Prep ch2


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Prep ch2

  1. 1. Understanding Financial Reports and the Income Statement Chapter 2 UWYO COB ACCT2000
  2. 2. Learning Objectives <ul><li>Financial statements, reports, and filings </li></ul><ul><li>Income statements </li></ul><ul><li>Quality of earnings </li></ul>
  3. 3. Required components of financial statements (US GAAP) <ul><li>A complete set of financial statements shows: </li></ul><ul><li>Financial position at the end of the period </li></ul><ul><li>Earnings for the period </li></ul><ul><li>Comprehensive income </li></ul><ul><li>Cash flows </li></ul><ul><li>Investments by and distributions to owners </li></ul>
  4. 4. Reports and filings <ul><li>Annual report to shareholders </li></ul><ul><ul><li>Management analysis and discussion </li></ul></ul><ul><ul><li>Financial highlights and summary </li></ul></ul><ul><ul><li>Auditor report </li></ul></ul><ul><ul><li>Financial statements and footnotes </li></ul></ul><ul><li>Schedule 14A Proxy solicitation materials </li></ul><ul><ul><li>Ownership of Securities (insider, institution, block holder) </li></ul></ul><ul><ul><li>Board composition and ownership (insiders and outsiders) </li></ul></ul><ul><ul><li>Executive Compensation </li></ul></ul><ul><ul><li>Audit committee, compensation committee, etc </li></ul></ul><ul><li>SEC filings </li></ul><ul><ul><li>Form 10K Annual report (audited) </li></ul></ul><ul><ul><li>Form 10Q Quarterly report (not audited) </li></ul></ul><ul><ul><li>Form 8K Current report (special relevant events, not audited) </li></ul></ul>
  5. 5. Auditor’s Report <ul><li>Unqualified opinion </li></ul><ul><ul><li>Statements fairly present the the company’s position or results </li></ul></ul><ul><li>Qualified opinion </li></ul><ul><ul><li>Everything is fine except for… </li></ul></ul><ul><li>Adverse opinion </li></ul><ul><ul><li>Statements do not fairly present the the company’s position or results </li></ul></ul><ul><li>Disclaimer of opinion </li></ul><ul><ul><li>Auditor is unable to state an opinion </li></ul></ul>
  6. 6. <ul><li>Proxy Statement Table of Contents (edited)  </li></ul><ul><li>•   Voting Procedures </li></ul><ul><li>•   Proposals 1—8 </li></ul><ul><li>•   Ownership of Securities </li></ul><ul><li>•   Executive Compensation </li></ul><ul><li>•   Report of Compensation Committee on Executive Compensation </li></ul><ul><li>•   Report of Audit and Legal Committee </li></ul><ul><li>•   Performance Graph </li></ul><ul><li>•   Other Matters </li></ul><ul><li>APPENDIX </li></ul><ul><li>•   Management's Discussion and Analysis of Financial Condition and Results of Operations </li></ul><ul><li>•   Financial Highlights </li></ul><ul><li>•   Financial Statements and Notes </li></ul>
  7. 7. <ul><li>Form 10K includes </li></ul><ul><li>Annual report </li></ul><ul><li>Items included by reference to another report </li></ul><ul><ul><li>Financial statements included in Proxy statement </li></ul></ul><ul><li>Discussion of the nature of business operations </li></ul><ul><ul><li>Geographic locations </li></ul></ul><ul><ul><li>Stock trading information </li></ul></ul><ul><ul><li>Auditor information </li></ul></ul><ul><ul><li>Information on management </li></ul></ul><ul><li>Other information </li></ul>
  8. 8. Income statement: a single-step example
  9. 9. Income statement: a multi-step example
  10. 10. Sales revenue <ul><li>Proceeds from customers in exchange for the delivery of goods or services for the use of assets </li></ul><ul><li>Generally recognized when earned and realized or realizable </li></ul><ul><ul><li>When goods/services are exchanged for cash or claims to cash </li></ul></ul><ul><ul><li>Substantially accomplished what must be done </li></ul></ul><ul><ul><li>Service revenue is recognized with reference to the percentage of completion </li></ul></ul><ul><li>Management may recognize revenue prematurely </li></ul><ul><li>See P2-1, P2-2, & P2-5 </li></ul>
  11. 11. Net sales <ul><li>Net sales = Sales revenue - Returns and allowances </li></ul><ul><ul><li>Returns: customer returns goods for a refund </li></ul></ul><ul><ul><li>Allowance: customer retains goods but receive a partial refund if unhappy with quality of merchandise </li></ul></ul>
  12. 12. Cost of Sales <ul><li>Direct cost of purchasing or producing the goods or services to be delivered to customers </li></ul><ul><ul><li>Retail: purchase cost (Cost of good sold) </li></ul></ul><ul><ul><li>Manufacturing: material, labor and overhead (Cost of good sold) </li></ul></ul><ul><ul><li>Service: labor and supplies (Cost of services provided) </li></ul></ul><ul><li>Management has considerable discretion in recognizing these costs </li></ul>
  13. 13. Gross Profit & Gross Margin <ul><li>Gross profit = Net sales – Cost of sales </li></ul><ul><li>Gross margin = Gross profit ÷ Sales </li></ul><ul><li>Motorola </li></ul><ul><ul><li>Margin = (30,004-21,445) ÷30,004 = 28.6% </li></ul></ul><ul><li>Nokia </li></ul><ul><ul><li>Margin = (31,191-19,787) ÷31,191 = 36.6% </li></ul></ul>
