Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1 Understanding Financial Statements NINTH EDITION Lyn M. Fraser Aileen Ormiston

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-2 Copyright Notice All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-3 Chapter 5: A Guide to Earnings and Financial Reporting Quality Quality of reported financial information is a critical element in evaluating financial statement data. The higher the quality of financial reporting, the more useful the information is for business decision making.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-4 A Guide to Earnings and Financial Reporting Quality There are a number of areas on the earnings statement that provide management with opportunities for influencing the outcome of reported earnings.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-5 A Guide to Earnings and Financial Reporting Quality These areas include accounting choices, estimates, and judgments changes in accounting methods and assumptions discretionary expenditures nonrecurring transactions nonoperating gains and losses revenue and expense recognitions that do not match cash flow

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-6 A Guide to Earnings and Financial Reporting Quality The financial statement analyst should consider the qualitative as well as the quantitative components of earnings for an accounting period develop an earnings figure that reflects the future ongoing potential of the firm

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-7 A Guide to Earnings and Financial Reporting Quality In addition to earnings quality, the quality of information on the balance sheet and statement of cash flows is equally important. Because these financial statements are interrelated, quality of financial reporting issues often affects more than one financial statement.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-8 A Checklist for Earnings Quality I.Sales II.Cost of Goods Sold III.Operating Expenses IV.Nonoperating Revenue and Expense V.Other Issues

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-9 A Checklist for Earnings Quality Sales 1.Premature revenue recognition 2.Gross vs. net basis 3.Allowance for doubtful accounts 4.Price vs. volume changes 5.Real vs. nominal growth Key areas that affect earnings quality

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-10 Sales Premature revenue recognition Revenue should notbe recognized until there is evidencethat a true sale has taken place. Many firms record revenue before the conditions for a true sale have been met.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-11 Sales Premature revenue recognition Analysts should look at revenue recognition policy look at revenue recognition policy evaluate any changes in revenue recognition policies evaluate any changes in revenue recognition policies study the relationship among sales, accounts receivable, and inventory study the relationship among sales, accounts receivable, and inventory

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-12 Another tactic to boost revenues is to record sales at the gross rather than the net price. Gross refers to the total amount that the final customer pays for an item. Net refers to the gross amount less the cost of the sale. Sales Gross versus net basis

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-13 Revenues appear larger when reported at gross amounts. Gross profit margins appear better when revenues are reported at net amounts. Analysts should read the notes to determine how revenue is recorded. Sales Gross versus net basis

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-14 There should be a consistent relationship between the rate of change in sales, accounts receivable, and allowance for doubtful accounts. Analyst should be alert to the potential for manipulation through the allowance account. Sales Allowance for doubtful accounts

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-15 If sales are changing, it is important to determine whether the change is a result of price, volume, or both. In general, higher quality earnings would be the product of both volume and price increases (during inflation). Sales Price versus volume changes

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-16 It is important to determine if sales are growing in “real” (inflation-adjusted) as well as “nominal” (as reported) terms. Change in sales in nominal terms can be readily calculated from figures on the income statement. Sales Real versus nominal growth

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-17 An adjustment of the reported sales figure with the Consumer Price Index (or some other measure of general inflation) will enable the analyst to make a comparison of the changes in real and nominal terms. Sales Real versus nominal growth

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-18 To make the calculation, begin with the sales figure from the income statement, and adjust years prior to the current year with the CPI (or other price index). Sales Real versus nominal growth

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-19 Using base period CPI ( =100) (2007CPI/2006CPI) x 2006 Sales = Adjusted Sales (207.3/201.6) x $171,179 = $176,019 When adjusted for inflation, sales grew at a rate of 1.24%, which means that sales growth has kept pace with general inflation. Sales Real versus nominal growth Sales (in millions) % Change As reported (nominal) $178,199$171, Adjusted (real) $178,199$176,

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-20 Cost of Goods Sold 6.Cost-flow assumption for inventory 7.Base LIFO layer liquidations 8.Loss recognitions on write-downs of inventories Key areas that affect earnings quality

