Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Understanding the Corporate Annual Report: Nuts,

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Understanding the Corporate Annual Report: Nuts, Bolts, and

a Few Loose Screws

Chapter 2


Chapter 2 will cover:

• Earnings statement (income statement)

• Kodak’s statement of earnings

• “Creative “ accounting practices

• Merits & demerits of financial performance

• How some companies cook their books


Why Don’t Accounting Rules Ensure Quality Earnings?

To find the answer, let’s learn some accounting rules. . . .


Basis of Accounting: Accrual• Basis of US financial statements

• Revenues recorded when earned

• Expenses recorded when incurred

• Earnings are the difference between revenues & expenses for the period


Accrual Accounting:

• Is based on the matching principle

• Matches revenues against expenses

• Revenues & expenses are allocated to appropriate accounting period


Generally Accepted Accounting Principles (GAAP)

• Uniform standards are necessary but management discretion is allowed in– Choices & applications of accounting policies– Timing of revenue & expense recognition


Example: Depreciation

• Process of allocating cost of long-lived assets


Depreciation--Management’s Estimates & Choices

• Useful life of asset

• Expected salvage value

• Choice of depreciation methods


Depreciation Affects:

• Depreciation expense on income statement

• Amount of asset on balance sheet

• Long-lived assets are:– Reported at the cost of asset less accumulated

depreciation


Two Sets of Books

Different rules for:

• Reporting purposes

• Tax purposes

Differences are reconciled in deferred taxes account


Time Periods

• Life of firm is continuous, but. . .

• Financial statements are prepared at certain specific times– e.g., end of year– e.g., end of quarter


Earnings Statement Shows:• Revenues

• Expenses

• Profit or loss for period


Nonrecurring Items

• Do not relate to ongoing operations

• May have major impact on reported earnings


Nonrecurring Items Examples:

• Sale of a building

• Write-down of impaired assets

• Restructuring costs

• Changing an accounting policy


Discretionary Costs

Choices relating to discretionary costs have:

• Short-term effect on profits

• Long-term effect on profits

• Are not always in same direction!


Discretionary Costs Continued:

Management controls budget & timing of expenditures for:

• Repair & maintenance of equipment

• Marketing & advertising

• Research & development


Discretionary Costs Continued:

• Capital expansion

• Replacement of machinery

• Development of new product lines

• Disposal of unproductive divisions


Intangibles

Impact operating success but difficult to measure:

• Brand awareness

• Product innovation

• Employee relations with management

• Morale & efficiency of employees


Intangibles, Continued:

• Reputation of firm with customers

• Company’s prestige in its operating environment

• Provisions for management succession

• Exposures to changes in regulations

• Publicity in the media


3 Approaches to Earnings Measurement

• Conservative

• Aggressive

• Ideal

Affects earnings quality


A Conservative Approach

• Accounting choices & timing decisions lead to a higher quality of earnings


An Aggressive Approach

• Accounting choices & timing decisions lead to a lower quality of earnings


• Presents financial information that helps users make realistic assessment of company’s financial condition & performance

The Ideal Approach


Statement of Earnings(Income Statement)

• Shows results for period of time

• Requires 3 years of audited statements

Calendar year: for year ended December 31

Fiscal year: for year ending on another

day, e.g. June 30


Sales (or Revenues)

• Major source of income

May be shown net of

• Returns (cancellation of sale)

• Allowances (deduction from original price)


Cost of Goods Sold

• Cost to seller of products or services sold to customers

Affected by

• Accrual basis of accounting

• Cost flow assumption for inventory


Cost of Goods Sold Continued

• LIFO = Last in, first out

• FIFO = First in, first out

• Average Cost = Average of all purchases


Cost of Goods Sold Continued

Inventory cost flow assumption determines

• Cost of goods sold expense on income statement

• Value of inventory on balance sheet


Gross Profit

Key profitability measure:

• Difference between sales & cost of goods sold

Gross profit margin:

• Gross profit as a percentage of sales


Selling, General, & Administrative Expenses

Includes expenses in relation to:

• Sale of products and services

• Management of the business– Salaries– Rent– Insurance– Utilities – Supplies


More Selling, General, & Administrative Expenses

These items may be shown separately on the income statement:

