5(a). Income Statement, including Core Earnings and Comprehensive Income
As part of its oversight activities, the Oversight Committee of the Financial Accounting Foundation interviewed and requested written comments (collectively, "the interviews") from thought leaders among the FASB's constituencies. There were 107 interviews in total, including 12 with representatives of financial statement users and 17 with regulators (a special class of financial statement users). [FASOversight, p. 1]
While the interviews were not designed to elicit criticisms of financial reporting, in general, or to identify the needs of users of financial information, interviewees did comment on those matters. [FASOversight, p. 1]
Following is a summary of the principal comments received [on the subject] from users and regulators relating to criticisms of financial reporting. . . . [FASOversight, p. 1]
The conceptual focus on the balance sheet results in confusion in the income statement. It is difficult to identify "operating income before nonrecurring events," which is an important basis for assessing expected future cash flows. [FASOversight, p. 2]
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Consideration of Reporting Unusual or Infrequent Events [following 6 paragraphs]: Our lender participants declined to criticize or suggest changes in the standards of financial reporting in effect today, although some felt that these standards often are not implemented well or in good faith. Rather than attempting to state what the accounting standards should be, our members expressed themselves more in terms of what type of information they required and how they used it. A summary of those remarks follows. [RMA92, p. 1]
First of all, bankers look for income to be reported on the income statement and to be displayed in a good amount of detail. Therefore, items carried directly to equity (thus bypassing the income statement) should be the exception rather than the rule. They would be confined to the correction of outright errors made in prior years and the cumulative retroactive effect of certain changes in accounting principles. The idea is that it is better to have an item on the income statement in the wrong period rather than not have it there at all. Both types of restatement of the past must be accompanied by full disclosure to enable users to revise prior years' amounts carried in their databases. [RMA92, p. 1-2]
The use of the term and category "extraordinary item" is unfortunate. Bankers want to be able to consider separately each item affecting income that can be considered either unusual in character or nonrecurring or both. Bankers, together with most financial statement users, are "future oriented." They use data from current financial statements as a means of estimating what earnings statement items will: (1) persist in the future, and (2) result in cash inflows either in the current period or within the near future. Unusual and nonrecurring items usually fail one or both of those two tests. We do believe that disclosure of all such items should be required, not merely permitted. Furthermore, the tax effects of each such item should be disclosed, although we are indifferent as to whether or not intraperiod income tax allocation procedures need be followed on the income statement. Obviously, it is important to establish materiality thresholds for such disclosures. [RMA92, p. 2]
The separate disclosure of discontinued operations is essential to credit analysis. First, lenders focus on ongoing operations for trend analysis and projections of future cash flows. We look at discontinuances of operations and other asset disposals as changing the financial position of the company and its availability for loan repayment. Discontinued operations may have weakened a company; it's the ongoing ones that will pay us back. [RMA92, p. 2]
Changes in accounting estimates should be effected without restatement of the past. However, it is vital, for all the reasons given above, that their effect on both the financial position of the enterprise and its earnings for current and future periods be disclosed clearly. [RMA92, p. 2]
[L]egalistic approaches to financial reporting seem to impede rather than facilitate communication of financial information. We suggested a private companies version of the Management Discussion and Analysis (MD&A) required of public companies by the SEC. Lenders need to understand their customers' businesses, a necessity best met by open and good faith explanations of the business by the customer and his or her accountant, either in writing or verbally. [Also included in 10(b) and final sentence also included in 13] [RMA92, p. 2]
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The APC [Accounting Policy Committee] has considered and expresses below its opinions on a number of specific issues affecting financial accounting standards and financial reports. The APC believes that the following items should be included in the single body of accounting concepts, standards, principles and methods: [RMA90, p. 5]
The income statement and balance sheet should be prepared under the principles of accrual accounting. The income statement should reflect economic events of the current period by matching to the accomplishments of that period (revenue), the efforts necessary to achieve them (expense). The balance sheet should reflect the cumulative effect of that matching process. Accruals and deferrals are necessary for proper matching to occur, and by their nature deferrals, which require allocations, and accruals, which require estimates of future expenditures, are arbitrary and imprecise. Therefore, care must be taken to see that their use not be extended to permit "normalization" of earnings in any accounting period, annual or interim. Normalization, like forecasts and projections, is the province of the financial statement user and should not be incorporated into financial reporting. [Also partly included in 2(b)] [RMA90, p. 5-6]
The APC [Accounting Policy Committee] favors an all-inclusive income statement. Net income should include the effect of all of the current period's economic transactions and other activity of the entity. Retained earnings should be increased by earnings/(losses) and decreased only by distributions to owners of the company. The only other adjustments that should be made to retained earnings are: (1) correction(s) of material error(s) in the computation of income of previous periods, and (2) the cumulative retroactive effect of a change in accounting principles. In both of those circumstances, information should be provided to allow restatement of individual prior years' income for purposes of comparison to the income of the current and future years. [RMA90, p. 6]
Within an all-inclusive income statement and in supplementary disclosures the APC [Accounting Policy Committee] recommends extensive disclosure of the composition of income. Lenders require detail in order to assess the quality of earnings and to make intelligent comparisons both among different enterprises and over time for a single entity. Important disclosures include all of the following: [RMA90, p. 6]
a. Separate reporting of the results of: (1) continuing operations, (2) discontinued operations, (3) extraordinary items, and (4) retroactive effects of changes in accounting principle. Each of the four categories should conform to GAAP standards, and each should be shown both before and after its impact on the period's income tax provision (credit). [RMA90, p. 6]
b. Items that affect the reported results of continuing operations, but which management considers to be unusual or nonrecurring, should be identified clearly with supplementary information discussion. [RMA90, p. 6]
c. Within continuing operations, the enterprise should disclose each major source of revenues (product sales, services, financing of customers, etc.), expenses by function (cost of sales, selling, administration, etc.), and within functions by object of expenditure (wages, utilities, etc.). The company should disclose the methods it uses to recognize revenue, amortize costs, and to record significant accruals and deferrals. [RMA90, p. 6-7]
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[Equity sell-side] analysts employ a literal definition of nonrecurring income statement items, which are usually referred to as "one time" items. They take notice of reported nonrecurring items as listed below continuing operations and also note the effect of new accounting rules. One report contained a section entitled "Non-operating earnings - A Source of Confusion in the Past". [Also included in 1(b), 1(c), and 5(d)] [PREVITS, p. 15]
[Equity sell-side analysts] also identify "potential" nonrecurring items contained in continuing operations, and often report EPS net of these items, as in the case of the analyst who noted "several unusual items" included in continuing operations. Correspondingly, a number of analysts report operating earnings per share, which of course is not required under GAAP, or compute an "adjusted earnings" number which includes all items judged to be nonrecurring, and corresponding EPS. Restructuring charges are an example of one common item often removed in analysts EPS reports. Occasionally analysts identify a nonrecurring cost but are unable to estimate an amount. In one case an analyst was unable to determine the amount of a corporate relocation charge buried in continuing operations. In another report the relocation charge of the company was identified in continuing operations and removed in calculating EPS. [Also included in 1(b), 1(c), and 5(d)] [PREVITS, p. 15-16]
[Equity sell-side] analysts define "earnings quality" differently than [was] expected. To financial analysts, a company with high earnings quality is one that uses very conservative accounting principles; for instance a company that has accrued reserves against future losses, write downs, etc. One analyst, for instance, reported earnings quality as high when a firm had an "aggressive" policy towards establishing reserves. Another substantiated an assertion of high earnings quality for a company by stating that "the company is over-accruing foreign taxes as a way of managing earnings." A third supported its assertion of high quality earnings by noting that "the opportunity to 'manage down' earnings exists". A fourth argued that a financial company's earnings were more 'credible' because the company applied "more aggressive accounting" methods in writing down assets. [Also included in 1(b) and 1(c)] [PREVITS, p. 16]
This suggests a possible analyst preference for secret reserves. [Also included in 1(b) and 1(c)] [PREVITS, p. 16]
[Sometimes,] earnings quality . . . seem[s] to be related to "representational faithfulness," and management's forthrightness in disclosure. For example, one analyst reported that an extreme drop in the reported tax rate of a company "caused some to doubt the quality of (its) earnings". Another expressed concern about earnings quality on the basis of the amount of costs included by a company in the determination of cost of goods sold. [Also included in 1(b), 1(c), and 2(b)] [PREVITS, p. 16]
Other income analysis factors:
- Analysts see a "strategic acquisition" to be one which reduces a company's short term earnings but increases longer term earning potential.
- Analysts report sale backlog (at company or operating unit levels) and use these as a basis for estimating future performance.
- Average tax rates are calculated for most companies with income data on a comparative and trend basis. Current and deferred portions of income tax expense are often disclosed.
