Problems, Chapter 6 Acct 460
P6-3. Identifying components of earnings
Requirement 1: a) Permanent earnings is the reported earnings component that is value-relevant. Permanent earnings are those earnings that are expected to continue into the future. This component roughly corresponds to income from continuing operations as reported in the income statement.
b) Transitory earnings is the earnings component that is value-relevant, but not expected to persist into the future. This component roughly corresponds to income from discontinued operations and extraordinary gains and losses as reported in the income statement.
c) Value-irrelevant earnings is the “noise” component of reported earnings. This component is unrelated to a firm’s future profitability or future cash flows, and thus irrelevant when it comes to valuation of the firm’s stock. An example would be an earnings increase due to a change in depreciation methods or assumptions (e.g., useful life) that has no impact on the firm’s future cash flows.
Requirement 2: Consider an airline company:
An example of permanent earnings would be the earnings that arise from the firm’s ongoing passenger and cargo operations. An example of transitory earnings would be the temporary earnings generated from a one-year contract to handle charter flights for an outside travel company.
An example of value-irrelevant earnings would be the increase in earnings due to a change in the useful lives and/or salvage values of the firm’s aircraft.
Consider an automobile manufacturer:
An example of permanent earnings would be the earnings that arise from the firm’s ongoing sales and leasing of passenger cars and trucks. An example of an increase in the firm’s permanent earnings would be a contract to supply all of the new vehicles every year in the future to one of the nation’s rental car companies.
An example of transitory earnings would be the one-time earnings
Requirement 1: a) Permanent earnings is the reported earnings component that is value-relevant. Permanent earnings are those earnings that are expected to continue into the future. This component roughly corresponds to income from continuing operations as reported in the income statement.
b) Transitory earnings is the earnings component that is value-relevant, but not expected to persist into the future. This component roughly corresponds to income from discontinued operations and extraordinary gains and losses as reported in the income statement.
c) Value-irrelevant earnings is the “noise” component of reported earnings. This component is unrelated to a firm’s future profitability or future cash flows, and thus irrelevant when it comes to valuation of the firm’s stock. An example would be an earnings increase due to a change in depreciation methods or assumptions (e.g., useful life) that has no impact on the firm’s future cash flows.
Requirement 2: Consider an airline company:
An example of permanent earnings would be the earnings that arise from the firm’s ongoing passenger and cargo operations. An example of transitory earnings would be the temporary earnings generated from a one-year contract to handle charter flights for an outside travel company.
An example of value-irrelevant earnings would be the increase in earnings due to a change in the useful lives and/or salvage values of the firm’s aircraft.
Consider an automobile manufacturer:
An example of permanent earnings would be the earnings that arise from the firm’s ongoing sales and leasing of passenger cars and trucks. An example of an increase in the firm’s permanent earnings would be a contract to supply all of the new vehicles every year in the future to one of the nation’s rental car companies.
An example of transitory earnings would be the one-time earnings