Income Reporting
RCJ Chapters 2(53-73), 5(247-250), 6(282-288)
Key Issues

Income statement format



Special item: ex. restructuring charges
Non-GAAP earnings reports

Companies’ pro-forma earnings

Analysts’ operating earnings
Accounting changes
Paul Zarowin
2
Income Statement Format

Purpose of multiple-step income statement:
separate permanent from transitory items.

enables a more accurate prediction of future
earnings and future cash-flows.
Paul Zarowin
3
Mythical Corporation
2001
$3,957
(1,364)
$2,593
(1,093)
(251)
Net sales
Cost of goods sold
Gross profit
SG&A
Special or unusual charges
Income from continuing operations
“Above $1,249
before tax expense
the line” (406)
Income tax expense
Income from continuing operations
$843
Discontinued operations:
“Below
Income, net of tax
203
the
line”
Gain on disposal, net of tax
98
Income before extraordinary item and
change in accounting principle
$1,144
Extraordinary loss, net of tax
----Cumulative effect of change in accounting
principle, net of tax
(118)
Net Income
$1,026
RCJ page 54, Exhibit 2.1
Income from continuing
operations is intended
to capture the
sustainable part of
income.
The items appearing
below Income from
continuing operations,
called the non-recurring
items (gains/losses),
represent the transitory
portion of earnings.
Mythical Corporation
2001
$3,957
(1,364)
$2,593
(1,093)
(251)
Net sales
Cost of goods sold
Gross profit
SG&A
Special or unusual charges
Income from continuing operations
“Above $1,249
before tax expense
the line” (406)
Income tax expense
Income from continuing operations
$843
Discontinued operations:
“Below
Income, net of tax
203
the
line”
Gain on disposal, net of tax
98
Income before extraordinary item and
change in accounting principle
$1,144
Extraordinary loss, net of tax
----Cumulative effect of change in accounting
principle, net of tax
(118)
Net Income
$1,026
Nonrecurring
gains/losses
include

Before
Tax


Tax
Expense
Net of
Tax
discontinued
operations
extraordinary
losses/gains
cumulative effect of
accounting changes
These items are
reported below
income from
continuing
operations net of
income tax effects.
What are management incentives?
Discontinued Operations

Example of restated financial report due to Discontinued
Operations: (* assume that the discontinued operation
constitutes 10% of the firm)
Restated
Original
Revenue
(CGS)
90
54
100
60
GM
(SGA)
36
9
40
10
Income before tax
Tax exp. 40%
27
10.8
30
12
Inc from Cont. Op.
Inc from Disc. Op.
16.2
1.8*
18
-
18
18
NI
Key point: NI is unchanged, but is allocated between income from
continued operations and income from discontinued operations
6
Comprehensive Income
NI ± certain unrecognized gains/losses:




unrealized gains (losses) on “available-for-sale”
marketable securities,
foreign currency translation gains (losses)
unrealized losses resulting from minimum pension
obligations
These are open transactions - balance sheet
carrying amounts are changed even though
the transaction is not yet closed (i.e. asset is
not yet sold).
Paul Zarowin
7
Special Items
Mythical Corporation
2001
$3,957
(1,364)
$2,593
(1,093)
(251)
Net sales
Cost of goods sold
Gross profit
SG&A
Special or unusual charges
Income from continuing operations
“Above $1,249
before tax expense
the line” (406)
Income tax expense
Income from continuing operations
$843
Discontinued operations:
“Below
Income, net of tax
203
the
line”
Gain on disposal, net of tax
98
Income before extraordinary item and
change in accounting principle
$1,144
Extraordinary loss, net of tax
----Cumulative effect of change in accounting
principle, net of tax
(118)
Net Income
$1,026
income from continuing
operations sometimes
includes gains and
losses that occur
infrequently— called
special or unusual
items—but that arise
from a firm’s ongoing,
continuing operations.
Example:
Restructuring charges
8
Example: IBM’s Restructuring Charges
20,000
Millions $
15,000
10,000
5,000
0
86
88
90
92
94
96
98
2000
-5,000
-10,000
Year
Net Income
Operating Income
Operating Income without unusual and special items
Which of the income numbers better reflect the sustainable level of earnings?
1. Net income
2. Operating income
3. Operating income without unusual and special items
Paul Zarowin
9
IBM Example (cont’d)
4,000
2,000
Millions $
0
-2,000
86
88
90
92
94
96
98
2000
-4,000
IBM's
Special
Items
-6,000
-8,000
-10,000
-12,000
-14,000
Year



