Understanding the Corporate
Annual Report: Nuts, Bolts, and
a Few Loose Screws
Chapter 2
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Chapter 2 will cover:
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•
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Earnings statement (income statement)
Kodak’s statement of earnings
“Creative “ accounting practices
Merits & demerits of financial performance
How some companies cook their books
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Why Don’t Accounting Rules
Ensure Quality Earnings?
To find the answer, let’s learn some
accounting rules. . . .
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Basis of Accounting: Accrual
• Basis of US financial statements
• Revenues recorded when earned
• Expenses recorded when incurred
• Earnings are the difference between
revenues & expenses for the period
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Accrual Accounting:
• Is based on the matching principle
• Matches revenues against expenses
• Revenues & expenses are allocated to
appropriate accounting period
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Generally Accepted Accounting
Principles (GAAP)
• Uniform standards are necessary but
management discretion is allowed in
– Choices & applications of accounting policies
– Timing of revenue & expense recognition
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Example: Depreciation
• Process of allocating cost of long-lived
assets
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Depreciation--Management’s
Estimates & Choices
• Useful life of asset
• Expected salvage value
• Choice of depreciation methods
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Depreciation Affects:
• Depreciation expense on income statement
• Amount of asset on balance sheet
• Long-lived assets are:
– Reported at the cost of asset less accumulated
depreciation
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Two Sets of Books
Different rules for:
• Reporting purposes
• Tax purposes
Differences are reconciled in deferred taxes
account
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Time Periods
• Life of firm is continuous, but. . .
• Financial statements are prepared at certain
specific times
– e.g., end of year
– e.g., end of quarter
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Earnings Statement Shows:
• Revenues
• Expenses
• Profit or loss for period
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Nonrecurring Items
• Do not relate to ongoing operations
• May have major impact on reported
earnings
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Nonrecurring Items Examples:
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Sale of a building
Write-down of impaired assets
Restructuring costs
Changing an accounting policy
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Discretionary Costs
Choices relating to discretionary costs have:
• Short-term effect on profits
• Long-term effect on profits
• Are not always in same direction!
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Discretionary Costs Continued:
Management controls budget & timing of
expenditures for:
• Repair & maintenance of equipment
• Marketing & advertising
• Research & development
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Discretionary Costs Continued:
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Capital expansion
Replacement of machinery
Development of new product lines
Disposal of unproductive divisions
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Intangibles
Impact operating success but difficult to
measure:
• Brand awareness
• Product innovation
• Employee relations with management
• Morale & efficiency of employees
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Intangibles, Continued:
• Reputation of firm with customers
• Company’s prestige in its operating
environment
• Provisions for management succession
• Exposures to changes in regulations
• Publicity in the media
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
3 Approaches to Earnings
Measurement
• Conservative
• Aggressive
• Ideal
Affects earnings quality
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
A Conservative Approach
• Accounting choices & timing decisions lead
to a higher quality of earnings
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
An Aggressive Approach
• Accounting choices & timing decisions lead
to a lower quality of earnings
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
The Ideal Approach
• Presents financial information that helps
users make realistic assessment of
company’s financial condition &
performance
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Statement of Earnings
(Income Statement)
• Shows results for period of time
• Requires 3 years of audited statements
Calendar year: for year ended December 31
Fiscal year:
for year ending on another
day, e.g. June 30
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Sales (or Revenues)
• Major source of income
May be shown net of
• Returns (cancellation of sale)
• Allowances (deduction from original price)
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Cost of Goods Sold
• Cost to seller of products or services sold to
customers
Affected by
• Accrual basis of accounting
• Cost flow assumption for inventory
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Cost of Goods Sold Continued
• LIFO = Last in, first out
• FIFO = First in, first out
• Average Cost = Average of all purchases
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Cost of Goods Sold Continued
Inventory cost flow assumption determines
• Cost of goods sold expense on income
statement
• Value of inventory on balance sheet
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Gross Profit
Key profitability measure:
• Difference between sales & cost of goods
sold
Gross profit margin:
• Gross profit as a percentage of sales
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Selling, General, &
Administrative Expenses
Includes expenses in relation to:
• Sale of products and services
• Management of the business
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Salaries
Rent
Insurance
Utilities
Supplies
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
More Selling, General, &
Administrative Expenses
These items may be shown separately on the
income statement:
• Depreciation
• Amortization
• Research & development
• Advertising
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Depreciation
