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Understanding Financial Reports and the Income Statement

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  1. Understanding Financial Reports and the Income Statement Chapter 2

  2. Learning Objectives • Income statements • Operating and non-operating results • Quality and conservatism of earnings Chap 2

  3. A complete set of financial statements includes: • Balance sheet • Income statement • Statement of changes in equity • Cash flow statement • Explanatory notes Chap 2

  4. 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 Chap 2

  5. US Securities Regulations • Annual report to shareholders • Schedule 14A Proxy solicitation materials • Form 10K Annual report • Form 10Q Quarterly filing • Form 8K Current report Chap 2

  6. Proxy Statement Table of Contents (edited)  •  Voting Procedures •  Proposals 1—8 •  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 Chap 2

  7. 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 Chap 2

  8. Auditor’s Report • Unqualified opinion • Statements fairly present the the company’s position or results • Qualified opinion • Everything is fine except for… • Adverse opinion • Statements do not fairly present the the company’s position or results • Disclaimer of opinion • Auditor is unable to state an opinion Chap 2

  9. Of the 4 statements, • the income statement receives the greatest scrutiny by analysts. Chap 2

  10. Chap 2

  11. Nokia Consolidated profit and loss (IAS) Chap 2

  12. Sales revenue • Proceeds from customers in exchange for the delivery of goods or services • 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 Chap 2

  13. 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 Chap 2

  14. 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) Chap 2

  15. 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% Chap 2

  16. Selling, General and Administrative (SG&A) Expenses • Operating expenses including • Salaries • Pension costs • Marketing costs • Insurance • Rent • Depreciation • Other • Generally reported as a single line item Chap 2

  17. Depreciation • Can be a component of Cost of sales or SG&A • Straight-line depreciation • Most common method • Annual expense = (Cost – salvage value) ÷ Life • Accelerated depreciation • Greater expense in early years of assets life Chap 2

  18. 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 R&D appears when one company purchases another Chap 2

  19. Restructuring and Other Charges • Appears when a business reorganizes • Includes charges associated with asset write downs and employee separations • Be aware whether these charges will continue Chap 2

  20. Operating income • Results of primary operations, independent of investment, financing and tax expenses Chap 2

  21. Income statement, continued • Operating Income • 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 Chap 2

  22. 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 Chap 2

  23. SFAS 154 • Retrospective application: a change in accounting principle is treated by restating comparative financial statements to reflect the new method as though it had been applied all along. • For fiscal year beginning after Dec 15, 2005. • To be consistent with IAS Chap 2

  24. 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 Chap 2

  25. Special revenue recognition methods • Long-term contract • Completed contract • Percentage of completion • Warranty contracts Chap 2

  26. 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 Chap 2

  27. Earnings Quality • Earnings that reflect underlying economic effects • Earnings that are better estimates of cash flows • Earnings that are more conservative • Earnings that are more predictable Accounting methods that could affect earnings quality: • depreciation, inventory valuation, revenue recognition, assumptions regarding retirement benefits, reserves (sales returns, bad debts, etc. Chap 2