- Regulated companies reported "statutory" or regulatory income compared with GAAP income. [Also included in 1(b) and 1(c)] [PREVITS, p. 16]
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Effect of Market Value Changes on Income
No matter how well mark-to-market accounting could be implemented and applied judiciously to matched assets and liabilities, it still would increase significantly the volatility of reported earnings. Some argue that the volatility exists and that a primary benefit of mark-to-market accounting is that real volatility would be revealed. Even if we concede that point, the question becomes one of how business enterprises and the capital markets are to deal with it. [Also included in 4] [AIMR/FAPC92, p. 28]
As financial reporting is practiced today, financial managers have much discretion over the recognition of changes in value by astute timing of exchange transactions and by the adoption of artful allocation procedures. Mark-to-market accounting would take away much of that discretion. Even where the relative influence of market value changes is small overall, at the margin it has the propensity to make earnings exceedingly unpredictable, a disconcerting fact for enterprises trying to minimize their capital costs by reporting smooth and growing earnings. [Also included in 4] [AIMR/FAPC92, p. 28]
Some analysts are quite willing to accept the increases in reported income volatility that would be produced under mark-to-market accounting. Many of them even would welcome it. They feel that the effects on a particular enterprise of general economic conditions and financial market movements are relevant and to some degree vital to their assessments of its economic status and progress over time. They may not yet be ready to do away with historic cost entirely, but they look forward to the opportunity of integrating FAS 107 data into their evaluations and forecasts as soon as they become generally available. [Also included in 4] [AIMR/FAPC92, p. 28]
One method for dealing with changing market values and their effect on income would be for the FASB to generate accounting standards that put into practice the concept of comprehensive income that appears in Concepts Statement No. 6. As defined in Paragraphs 73-77 of that statement, comprehensive income would encompass all changes in owners' equity exclusive of transactions with owners themselves. It would also be disaggregated into a variety of basic components and intermediate components. Thus the effect of exogenous events such as market value changes would be separated from the effect of endogenous productive activities. If market value changes were reported separately and clearly, their effect isolated, then their unpredictability would assume a lesser importance as it was assessed separately from productive activities. [Also included in 4] [AIMR/FAPC92, p. 28]
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One might ask whether a goodwill write-off should appear on the income statement or go directly to owners' equity. Regardless of the answer, a more appropriate question is where on the income statement or where in the owner's equity section it should emerge. We believe that it should appear on the income statement as part of comprehensive income and that this is another instance that illustrates the need for the FASB to develop standards for reporting comprehensive income. Cumulative amounts of goodwill write-offs also should be reported as a separate component of shareholders' equity together with complete disclosure of the changes in those amounts during each of the periods covered by the financial report. [Also included in 7(a)] [AIMR/FAPC92, p. 31]
[Context] The following brief summary of the topic "Income and Cash Flow Statements," is from the "Executive Summary" of the report the AIMR's Financial Accounting Policy Committee (FAPC):
Throughout the report, there are repeated recommendations that the FASB needs to develop its concept of "comprehensive income." Much of this section of the report is devoted to integrating those references and explaining in much greater detail all the reasons why that development is needed and how it should proceed. [Also included in 5(c)] [AIMR/FAPC92, p. ix]
The other part of this section deals with the cash flow statement. Most financial analysts were pleased with the issuance of FAS 95, which requires that a cash flow statement replace the less useful statement of changes in financial position. They are not pleased with the quality of information contained in many of the cash flow statements they currently receive. First, virtually no companies have chosen to present cash flows from operations on the direct method. Failure to do so has been accompanied by arguments that are unconvincing because they are contradictory. Second, because so many cash flow statements contain detectable errors, we call for establishment of an authoritative literature on cash flow statement preparation. [Also included in 5(c)] [AIMR/FAPC92, p. ix]
[Context] It indicates the scope of the discussion of the topic and lists the report's major recommendations, providing an introduction to the following excerpts from the report.
Over the span of the FASB's existence, its pronouncements have become more and more oriented to the statement of financial position. This is meant as an observation, not criticism. [Also included in 5(b) and 5(c)] [AIMR/FAPC92, p. 41]
Perhaps the most apt example is FAS 109, "Accounting for Income Taxes." It fixes its attention on identifying at a point in time those transactions and events that are deemed to have future tax consequences, then measuring the effect on financial position of the benefit(s) and/or obligation(s) resulting from them. Their effect on periodic income is calculated only as the necessary consequence of those financial position assessments. This is an approach opposite from the now-superseded Accounting Principles Board Opinion 11 in which the objective was to measure the deferred portion of the current period's provision for income taxes, with resultant balance sheet residuals called deferred tax liabilities and/or assets. [Also included in 5(b) and 5(c)] [AIMR/FAPC92, p. 41]
We applaud the efforts and accomplishments of the FASB in making balance sheet amounts more meaningful than before. Prior to FAS 109 (and its short-lived predecessor, FAS 96), deferred tax accounts on the balance sheet had little meaning since they were remnants of past income statements, whereas today they depict amounts that the enterprise expects to result in future cash flows. However, as FAS 109 and various other standards have been promulgated we feel that the development of the income statement has been neglected. We also feel as if more could be done to make cash flow statements more accurate and more useful to analysts. The purpose of this short section is to summarize our views on those matters: (a) with respect to the income statement, primarily to summarize information scattered throughout earlier parts of this report; (b) with respect to cash flow statements to introduce new material. [Also included in 5(b) and 5(c)] [AIMR/FAPC92, p. 42]
Comprehensive Income
The FASB's Statement of Financial Accounting Concepts No. 6, "Elements of Financial Statements," paragraph 70, defines comprehensive income as follows: [AIMR/FAPC92, p. 42]
Comprehensive income is the change in the equity of a business enterprise 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. [AIMR/FAPC92, p. 42]
We refer to comprehensive income several times above and have urged the FASB to construct the bridge from concept to standard. It is needed for better and more useful financial reporting in the following areas: [AIMR/FAPC92, p. 42]
1. Reporting the effect of changing market values and their effect on the wealth of the enterprise. One of the primary obstacles to acceptance of "mark-to-market" accounting is how it would magnify the volatility of reported earnings. If both unrealized and realized changes in market value could be revealed for what they are, separately from the results of operating activities, we as analysts would have more information than we do currently and we might avoid the stock market palpitations that frequently occur because of the information content of a single aggregated number called net income or earnings per share. [AIMR/FAPC92, p. 42]
2. Earlier we suggested that goodwill should be written off at the time it is acquired. We did not opine as to whether the write-off should appear on the income statement or go directly to owners' equity. If the concept of comprehensive income were developed, we would expect the goodwill write-off to appear as a component of income separate from the operating activities of the enterprise. [AIMR/FAPC92, p. 42]
3. In our discussion of the attest function, we advised an experiment with five-year intervals between audits, accompanied by a retrospective view of annual income for the five-year period that discloses all components of income making one year not comparable with the others. Before that experiment is launched, some attention must be paid to the concept of income used to guide the five-year retroactive view. [AIMR/FAPC92, p. 42]
There are other topics in which there is need for a developed concept of comprehensive income. The Financial Accounting Policy Committee of AIMR (and its predecessor organization, the Financial Analysts Federation) has consistently supported the an all-inclusive income statement format, known colloquially as the "clean surplus" approach. We consider income to include all of an enterprise's wealth changes except those engendered from transactions with its owners. We have profound misgivings about other wealth changes that elude disclosure on the income statement. Yet, individual items may be interpreted differently. That calls for a display of comprehensive income that allows components of different character to be seen and evaluated separately. Some examples follow. [AIMR/FAPC92, p. 43]
Unrealized Losses on a Long-Term Portfolio of Marketable Equity Securities FAS 12 requires the cumulative net unrealized loss on equity securities to be reported directly and separately in the owners' equity section of the balance sheet. That treatment has the effect of reporting the portfolio on the balance sheet at the lower of cost or market, but recognizing gain and loss on the income statement strictly on the cost basis of valuation. There seems to be no conceptual basis for such accounting, nor does it serve in any way the interests of financial statement users. However, we consider unrealized security gains and losses to differ in character from realized ones, and even more so from other corporate operating activities. They should be included in comprehensive income, but displayed in such a manner so that they may be evaluated on their own. This is an important matter to be considered by the FASB, the IASC, other standards-setting bodies, and the SEC as they propel corporate reporting nearer to mark-to-market accounting. [AIMR/FAPC92, p. 43]
Accumulated Net Gain or Loss from the Translation of Foreign Currencies FAS 52 changed the criteria and methodology for the translation of foreign currency and at the same time mandated that the "gain" or "loss" from using the current rate method of translation bypass the income statement until such time as the foreign operation was wholly or partially disposed of. We must observe that these are not true "gains" and "losses." They merely are the amount(s) by which the balance sheet is thrown out of balance because the assets and liabilities of a foreign operation are translated at the current rate, but the owners' equity accounts are not. Although it is difficult to visualize those gains and losses as legitimate components of income, under the translation methodology specified by FAS 52 we have no other choice.13 [AIMR/FAPC92, p. 43]
Unusual and Nonrecurring Items, Restructuring Charges and Similar Items This classification could be broadened well beyond the current category of extraordinary items. It also should be presented in some detail. Some of the items in this group are now presented as extraordinary and shown net of tax. Others are set out as separate line items in income from continuing operations. Still others, such as the effect of lifo liquidations, are ascertainable only by scrutinizing the footnotes. Individual companies tend to have idiosyncratic definitions of what is unusual or nonrecurring, as well as eccentric thresholds of materiality. Analysts often are confounded by all of this as they attempt to make comparisons between and among companies, particularly over a time span of several years. [AIMR/FAPC92, p. 43-44]
The above lists are not exhaustive, but they should be sufficient to support our case. We have not suggested the form or content one or more standards on this subject should take. That is a task for the standards-setters themselves. Our more modest objective merely is to establish the compelling need for attention to this topic. Financial statement users need in one place all the data reporting economic activity which they then may sort out to suit their own purposes. The resulting income statement format needs codification of its structure to assure that like items are classified similarly by different companies. Only then will analysts be able with increased confidence to make many of the comparisons so vital to their work. [AIMR/FAPC92, p. 44]
[Context] The AIMR report's introduction to the section entitled "Summary of Important Positions and Guide to Future Actions" begins and ends as follows:
Much of this report relates to the present state of the art and implications for future developments in financial reporting. Righfully, so do most of the positions stated in this section . . . [T]hey all build on positions taken by AIMR in the past . . . [Also included in 1(b), 1(d), 3(d), 4, 8(c), 11(a), 12, 18(a), 18(c) and 18(d)] [AIMR/FAPC92, p. 59]
We expect the positions set forth below to build on the precedents of the past. That does not prevent them from breaking new ground, but they do not introduce significant inconsistencies with previous AIMR positions. To the extent that they do establish new stances those are largely the result of the changing world that we describe earlier in this report. [Also included in 1(b), 1(d), 3(d), 4, 8(c), 11(a), 12, 18(a), 18(c) and 18(d)] [AIMR/FAPC92, p. 60]
Those two paragraphs introduce the following summary of a position taken by the Committee.
Develop Standards for Reporting Comprehensive Income
Financial analysts continue to place heavy emphasis in their work on the income statement. It produces the numerator of earnings per share calculations and the denominator of the price to earnings ratio, two stalwart numbers in the investment world. Analysts also recognize that earnings comprises a multitude of components of varying quality: some are repetitive, others are not; some are operating items, others are not; some are the product of accounting rituals, others are not; some represent economic events of the current period, others do not. Much effort is required of analysts to locate and evaluate all of the income statement items that can have a bearing on their forecasts of the future and the valuation of the firm. [Also included in 1(d)] [AIMR/FAPC92, p. 63]
Much of this report is devoted to marshalling evidence and arguments to support our position that the FASB needs to move comprehensive income from concept to application. We believe the arguments are strong and hope to see progress in this matter in the not-too-distant future. [Also included in 1(d)] [AIMR/FAPC92, p. 63]
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[Context] Meeting of the Investor Discussion Group on October 16, 1992. When discussing the types of information they use to achieve their objectives, investors were asked about the notion of "core earnings." One investor also made a comment on the display of the income statement.
