Understanding Financial Reports and the Income Statement

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Understanding Financial Reports and the Income
Statement

• Chapter 2
• Robinson, Munter, Grant

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Learning Objectives

• Securities regulations
• Required components of financial statements
• Income statements
• Operating and non-operating results
• Inventory, fixed assets and RD
• Quality and conservatism of earnings

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Securities Regulation Principal Objectives

• Protect investors.
• Ensure that market are fair, efficient, and
  transparent.
• Reduce systematic risk.

International Organization of Securities
Commissions
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Securities Regulation Issuers of Securities

• Full, accurate and timely disclosure of relevant
  information
• Treat securities holders in fair and equitable
  manner
• Accounting and auditing standards should be of
  high and internationally acceptable quality

International Organization of Securities
Commissions
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International Accounting Standards (IAS)

• A complete set of financial statements includes
• Balance sheet
• Income statement
• Statement of changes in equity
• Cash flow statement
• Explanatory notes

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Generally Accepted Accounting Principals (GAAP)

• A complete set of financial statements shows
• Financial position at the end of the period
• Earnings for the period
• Comprehensive income
• Cash flows
• Investments by and distributions to owners

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US Securities Regulations

• Annual report to shareholders
• Schedule 14A Proxy solicitation materials
• Form 10K Annual report
• Form 10Q Quarterly filing
• Form 8K Current report

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• Proxy Statement Table of Contents (edited) 
•   Voting Procedures
•   Proposals 18
•   Ownership of Securities
•   Executive Compensation
•   Report of Compensation Committee on Executive
  Compensation
•   Report of Audit and Legal Committee
•   Performance Graph
•   Other Matters
• APPENDIX
•   Management's Discussion and Analysis of
  Financial Condition and Results of Operations
•   Financial Highlights
•   Financial Statements and Notes

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• Form 10K includes
• Annual report
• Items included by reference to another report
• Financial statements included in Proxy statement
• Discussion of the nature of business operations
• Geographic locations
• Stock trading information
• Auditor information
• Information on management
• Other information

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Auditors Report

• Unqualified opinion
• Statements fairly present the the companys
  position or results
• Qualified opinion
• Everything is fine except for
• Adverse opinion
• Statements do not fairly present the the
  companys position or results
• Disclaimer of opinion
• Auditor is unable to state an opinion

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(No Transcript)
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Nokia Consolidated profit and loss (IAS)
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Sales revenue

• Proceeds from customers in exchange for the
  delivery of goods or services for the use of
  assets
• Also use the terms revenue and turnover (U.K.)
• Generally recognized when earned and realized or
  realizable
• When goods/services are exchanged for cash or
  claims to cash
• Substantially accomplished what must be done
• Service revenue is recognized with reference to
  the percentage of completion

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Net sales

• Sales revenue less returns and allowances
• Returns
• Customer returns goods for a refund
• Allowance
• Customer retains goods but receive a partial
  refund if unhappy with quality of merchandise

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Cost of Sales and Gross Profit

• Net sales Cost of sales Gross profit
• Cost of sales
• Direct cost of purchasing or producing the goods
  or services to be delivered to customers
• Also Cost of good sold or Cost of services
  provided
• Retail purchase cost of goods sold to customers
• Manufacturing material, labor and overhead used
  in the production of goods
• Service cost required to provide service (labor
  and supplies)

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Gross Margin

• Gross profit Sales
• Motorola
• Margin (30,004-21,445) 30,004 28.6
• Nokia
• Margin (31,191-19,787) 31,191 36.6

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Selling, General and Administrative (SGA)
Expenses

• Operating expenses including
• Salaries
• Pension costs
• Marketing costs
• Insurance
• Rent
• Depreciation
• Other
• Generally reported as a single line item

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Depreciation

• Can be a component of Cost of sales or SGA
• Allocation of the cost of assets that are
  expected to provide benefits over more than one
  accounting period
• Straight-line depreciation
• Most common method
• Annual expense (Cost salvage value) Life
• Accelerated depreciation
• Greater expense in early years of assets life

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Accelerated Depreciation

• Sum of the years digits
• Annual expense
• (Cost SV) (Years remaining/Sum of the
  years digits)
• A 4-year asset costing 450,000 with a 50,000 SV
• Year 1 (450,000-50,000)(4/10) 160,000
• Year 2 (450,000-50,000)(3/10) 120,000
• Year 3 (450,000-50,000)(2/10) 80,000
• Year 4 (450,000-50,000)(1/10) 40,000
• Total depreciation expense 400,000

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Accelerated Depreciation

• Declining balance
• Determine straight-line rate (1/Useful life)
• Determine acceleration factor (150, 175, 200)
• Depreciation rate (SL rate acceleration
  factor)
• Depreciation expense
• Cost Accumulated depreciation
  Depreciation rate
• Return to previous data, use acceleration factor
  of 150
• Year 1 (450,000)(.375) 168,750
• Year 2 (450,000-168,750)(.375) 105,469
• Discontinue depreciation when Net book value SV
• Total depreciation expense 400,000

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Research and Development

• Searching for new knowledge and translating this
  knowledge into a plan or design for a new process
  or product.
• Expensed immediately on the income statement
• Purchased in-process RD appears when one company
  purchases another

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Restructuring and Other Charges

• Appears when a business reorganizes
• Includes charges associated with asset write
  downs and employee separations
• Consider whether these charges will continue

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Operating income

• Results of primary operations, independent of
  investment, financing and tax expenses

Sales
(Cost of sales)
Gross profit
(S G A)
Operating income
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Income statement, continued

• Nonoperating income
• Peripheral activities interest income/expense,
  dividend income, gain/losses on asset sales
• Income before income taxes
• Provision for income taxes
• Expected amount of taxes to be paid
• Net income or loss

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Income statement - Special items

• Minority share of income
• Subsidiaries owned less than 100
• Discontinued operations
• Disposition (actual or planned) of a large
  component of business
• Extraordinary items
• Unusual and infrequent
• Cumulative effect of change in accounting
  principles

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Earnings per share

• Basic
• Net income/Weighted average number of shares
  outstanding
• Diluted
• EPS equation includes securities that can be
  converted into common stock (options)
• As if dilutive securities were exercised
• Discontinued operations, extraordinary items and
  changes in accounting principles are shown in
  total and on a per share basis

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Special revenue recognition methods

• Long-term contract
• Completed contract
• Percentage of completion
• Warranty contracts
• Installment sales
• Commodities

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Comprehensive income

• All income statement items
• Other comprehensive income
• Change in the value of some securities held for
  investment
• Gain/losses on foreign currency translation

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Quality of income

• Consider
• Conservatism
• Accounting method (depreciation, inventory
  valuation, revenue recognition)
• Assumptions regarding retirement benefits
• Reserves (sales returns, bad debts)
• Deferral or unusual expenses

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Summary

• Securities filings
• Auditors reports
• The income statement
• Depreciation
• Quality of income