Problems, Chapter 6 Acct 460

1706 Words Apr 3rd, 2011 7 Pages
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
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Its business risk is relatively low but so is its P/E. Amazon.com operates in a evolving industry and the company first became profitable in 2003. Its business risk is relatively high and so is its P/E. For these firms, factors other than risk must be influencing the P/E ratio differences.

• Without a detailed examination of the financial reporting practices and related disclosures of each company, it is difficult to draw conclusions about the degree to which the P/E ratio differences might be related to differences in earnings quality. Concerns about earnings quality have occasionally surfaced in financial press articles on each company.

Absent information about investors’ earnings quality concerns, it is likely to be the case that most of the variation in P/E ratios is due to differences in growth opportunities and (to a lesser extent) risk.

Requirement 2: The firms in Group B are all from the same industry—grocery chains—so there is less variation in P/E ratios among these firms than was the case for firms in Group A.

• Kroger, Pantry, and Safeway have P/E ratios that are quite close to one another. These companies are large, financially strong, and already have numerous U.S. locations. While new locations are added each year, the pace of growth is rather modest. • Whole Foods Market has a P/E ratio that exceeds those of

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