Understanding Financial Reports and the Income Statement Chapter 2 Robinson, Munter, Grant

Grant, Munter & Robinson Chapter 22 Learning Objectives Securities regulations Required components of financial statements Income statements Operating and non-operating results Inventory, fixed assets and R&D Quality and conservatism of earnings

Grant, Munter & Robinson Chapter 23 Securities Regulation Principal Objectives Protect investors. Ensure that market are fair, efficient, and transparent. Reduce systematic risk. International Organization of Securities Commissions

Grant, Munter & Robinson Chapter 24 Securities Regulation Issuers of Securities Full, accurate and timely disclosure of relevant information Treat securities holders in fair and equitable manner Accounting and auditing standards should be of high and internationally acceptable quality International Organization of Securities Commissions

Grant, Munter & Robinson Chapter 25 International Accounting Standards (IAS) A complete set of financial statements includes: Balance sheet Income statement Statement of changes in equity Cash flow statement Explanatory notes

Grant, Munter & Robinson Chapter 26 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

Grant, Munter & Robinson Chapter 27 US Securities Regulations Annual report to shareholders Schedule 14A Proxy solicitation materials Form 10K Annual report Form 10Q Quarterly filing Form 8K Current report

Grant, Munter & Robinson Chapter 28 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

Grant, Munter & Robinson Chapter 29 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

Grant, Munter & Robinson Chapter 210 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

Grant, Munter & Robinson Chapter 211

Grant, Munter & Robinson Chapter 212 Nokia Consolidated profit and loss (IAS)

Grant, Munter & Robinson Chapter 213 Sales revenue Proceeds from customers in exchange for the delivery of goods or services for the use of assets 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

Grant, Munter & Robinson Chapter 214 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

Grant, Munter & Robinson Chapter 215 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)

Grant, Munter & Robinson Chapter 216 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%

Grant, Munter & Robinson Chapter 217 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

Grant, Munter & Robinson Chapter 218 Depreciation Can be a component of Cost of sales or SG&A Allocation of the cost of assets that are expected to provide benefits over more than one accounting period Straight-line depreciation –Most common method –Annual expense = (Cost – salvage value) ÷ Life Accelerated depreciation –Greater expense in early years of assets life

Grant, Munter & Robinson Chapter 219 Accelerated Depreciation Sum of the years’ digits Annual expense = (Cost – SV) * (Years remaining/Sum of the years’ digits) A 4-year asset costing $450,000 with a $50,000 SV Year 1 = ($450,000-$50,000)*(4/10) = $160,000 Year 2 = ($450,000-$50,000)*(3/10) = $120,000 Year 3 = ($450,000-$50,000)*(2/10) = $ 80,000 Year 4 = ($450,000-$50,000)*(1/10) = $ 40,000 Total depreciation expense = $400,000

Grant, Munter & Robinson Chapter 220 Accelerated Depreciation Declining balance Determine straight-line rate (1/Useful life) Determine acceleration factor (150%, 175%, 200%) Depreciation rate = (SL rate * acceleration factor) Depreciation expense = Cost – Accumulated depreciation * Depreciation rate Return to previous data, use acceleration factor of 150% Year 1 = ($450,000)*(.375) = $ 168,750 Year 2 = ($450,000-$168,750)*(.375) = $ 105,469… Discontinue depreciation when Net book value = SV Total depreciation expense = $400,000

Grant, Munter & Robinson Chapter 221 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

Grant, Munter & Robinson Chapter 222 Restructuring and Other Charges Appears when a business reorganizes Includes charges associated with asset write downs and employee separations Consider whether these charges will continue

Grant, Munter & Robinson Chapter 223 Operating income Results of primary operations, independent of investment, financing and tax expenses Sales (Cost of sales) Gross profit (S G & A) Operating income

Grant, Munter & Robinson Chapter 224 Income statement, continued 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

Grant, Munter & Robinson Chapter 225 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

Grant, Munter & Robinson Chapter 226 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

Grant, Munter & Robinson Chapter 227 Special revenue recognition methods Long-term contract –Completed contract –Percentage of completion Warranty contracts Installment sales Commodities

Grant, Munter & Robinson Chapter 228 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

Grant, Munter & Robinson Chapter 229 Quality of income Consider –Conservatism –Accounting method (depreciation, inventory valuation, revenue recognition) –Assumptions regarding retirement benefits –Reserves (sales returns, bad debts) –Deferral or unusual expenses

Grant, Munter & Robinson Chapter 230 Summary Securities filings Auditor’s reports The income statement –Depreciation Quality of income