Committee/Staff/Observer
Also, another thing we keep hearing is that analysts really want to get at "core earnings"; if everything was the same on an ongoing basis, eliminating the nonrecurring items, what would be the earnings? So, perhaps we should recommend that the income statement show "core earnings" and "comprehensive earnings"? [TI 10/16, p. 38-39]
Participant I-2
I used a similar concept, "normalized earnings" on a quarterly basis. For example, for [name deleted], I take out the $280 million pension credit, I take out foreign exchange gains and losses, and I normalize the tax rate. You have to be careful not to confuse people too much because you can normalize things so much that they won't have any idea of what you are talking about. But you have to normalize on a quarterly basis. Other adjustments are gains and losses on asset sales and insurance settlements, etc. [Also included in 1(b) and 11(a)] [TI 10/16, p. 39]
Participant I-6
I try to come down to what are the earnings from the current businesses that are there today, and are they going to be the same ones next year? So, if they have written off a complete line of business, I back it out and get rid of it. What I have seen from a couple of companies I follow, and what I would like to see, is two EPS numbers; one is the traditional GAAP reporting number, and one based on the earnings excluding the nonrecurring items and comparing them to the prior period excluding the same things so that we have some comparability. But that is just starting to come out. [Also included in 1(b) and 2(c)] [TI 10/16, p. 41]
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Participant I-9
One thing for the committee to consider on the previous question. Look at the "other income" line of the company going forward. You're going to have joint ventures and a more complex world. The "other income" line was set up to net interest income and interest expense and when you put [names deleted] and all these deals in there, this line can go from $10 to $200 million in 3 years and it's not adequately reported now. [Also included in 1(b) and 6] [TI 10/16, p. 51]
[Context] Meeting of the Investor Discussion Group on December 9, 1992. Part of the meeting was devoted to the topic of unconsolidated entities. During the discussion, comments were made on income statement display.
Participant I-7
At a very minimum, there should be a clear distinct separate line item called equity income. Most of my companies fold the equity income in the "other income" account. [Also included in 6] [TI 12/9, p. 34]
Participant I-12
In some companies, I've found that the other income line is the second largest revenue line, and in some the largest, and it's shown at the very bottom. So we know there's something in there of some order of magnitude, but the company is not breaking that out. The same goes for the "other expense" line. [Also included in 6] [TI 12/9, p. 34]
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Participant I-6
Yes, but again subject to materiality. Something that would also be helpful would be a list of everything that's in the equity line. It doesn't have to be in the annual report; maybe it could be an exhibit that you could call and ask for if you really care about it. The key point is that the make-up of that line item changes over time dramatically and if you're looking at 5 year disclosure, it's not unimaginable that 80% of the make-up has changed in that 5 year period. [Also included in 6] [TI 12/9, p. 37]
Participant I-7
The information that we're looking for could be issued as part of the 10-K rather than the annual report because companies are increasingly complaining about the cost of their annual report. [Also included in 6] [TI 12/9, p. 37]
Participant I-6
It could be in the 10-K or in the exhibit to the annual report, but I think that we need more than just that one line item in the annual report. [Also included in 6] [TI 12/9, p. 38]
[Context] Meeting of the Investor Discussion Group on January 13, 1993. Part of the meeting was devoted to the topic of display.
Committee/Staff/Observer
The next three questions refer to an area that accountants refer to as display. By that we mean the classification, layout, and level of detail of information on the face of the financial statements or the related notes that provide additional information about the details of amounts recognized in the financial statements. Is everybody comfortable by what we mean by display? [TI 1/13, p. 26]
Accounting standards do not provide much guidance about display of information in external reporting. Most of the guidance we have is 20-25 years old. Thus, there may be considerable opportunity to help you with your work through better display of information. We suspect that better display could improve your ability to predict a company's future for at least three reasons: (1) first, more details or a better classification could provide more insight about a company's business than you currently get, (2) second, rearranged classification of information between recurring and nonrecurring items could help you identify core or basic or recurring earnings, (3) and third, more explicit guidance about display could reduce diversity in reporting by companies in similar circumstances and improve comparability of information. We think that the seldom-heard-about topic of display offers fertile ground for improvement and we look forward to your ideas and views. [TI 1/13, p. 26]
First, let's talk about the income statement, more specifically about the reporting of nonrecurring items in the income statement. Should financial reporting do a better job of identifying nonrecurring items? If so, what definition of nonrecurring items would you find most helpful in your work? [TI 1/13, p. 27]
Participant I-11
I hope you recognize this is about as much of a pandora's box as fair value! I would like to see identified, either on the face of the financial statements or notationally, those income statement items which are not related to the normal course of business for the company. If you ask me what that means, I say it's subject to interpretation. I can remember a number of years ago when a number of companies reported extraordinary items virtually every quarter because that way they could keep the preextraordinary earnings' track heading up. It's a continuum but clearly there are items that are not directly related to the normal course of business of the company and clearly it would be helpful to me as an analyst to have those items segregated and identified so that I can assess them and adjust for them. [TI 1/13, p. 27]
Participant I-8
You're getting all that you want now only when it's a negative. I would love to see some management say something on the positive side. You get pretty much all the negative stuff. I can't imagine a management not wanting to disclose something that is extraordinary and that is negative. [TI 1/13, p. 27]
Committee/Staff/Observer
Restructuring charges, for example, are required by the SEC to be shown above the line, before you get to operating earnings. Is that a problem? [Also included in 1(c)] [TI 1/13, p. 27]
Participant I-8
No, because it's disclosed. I can make whatever adjustment I want to it. [Also included in 1(c)] [TI 1/13, p. 27]
Committee/Staff/Observer
But you would make an adjustment to get to core earnings? [Also included in 1(c)] [TI 1/13, p. 27]
Participant I-8
Well, there are extraordinary charges and extraordinary charges. There are some that are really a result of some change somewhere and there are others that just reflect poor management judgment over some period of time. My guess is that management is less inclined to disclose positive items than negative items because the latter explain why they did so poorly. [Also included in 1(c)] [TI 1/13, p. 28]
Participant I-7
You're a $15-$20 million company and in the normal course of business, you get the Walmart account just to fill the pipeline; there's $10 million worth of business. It's going to show up in the normal course of business, but I would like to have some notational evidence that you got that piece of business. [TI 1/13, p. 28]
Participant I-8
We talked the last time about purchase accounting and that's the one area where I think there is not sufficient disclosure. For example, write-downs of inventories purchased and then subsequent gains on the sale of those inventories; this is a one-time deal that is not properly disclosed. It doesn't reflect what is going to be the ongoing profitability of that manufacturing operation. [Also included in 8(b)] [TI 1/13, p. 28]
Participant I-15
Lots of companies define differently what is nonrecurring and what is material, even from quarter to quarter. It's not consistent. [TI 1/13, p. 28]
Committee/Staff/Observer
Even though there might be a "big bath" writeoff, isn't the bottom line number before that writeoff the more meaningful number going forward? [TI 1/13, p. 28]
Participant I-8
I agree with that. But [committee/staff/observer] was asking whether it matters if it's above or below the line, and the answer is no. [TI 1/13, p. 28]
Participant I-7
I just don't think we're getting enough information, especially when major restructuring charges are made. [TI 1/13, p. 29]
Committee/Staff/Observer
Next question. If financial reporting should better identify nonrecurring items, what information should be reported? [TI 1/13, p. 29]
Participant I-7
At a minimum, if you take a $5 billion writeoff, I would like notationally some idea about how the $5 billion is split between inventory, physical assets, and what's to be paid out to the employees, and anything else. [TI 1/13, p. 29]
Participant I-8
The distinction between cash and noncash is more important to me; how much is going to be noncash. You always have to ask that; I think it should be part of the disclosures. [TI 1/13, p. 29]
Participant I-7
To the extent you get a split between the different assets, you should be able to get some idea. For example, if out of the $5 billion, $4.5 billion is employee related, that's cash. [TI 1/13, p. 29]
Participant I-8
Of the noncash portion of it, I'm not sure I learn anything from whether they wrote down plant or inventory. [TI 1/13, p. 29]
Committee/Staff/Observer
Would it be a useful exercise to attempt to define core earnings? If so, would it be helpful to you if a company presented an income statement to arrive at core earnings? [TI 1/13, p. 29]
Participant I-8
How would you say that's different from what the company is reporting as earnings before extraordinary items? [TI 1/13, p. 30]
Committee/Staff/Observer
For example, securities gains for manufacturing companies. [TI 1/13, p. 30]
Participant I-8
I said that before. We have a harder time seeing when they have unusual pluses; they're very happy to show you unusual minuses. [TI 1/13, p. 30]
Committee/Staff/Observer
So it would be useful if there was a common definition of core earnings? [TI 1/13, p. 30]
Participant I-11
I get a little confused on the differing definitions of unusual items, nonrecurring items, extraordinary items. In addition to the cash and noncash aspects, I would like to see the tax consequences of these events. Sometimes I get reports that just have the net after tax effect, sometimes only pretax effect, sometimes both. Trying to translate back and forth between operating income and net income is impossible. I think we would find that core earnings is a difficult thing to define precisely, although we all have an intuitive sense of what it is. [TI 1/13, p. 30-31]
Committee/Staff/Observer
There are rules that specify that management cannot say "we consider this to be an unusual item; although it is part of our business, we don't believe it will happen again". Companies are prohibited to show that as a separate line item as an excuse. It's not a restructuring, it's not a "big bath", it's something that happened and is incidental to the company's business, but it is unusual. [TI 1/13, p. 31]
Participant I-10
But can't you allude to that fact in the notes to the financial statements? [TI 1/13, p. 31]
Committee/Staff/Observer
Yes, in notes you can. If we focus on core earnings as being the best evidence of what happened during the period, that is likely to be the best evidence of what's going to happen in the next period. We would get a considerably different answer than we get today for operating income. [TI 1/13, p. 31]
Participant I-12
Every analyst I know has a different definition of core earnings. I'm not sure there is a proper definition. For example, bond trading for a securities firm; is that recurring? If the bond trader doesn't come in, you're not going to have bond trading gains or losses. There are certain volatile elements that have a lot of discretionary aspects to them, and I'm not sure how you would break those out or create an accounting rule to cover those instances. [TI 1/13, p. 31]
Committee/Staff/Observer
What if the accounting rule or the definition attempted to equate items that you apply a multiple to versus those that you treat one to one? The former would be included in core earnings, the latter would not be. [TI 1/13, p. 32]
Participant I-11
But those items are not going to be the same this week and the next. [TI 1/13, p. 32]
Participant I-5
It's true that we won't all agree on what that exact right number is for core earnings, but what's wrong with having some rough consensus around which we adjust, rather than having only net income? For presentation purposes, I don't see why it wouldn't add more relevance. [TI 1/13, p. 32]
Committee/Staff/Observer