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-21 LIFO results in the matching of current costs with current revenues and produces higher quality earnings than either FIFO or average cost. Inventory accounting system used is described in the note that details accounting policies or the note that discusses inventory. Cost of Goods Sold Cost-flow assumption for inventory

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-22 Base LIFO layer liquidation occurs when companies are shrinking rather than increasing inventories. There is an actual reduction of inventory levels, but the earnings boost stems from the cost flow assumption that the older and lower-priced products are being sold. Cost of Goods Sold Base LIFO layer liquidation

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-23 Effects of LIFO reductions are disclosed in the notes and can be substantial. Reduces the quality of earnings, because there is an improvement in operating profit from what would generally be considered a negative occurrence: inventory reductions. Cost of Goods Sold Base LIFO layer liquidation

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-24 If the value of inventory falls below its original cost, the inventory is written down to market value. Amount of the write-down will affect comparability and quality of profit margins. Cost of Goods Sold Loss recognitions on write-downs of inventories

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-25 When write-down is included in cost of goods sold, the gross profit margin is affected. Analyst should be aware of the impact of write-downs on the gross profit margin when comparing between periods. Cost of Goods Sold Loss recognitions on write-downs of inventories

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-26 A Checklist for Earnings Quality Operating Expenses 9.Discretionary expenses 10.Depreciation 11.Asset impairment 12.Reserves 13.In-process research and development 14.Pension accounting-interest rate assumptions Key areas that affect earnings quality

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-27 Operating Expenses Discretionary expenses A company can increase earnings by reducing variable operating expenses in a number of areas such as repair and maintenance of capital assets repair and maintenance of capital assets research and development research and development advertising and marketing advertising and marketing

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-28 Operating Expenses Discretionary expenses If such discretionary expenses are reduced to benefit the current year’s reported earnings, the long-run impact on the firm’s operating profit may be detrimental and thus the quality lowered.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-29 Operating Expenses Depreciation Amount of depreciation expense depends on the choice of depreciation method (straight-line or accelerated) the choice of depreciation method (straight-line or accelerated) estimates regarding the useful life and salvage value estimates regarding the useful life and salvage value

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-30 Operating Expenses Depreciation Straight-line method is used more often is used more often produces a smoother earnings stream and higher earnings in the early years of the depreciation period produces a smoother earnings stream and higher earnings in the early years of the depreciation period does not reflect the economic reality of product usefulness does not reflect the economic reality of product usefulness is lower in quality is lower in quality

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-31 Operating Expenses Depreciation Misclassification of operating expenses as capital expenditures creates poor quality of financial reporting on all financial statements. Comparing companies is difficult when they use different depreciation methods and different estimates for the lives of their long-lived assets.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-32 The write-down of asset values affects the comparability and thus the quality. Reasons for write-downs are also important in assessing quality. Information on asset write-downs is presented in the notes. Operating Expenses Asset impairment

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-33 Creation and use of reserve accounts is required to properly match revenues and expenses. Abuse of reserve accounts has been an ongoing issue. Operating Expenses Reserves

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-34 Cookie-jar accounting occurs when companies create or use reserve accounts for setting aside funds in good years and reducing or reversing charges in poor years. Firms often take enormous write-offs in one period (big bath charges) to clean up balance sheets. Operating Expenses Reserves

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-35 Operating Expenses In-process research and development One-time charges taken at the time of an acquisition Can be written off immediately Can increase earnings in later years due to revenue gains from the research

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-36 Operating Expenses Pension accounting – interest rate assumptions A change in the pension interest rate assumption can impact earnings equality. If the rate is decreased, the annual pension cost and the present value of the benefits will increase. If the rate is decreased, the annual pension cost and the present value of the benefits will increase. If the rate is increased, pension cost and the present value of the benefits will decrease. If the rate is increased, pension cost and the present value of the benefits will decrease.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-37 A Checklist for Earnings Quality Nonoperating Revenue and Expense 15.Gains (losses) from sales of assets 16.Interest income 17.Equity income 18.Income taxes 19.Unusual items 20.Discontinued operations 21.Extraordinary items Key areas that affect earnings quality

