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6CHAPTERAnalyzingOperatingActivitiesMcGraw-Hill/Irwin©2004TheMcGraw-HillCompanies,Inc.,AllRightsReserved.IllustrationFacts:•Companywith$100,000incash•Buyscondofor$100,000•Rentscondofor$12,000peryear•Endofthefirstyear:Condovaluedat$125,000IncomeMeasurementConceptsIllustrationFacts:•Net(free)cashflow=$(88,000)•Operatingcashflow=$12,000•Economicincome=$37,000•($12,000rentalincome+$25,000holdinggain)•Accountingincome=$11,500($12,000rentalincome-$500depreciation*)*Condo’susefullifeis50yearsanditssalvagevalueis$75,000—yearlystraight-linedepreciationis$500IncomeMeasurementConceptsEconomicIncome:Twomeasuresreflecttheeconomicconcept•economicincome•permanentincomeIncomeMeasurementConceptsEconomicIncome:•Equalsnetcashflows+thechangeinthepresentvalueoffuturecashflows•Measureschangeinshareholdervalue—reflectingthefinancialeffectsofalleventsinacomprehensivemanner•Includesbothrecurringandnonrecurringcomponents—renderingitlessusefulforforecastingfutureearningspotential•RelatedtoHicksianconceptofincome—incomeincludesbothrealized(cashflow)andunrealized(holdinggainorloss)componentsIncomeMeasurementConceptsPermanentIncome*•Equalsstableaverageincomethatacompanyisexpectedtoearnoveritslife•Reflectsalong-termfocus•Directlyproportionaltocompanyvalue•Oftenexpressedbydividingpermanentincomebycostofcapital*Alsocalledsustainableearningpower,orsustainableornormalizedearningsIncomeMeasurementConceptsEconomicIncomeandPermanentIncomeIncomeMeasurementConcepts012313579111315171921232527293133353739414345474951Years$MillionPermanentIncomeEconomicIncomeAccountingConceptofIncome:•Basedonaccrualaccounting•Captureaspectsofbotheconomicincomeandpermanentincome•Suffersfrommeasurementproblems—yieldsaccountinganalysisIncomeMeasurementConceptsRevenueRecognitionandMatching:RevenuerecognitionRevenuesmustbe(1)realizedorrealizable,and(2)earnedCosts/ExpensesmatchedwithrecognizedrevenuesProductcosts—recognizedwhenproductorservicesoldPeriodcosts--recognizedwhenincurredIncomeMeasurementConceptsEconomicIncomevs.AccountingIncome:EconomicIncomeandAccountingIncomereflectsimilarconceptsBUT:Accountingincomeisaproductofthefinancialreportingenvironment—accountingstandards,enforcementmechanisms,managers’incentives,etc.HENCE:Accountingincomecandivergefromeconomicincome(yieldingaccountingdistortions)IncomeMeasurementConceptsAccountingIncomeconsistsof:•PermanentComponent--therecurringcomponentexpectedtopersistindefinitely•TransitoryComponent--thetransitory(ornon-recurring)componentnotexpectedtopersist(Note:Theconceptofeconomicincomeincludesbothpermanentandtransitorycomponents.)•ValueIrrelevantComponent--valueirrelevantcomponentshavenoeconomiccontent;theyareaccountingdistortionsIncomeMeasurementConceptsAnalysisImplications:•Adjustingaccountingincomeisimportanttask•Necessarytospecifyanalysisobjectives--e.g.,determiningeconomicincomeorpermanentincomeorsustainableearningpower•Adoptaninclusiveapproach—includingrecurringandnon-recurringcomponentsIncomeMeasurementConceptsIncomeMeasurementMeasurementTwomaincomponentsofaccountingincome:Revenues(gains)Expenses(losses)SampleIncomeStatementIncomeMeasurementMeasurementAmberCorp.andSubsidiaries2001Sales$14,314$12,716$13,033Equityincome513943Interestincome127415Costofgoodssold(8,333)(7,567)(8,001)Grossprofit$6,044$5,262$5,090Expenses:Sellingandadministrative$(2,964)$(2,478)$(2,396)Researchanddevelopment(1234)(899)(855)Restructuringcharge--(1016)--Interestexpense(725)(715)(654)Incomebeforetaxes$1,121$154$1,185Incometaxes(336)(351)(356)Incomefromcontinuingoperations$785$(197)$830Gainfromextinguishmentofdebt38----Lossfromoperatingdiscontinuedsegment--0(23)Gainfromsaleofdiscontinuedsegment----66Netincome$823$(197)$873Foreigncurrencytranslationadjustments82(54)(31)Unrealizedholdinggainsonavailable-for-salesecurities24226Additionalminimumpensionliabilityadjustment0(4)--Comprehensiveincome$929$(233)$84820001999RevenuesandGains•Revenuesareearnedinflowsorprospectiveinflowsofcashfromoperations*•Gainsarerecognizedinflowsorprospectiveinflowsofcashfromnon-operations***Revenuesareexpectedtorecur**Gainsarenon-recurringIncomeMeasurementMeasurementExpensesandLosses•Expensesareincurredoutflows,prospectiveoutflows,orallocationsofpastoutflowsofcashfromoperations•Lossesaredecreasesinacompany’snetassetsarisingfromnon-operationsExpensesandlossesareresourceconsumed,spent,orlostinpursuingrevenuesandgainsIncomeMeasurementMeasurementTwomajorincomedimensions:1.operatingversusnon-operating2.recurringversusnon-recurring**MotivatedbyneedtoseparatepermanentandtransitorycomponentsIncomeMeasurementAlternativesOperatingvs.Non-OperatingandRecurringvs.Non-RecurringIncomeMeasurementAlternativesOperatingIncomeNon-OperatingIncomeRecurringIncomeNon-RecurringIncomeAlternativeIncomeStatementMeasures•Netincome—widelyregardedas“bottomline”measureofincome•Comprehensiveincome--includesmostchangestoequitythatresultfromnon-ownersources;itisactuallythebottomlinemeasureofincome;istheaccountant’sproxyforeconomicincome•Continuingincome--excludesextraordinaryitems,cumulativeeffectsofaccoun