• Depreciation

• Amortization

• Research & development

• Advertising


Depreciation

Allocates the cost of long-lived, tangible assets

• Machinery & equipment

• Buildings


Amortization

Allocates the cost of intangible assets

• Patents

• Copyrights

• Trademarks

• Licenses

• Franchises


Depletion

Allocates cost of acquiring & developing natural resources

• Oil

• Gas

• Other minerals

• Standing timber


Earnings from Operations(Operating Profit)

• Second step of profit measurement on the earnings statement

• Used to assess success of company

Operating profit margin:

• Relationship between operating profit and sales


Interest Expense

• Amount paid on borrowed funds


Other Income (Charges)

Includes non-operating revenues & costs

• Dividend & interest income

• Gains (losses) from investment sales

• Income (loss) from investments

• Write-downs from asset impairments

• Gains (losses) from asset sales


Earnings Before Income Taxes

• Next step of profit measurement


Income Tax Expense

• Not the same as taxes actually paid

• Based on “reported” income rather than “taxable” income


Net Earnings, Net Income &Net Profit

The so-called “bottom line”:

• Profit or loss after considering all revenue & expenses


Net Earnings, Net Income &Net Profit Continued

Net Profit Margin:

• Net earnings as a percentage of sales


Net Earnings, Net Income &Net Profit Continued

Earnings per share:

• Net income per common stock share


Two Amounts forEarnings Per Share:

• Basic--uses weighted-average number of common shares currently outstanding

• Diluted--uses the amount of common shares that would be outstanding if convertible securities were converted into common stock and/or options & warrants were exercised


Extraordinary Items,Discontinued Operations &

Accounting Changes

• Reported separately on the earnings statement if they occur during an accounting period


Discontinued Operations

• Occur when a firm sells a major portion of a business

• Results of continuing operations are shown separately

• Gain or loss on the disposal is also shown separately


Extraordinary Gains & Losses

• Items that are unusual in nature

• Not expected to recur


Cumulative Effect of a Change in Accounting Principle

• Is disclosed when a firm changes an accounting policy


Five Earnings Figures:

1. Net income:

• Bottom line figure on the statement of earnings

2. EBITDA:

• Earnings before interest, taxes, depreciation, and amortization


Five Earnings Figures continued

3. Operating profit:

• Earnings from operations from the firm’s statement of earnings

4. Pro forma or core earnings:

• Adjusts net income for items not expected to be part of ongoing business operations


Five Earnings Figures continued

5. Cash flow from operations:

• Adjusts accrual-based net income to cash basis

• Figure shown on statement of cash flows

• Highly useful for analysis


So. . .which earning figure to use?

Sorry, but there is no answer


But Remember. . .

• It is important to understand each measure--especially those that have no standard method of calculation and are often hyped by companies and analysts


Also,

• Evaluating a company’s performance should never rely on any one single measure of performance


Some Ways That Companies “Cook” the Books:

Big Bath

• Taking huge write-offs in one accounting period

Channel Stuffing

• Encourages customers to purchase more products than they need or before they are ready to buy


More Ways That Companies “Cook” the Books:

Vendor Financing

• Lending to customers to promote purchases

Barter

• Recording revenues not involving cash


Even More Ways That Companies “Cook” the Books:

Gross Price Revenue Recognition

• Recording gross price of items sold when company retains only small portion

Changing Assumptions & Estimates

• Useful life of assets changed

• Reducing allowance for doubtful accounts


Yet, More Ways That Companies “Cook” the Books:

Reserves

• Stashing away profits in reserve account to offset declining earnings in bad years

Premature Revenue Recognition

• Booking more revenue than is appropriate for current accounting period


How to Spot Problems

• Read financial statement notes

• Recognize caution flags

Remember:

• Not all companies mislead & manipulate


Caution Flags

• Revenue & earnings – growing at substantially different rates– moving in opposite directions

• Accounts receivable and/or inventories growing much faster than sales


More Caution Flags

• Large, unexplained reductions in discretionary items

• Profit margins– Dramatically shrinking– Dramatically growing– Moving in opposite directions


Even More Caution Flags

• Earnings reports featuring “pro forma” and other earnings figures not prepared according to GAAP

• Showing more than one “pro forma” earnings amount


Yet, More Caution Flags

• Taking large, one-time (special) charges against earnings

• Increasing reserves without justification

• Reducing the allowance for doubtful accounts when sales are rising

• Changing accounting estimates & assumptions

Documents

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Understanding the Corporate Annual Report: Nuts,