Download Income Measurement Concepts: Economic, Permanent, and Accounting Income and more Lecture notes Finance in PDF only on Docsity!
Illustration Facts:
- Company with $100,000 in cash
- Buys condo for $100,
- Rents condo for $12,000 per year
- End of the first year: Condo valued at $125, Illustration Facts:
- Company with $100,000 in cash
- Buys condo for $100,
- Rents condo for $12,000 per year
- End of the first year: Condo valued at $125, Concepts
Illustration Facts:
- Net (free) cash flow = $(88,000)
- Operating cash flow = $12,
- Economic income = $37,
- ($12,000 rental income + $25,000 holding gain)
- Accounting income = $11,500 ($12,000 rental income - $500 depreciation*) *Condo’s useful life is 50 years and its salvage value is $75,000—yearly straight-line depreciation is $ Illustration Facts:
- Net (free) cash flow = $(88,000)
- Operating cash flow = $12,
- Economic income = $37,
- ($12,000 rental income + $25,000 holding gain)
- Accounting income = $11,500 ($12,000 rental income - $500 depreciation*) *Condo’s useful life is 50 years and its salvage value is $75,000—yearly straight-line depreciation is $ Concepts
Economic Income:
- Equals net cash flows + the change in the present value of future cash flows
- Measures change in shareholder value—reflecting the financial effects of all events in a comprehensive manner
- Includes both recurring and nonrecurring components— rendering it less useful for forecasting future earnings potential - Related to Hicksian concept of income—income includes both realized (cash flow) and unrealized (holding gain or loss) components Economic Income:
- Equals net cash flows + the change in the present value of future cash flows
- Measures change in shareholder value—reflecting the financial effects of all events in a comprehensive manner
- Includes both recurring and nonrecurring components— rendering it less useful for forecasting future earnings potential
- Related to Hicksian concept of income—income includes both realized (cash flow) and unrealized (holding gain or loss) components Concepts
Permanent Income*
- Equals stable average income that a company is expected to earn over its life
- Reflects a long-term focus
- Directly proportional to company value
- Often expressed by dividing permanent income by cost of capital Also called sustainable earning power, or sustainable or normalized earnings Permanent Income
- Equals stable average income that a company is expected to earn over its life
- Reflects a long-term focus
- Directly proportional to company value
- Often expressed by dividing permanent income by cost of capital *Also called sustainable earning power, or sustainable or normalized earnings Concepts
Accounting Concept of Income:
- Based on accrual accounting
- Capture aspects of both economic income and permanent income
- Suffers from measurement problems—yields accounting analysis Accounting Concept of Income:
- Based on accrual accounting
- Capture aspects of both economic income and permanent income
- Suffers from measurement problems—yields accounting analysis Concepts
Revenue Recognition and Matching : Revenue recognition Revenues must be (1) realized or realizable, and (2) earned Costs/Expenses matched with recognized revenues Product costs—recognized when product or service sold Period costs--recognized when incurred Revenue Recognition and Matching : Revenue recognition Revenues must be (1) realized or realizable, and (2) earned Costs/Expenses matched with recognized revenues Product costs—recognized when product or service sold Period costs--recognized when incurred Concepts
Accounting Income consists of:
- Permanent Component--the recurring component expected to persist indefinitely
- Transitory Component--the transitory (or non- recurring) component not expected to persist (Note: The concept of economic income includes both permanent and transitory components.)
- Value Irrelevant Component--value irrelevant components have no economic content; they are accounting distortions Accounting Income consists of:
- Permanent Component--the recurring component expected to persist indefinitely
- Transitory Component--the transitory (or non- recurring) component not expected to persist (Note: The concept of economic income includes both permanent and transitory components.)
- Value Irrelevant Component--value irrelevant components have no economic content; they are accounting distortions Concepts
Analysis Implications :
- Adjusting accounting income is important task
- Necessary to specify analysis objectives--e.g., determining economic income or permanent income or sustainable earning power
- Adopt an inclusive approach— including recurring and non-recurring components Analysis Implications :
- Adjusting accounting income is important task
- Necessary to specify analysis objectives--e.g., determining economic income or permanent income or sustainable earning power
- Adopt an inclusive approach— including recurring and non-recurring components Concepts
Sample Income Statement Measurement Amber Corp. and Subsidiaries 2001 Sales $14,314 $12,716 $13, Equity income 51 39 43 Interest income 12 74 15 Cost of goods sold (8,333) (7,567) (8,001) Gross profit $ 6,044 $5,262 $ 5, Expenses: Selling and administrative $(2,964) $(2,478) $(2,396) Research and development (1234) (899) (855) Restructuring charge -- (1016) -- Interest expense (725) (715) (654) Income before taxes $ 1,121 $ 154 $ 1, Income taxes (^) (336) (351) (356) Income from continuing operations (^) $ 785 $ (197) $ 830 Gain from extinguishment of debt 38 -- -- Loss from operating discontinued segment -- 0 (23) Gain from sale of discontinued segment -- -- 66 Net income $ 823 $ (197) $ 873 Foreign currency translation adjustments 82 (54) (31) Unrealized holding gains on available-for-sale securities 24 22 6 Additional minimum pension liability adjustment 0 (4) -- Comprehensive income $ 929 $ (233) $ 848 2000 1999
Revenues and Gains
- Revenues are earned inflows or prospective inflows of cash from operations* - Gains are recognized inflows or prospective inflows of cash from non-operations**
- Revenues are expected to recur **Gains are non-recurring Measurement
Two major income dimensions :
- operating versus non-operating
- recurring versus non-recurring* *Motivated by need to separate permanent and transitory components Alternatives
Operating vs. Non-Operating and Recurring vs. Non-Recurring Alternatives Operating Income Non-Operating Income Recurring Income Non- Recurring Income
Analysis What constitutes the ‘correct’ measure of income for analysis purposes? There is no answer for two reasons:
- Correct measurement depends on analysis objectives
- Alternative accounting income measures result from including or excluding line items —still subject to accounting distortions What constitutes the ‘correct’ measure of income for analysis purposes? There is no answer for two reasons:
- Correct measurement depends on analysis objectives
- Alternative accounting income measures result from including or excluding line items —still subject to accounting distortions
Analysis Operating versus Non-Operating Income Operating income --measure of company income as generated from operating activities Three important aspects of operating income (^) Pertains only to income generated from operations (^) Focuses on income for the company, not simply for equity holders (means financing revenues and expenses are excluded) (^) Pertains only to ongoing business activities (i.e., results from discontinued operations is excluded) Non-operating income --includes all components of net income excluded from operating income Useful to separate non-operating components pertaining to financing and investing Operating versus Non-Operating Income Operating income --measure of company income as generated from operating activities Three important aspects of operating income (^) Pertains only to income generated from operations (^) Focuses on income for the company, not simply for equity holders (means financing revenues and expenses are excluded) (^) Pertains only to ongoing business activities (i.e., results from discontinued operations is excluded) Non-operating income --includes all components of net income excluded from operating income Useful to separate non-operating components pertaining to financing and investing
