Why are reformulated financial statements necessary to discover operating profitability?

 Financial Reporting
Why are reformulated financial statements necessary to discover operating profitability?
Most of the operational decisions of an organization are based on their financial statements like income statement, cash flow and balance sheet. All these statements provide the information about company’s finance and by analyzing these statements financial performance of the organization can be measured. In order to more accurately depict various aspects of the business several items of these stamens are reorganized. Before doing so the finical statements are changed for a particular time period that is called reformulation. The analysis of financial statements of an organization is based on three stages first is reformulating reported financial statements, then the second is analysis and adjustments of measurement errors and last is financial ratio analysis on the basis of adjusted and reformulated financial statements. The financial performance of the organization is based on reformulated financial statements.

In order to discover the operating profitability of an organization formulated financial statements are necessary because reformulating can help highlight recent changes in the income statement that led to extra income or a lower income than previously reported. In most of the cases it is connected with shareholder changes. For example if there is any change in shareholder equity or company made the dividend distribution it is must for the business to reformulate its income statement and show the actual profitability for that period. In order to distinguish profitability that earned from operating and financial activity reformulated income statement is necessary (Nissim and Penman, 2003).

Permanent income is the discounted expected flow of income smoothed out and it always differ from measured income. On the other hand transitory earnings result from transactions that are not likely to occur again in the foreseeable future or expected to make a different impact on earnings in future (Sepe and Spiceland, 2008).

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Explain the concept of residual earnings and discuss its drivers.
There are several methods that can be used for valuing the common stock in order to determine the value of the firm. In order to determine the equity change of a firm the key calculation is residual income of the firm. This measures the return to shareholders above the required return on capital. The residual income can be defined as income earned by capital invested in a firm’s assets that take into account the opportunity cost of the capital.
Currently there are seven concepts of residual income measurement. The common universal formula is used by all of them assuming that residual income is the fiscal variation among cost of the capital and return on capital invested in a firm’s assets. Yet several asset valuation methods are employed by various concepts along with different conventions of return on capital estimation. It is a performance measurement of an organization and can also be used to evaluate investment alternatives. The basics concept of residual income dates back in the late 1880s. The residual income is also called Economic Value Added.
The below formula can be used to calculate the residual income:

If the amount of residual income is positive it indicates that company is gaining wealth but if the figures is negative than means the company is consuming capital.

Basically residual earning is the rate of return in equity which expressed as a dollar excess return on equity. It has two key drivers one is ROCE (Return on Capital Employed) and book value. So residual earning always changes according to changes in ROCE and book value. If the forecasted ROCE is equals to require return then residual earning will be zero (Yehuda, 2003).

A) Managerial incentives underlying earnings management.
An organization provides special benefits to their employee for achieving specific goals. The most common form managerial incentive is bonus or increment in salary. The link between compensation and earning management has been highlighted my several researches. The earning management can also be a tool to increase compensation of corporate manager along with increasing the job security with expense of shareholders as it is a useful tool to prepare financial statements before the period of public securities offerings, to increase regulatory benefits, to reduce regulatory costs or to avoid violating lending contracts. There are several techniques of earning management such as channel stuffing and cookie jar accounting. These techniques are used to fulfill the short term objectives of the organization but it ultimately leads to loss (Murphy, 2000).

It is a well documented fact of corporate behavior that in order to manage their reported earnings accounting rules are exploited