We will now consider opportunities for display of information that would give you better insight into the operations of the company's business. In previous meetings, each of you have stressed the importance of understanding as much as possible the operations of the company's business. As discussed in the meeting materials (pages 16 and 17) the form of display used today provides some information about the company's business. Nevertheless, there may be opportunities to improve the display in a manner that gives you more insight into companies' operations. Our questions are: would more information about the detail of certain amounts currently reported in the income statement be useful? If so, which amounts and what information would you like to know? Alternatively, would a different method of classifying information on the income statement give you more insight about the company's business than the current method of classification? [TI 1/13, p. 32]
Participant I-12
The display required for the companies I follow (banks and securities brokers) were determined 50 or 60 years ago. That display has little or no relationship to the way these businesses are run today. First of all, the average balance sheets in most intermediation companies is an absolute essential. In fact, if it were the only thing that I got, with notes on revenues and expenses, I would probably be very happy. With the income statement, I reclassify everything. I have a net interest classification, a fee and commission classification, a trading gain classification, a capital gain classification, and the ubiquitous "all other". So I restructure the income statement on an ongoing basis for the companies I do a model for. [Also included in 1(c)] [TI 1/13, p. 32-33]
Participant I-8
I'd certainly welcome having operating expenses broken down into the 3 categories of fixed, semi-variable, and variable for manufacturing companies. If you'd give me the cost accounting, I'm not sure I'd know what to do with it. [TI 1/13, p. 33]
Participant I-14
I had that one marked also. [TI 1/13, p. 33]
Participant I-11
I'm not so sure about the semi-fixed and variable, but personally I'd like to see selling expenses separated from general and administrative expenses, because selling expense are more closely related to sale volume and has different dynamics from G&A. [TI 1/13, p. 33]
Participant I-8
That's not entirely true. In a lot of companies that I deal with, the salesmen get paid a fixed salary and there's also a variable part in the compensation. I have encountered very few cases where selling expenses are all variable. [TI 1/13, p. 33]
Participant I-11
I deal a lot with distribution companies and I have some formulas that I use and that seem to work pretty well, where I drive my projection of selling expenses based on sales, and I drive my projection of G&A based on some other factors and, occasionally, my forecasts are right. I would like to see notational information about where the depreciation comes from; how much goes into costs of goods, how much goes into S,G&A. [Also included in 1(c)] [TI 1/13, p. 33]
Participant I-7
I don't know if there necessarily has to be a dramatic change in the display of the P&L. For example, [name deleted] notationally breaks out the costs of goods sold and the S,G&A. If you're doing some ratio studies, there are some companies that will give you a separate line item for R&D; other companies will include R&D in the S,G&A account; still others will include it in the costs of goods sold account. I would like to use as a guideline the cost breakouts that a company like [name deleted] gives in their annual report, including things such as social security taxes, advertising expenditures, etc. [TI 1/13, p. 34]
Participant I-12
In this day and age, it's important to be able to identify the people costs from the nonpeople costs in the income statement. The one good thing about the disclosures of financial companies is that they show personnel expense (basic salaries plus fringe benefits) and that's very useful. [TI 1/13, p. 34]
Committee/Staff/Observer
Are those consistently defined, [participant I-12]? [TI 1/13, p. 34]
Participant I-12
I don't know. It's about as consistent as you can get considering the variability across the spectrum of financial companies that I cover. I feel fairly confident that I can rely on those numbers. [TI 1/13, p. 34]
Participant I-7
The only consistency there is in my industry is the fact that only one company discloses that information. [TI 1/13, p. 34]
Participant I-12
Another point is that companies that run similar businesses report in vastly different fashions. The income statement of [name deleted] is vastly different from the income statements of other kinds of financial companies; yet, their basic business is very similar. So there is an issue of noncomparability for comparable businesses, both in the income statement and the balance sheet. [Also included in 2(c)] [TI 1/13, p. 34]
[Context] Meeting of the Investor Discussion Group on January 13, 1993. Part of the meeting was devoted to the topic of display. At the end of the discussion, participants were asked whether they had any enthusiasm for display issues.
Participant I-8
I have great enthusiasm for [the presentation of] fixed, semi-fixed, and variable [expenses], just as much as for segment reporting. [Also included in 3(e)] [TI 1/13, p. 41]
Participant I-7
I would like more consistency on the display of depreciation and R&D expenditure. On R&D, I'd like to know whether it falls under a separate category or in the S,G&A. In depreciation, where I get one number, I'd like to know how that is split up between the two major cost accounts (S,G&A and costs of goods sold). [TI 1/13, p.42]
[Context] Meeting of the Investor Discussion Group on January 13, 1993. Part of the meeting was devoted to the topic of disclosure about operating opportunities and risks. During the discussion, an investor answered a question on core earnings.
Committee/Staff/Observer
Do you adjust core earnings for items that you think are hedges but are not accounted for as hedges, or vice versa? Or do you generally go along with the accounting for these instruments? [Also included in 19] [TI 1/13, p. 51]
Participant I-7
To the extent that some of my companies operating in the international markets try to currency hedge, I won't change the accounting unless it's significantly material (for me, above 5%). I won't make a change in my written material. [Also included in 19] [TI 1/13, p. 52]
[Context] Meeting of the Investor Discussion Group on March 17, 1993. Part of the meeting was devoted to the topic of conservatism, volatility, reliability, and neutrality. During the discussion, comments were made on core earnings.
Committee/Staff/Observer
We've talked about the quality of earnings; how would you define quality earnings? We've talked about the concept of core earnings, which I would define as the earnings to which a multiple greater than one is applied. Can any analogy be drawn between core earnings and quality earnings? Could I think about quality earnings in terms of a multiple? Are good quality earnings that you apply a multiple greater than one to, lower quality earnings something you apply a multiple of one to? [Also included in 2(b)] [TI 3/17, p. 34]
Participant I-16
There are two ways of looking at it. One is the conservatism aspect; for example, companies using accelerated depreciation using the same useful lives as another company using straight-line, are clearly more conservative and are perceived as having better quality of earnings. The second aspect is predictability and stability. If you believe a company can report earnings of at least that much in the next year, it's worth more than if you have no idea. For example, if I had the earnings of [name deleted] for one year and ask how much it's worth, I wouldn't have any idea because I don't know whether they made any money in the prior year and whether they would make any money in subsequent years. [Also included in 2(b)] [TI 3/17, p. 34-35]
Participant I-7
One of the problems I have in answering that question is that earnings quality is only one aspect entering into the valuation of a company. For me, earnings quality is only one measurement of valuation. [Also included in 2(b)] [TI 3/17, p. 35]
Participant I-12
I would focus on the concept of earnings quality equals predictability. For example, [name deleted] is considered among the highest quality in the brokerage business, a highly volatile business. The company typically gets a substantial discount to the S&P multiple because they have a merchant banking operation where they periodically take gains. You take those numbers out and then look at the P/E and it gives you an entirely different perspective, because the market is looking at the predictable elements. I think of core earnings as operating earnings; the merchant banking part is not an operating business. What I assign a multiple to is the portion of the earnings where I have some ability to predict them. [Also included in 2(b)] [TI 3/17, p. 35]
[Context] Meeting of the Creditor Discussion Group on December 8, 1992. Part of the meeting was devoted to the topic of creditors' objectives and approaches. During the discussion, comments were made on core earnings and income statement display.
Committee/Staff/Observer
Question 3. To what extent, if any, do you consider the entrenched intrinsic value of a company as you think about credit? We have a mirror group of folks that are equity side people who meet like this, and clearly intrinsic value of company is a very big discussion with them, including things like normalized core earnings. So what we're trying to find out is whether or not their concerns and your concerns run parallel, or on different paths, and if so, how. [Also included in 1(a)] [TC 12/8, p. 13]
Participant C-1
We use multiples of cash flow. So we're using earnings before taxes, depreciation, amortization, and multiples of that. The problem with determining normalized or core earnings is the amount of so-called one time charges which are always run through a company's income statement. The amount of time spent looking at pro forma cash flows or pro forma earnings is tremendous. The number of companies selling divisions, selling plants, closing plants, or looking at buying companies and then merging them makes it very difficult for us to look at normalized cash flow and determining intrinsic value of that. [Also included in 1(a) and 1(c)] [TC 12/8, p. 13]
__________
Participant C-13
Second, an entirely unrelated observation would be that in the area of company data, I think it would be very helpful to us to get a sense of the distinction between fixed and variable costs. [Also included in 1(b)][TC 12/8, p. 25]
__________
Participant C-1
That's very difficult, because I think that core earnings is equally critical. The problem with core earnings is just that the accounting standards have become so much more complicated that they tend to even hide further what core earnings are. [Also included in 15] [TC 12/8, p. 26]
__________
Participant C-4
I deal with a lot of smaller companies that probably a lot of you, revenues of $50 million and less primarily. Understanding core earnings is a key to our analysis, and I see no consistency in footnotes of supplemental information that we're receiving for customers of that size. One good example of what we need would be a cost of sales breakdown. That helps us assess cash flow, assess profitability, gross profits, and what's causing the gross profits to fluctuate, what's causing the cash flow to fluctuate. Overhead schedules are very important, and in percentage of completion accounting, open and closed job schedules are essential in determining the success and the prospects of the company that we're trying to grant credit to. [Also included in 5(b) and 15] [TC 12/8, p. 27-28]
Participant C-12
I deal mostly with large investment grade institutions, and I find in general they do a pretty good job of giving me information I need to see to know what the core earnings are. For example, [name deleted] in its quarterly press release will give me a chart showing the changes quarter to quarter in ten different items, but they've never told me what they earn in credit card. One of the most basic segments I'd want to get just is not there. So, segment information is my first priority. [Also included in 3(a), 3(b), and 15] [TC 12/8, p. 28]
Participant C-5
Core earnings are the key for us. Comparability of revenues and expenses from prior periods, same store sales, subscriber counts, whatever it is. And then capital expenditures is an item that is just under-addressed. And all of that allows me to understand the contribution to future earnings or future reduction in cost, likely expenditures moving forward, the quality of return on recent investment in plant and equipment. It all gets back to core earnings. [Also included in 15] [TC 12/8, p. 28]
__________
Participant C-3
When you look at a large financial institution, the biggest question that pops up is whether the accounting model that we're using is right. That focuses on the mark-to-market issue. The investment portfolio discussions that have gone on is really just the tip of the iceberg. In looking at some of the companies that I look at, segments become the secondary issue; how you determine earnings is the number one issue, or what are the earnings of a company. [Also included in 4 and 15] [TC 12/8, p. 28-29]
__________
Participant C-5
Management salaries are important in the small company environment. And those typically we don't get broken out. We also deconsolidate finance companies from the consolidated financial statements of commercial companies. [Also included in 1(b)] [TC 12/8, p. 46]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of value information. During the discussion, comments were made on income statement display.
