Financial Statement Analysis Earnings
Outlines • Statement of Comprehensive Income • Proxy statements • Long term assets • Earnings & Revenue Recognition • Format of Income statement • Cash flow statement • FASB changes & GAAP challenges.
Statement of Comprehensive Income • It reports the change in equity from transactions and from non-owner sources. • It includes all changes in equity during a period except those resulting from; • Investments by owners, and • Distributions to owners. • Purpose: To help distinguish income form continuing operations from changes in carrying amounts of assets & liabilities.
Proxy statements • They are issued to shareholders when there are matters that require a shareholder vote. • These statements are a good source of information about; • the election of BOD, • compensations, • management qualifications, and • the issuance of stock options.
Long term assets • Categories include; • Tangible assets • Natural Resources • Intangible assets (Goodwill is not amortized) • Main questions; • How to spread the cost over the useful life? • How to represent the remaining value of the asset each period on the B/S?
Depreciation • Straight line method • Units of production • Accelerated methods; • Double declining balance method (DDB) • Triple declining balance method (TDB)…etc. • (X/useful life*(Cost-Accumulated depreciation) • Depletion
Example: Depreciation Methods • A truck has a historical cost of $11,000 • Necessary cost include; Transportation, insurance, installation, research, broker, & legal cost $1000. • Estimated useful life is 10 years, and estimated salvage value is $2000. • Estimated useful 300,000 miles
Earnings • Economic earnings: Net cash flow + changes in the MV of firms’ assets. • Distributable earnings: Amounts of earnings that can be paid out as dividends • Sustainable earnings: level of income that can be sustained in the future given the firm’s stock capital invested. • Permanent income: the amount of income that can normally be earned each period given the firm’s assets • Permanent income = MV of assets X RROR
Revenue Recognition • The two requirements for revenue recognition to occur are; • Completion of the earning process • Assurance of payment
Revenue Recognition Methods • Sales basis. • Percentage of completion. • Completed contract. • Installment method. • Cost recovery method.
1. Sales basis • Under this method, goods and services are provided when the sale is made, and the sale is for cash or credit to a customer with a high probability of repayments.
2. Percentage of completion • This method is used for long term projects when there is a contract and there are reliable estimates for the revenues, costs, and completion time. • It is recognizes revenue (and corresponding cost) in proportion to the work completed. • There are 2 methods to measure the proportion; • An engineering estimate or physical milestone • The ratio of incurred costs to the total estimated cost.
Ex. Percentage of completion • A company is building a stadium for $100M to be received in equal installments over 4 years. A reliable estimate of the total cost of this contact is $80M. • Part A: During the first year of construction, the total cost incurred was $16M. How much revenue and income is recognized in the first year? • Part B: During the second year, the total cost incurred was $20M. Moreover, the company has revised its estimate of the total cost to $90M. How much revenue and income is recognized in the second year?
3. Completed contract • It is used for long term projects when there is no contact or estimates of revenues or costs are unreliable. • In this method, revenues and expenses are not recognized until the entire project has been completed. • The completed contract method must be used for short term contacts as well.
Ex: Completed contract • A company is building a stadium for $100M, to be received in equal installments over 4 years. However, no reliable estimate can be made of its cost. It spends $16M in the first year. • How much revenue and expense will be recognized in the first year?
4. Installment method • It is used when there is no way to estimate the likelihood of collecting the sales proceeds, but the cost of the goods & services are known. • It recognizes sales and COGS as proportion of cash collected each period, based on the gross profit margin (GPM).
Ex: Installment method • Company A uses the installment method to account for its sales. In 2002, the company sold goods costing $14M for $20M, representing a GP of $6M & a GPM of 30%. • Company A collected; • $10M in 2003, • $5M in 2004, and • $5M in 2005. • How much did company A recognize as gross profit in 2003, 2004, & 2005?
5. Cost recovery method • It is used when the costs to provide goods or services are not known or when there are uncertainties surrounding the collection of the proceeds from the sale. • Under this method, sales are recognized when cash is received, but no gross profit is recognized until the seller’s COGS is fully recovered buyer’s cash payments.
Ex: Cost recovery method • Company A uses the cost recovery method to account for its sales. In 2002, the company sold goods costing $14M for $20M, representing a GP of $6M and a GPM of 30%. • Company A collected; • $10M in 2003, • $5M in 2004, and • $5M in 2005. • How much gross profit did company A recognize each year?
FASB changes & GAAP challenges • FASB projects related to international convergence; • How to handle the expensing of Employee stock options. • The treatment of business combinations under the purchase method • Reconciling the standards on revenue recognition and adherence to a clear conceptual framework.
FASB changes & GAAP challenges • Other projects related to convergence address; • Revisions to the income statement format and contents • Accounting for financial instruments with both equity and liabilities characteristics. • Fair-value measurement.
Two different rules for revenue recognition discussed by FASB and IASB • Revenue recognition occur when; • Both the earnings process is complete and there is reasonable assurance that the revenue is collectible. • There is any increase in net assets that arise from transactions with non-stockholders (a more general concept). That is an increase in equity.
IASB • The International Accounting Standards Board (IASB) founded on April 1, 2001 is the successor of the International Accounting Standards Committee (IASC) founded in June 1973 in London. It is responsible for developing the International Financial Reporting Standards (new name for the International Accounting Standards issued after 2001), and promoting the use and application of these standards