Adjusting accounting income is an important task in financial analysis. Before making any adjustments, it is necessary to specify the analysis objectives. In particular, it is important to determine whether the objective is determining economic income or permanent income of the company. This determination is crucial because economic income and permanent income differ in both nature and purpose, and accordingly, the adjustments necessary to determine each measure can differ substantially.
Adjustments for Permanent Income
We already noted that determining a company’s permanent income (sustainable earning power) is a major quest in analysis. For this purpose, an analyst needs to first determine the permanent (or recurring) component of the current period’s accounting income by identifying and appropriately excluding, or smoothing, transitory (nonrecurring) components of accounting income. For example, an analyst may exclude gain on sale of a major business segment when determining the permanent component of earnings. Such adjusted earnings are often referred to as core earnings by practicing analysts. Determining the current period’s core earnings is useful for interpreting a company’s P/E ratio. It is also useful for valuation techniques using earnings’ multiples. Further, determining core earnings is also useful when forecasting earnings or cash flows by giving a meaningful “starting point” for the forecasting exercise and in helping derive assumptions used in forecasting.
However, we caution that the current period’s core earnings are not always a good estimate of the company’s permanent income. To represent permanent income, a company’s core earnings must reflect the long-term earning power of the company. Current period’s core earnings may not reflect a company’s long-term earnings prospects for two reasons. First, although core earnings exclude components of income that are clearly identified as being transitory, there is no guarantee that the components included in determining core earnings are necessarily permanent in nature.
This is especially true if the
company’s performance in the current period is unusual for any reason. For example, the company’s sales and earnings in a year may be unusually low because of protractedlabor unrest at its principal production facility. Second, an analyst must consider any long-term changes to the company’s business conditions that are reflected in the nonrecurringearnings’ components. For example, a company may have written down fixed assets because of adverse business conditions in one of its divisions. Such an asset writedown is transitory and should not be included in core earnings for the period. However, the asset write-down does reflect the diminished future earnings prospects for a divisionof the company, and this information must be factored by the analyst when determining permanent income. These caveats notwithstanding, determining core earnings is an important first step in estimating a company’s permanent income.
Adjustments for Economic Income
To adjust accounting income for determining economic income, we need to adopt an inclusive approach whereby we include all income components whether recurring or nonrecurring. One way to view economic income is the net change in shareholders’ wealth that arises from nonowner sources; hence it includes everything that changes the net wealth of shareholders. When we make adjustments to obtain economic income, we need to realize the adjusted numbers are not faithful representations of economic income because we cannot determine the change in the value of fixed assets, which are recorded at historical cost. It is also more difficult to justify the need for making adjustments to determine economic income than for determining permanent income. However, economic income serves as a comprehensive measure of change in shareholder wealth and is thus useful as the bottom-line indicator of economic performance for the period.
Adjustment for Operating Income
When determining operating earnings, practicing analysts often start off with core earnings from which they exclude nonoperating income components such as interest expense. However, as we note earlier, operating earnings includes all revenue and expense components that pertain to the company’s operating business, regardless of whether they are recurring or nonrecurring. Whether operating income should include or exclude nonrecurring items is a debatable point and will depend on the analysis objectives. For the purpose of consistency, in this book we refer to operating income strictly with reference to where the income was generated that is, the operating business activities rather than the treasury function, without regard to whether it is recurring or nonrecurring. Therefore, we shall view the operating/nonoperating and the recurring/ nonrecurring dimensions for classifying income as independent or mutually exclusive.
Adjustments for Permanent Income
We already noted that determining a company’s permanent income (sustainable earning power) is a major quest in analysis. For this purpose, an analyst needs to first determine the permanent (or recurring) component of the current period’s accounting income by identifying and appropriately excluding, or smoothing, transitory (nonrecurring) components of accounting income. For example, an analyst may exclude gain on sale of a major business segment when determining the permanent component of earnings. Such adjusted earnings are often referred to as core earnings by practicing analysts. Determining the current period’s core earnings is useful for interpreting a company’s P/E ratio. It is also useful for valuation techniques using earnings’ multiples. Further, determining core earnings is also useful when forecasting earnings or cash flows by giving a meaningful “starting point” for the forecasting exercise and in helping derive assumptions used in forecasting.
However, we caution that the current period’s core earnings are not always a good estimate of the company’s permanent income. To represent permanent income, a company’s core earnings must reflect the long-term earning power of the company. Current period’s core earnings may not reflect a company’s long-term earnings prospects for two reasons. First, although core earnings exclude components of income that are clearly identified as being transitory, there is no guarantee that the components included in determining core earnings are necessarily permanent in nature.
This is especially true if the
company’s performance in the current period is unusual for any reason. For example, the company’s sales and earnings in a year may be unusually low because of protractedlabor unrest at its principal production facility. Second, an analyst must consider any long-term changes to the company’s business conditions that are reflected in the nonrecurringearnings’ components. For example, a company may have written down fixed assets because of adverse business conditions in one of its divisions. Such an asset writedown is transitory and should not be included in core earnings for the period. However, the asset write-down does reflect the diminished future earnings prospects for a divisionof the company, and this information must be factored by the analyst when determining permanent income. These caveats notwithstanding, determining core earnings is an important first step in estimating a company’s permanent income.
Adjustments for Economic Income
To adjust accounting income for determining economic income, we need to adopt an inclusive approach whereby we include all income components whether recurring or nonrecurring. One way to view economic income is the net change in shareholders’ wealth that arises from nonowner sources; hence it includes everything that changes the net wealth of shareholders. When we make adjustments to obtain economic income, we need to realize the adjusted numbers are not faithful representations of economic income because we cannot determine the change in the value of fixed assets, which are recorded at historical cost. It is also more difficult to justify the need for making adjustments to determine economic income than for determining permanent income. However, economic income serves as a comprehensive measure of change in shareholder wealth and is thus useful as the bottom-line indicator of economic performance for the period.
Adjustment for Operating Income
When determining operating earnings, practicing analysts often start off with core earnings from which they exclude nonoperating income components such as interest expense. However, as we note earlier, operating earnings includes all revenue and expense components that pertain to the company’s operating business, regardless of whether they are recurring or nonrecurring. Whether operating income should include or exclude nonrecurring items is a debatable point and will depend on the analysis objectives. For the purpose of consistency, in this book we refer to operating income strictly with reference to where the income was generated that is, the operating business activities rather than the treasury function, without regard to whether it is recurring or nonrecurring. Therefore, we shall view the operating/nonoperating and the recurring/ nonrecurring dimensions for classifying income as independent or mutually exclusive.
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