Committee/Staff/Observer
At the bottom of page 4 of the meeting materials, there's a position put on the table that I haven't heard talked about yet. It says that if you used fair value, rather than historical cost, as the measurement basis of financial statements, you might get different measurements of income that might make cuts you don't currently see. The typical example is that inflation will allow companies to look like they're growing because historical cost makes no discrimination about the size of the dollar that's in the balance sheet or the income statement. Where dollar or standard dollar value financial statements or current cost statements or any other varieties that have been proposed over the years would separate out holding (inflation) gains from real gains. So, for example, ABC Company sells 100 widgets every year. And the 5% inflation every year makes it look like the sale of those same 100 widgets is revenue growth. And ABC Company has about the same profit every year. So, from the point of view of what's really happening, ABC Company is really losing against inflation, and perhaps even doing some self liquidating. Is that issue important to you to get an alternative measurement of earnings that somehow makes that cut? And if so, how do we do it, if at all? [Also included in 4] [TC 2/2, p. 9]
Participant C-13
In the example you cite, the very first question you ask management about revenues is what's the price impact; that's the simple answer to that question. [Also included in 4] [TC 2/2, p. 9]
Committee/Staff/Observer
And you're telling me that is part of what you do? [Also included in 4] [TC 2/2, p. 9]
Participant C-13
Yes. You're identifying the price impact on revenues directly for that particular enterprise as opposed to being on a generalized basis. So you're getting to the heart of the problem as it relates to that specific enterprise rise relative to inflation. [Also included in 4] [TC 2/2, p. 10]
Committee/Staff/Observer
If you start at the top, then, and you say, okay, I now am going to identify the price per unit effects here, do you do any analysis down from there? And, if so, what? [Also included in 4] [TC 2/2, p. 10]
Participant C-13
Let's take a soft drink company such as [name deleted]. The domestic unit growth is low. But the overseas unit growth continues to be very satisfactory. So, you disaggregate. Then you need to disaggregate the price impacts, domestically and also in major overseas markets. So the next stage is disaggregation of aggregate information. [Also included in 4] [TC 2/2, p. 10]
Participant C-4
In construction, all of the contractors typically lock at prices at the beginning of a contract so the gains that occur are on completion of projects. So this information to us is not that crucial. [Also included in 4] [TC 2/2, p. 10]
Participant C-2
I think we are accustomed to dealing with these issues of how comfortable we can get with this notion of inflation gains through the analytical process. I think we address the issues. We don't necessarily need to have them screened out for us. [Also included in 4] [TC 2/2, p. 10]
Participant C-4
You do run the risk of information overload here, too, at times. You've got to remember that the typical analyst has to get into separating those two elements out. We have some significant borrowers who have been pretty effective in locking in costs by hedging commodity prices or whatever. And that's part of what we would consider operating management. Is that truly manufacturing efficiency that allows you to take that commodity and turn it into a product at a low cost? Or is it your effectiveness of your hedging strategy such that you lock in early commodity prices? We look at it as one big operating process and the quality of management is all a part of that activity. We're pretty good at analyzing numbers but I could get into information overload if you gave me too much. [Also included in 4 and 19] [TC 2/2, p. 10-11]
Participant C-2
The point is the cost of determining that in light of that information. And I think for many credit granters we're working with financial statements of small businesses. I think if cost to develop that information becomes more onerous than it presently is, we're going to drive those businesses away from audited financial statements to our detriment. [Also included in 4 and 17(a)] [TC 2/2, p. 11]
Participant C-17
As lenders, you tend to know customers. So as these issues come up, because of increasing inflation, half the time they're telling you about it or you're asking about it, and whatever. So I think sometimes you can get to the point where it becomes overload. [Also included in 4] [TC 2/2, p. 11]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of display.
Committee/Staff/Observer
Assurance is an issue that we'll talk about at the next meeting. I'd like to move to page 7 of the meeting materials, Roman numeral II, to issues called display. Display is a notion of what information shows up on the face of a financial statements or in a footnote explaining the financial statements. It is different than measurement, where we're arguing about whether historical cost or some other values should be used. It has to do more with telling you how much information is needed to know about things. This discussion is broken up, beginning on page 8, among income statement, balance sheet, and cash flows and I think we have the final one that has to do with some risk and uncertainties, as well. From an accounting point of view, a non-recurring item is an item that's not supposed to happen again. As opposed to an unusual item, which is an item that probably is not an everyday occurrence, but the fundamental distinction is it is not part of our ordinary business. The questions of both 5a and b in the meeting materials are: are you satisfied with the amount of identification currently in financial reporting of non-recurring or unusual items? If not, where would you draw the line? Would you let management make its own decisions about what it would label as those? If not, who would make those decisions or should we have some objective criteria that we hold up and measure all these things against? [TC 2/2, p. 12]
Participant C-11
This is a very difficult area. Extraordinary, if we're talking about really non-recurring things like the adoption of 106 or something like that, that can be clear cut. I have been having a lot of problems, and I think every analyst must have had the same thing in every quarter now lately about people calling things non-recurring when they're actually happening rather often. And I'm thinking of the obvious restructuring activities that occur on an acquisition or the frequent dispositions we're now seeing. Or not dispositions necessarily, but, cost taken to restructure or to downsize a part of a company. I think that non-recurring is too absolute a word. But I do think we need differentiation between things that I just named that are certainly individually relatively unique events that occur and what I would call unusual items. But the bottom line really to me is that they get identified. I'm talking about the income statement here. I'm saying that as opposed to having it in the management discussion, particularly for the restructuring type things, because that's a two-year kind of picture that you're getting in the management discussion, and it can be just lost in the morass from one annual report to another. The most important thing is that they be identified so that an analyst, if he or she wants to ask more questions, at least is given a clue that something different happened here. I don't think that the magic answer is the difference between unusual and non-recurring. Non-recurring is an absolute word the way it's been used in recent years because there just are lots of restructures going on that aren't going to be non-recurring. [Also included in 13] [TC 2/2, p. 13]
Participant C-5
In day-to-day financial analysis, I've sort of given up distinguishing between non-recurring and unusual because of the types of items that have slipped in those categories. We are back to making our own determinations of what we consider to be non-recurring and not everybody does your own analysis. As a lender, you have the unfair advantage of getting additional supplemental financial information so that you explore into those items, to figure out what they are. You make your own determination. One of the big items that's not in there is the cash and non-cash nature of those items. These large reserves that are set up in these restructuring charges: how much of this is actually cash and how much of it is not? So we've got to get back to cash impacts in many cases. So I would just say that what I thought was a real restrictive guidance to get most things back into the operating statements, as true operations, and realizing that even disposing of businesses, cutting staff and laying off employees, were classified as operating activity, disturbs me and I've sort of given up on the way they've been presented except for our own analysis accounts. [TC 2/2, p. 13-14]
Participant C-13
The key is establishing what the core earning power is. I don't have any difficulty with your definition of non-recurring as something that never happens again. Although like in [name deleted], there were five straight years of non-recurring charges! But where I have a little difficulty is the definition that you made of unusual. An unusual item, it seems to me, can be something that does occur in the normal course of operations, but doesn't occur that frequently. Therefore, its occurrence is distorting the results. I guess a 100 year hurricane for a casualty insurance company would be one example. And I think under your definition, it wouldn't be necessary to disclose the separate impact of that on operations. Clearly, it's something that one would need to know. [TC 2/2, p. 14]
Participant C-2
I would basically concur with that. To me, it doesn't matter much if you call it non-recurring or unusual. I'd like to be able to quantify that out, look at it separately, understand the underlying transactions reflected in whatever those numbers may be. Make some judgments about whether or not they really would be part of earnings or not. What the impact on cash flow either has been or will be. And so to have them highlighted in some way would be very useful. [TC 2/2, p. 14]
Participant C-4
Our focus is on earnings as we said in our last session. Discretionary expenses--profit-sharing contributions, bonuses, may be very usual and recurring, but, nevertheless, not a true indicator of the operations. [TC 2/2, p. 14]
Participant C-14
I was just going reemphasize the importance, for a second, of cash and non-cash impacts. Just because companies have put things that may be not recurring does not mean that it will signify something very important. On the other hand, there's the quality of historical earnings. [TC 2/2, p. 14]
Committee/Staff/Observer
How would you feel about letting management pick and choose what is unusual or non-recurring? [TC 2/2, p. 14]
Participant C-13
I understand that problem, but to a certain extent, you're going to have to rely on management. There, too, you're raising a problem. But you've got the oversight of the auditors and the SEC, between that and your own investigation and knowing what the nature of the business is, you should be able to establish what these items are. [Also included in 17(a)] [TC 2/2, p. 15]
Participant C-5
On the expense side, you always assume that management would like to clean as much out of operating items as possible, so there you can take the broadest definition and converse on the income side. I'm not uncomfortable with management taking the lead on that decision with some accounting supervision. On the expense side, if they choose to treat them as operating expense, I've got to assume that they're leading us to believe that don't expect this to be a one-time event regardless of what the definitions are. That we are going to continue to downsize at [one company] over the course of quite a few years here or [another company] and the like. I think the accounting standard has forced them to try to get as much down there as possible instead of really trying to be honest with their constituents, the investors, the creditors, and so forth, about whether they believe they're non-recurring. [TC 2/2, p. 15]
Participant C-15
I believe a lot of management incentive compensation programs are tied to the operating earnings. I think I would prefer someone with a little bit more objectivity and less direct interest in the outcome make those judgments rather than having management make those types of judgments. [TC 2/2, p. 15]
Participant C-17
When I go through an income statement, what I'm trying to figure out is what are sustainable earnings? What's going to come in every year and what's ordinary to the operation? What are controllable expenses? What are discretionary expenses? And what's cash versus non-cash? And regardless of how you categorize it, all that gets back to what is the predictable level of cash flow that this company's going to be able to generate. [TC 2/2, p. 15]
Committee/Staff/Observer
