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Measuring Income: Accrual versus Cash Accounting
- In accrual accounting, you record transactions when they occur, rather than when cash flows occur.
- Revenues are recorded the a product or service is sold, not when the customer pays for that product or service.
- Expenses are recorded consistently, with the expenses associated with producing the sold product or service shown in the period, even though you may have spent the money in a prior period or will not pay until a future period.
- In cash accounting, you record revenues when you get paid for providing a product or service, and expenses when you pay.
- Unless you are a small or personal business, you will have to follow accrual accounting rules.
Classifications of Expenses: Operating, Financial and Capital Expenses
Operating Expenses are expenses associated with the operations of the business. That includes not only the direct costs of producing the product or service the firm sells, but also other expenses associated with production, including S, G & A expenses.
- associated with revenue generated this year,
Financing expenses are expenses associated with the use of non-equity financing. Most often, this takes the form of interest expenses on debt.
- bank loan or debt interest
Capital expenses are expenses that provide benefits over many years. For a manufacturing company, these can take the form of plant and equipment. For non-manufacturing companies, they can take on less conventional and tangible forms ( and accounting has never been good at dealing with these )
- create benefits over many years
Revisiting the Income Statement
- For many firms, revenue recognition is a simple process, where once a product or service is sold, it is recorded as revenues.
- For some firms, especially those that sell products or services over many years, it becomes trickier, since the question of how much of the revenue to record in the year of the sale and how much in subsequent years become debatable.
- for a real estate developer working on a multi-year construction, revenues should be recognized as construction progresses, and for a software firm that enters in a contract over years, performance obligations will determine when revenues get recognized.
- As companies enter multiple businesses and different geographies, it is useful to know where they generated their revenues.
- While the breakdown can sometimes by provided in income statements, they are more likely to be part of the footnotes to the financial statements:
- Companies generally breakdown revenues by geography, though the degree of detail can vary. ( US vs rest of the world )
- Companies also break down revenues by business segment, though there is an element of subjectivity to the segment categorization.
- Way they breakdown may not be the way we wanted to see.
Operating Expenses: A Break Down
COGS ( cost of goods sold) versus Other Operating Expenses: Operating expenses are broadly broken down into expenses directly related to producing the goods or services that given rise to revenues, ie, cost of goods sold, and expenses that are related to operations but which are not directly tied to revenues.
- The former are netted out from revenues to get to gross profits.
- The later get netted out of gross profits to get to operating income.
Selling, General and Administrative Costs: In many companies, the largest non-operating expense is S,G, & A, an amorphous term which can include everything but the proverbial kitchen sink.
Depreciation: Accounting, Tax and Economic Forms
- Economic Depreciation reflects the loss in value ( earning power ) in an asset, as it ages. It requires nuance, and will vary across even the same type of assets, depending on how it is used.
- Accounting depreciation is more mechanical and is driven largely by the aging of the asset, with the differences often being in whether it happens uniformly over the life of the asset or is more accelerated.
- Tax depreciation reflects what the tax authorities will allow as depreciation for purposes of computing taxable income.
The reason why depreciation matters is to minimize taxes payments.
- The most common financial expenses is interest expense on debt, either the form of bank loans or corporate bonds.
- As accountants calssify other commitments ( such as leases ) as debt, some of the interest expenses is implicit. ie, it is calculated by accountants based upon their assessment of the debt equivalent value of commitments and current interest rates.
- In some companies, interest expenses are netted out against interest income earned by the company on its cash holdings and financial investments, and reported as a net interest expense. If interest income exceeds interest expenses, this number will measure net interest income.
Income from non-operating investments
- Cash & Marketable Securities: Income earned on cash holdings ( which is invested in marketable securities, like treasury bills and commercial paper in most companies ) will be reported either as a stand alone income or netted against interest expenses.
- Cross holdings in other companies. The reporting can vary depending upon the magnitude of your holding:
- When you hold a ( small or minority ) portion of another company, the income from that holding usually be reported in the income statement.
- However, if you hold a majority stake of another company, you will generally have to consolidate your financials. That will require you to count 100% of the subsidiary’s revenues, operating expenses and operating income as your own.
Extraordinary Income / Expenses
- As the term implies, extraordinary income and expenses are designed to capture what a company dose not face in the ordinary course of operations.
- Extraordinary items include
- One-time expenses or gain from sale of assets or divisions
- Write offs or charges associated with past project, lawsuits or fines
- Impairment of goodwill from acquisitions in the past.
- If an item is truly extraordinary, it should show up infrequently and amount associated with it should vary. If it shows up every year, it is not extraordinary, even if switches signs ( goes from profits in some years to losses in others )
Pro-forma Accounting: Con game or legitimate restatement ?
- In recent years, companies have become creative in reporting pro-forma financial statements.
- In some cases, they do so to correct for what they believe are accounting inconsistencies.
- In other cases, they are motivated by the desire to increase their profitability.
- As investors, you should never take pro-forma financials at face value but devise y0ur own smell tests on what should be added back and what should not to get to pro forma income. In general, there are two items you should focus the most attention to:
- The movement of expenses from operating to capital, sometimes merited, sometimes not
- The removal of expenses because they are one time or extraordinary.