the firm.
3.
Losses
associated with discontinued operations, which measure both the loss from
the phase-out period and the estimated loss on the sale of the operations. To
qualify, however, the operations have to be separable from the firm.
4.
Gains or
losses associated with accounting changes, which measure earnings changes
created by accounting changes made voluntarily by the firm (such as a change in
inventory valuation and change in reporting period) and accounting changes
mandated by new accounting standards.