Allocates the cost of long-lived, tangible
assets
• Machinery & equipment
• Buildings
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Amortization
Allocates the cost of intangible assets
• Patents
• Copyrights
• Trademarks
• Licenses
• Franchises
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Depletion
Allocates cost of acquiring & developing
natural resources
• Oil
• Gas
• Other minerals
• Standing timber
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Earnings from Operations
(Operating Profit)
• Second step of profit measurement on the
earnings statement
• Used to assess success of company
Operating profit margin:
• Relationship between operating profit and
sales
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Interest Expense
• Amount paid on borrowed funds
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Other Income (Charges)
Includes non-operating revenues & costs
• Dividend & interest income
• Gains (losses) from investment sales
• Income (loss) from investments
• Write-downs from asset impairments
• Gains (losses) from asset sales
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Earnings Before Income Taxes
• Next step of profit measurement
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Income Tax Expense
• Not the same as taxes actually paid
• Based on “reported” income rather than
“taxable” income
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Net Earnings, Net Income &
Net Profit
The so-called “bottom line”:
• Profit or loss after considering all revenue
& expenses
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Net Earnings, Net Income &
Net Profit Continued
Net Profit Margin:
• Net earnings as a percentage of sales
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Net Earnings, Net Income &
Net Profit Continued
Earnings per share:
• Net income per common stock share
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Two Amounts for
Earnings Per Share:
• Basic--uses weighted-average number of
common shares currently outstanding
• Diluted--uses the amount of common shares
that would be outstanding if convertible
securities were converted into common
stock and/or options & warrants were
exercised
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Extraordinary Items,
Discontinued Operations &
Accounting Changes
• Reported separately on the earnings
statement if they occur during an
accounting period
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Discontinued Operations
• Occur when a firm sells a major portion of a
business
• Results of continuing operations are shown
separately
• Gain or loss on the disposal is also shown
separately
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Extraordinary Gains & Losses
• Items that are unusual in nature
• Not expected to recur
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Cumulative Effect of a Change in
Accounting Principle
• Is disclosed when a firm changes an
accounting policy
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Five Earnings Figures:
1. Net income:
• Bottom line figure on the statement of
earnings
2. EBITDA:
• Earnings before interest, taxes, depreciation,
and amortization
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Five Earnings Figures continued
3. Operating profit:
• Earnings from operations from the firm’s
statement of earnings
4. Pro forma or core earnings:
• Adjusts net income for items not expected
to be part of ongoing business operations
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Five Earnings Figures continued
5. Cash flow from operations:
• Adjusts accrual-based net income to cash
basis
• Figure shown on statement of cash flows
• Highly useful for analysis
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
So. . .which earning figure to
use?
Sorry, but there is no answer
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
But Remember. . .
• It is important to understand each measure-especially those that have no standard
method of calculation and are often hyped
by companies and analysts
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Also,
• Evaluating a company’s performance
should never rely on any one single measure
of performance
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Some Ways That Companies
“Cook” the Books:
Big Bath
• Taking huge write-offs in one accounting
period
Channel Stuffing
• Encourages customers to purchase more
products than they need or before they are
ready to buy
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
More Ways That Companies
“Cook” the Books:
Vendor Financing
• Lending to customers to promote purchases
Barter
• Recording revenues not involving cash
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Even More Ways That
Companies “Cook” the Books:
Gross Price Revenue Recognition
• Recording gross price of items sold when
company retains only small portion
Changing Assumptions & Estimates
• Useful life of assets changed
• Reducing allowance for doubtful accounts
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Yet, More Ways That Companies
“Cook” the Books:
Reserves
• Stashing away profits in reserve account to
offset declining earnings in bad years
Premature Revenue Recognition
• Booking more revenue than is appropriate
for current accounting period
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
How to Spot Problems
• Read financial statement notes
• Recognize caution flags
Remember:
• Not all companies mislead & manipulate
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Caution Flags
• Revenue & earnings
– growing at substantially different rates
– moving in opposite directions
• Accounts receivable and/or inventories
growing much faster than sales
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
More Caution Flags
• Large, unexplained reductions in
discretionary items
• Profit margins
– Dramatically shrinking
– Dramatically growing
– Moving in opposite directions
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Even More Caution Flags
• Earnings reports featuring “pro forma” and
other earnings figures not prepared
according to GAAP
• Showing more than one “pro forma”
earnings amount
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Yet, More Caution Flags
• Taking large, one-time (special) charges
against earnings
• Increasing reserves without justification
• Reducing the allowance for doubtful
accounts when sales are rising
• Changing accounting estimates &
assumptions
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002