Was the occurrence of ‘special items’ really infrequent in IBM at
the beginnings of the 1990?
Firms have an incentive to separately disclose and clearly label
losses as unusual and non-recurring. Why?
If an analyst conjectured that the ‘special items’ are infrequent,
how did it bias his earnings projections
Paul Zarowin
10
Mythical Corporation
Net sales
Cost of goods sold
Gross profit
SG&A
Special or unusual charges
Income from continuing operations
before tax expense
Income tax expense
Income from continuing operations
Discontinued operations:
Income, net of tax
Gain on disposal, net of tax
Income before extraordinary item and
change in accounting principle
Extraordinary loss, net of tax
2001
$3,957
(1,364)
$2,593
(1,093)
(251)
$1,249
(406)
$843
203
98
$1,144
-----
Cumulative effect of change in accounting
principle, net of tax
(118)
Net Income
$1,026
Ex. P.2-13
•Analyst Tip:
determine whether the
“special or unusual
items” are sustainable
or transitory.
If necessary addback
losses or subtract
gains (multiplied by
1-tax%, for after tax)
EBITDA



EBITDA: earnings before interest, taxes,
depreciation, and amortization.
An estimate of cash available for distribution to all
claimants.
Pervasively used in industries that heavily invest in
infrastructure (i.e. with high depreciation).

# Telecommunication
Paul Zarowin
12
Non-GAAP Earnings Reports

GAAP income from continuing operations includes
one-time items that are not indicative of future
growth prospects.


Examples:
 Merger and acquisition transaction costs
 amortization of goodwill (changed after SFAS 142)
 Asset write-offs
 Gain from sale of assets
Reports that correct for that:
 Companies’ pro-forma earnings
 Analysts’ adjusted earnings
Paul Zarowin
13
Companies’ Pro-Forma Earnings


In their earnings press-releases most(1) companies also
provide ‘pro-forma’ earnings that adjust for nonrecurring items.
These pro-forma earnings have become the main focus
of investors, analysts and companies since the end of
1990s.
(1) At the end of 2001 more than 300 companies in the S&P 500
excluded some ordinary expenses, as defined by GAAP, from the
pro-forma earnings numbers they feed to investors and analysts.
Paul Zarowin
14
Example 1: JDS Uniphase’s Pro-Forma
The following table summarizes JDS Uniphase pro forma results for the quarter:
(in millions, except per share amounts)
Three months ended June 30, 2001
2001
2000
Net sales
$601
$641
Gross profit
$(234)
$324
Income (loss) from operations
$(734)
$200
Income (loss) before income taxes
$(723)
$210
Net income (loss)
$(477)
$137
Pro forma results for the quarter ended June 30, 2001 exclude the $6,087.7 million
reduction of goodwill and purchased intangibles, $11.4 million effect on gross profit
related to purchase accounting adjustments of the value of inventory; $1,143.3 million of
purchased intangibles amortization and inprocess R&D (IPR&D) charges; $12.5 million
refund of payroll taxes on stock option exercises; $562.0 million of realized and unrealized
losses on equity investments; $30.4 million of non-cash stock compensation; and $30.6
million in activity related to investments accounted for under the equity method of
accounting…
The GAAP net loss for the first 3 quarters of 2001 was $7.889 billions, and
for the equivalent period in 2000 net loss was $401.6 million
15
Example 2: Marconi’s Pro-Forma
 RCJ page 249, Exhibit 5.13
Paul Zarowin
16
Pro-Forma Adjustments
Descriptive Statistics: Pro Forma Earnings Releases 1997-1999
Type
Number
All
479
Merger and acquisition costs
189
Unspecified nonrecurring charges
171
In-process R&D
73
Restructuring charges
67
Amortization charges
55
Gain/losses on asset sales
52
Compensation charges
49
Extraordinary items
41
Asset impairments/ write-offs
37
Startup/Closing costs
23
Litigation costs
19
Tax adjustments
18
Other
91
Units
$M
$M
$M
$M
$M
$M
$M
$M
$M
$M
$M
$M
$M
$M
ProForma
Mean
$40.60
$25.20
$22.20
$74.50
$32.98
$45.20
$35.00
$71.50
$27.80
$10.90
$9.40
$20.70
$21.70
$39.30
GAAP
Mean
$12.80
($10.40)
$2.50
$19.80
$1.70
$16.10
$13.30
$44.20
($11.30)
($39.60)
($27.80)
$7.10
$16.90
$15.40
Source: Lougee and Marquardt (2002), w orking paper New York University
PFADJ PFADJ %
Mean Positive
$27.80
88%
$35.60
94%
$19.80
86%
$54.70
99%
$31.20
93%
$29.10
95%
$21.70
48%
$27.30
84%
$39.10
85%
$50.50
94%
$37.20
91%
$13.60
84%
$4.80
83%
$24.00
77%
17
Pro-Forma Adjustments (cont’d)


