fraser/ormiston: understanding the corporate annual report (c) 2002 prentice hall business...
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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 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
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