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1.5. Other Comprehensive Income

In the long-term investments chapter, you were introduced to other comprehensive income. In that chapter, OCI arose from changes in the fair value of investments classified as "available for sale." OCI can also result from certain pension plan accounting adjustments and translation of the financial statements of foreign subsidiaries (both of which are beyond the scope of this discussion). Whatever the source of OCI, you have already learned that many companies merely charge or credit OCI directly to equity. However, another option is to position OCI at the very bottom of the income statement.

1.6. Recap

It is highly unlikely that a company would experience all of the previously discussed items within the same year. However, were that the case, its income statement might expand to look something like this (this illustration includes the less common approach of including OCI in the statement of income, rather than direct recording of OCI directly to equity):

RECAP CORPORATION Statement of Comprehensive Income For the Year Ending December 31, 20X7

Sales

$ 6,500,000

Cost of goods sold

4,000,000

Gross profit

$ 2,500,000

Operating expenses

Salaries

$ 750,000

Rent

250,000

Other operating expenses

300,000

1,300,000

Income from continuing operations before income taxes

$ 1,200,000

Income taxes

500,000

Income from continuing operations

$ 700,000

Discontinued operations

Profit on operations of food processing unit, including gain on disposal

$ 800,000

Less: Income tax on disposal of business unit

200,000

Gain on discontinued operations

600,000

Extraordinary item

Gain on discovery of diamonds in company landfill

$ 900,000

Less: Income tax on diamonds

250,000

Extraordinary gain

650,000

Net income/earnings

$ 1,950,000

Other comprehensive income adjustments from certain investments

100,000

Comprehensive income

$ 2 050 000

Before departing this rather elaborate look at income reporting, note that certain terms highlighted above are often tossed around rather casually. However, to the well-trained accountant, those terms have specific connotations. In a strictly correct technical sense, Net income or earnings is income from continuing operations plus/minus discontinued operations and extraordinary items. Comprehensive income is net income plus other comprehensive income.

You may feel a sense of dismay as it relates to the potential complexity of income reporting, but remember that this break out is intended to help investors sort out the results of operations that are ongoing from those parts that may not recur or are otherwise unique. Careful study allows financial statement users to fully comprehend the results of operations and gain a deeper understanding of how a company arrived at its "bottom line." As you can see, Recap Corporation sports a very nice bottom line of $2,050,000, but a huge portion is from special items that cannot be counted on to repeat themselves!

1.7. Ebit and Ebitda

You are apt to hear investors discuss a company's "earnings before interest and taxes" (EBIT) and "earnings before interest, taxes, depreciation, and amortization" (EBITDA). These are not numbers that you will find specifically reported in financial statements. However, they are numbers that someone has calculated from information available in the statements. Some people argue that EBIT (pronounced with a long "E" sound and "bit") and EBITDA (pronounced with a long "E" sound and "bit" and "dah") are important and relevant to decision making, because they reveal the core performance before considering financing costs and taxes (and noncash charges like depreciation and amortization). These numbers are sometimes used in evaluating the intrinsic value of a firm, because they reveal how much the business is producing in earnings without regard to how the business is financed and taxed. Use these numbers with great care, as they provide an overly simplistic view of business performance evaluation.

1.8. Return on Assets

Some financial statement analysts will compare income to assets, in an attempt to assess how effectively assets are being utilized to generate profits. The specific income measure that is used in the return on assets ratio varies with the analyst, but one calculation is:

Return on Assets Ratio = (Net Income + Interest Expense)/Average Assets

These calculations of "ROA" attempt to focus on income (excluding financing costs) in relation to assets. The point is to demonstrate how much operating income is being generated by the deployed assets of the business. By itself, the number can be meaningless, but when you calculate the number for several businesses and start making comparisons, you might be surprised at the variations in return. While this ratio is useful if used correctly, I must caution heavily against misinterpretation of its signals. For example, high-tech companies often have very few tangible assets against which to compare their income (even though they may have previously invested in and expensed massive amounts of research and development monies). In comparison, a manufacturer may have a large tangible asset pool (because GAAP allowed them to capitalize the construction costs of their plant). As a result, the tech company could have a much better ROA even though it would not necessarily be the better company. Always guard against reaching definitive conclusions based on single indicators.

 
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