Let me focus with you on page 9, item C [of the meeting materials]. Our question is whether or not more detail is what you wish, what users need. As users, would you say you need more detail in the income statements? Is that part of the solution? [TC 2/2, p. 16]
Participant C-11
I think that we're in a complex world and if there are "unusual or non-recurring" things going on, that's the reality. And if you force the accounting statement to do something else, to say something else, make it simple, indeed, for a database, you're making just a horrendous mistake. I think I can make an absolute statement along those lines. [Also included in 16(a)] [TC 2/2, p. 16]
Committee/Staff/Observer
Are we clear about what we're talking about, about a database? I think we need to be careful. We're talking about raw information about a company, not about a database of a lot of companies, all putting the same information in so that you can compare. We're talking about a company, in essence, opening up its books and saying, here, take whatever you want. That's what you were talking about, right? [Also included in 16(a)] [TC 2/2, p. 16]
Participant C-2
Kind of like on an on-line real time basis. [Also included in 16(a)] [TC 2/2, p. 16]
Participant C-11
As opposed to the EDGAR type. What we're talking about here is when an individual company has something occurring that either makes the reported earnings significantly different or if some restructuring or whatever is going on, that gives you specific information about something that's happened, that is not in the ordinary category of revenues and expenses. So I would answer in that context. If you talk about opening the books, that obviously doesn't work, you have to have some control and framework for the numbers that you're reporting. [Also included in 16(a)] [TC 2/2, p. 16]
Committee/Staff/Observer
Most accountants do not like standards or rules that are based upon a mathematical test. But if there were a mathematical test, for example, any transaction that is a disposal of an asset, or the settlement of a liability, which is not an ordinary course of business transaction, and that produced a result, gain or loss, above 5%. Would some notion of that kind of a disclosure or presentation be useful? [TC 2/2, p. 17]
Participant C-13
My answer to that question is yes. I think that there are two issues here. One is the one that [committee/staff/observer] brings up which is the issue of materiality. The other is the issue of what kinds of information you want to display. I believe that the 5% materiality test is not nearly severe enough. And the materiality test should relate to the year-to-year changes in a company. In other words, if the item that you're describing -- be it a disposal of assets, or settlement from liability -- affects a change in year-to-year income of 5%. [TC 2/2, p. 17]
Committee/Staff/Observer
But there is a trap there . . . and that is that if you had a break-even year-to-year, that would suggest every transaction would hit the materiality test. [TC 2/2, p. 17]
Participant C-13
I know. I realize that. But, on the other hand, you can do an either/or. But the point that I'm making is that the changes in earning power, cash flow, from year to year are very important. Also from period to period. [TC 2/2, p. 17]
__________
Participant C-4
A lot of times it may be difficult to release records of the company so if the accountants could standardize that information it would be helpful. Also, going back just for a second to the prior question about what additional information for the income statement. If some of the supplementary information that the accountants provide could be standardized, it would help in analyzing cash flows and doing some standard tests of balance sheet items. That type of information, if it's standardized, makes it a lot easier for an analyst to discuss with management and, looking at their internal records, to make comparisons based on year-end audits between companies. [Also included in 5(b)] [TC 2/2, p. 18]
__________
Participant C-11
I have a subsidiary point to make on the indirect method. Often times, the item lumped together is depreciation and amortization. I think that there's a real absence often of good data, both in terms of what the amortization is, as opposed to depreciation of equipment. And also in a footnote context the time period for the amortization. Everyone knows that there are now new capital ratios that give different weighting allowances for goodwill of different types. And it's astonishing to me that still very well recognized companies do not disclose goodwill at all in the published financials. So I think a lot more weight has to be put on differentiating those items than has been the case. [Also included in 5(c) and 7(a)] [TC 2/2, p. 26]
[Context] Responses to the postmeeting questionnaire to the February 2, 1993 Creditor Discussion Group meeting.
QUESTION 4-Income statement display
a. Does the information in the current income statement, related notes and MD&A generally provide you with sufficient information about nonrecurring and unusual transactions and events?
3 _ Yes 11 _ No
Participant C-2: Depends on the quality of the statements and disclosures, but generally no.
b. If NO, please indicate your preference for each following proposal regarding income statement display of nonrecurring or unusual amounts, by marking:
H Offers high potential for helping you in your work
M Offers moderate potential for helping you in your work
L Offers very low or no potential for helping you in your work
(If you checked YES in 4a, skip to question 4c.)
H, M, or L
____H-5,M-4,L-2 Display separately the effects of nonrecurring or unusual transactions or events based on management and auditor judgments about which transactions or events are nonrecurring or unusual.
____H-4,M-7,L-0 Identify nonrecurring or unusual transactions or events to be separately reported based on specified criteria. (Those criteria could be based on, for example, (1) the type of transaction, (2) the frequency of the transaction, or (3) the size of effect.)
____H-8,M-3,L-0 Provide more detail about the cash and noncash portions of restructuring charges.
____H-7,M-2,L-2 Provide more detail of items in the other income and expense caption(s), and nonoperating captions, using a materiality threshold that is much lower than currently used in practice.
____H-2 Something else. Please describe.
Participant C-17: Statement footnote or management narratives to detail and explain sources and cause: Also would allow annual comparison to check if nonrecurring had a habit of re-occurring.
Participant C-13: -- Note amounts before and after tax.
-- No netting of material amounts.
Participant C-4: Include a section in the P&L entitled "Discretionary Expenses." Include bonuses, profit sharing contributions, etc.
Participant C-11: In the present framework, realized gains or losses should be separated from operating income.
c. Please help us understand the types of information that you would find useful about unusual or nonrecurring events regardless of how defined:
Enter
H, M, or L
as in question b
____H-11,M-3,L-0 A brief description of each nonrecurring or unusual transaction or event.
Participant C-2: Will alert analyst so more information can be obtained.
____H-9,M-4,L-1 The gross effects on revenues and expenses of nonrecurring and unusual transactions when shown "net".
Participant C-11: This would depend on the type of transaction.
____H-4,M-7,L-3 The tax effects of nonrecurring and unusual transactions or events.
____H-2,M-5,L-6 The effect only on net income of nonrecurring and unusual transactions or events.
____ Something else. Please describe.
Participant C-14: Cash flow impact (after-tax).
d. Does the information in the income statement, related notes, and MD&A generally provide you with sufficient information about the recurring operations of the company's business?
4 _ Yes 10 _ No
Participant C-2: Could be improved.
Participant C-6: Want to stress importance of consistency in reporting which I feel is not always followed.
e. If NO in 4d, please indicate your preference for the following:
H, M, or L
as in question b
____H-8,M-2,L-0 Divide operating expenses into fixed, semi-variable, and variable categories
Participant C-11: For many nonfinancial companies.
____H-7,M-1,L-2 Divide operating expenses into required and discretionary categories
Participant C-5: And capital expenditures.
____H-8,M-2,L-0 Display the types and amounts of costs included in certain major captions (for example, cost-of-sales broken down by purchased materials, salaries, fringe benefits, occupancy costs, property taxes, and other major components of costs).
____H-3,M-5,L-2 Display selling expenses separately from general and administrative expenses.
Participant C-11: On occasion.
____H-8,M-1,L-1 Display the portion of cost-of-sales and SG&A expenses that is depreciation.
____H-3,M-5,L-2 Indicate separately the portion of costs and expenses that relate to employees versus those that do not.
____H-6,M-2,L-2 Indicate separately amortization of goodwill and amortization of identified intangibles from depreciation of property and equipment.
____ Something else. Please describe.
Participant C-17: 1) Rental (operating expenses) for real property and personal property.
2) Provision for bad debts or loan loss expense.
Participant C-5: Capital expenditures by revenue creating expense saving maintenance.
Participant C-12: The best format is a table showing "miscellaneous" income and expense items, with MD&A, providing comment on any nonrecurring items (as well as occurring, some of which I may discount as well).
Participant C-11: It is probably unproductive to devise one format that fits everyone. Data should be displayed that best fits the business of the entity, and preparers should feel under pressure to provide a breakdown that shows the most important dynamics in each operation.
[PMQC 2/2, p. 7-10]
[Context] Meeting of the Creditor Discussion Group on March 11, 1993. Part of the meeting was devoted to the topic of priority of improvements needed in external reporting. During the discussion, comments were made on display.
Participant C-1For me, the most important one would be number eleven, this concept of core earnings. There are things which we consider unusual or extraordinary that are not classified that way. I think it's more a rule change. Now maybe it doesn't need to be a rule change, maybe additional disclosure on it, but if I had to go through this whole list, that would be the most important thing to me. [Also included in 15] [TC 3/11, p. 69]Participant C-4
I had three circled, one being the core earnings. We find it very difficult to pick out what core earnings truly are on a consistent basis. I also had ten; we see a real need to get more information about off balance sheet activity including particularly operating risks. And disclosure of measurement uncertainties is the final area that I circled. [Also included in 15 and 19] [TC 3/11, p. 69]
Participant C-12
I think the number 11 concept of core earnings is important to the analysis. I'm not sure that it's something that you're going to be able to give me. If the object is to give me the detail in the financial statements so that I can, in the end, make my own judgment as to what is core earnings, that's fine. On the other hand, if the object is to do what a lot of foreign institutions do and say this is core earnings, I'm always going to adjust that number. This year in [name deleted's] numbers I'm taking out $170 million of foreign exchange gains in the third quarter because it was a great quarter and they've said it was about that much over and above the normal quarter. My second choice is number 13, accounting for financial instruments. I'd also put in a vote for number one, statistics on the economy. Maybe in general, maybe when it comes to banking in terms of local economy, a lot of my decisions don't make it worth my while to figure out what's going on in the local economy in whatever state, whatever city, whatever regions. And one of the things that foreign banks do that's very good is they give me that information. They tell me what rates are doing, which I need to know, they tell me what real estate prices are doing, they tell me what lending volume is doing. I could go out and do that myself but often the decision I'm making doesn't justify doing it. And it's a great help to me to have it in the annual report. [Also included in 13 and 15] [TC 3/11, p. 72]
Participant C-10
9 (display), 11 (core earnings) and 12 (interim reporting). Basically try to improve cash flow information. Under nine, I think there's too much alternative uses here. I'd like to get more consistency. And like core earnings, one of the things that we're always doing is pulling out depreciation, normal depreciation and extraneous or non-normal. Most companies will just lump it in one figure. On interim reporting I just think that we have to keep hitting on this issue with you folks, otherwise you'll back up on us. [Also included in 5(d) and 15] [TC 3/11, p. 72]
[Context] Responses to the postmeeting questionnaire of the December 9, 1992 and January 13, 1993 Investor Discussion Group meetings.