  14. 14. Other operating expenses <ul><li>Selling, General and Administrative Expenses (SG&A) </li></ul><ul><ul><li>Salaries </li></ul></ul><ul><ul><li>Pension costs </li></ul></ul><ul><ul><li>Marketing costs </li></ul></ul><ul><ul><li>Research & development costs </li></ul></ul><ul><ul><li>Insurance </li></ul></ul><ul><ul><li>Rent </li></ul></ul><ul><ul><li>Depreciation </li></ul></ul><ul><ul><li>Other </li></ul></ul><ul><li>Restructuring and Other Charges </li></ul>
  15. 15. Research and Development <ul><li>Searching for new knowledge and translating this knowledge into a plan or design for a new process or product </li></ul><ul><li>Should be assets but are expensed immediately on the income statement </li></ul><ul><li>Positively associated with market value </li></ul><ul><li>Management may cut R&D to boost short-term earnings. This will hurt a firm’s future profitability. </li></ul><ul><li>See P2-4 Advertising & P2-6 R&D </li></ul>
  16. 16. Depreciation <ul><li>Allocation of the cost of assets that are expected to provide benefits over more than one accounting period </li></ul><ul><li>Can be a component of Cost of sales or SG&A </li></ul><ul><li>Methods and their effect on earnings </li></ul><ul><ul><li>Straight-line depreciation: equal amount of expense for each period (aggressive) </li></ul></ul><ul><ul><li>Accelerated depreciation: greater expense in early years of assets life (conservative) </li></ul></ul><ul><li>It’s a matter of allocating a fixed amount of expense across periods. </li></ul><ul><li>See P2-7 & P2-12 </li></ul>
  17. 17. Restructuring and Other Charges <ul><li>Appears when a business reorganizes </li></ul><ul><li>Includes charges associated with asset write downs and employee separations </li></ul><ul><li>Generally a one-time charge </li></ul><ul><li>Management tends to take excessive restructuring charges to boost future earnings </li></ul>
  18. 18. Operating income <ul><li>Results of primary operations, independent of investment, financing and tax expenses </li></ul>Operating income (S G & A) (Restructuring and Other Charges) Gross profit (Cost of sales) Sales
  19. 19. Income statement, continued <ul><li>Nonoperating income </li></ul><ul><ul><li>interest income/expense </li></ul></ul><ul><ul><li>dividend income </li></ul></ul><ul><ul><li>gains/losses on asset sales </li></ul></ul>Income after taxes (Provision for income taxes) Income before taxes Nonoperating income Operating income
  20. 20. Income statement - Special items <ul><li>Minority share of income </li></ul><ul><ul><li>Subsidiaries’ income that belongs to others </li></ul></ul><ul><li>Discontinued operations </li></ul><ul><ul><li>Disposition of a large component of business </li></ul></ul><ul><li>Extraordinary items </li></ul><ul><ul><li>Unusual and infrequent </li></ul></ul><ul><li>Cumulative effect of change in accounting principles </li></ul><ul><li>Management may shift net income across the line </li></ul><ul><li>See P2-8, P2-9, & P2-10 </li></ul>
  21. 21. Comprehensive income <ul><li>All income statement items </li></ul><ul><li>Other comprehensive income </li></ul><ul><ul><li>Change in the value of some securities held for investment </li></ul></ul><ul><ul><li>Gains/losses on foreign currency translation </li></ul></ul>
  22. 22. Quality of income <ul><li>Management has discretion in reporting income </li></ul><ul><ul><li>Accounting methods (depreciation, inventory valuation, revenue recognition) </li></ul></ul><ul><ul><li>Assumptions (retirement benefits) </li></ul></ul><ul><ul><li>Estimations (sales returns, bad debts) </li></ul></ul><ul><li>The tradeoff </li></ul><ul><ul><li>Pros: allow management to provide more relevant information </li></ul></ul><ul><ul><li>Cons: enable management to manipulate earnings </li></ul></ul>
  23. 23. Summary <ul><li>Financial statements </li></ul><ul><li>Reports and filings </li></ul><ul><li>Income statements </li></ul><ul><li>Quality of earnings </li></ul>
  24. 24. Problems and Cases <ul><li>Revenue recognition </li></ul><ul><ul><li>P2-1, P2-2, & P2-5 (D) </li></ul></ul><ul><li>Operating Expenses </li></ul><ul><ul><li>Advertising P2-4, R&D P2-6, & Depreciation P2-7 (D) </li></ul></ul><ul><li>Special Items </li></ul><ul><ul><li>Minority Interest P2-8 (C) , Discontinued operations P2-9 (D) , & Extraordinary items P2-10 (C) </li></ul></ul><ul><li>Basic Calculations (CFA exam) </li></ul><ul><ul><li>EPS P2-11 (A) & Depreciation P2-12 (C) </li></ul></ul>
  25. 25. Problems and Cases <ul><li>Case 2-1 </li></ul><ul><ul><li>The importance of footnotes (things behind the reported numbers) </li></ul></ul><ul><ul><li>Understate expenses (e.g. depreciation expenses) </li></ul></ul><ul><ul><li>Shift income across lines (e.g. move non-operating income to operating income) </li></ul></ul><ul><ul><li>Don’t be fooled by numbers! </li></ul></ul>