Income Statement - College of Business and Economics

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EMBA 512

Assessing Business

Opportunities

Financial Reporting Module

Objective of this Module

Assist you in becoming more sophisticated in your understanding and use of financial statements

– what’s the link to opportunity assessment?

» financial accounting provides much of the information by which prospects are measured

 Complex area

– focus of a semester long course

The Accounting System

Provides information for many financial decisions

– internal users (managerial accounting)

» planning

» control

– external users (financial accounting)

» investing

» lending

» customer/supplier negotiations

» labor negotiations

The Financial Statements

Balance Sheet

– statement of financial position (moment in time)

»

assets

--the valuable resources of a company

 subject to GAAP measurement conditions

»

liabilities

--the claims of outsiders to the resources

 subject to GAAP measurement conditions

»

equity

--the residual that belongs to the owners

Fundamental asset characteristics:

a future benefit controlled by the company flowing from a past transaction

Google, Inc.’s

Balance Sheet

Assets

Current Assets

Cash and cash equivalents

Short term investments

Net receivables

Other current assets

Total Current Assets

Long term investments

Property, plant and equipment

Intangible assets

Other long term assets

Total Assets

Liabilities

Current Liabilities

Accounts payable

Other current liabilities

Total Current Liabilities

Long-term liabilities

Total Liabilities

Stockholders' Equity

Common stock

Retained earnings

Total Stockholders' Equity

Total Liab. & Stockholders' Equity

All numbers in thousands

2009 2008

$10,198 $ 8,657

14,287

3,846

836

29,167

129

4,845

5,677

679

7,189

2,928

1,404

20,178

85

5,234

5,837

434

$40,497 $31,768

$2,463

285

2,748

1,745

4,493

15,922

20,082

36,004

$40,497

$ 2,002

300

2,302

1,227

3,529

14,677

13,562

28,239

$31,768

The Financial Statements

Income Statement (P&L)

– summarizes performance for a past period

»

revenues

--asset inflows from operations

»

expenses

--asset outflows for operations

»

gains

--net inflows from nonoperating items

»

losses

--net outflows for nonoperating items

Google, Inc.’s

Income Statement

All numbers in thousands

Years Ending December 31

Total Revenue

Cost of Revenue

Gross Profit

Operating Expenses

Research Development

Selling General and Administrative

Total Operating Expenses

Income from Continuing Operations

Total Other Income/(Expense)

Earnings Before Interest and Taxes

Interest Income

Income Before Tax

Income Tax Expense

Net income

2009

$23,650

8,844

14,806

2,843

3,651

6,494

8,312

8,312

69

8,381

1,861

$ 6,520

2008

$21,796

8,622

13,174

2,793

3,749

6,542

6,632

5,538

316

5,854

1,627

$ 4,227

The Financial Statements

Statement of Cash Flows

– summarizes flows for the period by type

»

operating

 typically prepared indirectly

»

investing

 purchases and sale of ‘capital’ investments

»

financing

 transactions with creditors and owners

Google, Inc.’s

Statement of Cash Flow

Years Ending December 31

Operating Activities

Net Income

Depreciation

Adjustments To Net Income

Changes In Accounts Receivables

Changes In Liabilities

Changes In Other Operating Activities

Net Cash Flow From Operating Activities

Investing Activities

Capital Expenditures

Investments

Other Cashflows from Investing Activities

Net Cash Flow From Investing Activities

Financing Activities

Sale/(Purchase) of Stock

Other Cash Flows from Financing Activities

Net Cash Flow From Financing Activities

Effect Of Exchange Rate Changes

Change In Cash and Cash Equivalents

All numbers in thousands

2009 2008

$6,520 $4,227

1,524 1,500

785

(504)

511

480

9,316

(810)

(7,101)

(108)

(8,019)

143

90

233

11

$ 1,541

1,799

(335)

183

479

7,853

(2,358)

359

(3,320)

(5,319)

(72)

159

87

(46)