QUESTION 10--Income statement display
a. Does the information in the income statement, related notes, and MD&A generally provide you with sufficient information about nonrecurring and unusual tansactions and events?
Yes 1 No 6
b. If you checked "no" in 10a, please indicate your relative preference for the following items, each of which relates to display on the income statement of nonrecurring or unusual amounts, by marking:
H - the item offers high potential for helping you in your work
M - the item offers moderate potential for helping you in your work
L - the item offers very low or no potential for helping you in your work
(If you checked "yes" in 10a, please skip to question 10c)
rank
H, M, or L
High Moderate Low or no
potential potential potential
Display separately the effects of nonrecurring 3 2 1
or unusual transactions or events, particularly
those that increase income, based on management
and auditor judgments about which transactions
or events are nonrecurring or unusual.
Display separately the effects of nonrecurring 6
or unusual transactions or events, particularly
those that increase income, based on specified
criteria to identify the nonrecurring or
unusual transactions or events. (Those
critieria could be based on, for example, (1)
the type of transaction, (2) the size of the
impact, or (3) the frequency of the transaction
or event.)
Provide more detail about restructuring 5 1
charges. That detail should distinguish
between the cash and noncash portions of the
charge and perhaps the tax effects of the
various components.
Provide more detail of items in the other 3 3
income and expense caption(s) and nonoperating
captions, using a materiality threshold that is
much lower than currently used in practice.
Something else. Please describe. 2
Participant I-8: Unusual distributor ordering
and stocking either of a new product or in
advance of a price increaseon an existing
product. Particularly where subsequent sales
to reflect "move through" are likely to be well
below the inventorying period.
Participant I-12: Extra high. For my earnings
models, I have above-the-line categories for
recurring, nonrecurring items (sale of
subsidiary, gains/losses on mortgage backed
securities, etc.) Perhaps something along
these lines might be helpful.
c. Please help us understand the types of information that you would find useful about unusual or nonrecurring events by indicating your preference for the following items:
rank
H, M, or L
as in question 10b
High Moderate Low or no
potential potential potential
a brief description of each nonrecurring or 7
unusual transaction or event or group of
similar transactions or events
the effects on revenues and expenses of 7
nonrecurring and unusual transactions or events
that affect both
the tax effects of nonrecurring and unusual 5 2
transactions or events
the effect only on net income of nonrecurring 1 3 3
and unusual transactions or events
aggregated amounts resulting from nonrecurring 1 5 1
and unusual transactions or events taken as a
whole
separate disclosure of the effects of each 6 1
significant nonecurring or unusual item or
event, or each group of similar transactions or
events
Something else. Please describe. 1
Participant I-6: All items should be listed
separately, but in a fashion that would
quantify the total amount involved.
d. Does the information in the income statement, related notes, and MD&A generally provide you with sufficient information about the operations of the company's business?
Yes 1 No 6
Participant I-12: We analysts can't get enough information
e. If you checked "no" in 10d, please indicate your relative preference for the following items, each of which relates to display on the income statement that could possibly be helpful in understanding the operations of the company's business:
rank
H, M, or L
as in question 10b
High Moderate Low or no
potential potential potential
Divide operating expenses into fixed, 4 1 1
semi-variable, and variable categories
Divide operating expenses into controllable and 2 2 2
noncontrollable categories
Divide operating expenses into discretionary 3 2 1
and non-discretionary categories
Display the types and amounts of costs included 5 1
in certain major captions (for example,
cost-of-sales broken down by purchased
materials, salaries, fringe benefits, occupancy
costs, property taxes, and other major
components of costs).
Display selling expenses separately from 6
general and administrative expenses.
Display the portion of cost-of-sales and SG&A 5 1
expenses that is depreciation.
Indicate separately the portion of costs and 3 3
expenses that relate to employees versus those
that do not.
Something else. Please describe. 1
Participant I-11: More responsive explanation
of changes in MD&A ("cost of goods was up
because sales were up" is not helpful.
[PMQI 12/9 and 1/13, p. 16-19]
[Context] Responses to the postmeeting questionnaire to the March 17, 1993 Investor Discussion Group meeting.
QUESTION 12
In prior meetings, investors have used the term core earnings when discussing their methods for valuing companies. We presume that by core earnings investors generally mean:
Core earnings - the portion of a company's reported historical earnings that are stable and recurring and that provide a basis for estimating its expected repeatable average earnings over a span of future years. Thus, core earnings excludes those portions of historical earnings that are infrequent, nonrecurring, or otherwise unusual enough to be distinguished from that portion of earnings that results from the usual operations of the company.
a. Does the foregoing accurately describe your definition of core earnings?
Yes 4 No 1
If not, how should the description be changed?
Participant I-16: Accounting should not attempt to report stable earnings. It should report what actually happened during the period, while identifying (non-recurring events which actually happened during the period) and corrections of prior misallocations which are part of recurring items - but not of the current period.
You have an exceedingly oversimplified conception of core earnings. It is in the mind of the beholder. It is a normalized trend- not a stable level. It relates to specific business operations, not to an overall company. Disaggregation in disclosure would assist investors in their estimation of core earnings. Valuation and earning power are forward looking- not historically based.
b. To what extent do investors' judgments about core earnings differ? That is, if a dozen investors independently determined a company's core earnings, would the resulting twelve measures of core earnings likely be: (Please check one.)
nearly the same amount? 1 Participant I-9: Except for very cyclical or volatile industries like metals or hogs different amounts showing a 3 tendency to cluster? different amounts scattered about, showing no predictable pattern? something else? Please explain. 1 Participant I-16: It depends upon the volatility of the company's business.
c. Core earnings is a concept of financial analysis and not currently of financial accounting. If forced to choose between the following, which one would you choose, and why? (Please check one.)
Financial accounting should be 1
updated to include the concept of
core earnings. That is accounting
standard setters should define core
earningsand require that the amount
be reported as a separate caption
on the face of the income
statement. Amounts that are
excluded from core earnings should
be separately displayed in the
income statement or disclosed in
the related notes.
Determining core earnings should 4
remain the job of financial
analysis and not financial
accounting. Thuscore earnings
should not be separately reported
on the face of the income
statement. Howeverfinancial
reporting should help investors
determine core earnings for
themselves. Thus standard setters
should define infrequent unusual
and nonrecurring transactions or
events and require that the effects
of those transactions or events be
separately displayed in the income
statement or disclosed in the
related notes.
Please briefly describe why you Participant I-16: Core earnings
chose one method and rejected the are more subjective than reported
other. earnings should be. Adequate
disclosure would allow individuals
to reach their own independent
estimates of "core earnings." In
some cases ([name deleted] et al)
there would be no agreed value- or
anything close to agreement.
Participant I-9: Key is financial
reporting should help investors
determine core earnings for
themselves.
Participant I-11: Core earnings is
an analytical concept, not an
accounting concept. Analytical
judgements differ, and properly so
(although sophisticated analysts'
judgements should tend to cluster
most of the time). Neutral,
reliable, consistent financial
statements provide a basis for
analysis; "analyzed" financial
statements don't.
d. Please answer the following questions about potential factors that investors use to distinguish between core and non-core earnings.
Is frequency of occurrence a condition for including a gain or loss in core earnings?
Yes 5 No
If so, how infrequently should a particular transaction or other event occur for you to exclude its financial effect(s) from core earnings?
Not more often than once in every 1
eight or ten years
Not more often than once in every
six or seven years
Not more often than once in every 1
four or five years
Not more often than once in every 1
two or three years
Other. Please explain. Participant I-16: It is impossible
to give a precise rule.
Participant I-11: This is not a
simple issue. Consider a
manufacturing company with several
parcels of land it acquired for
planned but since abandoned
expansion. If it sells off one
parcel a year for two, thre, four,
or X years, does this make
gains/losses "core"? I don't think
so. I think relevance to
continuing business operations has
to be taken into account. With
that major caveat, I'd say that
every 4-5 years is a good place to
start.
Is relationship to an ongoing major line of business of a company a condition for including a gain or loss in core earnings?
Yes 3 No 1
If so, would you usually consider gains or losses resulting from each of the following to be nonoperating and exclude them from core earnings?
Investment activities that are peripheral to a company's manufacturing operations but involve recurring transactions and price changes and result in significant gains and losses and cash flows Yes 3 No 1
Impairment of plant and equipment assets of a manufacturing company that has suffered a more-or-less constant decline in demand for its product
Yes 3 No 1 Disposal of plant and equipment assets of a manufacturing company whose products require regular modernization and upgrading of the manufacturing process Yes 2 No 2 Restructuring of a manufacturing company involving laying off employees for what is expected to be a long period Yes 2 No 1
Please explain the reason for each No answer.
Participant I-16: 1) I would estimate core earnings for specific businesses- not for a diversified company. 2) An analyst often has to reallocate "non-recurring costs" - they are often ordinary expenses that were undersestimated in prior periods.
Participant I-11: Recurring investment income from a company with large cash balances is part of its business, and reflects management's decisions as to the continuing deployment of those assets. Similarly, disposal of plant and equipment is part of being in, say, the semiconductor manufacturing business. Restructuriongs should be exceptional events - if they become commonplace, that raises some major non-accounting issues about management - all the more reason to red-flag the issue. Similarly, if a management sees steadily declining demand for a product, it should adjust its investment and adjust depreciation to reflect a realistic useful life. That's part of running a business!
What do you do if those two conditions are in conflict-if a transaction or event is essentially the same as the operations of a company but occurs only infrequently or otherwise gives unstable results? For example, would you include the financial effects of each of the following in the company's core earnings?
Sale of a large order of a company's product to the U.S. Department of Defense if the last sale of that kind was seven years ago and prospects for another within the next five years are virtually nil Yes 1 No 3 Fluctuating investment gains and losses of an insurance company if an investment portfolio is an essential part of the company's operations and the volatility of the returns is inherent in investments in equity securities Yes 2 No 2 Please explain the reason for each No answer.
Participant I-16: You are confusing two concepts: 1) Results of operations of a specific period, 2) Normalized or trend or average earnings. Accounting should focus on #1, financial analysis deals with #2.
Participant I-9: Accounting should not try to make an unstable earnings pattern appear stable. Its job is to point out significant items that are unlikely to recur so that past results do not mislead investors, who are mainly valuing companies' future prospects.
