littlebook 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.


[1]If a cost (such as an administrative cost) cannot be easily linked with a particular revenues, it is usually recognized as an expense in the period in which it is consumed.