Issues in analyzing the net income of a company
Beginner Stock Market Investing, Stock Market Investing Advice
While analyzing the financial statements of a company, the goal is to estimate what income would be in normal circumstances after stripping out all exceptional items that is to say good-quality recurring earnings. In other words, you need to establish the income that the company would earn from its existing businesses consistently year after year. This presents you with two major problems. The first problem concerns the timing of the accounting for the transactions and this could cause some short-term distortions in the reported earnings. The other problem concerns the treatment and classification of the income items so that you can separate earnings of a one-time nature or earnings not generated by the regular operations of the company or both.
Some of the issues in the timing of the transactions are described below:
- The premature recognition of revenue. Take a case where the sale is made on an extended deferred payment and the entire revenue is booked up front. If the customer does not subsequently pay, the transaction will have to be reversed.
- The postponement of accounting for costs. Pushing them into future years will reduce the cost for the current year. Examples of such postponement the capitalization of costs that could be written off to revenue and reducing the rate of depreciation. The reverse of the situation would be to write off large amounts in the current year.
- Overvaluing assets. This could be caused by the failure to write off assets that are damaged or not fully productive or carrying obsolete inventory and at the original cost. This would have the effect of inflating income.
- Undervaluing liabilities. This can be done in a number of ways such as not providing for stock options or additional pensions.
- The provision for an additional pension can be avoided by assuming a higher rate of return on the assets in the pension fund.
- This would have the effect of overstating income.
You should note that the last two items actually relate to the balance sheet and not the profit and loss account but eventually there will be an impact on the income by way of a reduction when these anomalies are adjusted.
The other major issue is in the classification of items. In other words, because the GAAP does not have a specific format for the statement of income, which number of profit should you be looking at? Many people use Earnings before Interest, Depreciation, Taxes and Amortization (EBIDTA) as a profit measure because it is a useful proxy for cash flow. Depreciation and amortization are added back because they are not operating cash outflows. Secondly no operating expenses such as interest and finance charges are excluded. There are two problems in using this measure:
- Not everything that is measured is operational or recurring in nature. For instance, if these figures include expenses related to a large employee layoff, this is unlikely to be a recurring expenditure.
- There is no accounting for long-term investment including the goodwill that arises from a major acquisition.
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