Most of the adjustment in companies’ pro-forma
reports are income increasing (see above table).
Companies strategically use pro-forma to show their
income in a better light.


Companies that miss an earnings benchmark are more likely
to report pro-forma earnings (Lougee and Marquardt 2002).
Skeptics argue that pro-forma earnings are nothing
than EEBS – Earnings Excluding Bad Stuff.
Paul Zarowin
18
Analysts’ Adjusted Earnings



Analysts use adjusted earnings measures that
exclude some transitory components included in
GAAP earnings.
Such adjusted earnings calculated by First Call and
S&P are widely used by investors for valuation and
analysis purposes.
The discrepancy between the different earnings
measures can be substantial.

Example: at the end of 2001 the average GAAP earnings for
the S&P500 firms was $28 a share, while the average
‘operating earnings’ calculated by First Call totaled $45 a
share.
Paul Zarowin
19
Valuation Under Different Earnings Measures
Different pro-forma earnings provide different perspective
on how expensive the market is. Here is the price-toearnings ratio of the S&P500 at the end of August 2001
based on the pro-forma earnings of:
1. Standard & Poor’s: P/E = 24.2
2. First Call:
P/E = 22.2
3. GAAP:
P/E = 36.8
According to which of the P/E ratios does the market
seem more expensive?
Paul Zarowin
20
Standards for Analysts’ Adjustments?

The very influential Standard & Poor’s company
releases their new standards of pro-forma
adjustments in hope to create an industry standard
among analysts.
Paul Zarowin
21
Non-GAAP Earnings: Take Away
Don’t get confused by non-GAAP income measures:
 When an earnings number is provided outside the
financial reports, it is important to understand whether
it is GAAP earnings, pro-forma earnings or other kind of
adjusted earnings measure.
 Note which items were excluded from the GAAP number
in the calculation of the pro-forma/adjusted number.
 Consider the reason for exclusion/inclusion of each item
 Sophisticated investors can find useful information in
pro-forma/adjusted earnings!
Paul Zarowin
22
Accounting Changes
Types of accounting changes:
1. Changes in accounting principle (ex. Straight line to/from accel. Dep’n)
2. Changes in accounting estimates (ex. Useful lives of PPE, bad debts %)
#1 is Cumulative Effect Accounting Change* (see I/S):
DR
CR
DR
CR
asset or liability
Gain
ex. Accumulated dep’n
Gain
or
DR
CR
DR
CR
Loss
asset or liability ex.
Loss
Accumulated dep’n
*unless retroactive or cumulative effect indeterminable (e.g, FIFO  LIFO)
Paul Zarowin
23
Accounting Changes (cont’d)
#2: just go forward with new estimates
Asset’s
net book
value
Change of estimate:
extends useful life
Time
ex. E2-13, 14; P10-14
Paul Zarowin
24