Financial analysts are concerned with more than just
the bottom line of the income statement—net income. The presentation of
the components of net income, and the related supplemental disclosures,
provide clues to the user of the statement in an assessment of earnings
quality.The term earnings quality refers to the
ability of reported earnings (income) to predict a company’s future earnings.
After all, an income statement simply reports on events that have already
occurred. The relevance of any historical-based financial statement hinges
on its predictive value. To enhance predictive value, analysts try to separate
a company’s “transitory earnings” effects from its “permanent earnings.”
Transitory earnings effects result from transactions or events that are
not likely to occur again in the foreseeable future, or that are likely
to have a different impact on earnings in the future.
Three items - extraordinary items, changes in accounting
principle, and discontinued operations - because of their transitory nature,
are required to be reported separately in the bottom of the income statement.
from continuing operations
operations (net of $xx in taxes)
items (net of $xx in taxes)
effect of a change in accounting principle (net of xx in taxes)
Income before these three items is commonly referred to
as income from continuing operations. Analysts begin their assessment of
permanent earnings with income from continuing operations.
It would be a mistake, though, to assume income from continuing
operations reflects permanent earnings entirely. In other words, there
may be transitory earnings effects included in income from continuing operations.In
a sense, the phrase “continuing” may be misleading.
Income and Income Smoothing
An often-debated contention is that, within GAAP, managers
have the power, to a limited degree, to manipulate reported company income.
And the manipulation is not always in the direction of higher income. For
instance, Kroger in 2001 announced it was restating profits for three prior
years due to intentional
and inappropriate earnings management that occurred within a company
it had purchased, prior to the acquisition. SEC chairman Arthur Levitt
recently began a crusade against earnings management activities.
One author states that “Most executives prefer to report earnings that
follow a smooth, regular, upward path. They hate to report declines, but
they also want to avoid increases that vary wildly from year to year; it’s
better to have two years of 15% earnings increases than a 30% gain one
year and none the next. As a result, some companies ‘bank’ earnings by
understating them in particularly good years and use the banked profits
to polish results in bad years.”
Many believe that manipulating income reduces earnings
quality because it can mask permanent earnings. A recent Business Week
issue was devoted entirely to the topic of earnings management. The issue,
entitled “Corporate Earnings: Who Can You Trust,” contains articles that
are highly critical of corporate America’s earnings manipulation practices.
While in office, Arthur Levitt, Jr., former chairman of the Securities
and Exchange Commission, was outspoken in his criticism of
corporate earnings management practices and their effect on earnings quality.In
a recent article
appearing in the CPA Journal, he states that "While
the problem of earnings management is not new, it has swelled in a market
that is unforgiving of companies that miss their estimates.I
recently read of one major U.S. company that failed to meet its so-called
“numbers” by one penny and lost more than six percent of its stock value
in one day" and that "[i]ncreasingly, I have become
concerned that the motivation to meet Wall Street earnings expectations
may be overriding common-sense business practices.Too
many corporate managers, auditors, and analysts are participants in a game
of nods and winks.In the zeal to satisfy consensus
earnings estimates and project a smooth earnings path, wishful thinking
may be winning the day over faithful representation.As
a result, I fear that we are witnessing an erosion in the quality of
earnings, and therefore, the quality of financial reporting.Managing
may be giving way to manipulation; integrity may be losing out to illusion."
following questions in two pages or less, including citations. Post
your essay to the BlackBoard by the Sunday night due date.
How do managers manipulate (smooth) income?
Is earnings management always intended to produce higher income?
While in office, Former SEC Chairman Levitt desired to see various rule
changes by standard setters to improve the transparency of financial statements.
Does this involve eliminating flexibility in financial reporting?
Using a fictitious example and numbers you make up, describe in your own
words how restructuring charges could be used to "manage earnings."
How might that benefit the company?
Read the Business Week article, "Earnings
Hocus Pocus." In your opinion, should financial statement
users consider restructuring
costs to be part of a company’s permanent earnings stream, or are they
transitory in nature?
Why? [You might want to investigate more recent reports of cost restructuring
over the last decade.]