Participant I -11: I'm not sure I mean my answer to #2. In an ideal world an insurance company would match its portfolio to its actuarial risk- especially a life insurance company. Gains and losses from "static" in actuarial experience should be ignored. In a world of "go-go" portfolio management, there's an additional risk element in the business as it's being managed. On further reflection, since the world is more nearly "go-go" than "ideal", perhaps they should be recognized.
[PMQI 3/17, p. 19-25]
QUESTION 13
Under current rules, in a handful of circumstances, amounts are charged or credited directly to shareholders' equity and bypass the income statement. One example is translation gains and losses resulting from changes in exchange rates. Supporters of the practice argue that it removes undesirable volatility from the income statement. The following statements relate to the desirability of recording certain gains or losses directly in equity. Please indicate your degree of agreement or disagreement by marking the applicable letter(s).
SA - Strongly Agree
A - Agree
N - Neutral
D - Disagree
SD - Strongly Disagree
Strongly Agree Neutral Disagree Strongly
Agree Disagree
No gains or losses should be 2 1 2
charged or credited directly
to equity. All of those
amounts should be recorded in
the income statement.
The amounts that are 1 2 1 1
currently charged directly to
equity should be reported in
income. However, they should
be separately displayed below
the caption titled net income
and above a new caption
titled comprehensive income.
The practice of reporting 2 2 1
certain amounts directly in
equity should be retained.
However, the practice should
not be expanded to include
additional amounts that are
currently recognized in
income.
The practice of reporting 4 1
certain amounts directly in
equity should be expanded to
reduce undesirable volatility
in the income statement.
Please describe which items
that are currently reported
in income should be reported
directly in equity.
Participant I-11: I haven't made up my mind on this one- it begins to make the face of the P&L unpleasantly complex.
[PMQI 3/17, p. 25-26]
[Context] Responses to the postmeeting questionnaire of the March 11, 1993 Creditor Discussion Group meeting.
QUESTION 13
It is clear users are interested in improvements which would enhance identification of core earnings and related cash flows. It is not clear what improvements would best serve users needs. Please indicate your agreement or disagreement with the following approaches to identification of core earnings and cash flows. Respond using the following:
SA - Strongly Agree
A - Agree
N - Neutral
D - Disagree
SD - Strongly Disagree
SA-3,A-4,N-3,D-3
a. Income statements and cash flow statements should be formatted so that each reports a subtotal of "Core Earnings" and "Core Cash Flows".
Participant C-21: Either method (a. or b.) would be acceptable.
A-5,N-2,D-5,SD-1
b. Current income statements and cash flow statements should not be reformatted, but supplemental disclosures should be included that provide breakdowns of revenues and expenses (cash inflows and outflows) between core amounts and other amounts.
SA-1,A-5,D-6,SD-1
c. It is not necessary to report a distinct amount as core earnings or cash flows. What is required is improved disclosure of unusual amounts by redefining "unusual" for accounting purposes. Thus, users can make their own judgements about which unusual items, if any, should be included in core earnings.
Participant C-14: This would work.
Participant C-21: This would be more difficult for user and consistency would not be maintained.
A-2,N-3,D-6,SD-2
d. It is not necessary to report a distinct amount as core earnings or cash flows. What is required is improved disclosure of unusual amounts. Accounting standards should not define "unusual". Instead, management should make its own determination of what is reported as "unusual". Thus, users can make their own judgements about which unusual items, if any, should be included in core earnings.
Participant C-14: Too much discretion can lead to misleading figures.
Participant C-21: No.
SA-1,A-8,N-2,D-2
e. Allowing management to determine what is "unusual" provides too much risk that only expenses, not revenues, will be considered "unusual".
Participant C-11: Auditors would be involved here.
A-1
f. Something Else. Please Describe:
Participant C-11: Apart from unusual items, another major category is valuation changes - realized and unrealized - caused by interest rate or market value changes for financial instruments.
Participant C-4: Standardize income statement and cash flow statement - operating section to include the same breakdowns - Rev, G.P. and core earnings.
Participant C-17: C - Unusual/extraordinary charge and income shall be carefully defined and cash vs non-cash charges clearly identified.
[PMQC 3/11, p. 20-22]
QUESTION 14
In determining core income for a company, to what extent would different creditors include and exclude the same components of net income? That is, if a dozen creditors independently adjusted a company's net income to determine its core income, would the resulting twelve measures of core income likely be (please check ONE):
0 a. The same amount
9 b. Different amounts showing a tendency to cluster
Participant C-21: Hopefully.
2 c. Different amounts showing no predictable pattern
2 d. Something Else.
Please Describe:
Participant C-14: Everyone's intended use of the information and subsequent conclusions would be very close but the method of adjusting the numbers would vary, i.e., I deduct cap ex from cash flow - others may not but we all look at it and use it the same way before we draw our conclusions.
Participant C-11: Opinions would vary depending on what elements a creditor thinks are critical, by economic or cyclical circumstances, types of operation, etc.
Participant C-4: Close to the same amount, depending on the creditors level of understanding.
[PMQC 3/11, p. 22]
[Context] For companies in the precious metals business, the Mining Industry Subcommittee of the AIMR Corporate Information Committee would like to see improvements in reporting the following:
[The Oil Industry Subcommittee of CIC] note[d] the wide disparity that very often exists between the reported earnings for many oil companies and true operating income that provides a basis for future expectations. With a large number of major corporations in the midst of major restructuring moves, the impact from nonrecurring events can completely distort reported earnings and conceal a company's true operating position. If professional analysts are confused with some of the reported earnings data we can only assume the individual investor is even more so. [Also included in 15] [AIMR/CIC91, p. 1]
Most [CIC] subcommittees agree . . . [that] the following suggestion seems appropriate: [Also included in 1(b), 2(b), 2(c), 3(b), 3(d), 5(d), 11(a), 13, and 16(b)] [AIMR/CIC92, p. 3]
Segregation of the financial impact from nonrecurring items (asset sales, write-offs, etc). [Also included in 1(b) and 16(b)] [AIMR/CIC92, p. 4]
__________
Pronouncements are concerned with balance sheet presentation with little attention to how results are reported in the income statement. AIMR's accounting committee has appreciated the attention the FASB has been giving the balance sheet but believes that the income statement is of equal importance. The committee supports the idea of comprehensive income as defined in Concepts Statement No. 6, but believes that the FASB should focus more attention on what is reported in the intermediate components of comprehensive income such as gross margin, operating income, income from continuing operations, and earnings as well as the basic components of comprehensive income, revenue, expense, gains, and losses. [AIMR/FAF91, p. 13]
The objectives of financial statements are to provide information useful in:
investment and credit decisions,
assessing cash flow prospects, and
evaluating enterprise resources, claims to
those resources, and changes in them.
[AIMR/FAF91, p. 14]
An income statement that contains only a few lines of aggregated information (the largest of which is frequently "other income and expense, net") does not achieve any of these objectives. [AIMR/FAF91, p. 14]
__________
[Background] The Financial Industry--Banks, Thrifts, Insurance Companies, and Securities Firms is the second in a series of AIMR Industry Analysis seminars and proceedings. The series was conceived by Charles D. Ellis, CFA, to provide educational material on the nuances of individual industries from the perspective of security analysis. . . . Each seminar is built around an analytical framework that identifies the key factors to consider in conducting an effective analysis of the industry and that highlights the specific interrelationships that underlie sound valuation decisions. . . . The speakers at the seminar, whose presentations this proceedings reproduces in full, are among the leading specialists in financial services industry analysis. [AIMR FINSER INDUSTRY, p. i]
[According to Picoult,[1]] the revenue mix is the most important item on the income statement. Analysts should determine what portion is premiums, what portion is net investment income, and what is "other" income. The sources of the other income figures are important. For example, the company may have separate operations or subsidiaries that generate other income. For many holding companies, just determining what they own is difficult; the information may be buried in the other income category, and sometimes it is worthwhile to go digging. [Also included in 1(b) and 1(c)] [AIMR FINSER INDUSTRY, p. 97]
__________
User Survey Results, Users: The comments made by analysts in the focus group meetings were generally consistent with and supportive of the survey results. Although direct comparisons are not possible, inferences were drawn. The table below presents the main conclusions from the survey with responses from the focus groups: [Also included in 2(b), 2(c), 4, 5(b), 5(d), 5(c), and 13] [KPMG BANK STUDY, p. 39]
Preferred historical cost financial statements supplemented with fair value disclosures [Also included in 4, 5(b), and 5(c)] [KPMG BANK STUDY,
p. 39]
[Context] The papers are a summary of a committee and staff members' discussions with selected sell-side analysts from Goldman Sachs.
[One analyst] could not see how fair market value accounting could be implemented for real estate entities. The key issue for real estate firms is the tremendous variance in accounting policies towards expensing items versus capitalizing items. He said that earnings per share is a useless number and that cash flow per share is paramount. He defines recurring net income or net funds from operations as net rents minus G&A minus interest. He feels a meaningful ratio is this number (funds from operations) divided by historical costs of all properties. [Also included in 1(b), 1(c), and 4] GOLDMAN, p 1]
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[One analyst] wants to know the core earnings of [a] bank. She eliminates unusual and nonrecurring items. She does not use the cash flow statement because she believes bank earnings and cash flow results are very close. She does not use the pension footnote because she cannot understand it. All she wants to know about pensions are the assumptions and if a plan is over or under funded. She does not understand tax accounting or the tax footnote. [Also included in 1(b)] [GOLDMAN, p. 2]
[One analyst] would like income to be determined more by cash activities than by accrual. He would like more disclosure and reconciliation between cash income and GAAP income every quarter. He feels that the standards are too loose in the allowance of one time charges. [Also included in 1(b) and 15] [GOLDMAN, p. 4]
From what has briefly been described of the [foreign] financial analysts' work, there results a series of requirements with regard to accounting data, which are but insufficiently met at present. We have broken them down into . . . major categories. [Also included in 1(b), 2(c), 2(d), 3(c) 4, 5(c), 6, 8(a), 9, 11(b), 11(c), and 15 [BETRIOU, p. 1]
It is likely that the objectives of all accounting data users do not coincide. As far as they are concerned, [foreign] financial analysts essentially need data which reflects the economic reality of entities they examine (groups or companies). Further progress is still required and we have broken this down into . . . categories: [Also included in 1(b), 4, 6, 8(a), 9, and 15] [BETRIOU, p. 3]
Exceptional earnings are still too often under detailed. The distinction made with regular profit permits a keener analysis of the past and future profitable developments. [Also included in 1(b) and 15] [BETRIOU, p. 3]