Analyzing Operating Activities 6 CHAPTER
6 CHAPTER Analyzing Operating Activities
Income measurement Concepts Illustration Facts Company with $100,000 in cash Buys condo for $100,000 Rents condo for $12,000 per year End of the first year: Condo valued at $125,000
Illustration Facts: • Company with $100,000 in cash • Buys condo for $100,000 • Rents condo for $12,000 per year • End of the first year: Condo valued at $125,000 Income Measurement Concepts
Income measurement Concepts lustration Facts Net (free)cash flow=$(88,000) Operating cash flow = $12,000 Economic income $37,000 ($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 $500
Illustration Facts: • Net (free) cash flow = $(88,000) • Operating cash flow = $12,000 • Economic income = $37,000 • ($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 $500 Income Measurement Concepts
Income measurement Concepts Economic comer Two measures reflect the economic concept economic ncome ● permanent income
Economic Income: Two measures reflect the economic concept • economic income • permanent income Income Measurement Concepts
Income measurement Concepts Economic comer 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 Income Measurement Concepts
Income measurement Concepts Permanent incomes 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 Income Measurement Concepts
Income measurement Concepts Economic Income and permanent Income s million 0 TTTT「T「下 TT「1 13579111315171921232527293133353739414345474951 Years ermanent Income Economic Income
Economic Income and Permanent Income Income Measurement Concepts 0 1 2 3 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 Years $ Million Permanent Income Economic Income
Income measurement 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 Income Measurement Concepts
Income measurement Concepts Revenue Recognition and Matching E 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 Income Measurement Concepts
Income measurement Concepts Economic Income VS, Accounting Income: Economic Income and Accounting Income reflect similar concepts BUTH Accounting income is a product of the financial reporting environment--accounting standards, enforcement mechanisms, managers'incentives, etc HENCER Accounting income can diverge from economic income( yielding accounting distortions)
Economic Income vs. Accounting Income: Economic Income and Accounting Income reflect similar concepts BUT: Accounting income is a product of the financial reporting environment—accounting standards, enforcement mechanisms, managers’ incentives, etc. HENCE: Accounting income can diverge from economic income (yielding accounting distortions) Income Measurement Concepts