Understanding Financial Reports and the Income Statement Chapter 2

LiChap 22 Learning Objectives Income statements Operating and non-operating results Quality and conservatism of earnings

LiChap 23 A complete set of financial statements includes: Balance sheet Income statement Statement of changes in equity Cash flow statement Explanatory notes

LiChap 24 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

LiChap 25 US Securities Regulations Annual report to shareholders Schedule 14A Proxy solicitation materials Form 10K Annual report Form 10Q Quarterly filing Form 8K Current report

LiChap 26 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

LiChap 27 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

LiChap 28 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

LiChap 29 Of the 4 statements, the income statement receives the greatest scrutiny by analysts.

LiChap 210

LiChap 211 Nokia Consolidated profit and loss (IAS)

LiChap 212 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

LiChap 213 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

LiChap 214 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)

LiChap 215 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%

LiChap 216 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

LiChap 217 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

LiChap 218 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

LiChap 219 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

LiChap 220 Operating income Results of primary operations, independent of investment, financing and tax expenses Sales (Cost of sales) Gross profit (S G & A) Operating income

LiChap 221 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

LiChap 222 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

LiChap 223 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, To be consistent with IAS

LiChap 224 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

LiChap 225 Special revenue recognition methods Long-term contract –Completed contract –Percentage of completion Warranty contracts

LiChap 226 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

LiChap 227 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.