$2,575

E3.13

P3.26

The Accrual Model

Financial statements are built from a company’s transactions

– record assets and liabilities

» revenues and expenses from the changes in them

The ever present accounting equation

A = L + SE

P2.23

E2.16

E2.17

Key Accounting Method Choices

Can dramatically impact reported results

– inventory

– depreciation

– research and development

– consolidations

Inventory Cost Flow Example

ABC Company’s inventory transactions:

– 1/01/x1--buys 1 unit @ $10

– 1/12/x1--buys 1 unit @ $12

1/21/x1--sells 1 unit @ $20

ABC Company’s Performance:

FIFO inventory (B/S)

1 @ $12 = $12

CGS(I/S)

$10

LIFO 1 @ $10 = $10 $12

Inventory Method Choice Summary

Method

FIFO

LIFO

Inventory(B/S) current prices old prices

Cost of Goods Sold(I/S) old prices current prices

Financial Statement Impact (assuming rising prices)

Balance Sheet

Inventory

Income Statement

FIFO > LIFO

Cost of Goods Sold

Net Income

FIFO < LIFO

FIFO > LIFO

Depreciation of Property, Plant and Equipment

Process of allocation, not valuation

» charge a portion of the cost to expense during each year of an asset’s useful life

 income statement shows depreciation expense

 balance sheet shows accumulated depreciation

 Amount of depreciation taken depends on:

» cost

» method (straight-line, accelerated)

» salvage value

» life

Why Might Depreciation Vary

Across Companies?

Method differences

– most U.S. firms use SL

» can convert SL to accelerated (MACRS) using income tax footnote

 Life differences (for companies using SL) average life = gross PP&E ÷ annual depr. exp.

Age differences (for companies using SL) average age = accumulated depreciation ÷ annual depr. exp.

Research and Development

Activity directed at developing new knowledge

– translate into

» products

» services

» processes

 Sometimes successful, often not

– tangible evidence of success

» patents

» trademarks

» profits!

The Challenge of R&D

When money is spent up front, how do we evaluate it’s future success?

 Necessary in order to

– capitalize (record as asset) the successful

– expense (write off) the rest

GAAP’s solution

– expense all R&D

» conservatism

The Conservatism Paradox

Assume:

1. R&D spending is constant @ $10,000/year

2. Creates benefits lasting 5 years

3. Company has $100,000 of assets and $25,000 of income, both before considering R&D

Required:

– Evaluate the impact of expensing R&D on

Return on Assets (ROA)

The Conservatism Paradox

Analyzing R&D Firms

Need to exercise care in interpreting profitability

– especially when level of R&D expenditures is changing

Consolidated Financial Statements

Consolidate holdings in excess of 50% of voting shares

– financial statements of affiliates combined as though a single legal entity

– tax reporting--may be separate or combined tax returns

Consolidations

Two methods

– pooling of interests

» commingling of existing interests

Book value (BV) basis of both affiliates maintained in consolidated statements

– purchase

» acquisition of one company by another

 subsidiary’s assets and liabilities remeasured at fair value at date of combination

– goodwill

Consolidation Methods

Change in GAAP in 2001 (SFAS 141)

– prohibits new poolings

» prior poolings left unchanged

– subsequent action modified the purchase accounting rules

» goodwill is no longer amortized

 still recorded as an asset

– written down (off) only if impaired

Impact of Consolidation on

Financial Statements

Income Statement

– Net income pooling > purchase

Balance Sheet

– Total assets---------purchase > pooling

– Total liabilities-----purchase = pooling

– Total equity---------purchase > pooling

Other Consolidation Issues

Noncontrolling interest (minority interest)

– stock of subsidiary owned by outsiders

– creates outside claims on

» assets

 minority interest in net assets (liability/equity)

» income

 minority interest in income (pseudo expense)

Other Consolidation Issues

Consolidation of unconsolidated subsidiaries (those just below 50%)

– happens occasionally but not common

» very suspicious

– reported using equity method

» would like them to be consolidated (controlled)

 income statement--net income is o.k.

 balance sheet--subsidiaries debts are left off the books

– can adjust data using footnote disclosures

» very involved adjustments

Financial Statement Analysis

For what purpose?

