Alternative Definitions of Profits
When you assess the profitability of a firm, the concern is with all revenues, expenses, gains, and losses that affected the economic value of the firm. However, when you use measures of past profitability to forecast the firm’s future profitability, the emphasis is on those items that are expected to persist. If net income in the recent past includes nonrecurring gains from sales of assets or nonrecurring losses from unusual asset impairment or restructuring charges, you might decide to eliminate those items from past earnings when forecasting future earnings. For purposes of valuation, the goal is to forecast the sustainable earnings of a firm. The famous investment text by Benjamin Graham and David Dodd refers to this concept of earnings persistence as ‘‘earnings power.’’7 Sustainable earnings, or earnings power, is the level of earnings and the growth in the level of earnings expected to persist in the future. Nonrecurring gains and losses may occur in future periods, but you cannot anticipate their occurrence, timing, or amount with sufficient precision to include them in sustainable earnings. Thus, a key to developing forecasts that are useful for valuation is to identify components of bottomline earnings that are recurring.
Segment Profitability
Many firms consist of more than one operating segment. Both U.S. GAAP and IFRS require that companies provide measures of profitability and certain additional information for each segment. The definition of segments follows the ‘‘management approach,’’ which leaves the identification of operating segments up to managers based on how they manage the operations of the company. For example, PepsiCo discloses four business units (Americas foods, Americas beverages, Europe, and Asia, Middle East and Africa) and PepsiCo further partitions these business units into six reportable segments . Most often, disclosure of segment profitability data is presented in the footnotes to the financial statements. Given the open-ended management approach to these required disclosures, there is generally wide variation in the details provided by firms, which makes cross-sectional comparisons of segments challenging. However, firms are required to reconcile revenues and other disclosed items presented for segments to the corresponding totals for the firm. It is important to note that firms often do not allocate all general and administrative expenses to individual segments (allocating a portion to the ‘‘corporate’’ segment), so it also is challenging t compare performance of a segment within a multisegment firm to that of a pure-playfirm, for which such expenses are included on the income statement.
Comprehensive Income
Financial statement users typically analyze net income as the summary bottom-line measure of performance. However, both U.S. GAAP and IFRS require presentation of comprehensive income, which is defined as: The change in equity (net assets) of a business entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners
When you assess the profitability of a firm, the concern is with all revenues, expenses, gains, and losses that affected the economic value of the firm. However, when you use measures of past profitability to forecast the firm’s future profitability, the emphasis is on those items that are expected to persist. If net income in the recent past includes nonrecurring gains from sales of assets or nonrecurring losses from unusual asset impairment or restructuring charges, you might decide to eliminate those items from past earnings when forecasting future earnings. For purposes of valuation, the goal is to forecast the sustainable earnings of a firm. The famous investment text by Benjamin Graham and David Dodd refers to this concept of earnings persistence as ‘‘earnings power.’’7 Sustainable earnings, or earnings power, is the level of earnings and the growth in the level of earnings expected to persist in the future. Nonrecurring gains and losses may occur in future periods, but you cannot anticipate their occurrence, timing, or amount with sufficient precision to include them in sustainable earnings. Thus, a key to developing forecasts that are useful for valuation is to identify components of bottomline earnings that are recurring.
Segment Profitability
Many firms consist of more than one operating segment. Both U.S. GAAP and IFRS require that companies provide measures of profitability and certain additional information for each segment. The definition of segments follows the ‘‘management approach,’’ which leaves the identification of operating segments up to managers based on how they manage the operations of the company. For example, PepsiCo discloses four business units (Americas foods, Americas beverages, Europe, and Asia, Middle East and Africa) and PepsiCo further partitions these business units into six reportable segments . Most often, disclosure of segment profitability data is presented in the footnotes to the financial statements. Given the open-ended management approach to these required disclosures, there is generally wide variation in the details provided by firms, which makes cross-sectional comparisons of segments challenging. However, firms are required to reconcile revenues and other disclosed items presented for segments to the corresponding totals for the firm. It is important to note that firms often do not allocate all general and administrative expenses to individual segments (allocating a portion to the ‘‘corporate’’ segment), so it also is challenging t compare performance of a segment within a multisegment firm to that of a pure-playfirm, for which such expenses are included on the income statement.
Comprehensive Income
Financial statement users typically analyze net income as the summary bottom-line measure of performance. However, both U.S. GAAP and IFRS require presentation of comprehensive income, which is defined as: The change in equity (net assets) of a business entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners
Thus, items included as part of ‘‘other comprehensive income’’ are added to or deducted from net income. Such items include certain foreign currency translation items, defined benefit pension plan and other postretirement plan adjustments, certain unrealized gains and losses on investment securities and derivatives, and other adjustments.
The overriding objective of reporting items of other comprehensive income is to present an all-inclusive picture of a company’s economic events during a period, where items included as other comprehensive income are generally more likely to be temporary in nature and may likely reverse prior to ultimate realization of the currently recognized gains and losses. Reliance on comprehensive income as a summary measure of performance is generally not emphasized as much as an understanding of the components. The primary interest of analysts in examining the components of other comprehensive income is to assess situations in which certain components are likely to persist. However, because of the volatility and uncertainty surrounding most of these items, they are generally not helpful for predicting future income.
The overriding objective of reporting items of other comprehensive income is to present an all-inclusive picture of a company’s economic events during a period, where items included as other comprehensive income are generally more likely to be temporary in nature and may likely reverse prior to ultimate realization of the currently recognized gains and losses. Reliance on comprehensive income as a summary measure of performance is generally not emphasized as much as an understanding of the components. The primary interest of analysts in examining the components of other comprehensive income is to assess situations in which certain components are likely to persist. However, because of the volatility and uncertainty surrounding most of these items, they are generally not helpful for predicting future income.
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