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Core Earnings and Quality of Earnings

Questions (also attached)

1. Describe the concept of "core earnings" as defined by Standard & Poor. What deficiencies in GAAP is this concept designed to remedy? In one paragraph, give your assessment of the usefulness of core earnings.

2. Describe the meaning of the phrase "quality of earnings" as it is currently used in practice, and discuss the importance of this concept in financial statement analysis.

I need very indepth answers for each. Thanks.


Solution Preview

1. Describe the concept of "core earnings" as defined by Standard & Poor. What deficiencies in GAAP is this concept designed to remedy? In one paragraph, give your assessment of the usefulness of core earnings.
The revenue derived from a company's main or principal business less all associated expenses.
Compared to net income, core earnings remove all secondary activities performed by a company so that investors will be not be as easily fooled by activities unrelated to the main business.

For example, a car manufacturer's main business is producing vehicles. All revenue and expenses associated with the production of cars would be included in the core earnings. Financing schemes, development of non automobile parts or engines, maintenance of pension funds, and real estate interests would be omitted from the core earnings figure.
Standard & Poor's, the ratings agency, tries to solve the problem with a new earnings metric: core earnings. While the core earnings approach gives investors a first glimpse of what truly "clean" earnings might look like, it also creates its own set of challenges.
The Standard and Poor's revised version of the measurement of core earnings, which excludes any gains related to pension activities, net revenues from the sale of assets, impairment of goodwill charges, prior-year charge and provision reversals, and settlements related to litigation or insurance claims. Expenses related to employee stock option grants, pensions, restructuring of present operations or any merger and acquisition costs, R&D purchases, write-downs of depreciable or amortizable operating assets, and unrealized gains/losses from hedging activities are all included in the core earnings.

This is a new standard created by S&P with the assistance from the financial and investment community. These core earnings provide for transparency and consistency, as well as a more stringent definition of a company's core earnings, clearly setting out exactly what can and cannot be considered earnings and expenses

Problems with the Traditional Metrics
Investors have lost faith in the three major categories of earnings: reported earnings, operating earnings and pro forma earnings. We've seen in the past that the traditional measure, the GAAP-based reported earnings, leaves companies with plenty of room for creative accounting and manipulation
Operating earnings, which leaves out one-time gains and expenses from the bottom line, is meant to make the numbers comparable across companies. Unfortunately, many Wall Street analysts now have their own criteria for what should be excluded, so analyzing and comparing companies using operating earnings can be awfully difficult. Meanwhile, the definition of pro-forma earnings - which treats significant corporate transactions "as if" they never occurred - has become so broad that it can hide almost anything from investors.

Core Earnings: an Attempt at Solutions
To restore consistency and credibility to earnings reports and analysis, S&P sets out in a white paper, its stringent new measure. Core earnings includes all the revenues and costs associated with a company's ongoing operations. But it strips out all items that can mask a company's real condition, including goodwill charges, gains or losses from asset sales, hedging operations, litigation settlements, merger expenses and financing costs. These costs might be big, but they are not part of a company's core operations.

Here is a chart detailing the items included/excluded from the core earnings calculation:
What's In
Employee stock options expenses
Restructuring charges from ongoing operations
Pension fund costs
Purchased R&D expenses
Write-downs or depreciable operating assets
What's Out
Goodwill impairment charges
Gains/losses from the sale of assets
Pension gains
M&A related expenses
Litigation/insurance settlement costs and proceeds
Unrealized gains from hedging ...