– price arbitrage

– lending

– customer/vendor evaluation

– labor negotiations

– government regulation

– litigation support

Financial Statement Analysis

What are we looking for?

Positive investment returns!

Where P t

D t

P t-1

= Share price at end of period,

= Dividends received during the period,

= Share price at beginning of period

What are we worried about?

Risk!

E1.29

Financial Statement Analysis

Factors affecting corporate performance

– industry characteristics (Porter’s five forces)

» buyer power (price sensitivity)

 costliness, competing products

» supplier power

 scarcity, quantity

» rivalry among firms

» threat of new entrants

 capital intensity, government regulation, rate technological change

» threat from substitute products

Financial Statement Analysis

Factors affecting corporate performance

– industry characteristics (Porter’s five forces)

– corporate strategy

» product focus

 differentiation, low cost leadership, niche

» location in the value chain

 manufacturing, distribution, integration

» diversification (geographic or industry)

» leverage

 use of financial and/or operating leverage

The Margin versus Turnover

Trade-Off

35%

30%

25%

20%

15%

10%

5%

0%

0 1 2 3 4 5 6

Turnover

7 8 9 10 11

ROE=10%

ROE=20%

Financial Statement Analysis

Factors affecting corporate performance

– industry characteristics (Porter’s five forces)

– corporate strategy

» product focus

 differentiation, low cost leadership, niche

» location in the value chain

 manufacturing, distribution, integration

» diversification (geographic or industry)

» leverage

 use of financial and/or operating leverage

Operating Leverage Illustration

ABC Company plans to sell a new product this year that can be sourced two ways:

1. subcontract to Asia for a cost of $1.50 each.

2. produce in a refurbished company owned facility at a variable production cost of $1 and facility operating costs of $275,000/year

What is product cost?

• at 500,000 units at 800,000 units

Option 1

$750K

($1.50/unit)

$1,200K

($1.50/unit)

Option 2

$775K

($1.55/unit)

$1,075K

($1.34/unit)

39

Financial Leverage Illustration

Company has $1,000 asset earning $150

(15%) before financing

 asset financed as follows:

» $300 by long-term debt (10% interest cost)

» $700 by equity

ROA = (150 ÷ 1,000) = 15%

ROCE = (120 ÷ 700) = 17%

Assets provided by creditors:

Return generated $300 x .15 = $45

Financing cost $300 x .10 = $30

$15 excess to equity

40

Gauging Performance

Ratios are popular

– performance measurement

» ROA, ROCE

– risk assessment

» extent to which current profits may be different that those in the future

 liquidity

 solvency

 turnover

 leverage (operating, financial)

Identify the Company

Complications

Financial Statements tell us…

– only part of the story

» hard to predict the future

 fundamental challenge of analysis

» limitations in GAAP

 substantial latitude in preparing information

– discretionary accounting choices

 important information left off the statements

– ‘off-balance-sheet” financing

Psychology of Reporting

Management’s natural desire to cast things in a favorable light

– management vs. manipulation

» why we have

GAAP

 audits

– millennium scandals

» why we now have

Sarbanes/Oxley Act

– 404

PCAOB

Financial Statement Analysis

Performance measurement framework

– profitability (Dupont Model—see p. 125)

» ROA

 profit margin

 asset turnover

» ROE

ROA

 financial leverage

– risk

» solvency risk

» operating leverage

» financial leverage

see ratio list

Financial Statement Analysis

Our focus is on the future

– to predict well we need to consider

» current economic conditions and forecasts

» industry characteristics

» company strategy

Measuring Earnings

Need to evaluate the components of GAAP income

– permanent earnings (recurring, persistent)

– transitory earnings

Finding the Nonrecurring

(Transitory) Earnings

Sales

-Cost of goods sold

Gross profit

Operating expenses

Income from operations

+ Other revenues/gains

- Other expenses/losses

Income before taxes

- Income tax expense

Net Income

Nonrecurring Earnings

Other Revenue/Gains

– gains from peripheral activities (e.g., the sale of

PP&E, investments)

