Chapter 3
Measuring Performance
Cash versus Accrual

Cash is basically a checking account method
 Cash
in and cash out
 Statement of cash flows
 Less subject to manipulation

Accrual
 Based
on GAAP
 Income Statement
 Lots of discretion
Accrual Accounting
Revenue Recognition
 Expense matching

Accruals

Insurance
 $2,400

for a two-year period ended 12/31/07
What should be recorded:
 01/01/06?
 12/31/06?
 12/31/07?
Form Matters!

Statement of cash flows
 Operating
 Investing
 Financing

Income Statement
 Operating
income
 Special items
Statement of Cash Flows

Cash from operations
 Direct
method
 Indirect method
Preparing Stmt of Cash Flows

Class demonstration
Alternative Measures of Cash Flow

EBITDA

Free Cash Flow
Transitory Income Items & Core
Earnings




Estimation of stock prices entails forecasts of future
earnings and cash flows.
Forecasts are better when we can identify transitory
items in reported earnings and cash flows and can
eliminate those from our forecasts.
Our goal is to identify core earnings and cash flows
of the company.
Core earnings and cash flows have the greatest
persistence or predictive power and are, therefore,
most useful for stock price estimation.
Recognition of Gains on Assets Sales



When assets are purchased they are recorded at their
purchase price. Subsequently, they are carried at their
historical cost, even if they appreciate in value, and
are written down only if they suffer a permanent
decline in value.
When they are sold, the company recognizes a gain
(loss) equal to the difference between their selling
price and the amount at which they are carried on the
balance sheet:
Selling price of asset – Asset carrying amount from
balance sheet = Gain (loss) on sale
Gains (Losses) on Asset Sales


Gain (loss) = sale proceeds – asset book value
Assume that a company sells a machine for
$10,000 that it carries on its balance sheet for
$8,000 (historical cost of $12,000 less
accumulation depreciation of $4,000).
 The
company reports a gain of $2,000 ($10,000$8,000).
 This gain is reported in income from continuing
operations.
Restructuring Charges: Employee
Severance


Employee severance costs represent the accrual of
estimated costs relating to the termination of
employees as a result of a restructuring program.
Asset write-downs: restructuring activities that usually
encompass closure or relocation of manufacturing or
administrative facilities.
 Inventory
 LT Assets
 Goodwill
Transitory Income Items
Discontinued Operations
 Extraordinary Items
 Changes in Accounting Principle

Disclosure and Presentation
Operating revenues and Expenses: usual
and frequent
 Other revenues and expenses: unusual or
infrequent
 Disposal of a segment
 Extraordinary items: unusual and
infrequent
 Changes in accounting principles

Discontinued Operations
Discontinued operations refer to any separately
identifiable business operation that the
company intends to sell.
 Profits (loss) of the discontinued operations
(net of tax), together with the gain (loss) on
sale, of the segment are reported in a separate
section of the income statement below income
from continuing operations.

Best Buy’s
Reporting of Discontinued
Operations
Best Buy’s
Reporting of
Discontinued
Operations
Extraordinary Items



Extraordinary items represent transitory events
that are both unusual and infrequent.
Extraordinary items are segregated from the
rest of the income statement items and
presented separately following income from
continuing operations.
The company makes the determination of
whether an event is unusual and infrequent.
Examples of Extraordinary
Items (Not)
• Write-down or write-off of assets
• Foreign currency gains and losses
• Gains and losses form disposal of specific assets or
segments
business
• Effects of a strike
• Accrual adjustments related to long-term contracts
• Costs of defense against a takeover
• Costs incurred as a result of the September 11, 2001 events.
Change in Accounting Principle

A change in accounting principle results from
adoption of a generally accepted accounting
principle different from the one previously
used for reporting purposes.
Pro Forma Earnings
Earnings per Share (EPS)