the owners’ investment, nor is it the amount earned on the common stock
equity. Nonrecurring losses or gains arise out of transactions such as the
sale of fixed assets (buildings, land, or equipment) or the sale of subsidiaries
or investments in securities. Losses can also occur because of natural disas-
ters (floods or fires) or because of liabilities on lawsuits. In any case, these
gains or losses do not arise out of the normal operations of the business.
The firm’s net income represents the profits of normal business operations.
These items are given separately, for they are special or nonrecurring
and we do not wish them to affect the analysis of the normal operations of
the firm. If a firm sells a plant or subsidiary at a profit, the earnings for a
given year are raised, but the earnings generated by the subsidiary will no
longer be available in the future. Whether or not nonrecurring losses are
fully deductible for tax purposes depends on the circumstances. It is sug-
gested that when nonrecurring gains or losses occur, they be entered net of
taxes (a loss would be reduced if there were regular income tax that could
be used as an offset) after the regular part of the income report. Details
should be provided in footnotes. In our illustrative statement, there are no
nonrecurring items.
Dividends declared on the preferred shares are subtracted from net
profits to obtain the earnings available to the common shareholders. Al-
though the preferred dividends are not a legally fixed obligation of the
firm, they represent a claim senior to any return on common shares, and
there can be no calculation of earnings on the common shareholders’ in-
vestment until they are accounted for. The preferred dividends are a prior
charge from the view of the true residual owners of the firm, the common
shareholders.
Earnings available to common stockholders (EACS) represent the ac-
counting profits or earnings accruing to the shareholders of the business af-
ter all prior deductions have been made. The phrase “accounting profits or
earnings” is used deliberately. The accounting profits and the true or eco-
nomic profits of the firm can differ considerably. Reported accounting
profits serve as a useful available measure of the firm’s success. Moreover,
under the discipline of the accounting formalities, profits are reported on a
sufficiently consistent basis to enable them to be used in the determination
of important legal obligations and privileges. But even within the account-
ing rules there exist legitimate alternative methods of reporting certain ex-
penses and charges, which can cause considerable variation in the
operating results of any year.
Net income, or profits, should be measured relative to the firm’s sales,
total assets, or equity. One must standardize net income for comparison
purposes. Johnson & Johnson has been consistently (and substantially)
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