Other Expenses/Losses

– losses from peripheral activities (e.g., the sale of PP&E, investments)

– restructuring charges

– impairment losses

Other Sources of Nonrecurring

Earnings

Sales

-Cost of goods sold

Gross profit

- Operating expenses

Income from operations

+ Other revenues/gains

- Other expenses/losses

Income before taxes

- Income tax expense

Income before …

Special Income Statement Items

Discontinued Operations

Extraordinary Items

Discontinued Operations

Results from disposal of segment

– a sizable component of operations

Reported in two separate components

– income/loss on operations

– gain/loss on disposal

Both components reported net of related tax effects

O’Sullivan Corporation

Manufacturer of flexible vinyl sheeting

– automotive, industrial, medical

– sold consumer products business in 2005

Income b/4 Disc. Operations

Loss from operations (net of

$428,489 in tax benefits)

Loss from disposal (net of

$1,825,954 in tax benefits)

Net Income

2005

8,813,858

- 593,593

-3,674,046

4,546,219

Extraordinary Items

Both

unusual

in nature and

nonrecurring

– fire, flood and other casualties

Reported net of related tax effects flood loss 1,000,000 tax effect (400,000) net loss 600,000

E3.19

Other Earnings Reporting Issues

Restatements

– change amounts in financial statements for prior years (comparative statements)

– Used for

» correcting errors

 on prior years’ income statements

» reporting changes in accounting principles

 retrospective method

» changes in the entity (acquisitions, divestitures)

Restatement Example

XYZ Co. began operations in 2002

– in 2002 recorded cost of a $100,000 building as a purchase of land.

– error not detected until this year (2006)

– building has a 20 year life and $0 salvage value.

– company uses straight-line depreciation.

– tax rate = 40%

Restatement Example (Cont.)

Income Statement

depreciation taken correct depreciation gross effect on inc.

taxes (40%) net effect on inc.

2002 2003

0 0

5

- 5

5

- 5

+2

- 3

+2

- 3

2004

0

5

- 5

+2

- 3

Corrections on Income Statement:

NI (as previously reported) error

NI (corrected)

41

-3

38

45

-3

42

Corrections on Statement of Retained Earnings:

2005

0

5

- 5

+2

- 3

2006

0

5

- 5

+2

- 3

--

--

47

-6

Restatement Example (Cont.)

XYZ’s 2006 Financial Statements

– Income Statement: depreciation expense

Net Income

2004 2005

5.0

5.0

38* 42*

*restated

– Statement of Retained Earnings: beg. balance prior period adjustment adjusted beg. balance

+ net income

- dividends ending balance

2004 xxxx

-6.0

xxxx

38.0

xxxx xxxx

2005 xxxx

0.0

xxxx

42.0

xxxx xxxx

2006

5.0

47

2006 xxxx

0.0 xxxx

47.0

xxxx xxxx

Overcoming GAAP Limitations

Many accounting standards provide opportunities for

– managing income

– off-balance sheet financing (OBSF)

Q1.13

 Why would managers want to do this?

– basic economics

» we are all self interested agents

Q3.6

 agency costs

Why would GAAP permit managers do this this?

PEAP, POOP, WYWAP

Not GAAP but…

Politically Expedient Accounting Principles

– Concessions, concessions, concessions!

» Footnote reporting of option expense

» Pensions (triple smoothing of volatility)

Whatever You Want Accounting Principles

– GAAP allow lots of choices

» FIFO/LIFO

» Accelerated/St. line

Not GAAP but…

Pitifully Old and Obsolete Principles

– Many old standards still around:

– Treasury stock (1934) – Stock splits (1941)

– Depreciation (1946) – Inventory (1947)

– LT contracts (1955) – Quarterly reporting (1934)

Fixing Up Poor GAAP

Measurement

Major problem areas

– investments (smoothing)

– leases (OBSF)

– retirement benefits (smoothing, OBSF)

Details forthcoming in our next session

(Saturday, February 16, 2013)

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