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-38 Nonoperating Revenue and Expense Gains (losses) from sales of assets The sale of a major asset is sometimes made to increase earnings and/or to generate needed cash when the firm is performing poorly. Such transactions are not part of the normal operations of the firm and should be excluded from net income when considering the future operating potential of the company.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-39 Nonoperating Revenue and Expense Interest Income Results primarily from short-term temporary investments in marketable securities to earn a return on cash not immediately needed. Analyst should be alert to the materiality and variability in the amount of interest income because it is not part of operating income.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-40 Nonoperating Revenue and Expense Equity income Use of equity method permits the investor to recognize as investment income the investor’s percentage ownership share of the investee’s reported income. Net effect is that the investor, in most cases, records more income than is received in cash.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-41 Nonoperating Revenue and Expense Income taxes Provision for income tax expense on the income statement differs from the tax actually paid. It is important to differentiate between increases and decreases to net earnings caused by tax events. Significant change in effective tax rate may be a one-time nonrecurring item. Income tax notes reveal year-to-year changes in deferred tax accounts.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-42 Nonoperating Revenue and Expense Unusual items Some companies will create a line item on the income statement for unusual items or special charges. Analyst should always investigate these items to determine if these items are nonoperating and/or nonrecurring.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-43 Nonoperating Revenue and Expense Discontinued Operations Should be excluded in considering future earnings Two items recorded if discontinued operations have been sold Gain (loss) from operations of the division up to the time of sale Gain (loss) from operations of the division up to the time of sale Gain (loss) as a result of the sale, both net of tax Gain (loss) as a result of the sale, both net of tax

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-44 Nonoperating Revenue and Expense Extraordinary items Gains and losses that are both unusual and infrequent in nature Should be eliminated from earnings when evaluating a firm’s future earnings potential

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-45 A Checklist for Earnings Quality Other Issues 22.Material changes in number of shares outstanding 23.Operating earnings, a.k.a. core earnings, pro forma earnings, or EBITDA Key areas that affect earnings quality

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-46 Other Issues Material Changes in Number of Shares Outstanding Changes can result from treasury stock purchases and the purchase and retirement of common stock. Reasons for the repurchase of common stock should be determined if possible to see if firm is spending scarce resources to merely increase earnings per share.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-47 Other Issues Operating earnings, a.k.a. core earnings, pro forma earnings, or EBITDA Operating earnings are important for assessing the ongoing potential of a firm. Companies have created their own operating profit numbers and tried to convince users that these figures are the ones to focus on.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-48 Other Issues Operating earnings, a.k.a. core earnings, pro forma earnings, or EBITDA “Company created” numbers go by a variety of names such as core earnings, pro forma earnings, or EBITDA (operating earnings before interest, tax, depreciation, and amortization expenses are deducted). SEC requires companies that report pro forma financial information to do so in a manner that is not misleading.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-49 What are the Real Earnings? Each individual user of financial statements should adjust the earnings figure to reflect what they believe is relevant to the decision at hand.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-50 Quality of Financial Reporting The Balance Sheet Items discussed in the earnings quality section also impact balance sheet quality. When evaluating balance sheet several other items should also be assessed:

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-51 Quality of Financial Reporting The Balance Sheet Type of debt used to finance assets should generally be matched (short-term debt for current assets and long-term debt/equity for long-term assets). “Commitments and Contingencies” disclosures in the notes should be carefully evaluated as information on off-balance-sheet financing and other complex financing arrangements are located here.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-52 Quality of Financial Reporting The Statement of Cash Flows from operations (CFO) figure, while highly useful, can be manipulated by The cash flows from operations (CFO) figure, while highly useful, can be manipulated by recording operating expenses as capital expenditures recording operating expenses as capital expenditures managing current asset and liability accounts to cause increases to CFO managing current asset and liability accounts to cause increases to CFO

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall5-53 Quality of Financial Reporting The Statement of Cash Flows Cash flows from the following types of items should be removed from CFO for analytical purposes: Investments in trading securities Investments in trading securities Discontinued operations Discontinued operations Nonrecurring expenses or income Nonrecurring expenses or income