Study Session 7, Reading 22

Various Definitions of Earnings (EBITDA, Operating Income, Net Income)

Operating earnings can be measured by earnings before interest and taxes (EBITDA), operating income and operating profit.

Operating earnings excludes the effects of financing taxes. Earnings before extraordinary and nonrecurring items is known

as income from continuing operations. The “bottom line” of the income statement is net income. It includes revenues, expenses, gains, losses and below the line

items.

Study Session 7, Reading 22

Reliability of Cash Flow Trends and Trends in Earnings

When a company has earnings growth greater than the industry and economy over the long run, a sceptical view in evaluation should be taken.

Growth in operating cash flow is important for a sustainable growth in the earnings of a company.

Over the long run, there should be no difference in the growth rate of operating cash flows and the operating income.

Study Session 7, Reading 22

Accounting Treatment of Fair Value Hedge

Derivative and hedged assets and liabilities are reported at fair value on the balance sheet.

Unrealized gains or losses are recognized in the income statement

The ineffective portion of the hedge is recognized in the income statement.

Study Session 7, Reading 22

Accounting Treatment of a Cash Flow HedgeThis hedge is used to cover for the changes in the variable

cash flows.The derivative is reported in the balance sheet at its fair value. Unrealized gains/losses on a derivative are recognized in other

comprehensive income. Unrealized gains and losses are recognized in the income

statement eventually when the transaction impacts earnings. Ineffective hedge is recognized in the income statement.

Study Session 7, Reading 22

Accounting Treatment for Foreign Currency exposure

Derivative reported at fair value. Gains and losses are recognized in other comprehensive

income. The ineffective hedge is recognized in the income statement.

Study Session 7, Reading 23

Cash vs Accrual Basis Accountingearnings management - Opportunistic use of the accruals

system

Under a cash basis system, the revenues are recorded when the cash is collected and expenses are recognized when the cash is paid for the expenses.

Revenue is recognized when earned under the accruals system.

Study Session 7, Reading 23

Relation Between Level of Accruals and the Persistence of Earnings

Earnings are of high quality if the earnings are sustainable and persistent.

The impact of accruals having an aggressive choice earlier are cancelled out by the conservative choice later.

Earnings at extreme levels tend to revert back to normal levels.

Future cash flows and rates of return will be lower if the earnings are largely comprised of accruals.

Study Session 7, Reading 23

Intervention of Managementin the External Financial Reporting Process

Security prices are often affected when financial information is reported to the capital markets.

This provides an incentive to management to intervene in the accounting process and engage in earnings manipulation.

Management is focussed on releasing information meeting or exceeding analyst expectations. It also manages future expectations.

Study Session 7, Reading 23

Earnings Quality and Mean Reversion in Earnings

Sustainable and persistent earnings are said to be of high quality. Reporting earnings too high or too low represents an inferior earnings measure. Earnings cannot be sustained at extreme levels. Earnings have the tendency to revert back to normal

levels

Formula(s):

Where: NOA - net operating assets

Study Session 7, Reading 23

Problems Affecting the Quality of Financial Reporting

Misstating revenue, recognizing revenue early and classifying non-operating gains as gains from operating activities can distort financial reports.

It impairs the sustainability and persistence of the earnings. The problem with revenue recognition in an accruals based system is

the revenue recorded at the end of the year is the cash collected plus increase in receivables minus increase in unearned revenue.

A company has considerable discretion in receivables recognition.

Study Session 7, Reading 24

Analysis of Financial Statements using a Framework

Step 1: Define the purpose and context of the analysis.Step 2: Data Collection Step 3: Data AnalysisStep 4: Interpret DataStep 5: The development and communication of conclusions and

recommendations Step 6: Follow-up

Study Session 7, Reading 24

Financial Reporting Choices and Biases Affecting the Quality of Financial Statements

Both US GAAP and IFRS give a certain level of independence in making some assumptions.

Management has sufficient discretion about reporting that they can affect the financial statements.

Management can make different assumptions about the revenue and expense recognition due to the discretion allowed.

This may result in earnings management by the company.

Study Session 7, Reading 24

Effects of Changes in Accounting RulesThe earnings quality of the company can be measured by the

accruals ratios. The higher the ratios, the lower the quality of earnings. Earnings are of higher quality if they are backed by the cash

flows. Cash flow can be compared to the operating profit