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

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Why Don’t Accounting Rules Ensure Quality Earnings? To find the answer, let’s learn some accounting rules....

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Accrual Accounting: Is based on the matching principle Matches revenues against expenses Revenues & expenses are allocated to appropriate accounting period

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Example: Depreciation Process of allocating cost of long-lived assets

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Depreciation--Management’s Estimates & Choices Useful life of asset Expected salvage value Choice of depreciation methods

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Two Sets of Books Different rules for: Reporting purposes Tax purposes Differences are reconciled in deferred taxes account

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Earnings Statement Shows: Revenues Expenses Profit or loss for period

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Nonrecurring Items Do not relate to ongoing operations May have major impact on reported earnings

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Nonrecurring Items Examples: Sale of a building Write-down of impaired assets Restructuring costs Changing an accounting policy

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Discretionary Costs Choices relating to discretionary costs have: Short-term effect on profits Long-term effect on profits Are not always in same direction!

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Discretionary Costs Continued : Management controls budget & timing of expenditures for: Repair & maintenance of equipment Marketing & advertising Research & development

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Discretionary Costs Continued : Capital expansion Replacement of machinery Development of new product lines Disposal of unproductive divisions

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Intangibles Impact operating success but difficult to measure: Brand awareness Product innovation Employee relations with management Morale & efficiency of employees

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing 3 Approaches to Earnings Measurement Conservative Aggressive Ideal Affects earnings quality

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing A Conservative Approach Accounting choices & timing decisions lead to a higher quality of earnings

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing An Aggressive Approach Accounting choices & timing decisions lead to a lower quality of earnings

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Presents financial information that helps users make realistic assessment of company’s financial condition & performance The Ideal Approach

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Sales (or Revenues) Major source of income May be shown net of Returns (cancellation of sale) Allowances (deduction from original price)

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Cost of Goods Sold Continued LIFO = Last in, first out FIFO = First in, first out Average Cost = Average of all purchases

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Cost of Goods Sold Continued Inventory cost flow assumption determines Cost of goods sold expense on income statement Value of inventory on balance sheet

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Gross Profit Key profitability measure: Difference between sales & cost of goods sold Gross profit margin: Gross profit as a percentage of sales

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Selling, General, & Administrative Expenses Includes expenses in relation to: Sale of products and services Management of the business –Salaries –Rent –Insurance –Utilities –Supplies

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing More Selling, General, & Administrative Expenses These items may be shown separately on the income statement: Depreciation Amortization Research & development Advertising

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Depreciation Allocates the cost of long-lived, tangible assets Machinery & equipment Buildings

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Amortization Allocates the cost of intangible assets Patents Copyrights Trademarks Licenses Franchises

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Depletion Allocates cost of acquiring & developing natural resources Oil Gas Other minerals Standing timber

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Interest Expense Amount paid on borrowed funds

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Earnings Before Income Taxes Next step of profit measurement

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Income Tax Expense Not the same as taxes actually paid Based on “reported” income rather than “taxable” income

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Net Earnings, Net Income & Net Profit The so-called “bottom line”: Profit or loss after considering all revenue & expenses

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Net Earnings, Net Income & Net Profit Continued Net Profit Margin: Net earnings as a percentage of sales

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Net Earnings, Net Income & Net Profit Continued Earnings per share: Net income per common stock share

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Extraordinary Items, Discontinued Operations & Accounting Changes Reported separately on the earnings statement if they occur during an accounting period

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Extraordinary Gains & Losses Items that are unusual in nature Not expected to recur

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Cumulative Effect of a Change in Accounting Principle Is disclosed when a firm changes an accounting policy

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Five Earnings Figures: 1.Net income: Bottom line figure on the statement of earnings 2.EBITDA: Earnings before interest, taxes, depreciation, and amortization

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

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing So...which earning figure to use? Sorry, but there is no answer

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Also, Evaluating a company’s performance should never rely on any one single measure of performance

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing More Ways That Companies “Cook” the Books: Vendor Financing Lending to customers to promote purchases Barter Recording revenues not involving cash

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

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

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing How to Spot Problems Read financial statement notes Recognize caution flags Remember: Not all companies mislead & manipulate

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Caution Flags Revenue & earnings –growing at substantially different rates –moving in opposite directions Accounts receivable and/or inventories growing much faster than sales

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing More Caution Flags Large, unexplained reductions in discretionary items Profit margins –Dramatically shrinking –Dramatically growing –Moving in opposite directions

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

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