Transitory Income Components and Risk

• In Event: Financial Accounting and Reporting 9

Abstract

According to FASB, the objectives of financial reporting include to help equity and debt investors to assess an entity’s prospects for future net cash inflows. This involves helping the investors to assess the resources in the entity, the claims against the entity, and how effectively and efficiently management and the governing board are using and protecting the entity’s resources from unfavorable effects of economic factors. This study identifies specific unfavorable effects of economic factors against which management fails to or is unable to protect the entity’s resources, and asks if they have implications for assessing the entity’s future risk. Those specific unfavorable effects reported in the income statement, are special items, discontinued operations and extraordinary items, items commonly referred to as transitory income components. This study finds that these items are negatively (positively) associated with the level (volatility) of future profitability. The items are also positively associated with future securities risk. These suggest that the loss of the resources impairs the entity’s level and diversification of future earnings capability, and provide evidence of potential risks that could plague the entity in future. This study informs, among others, on three main debates which are discussed: First is whether the income statement informs on (not only the extent to which management uses a firm’s resources to generate wealth as is generally known, but also on) the extent to which managers have exercised due care to safeguard the organizations resources in their stewardship; Second is the relative usefulness of the income statement and balance sheet reporting models; Third is whether analysts and market participants to interpret transitory income components.

Author

• Andrew Ayimbila Anabila, University of Texas-Pan American