Understanding Financial Reports and the
Income Statement
Chapter 2
Learning Objectives
• Income statements
• Operating and non-operating results
• Quality and conservatism of earnings
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A complete set of financial
statements includes:
•
•
•
•
•
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Balance sheet
Income statement
Statement of changes in equity
Cash flow statement
Explanatory notes
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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
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US Securities Regulations
•
•
•
•
•
Annual report to shareholders
Schedule 14A Proxy solicitation materials
Form 10K Annual report
Form 10Q Quarterly filing
Form 8K Current report
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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
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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
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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
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Of the 4 statements,
• the income statement receives the greatest
scrutiny by analysts.
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Motorola, Inc. and Subsidiaries
Consolidated Statements of Operations
(millions, except per share data)
Year ended December, 31
2001
2000
1999
Net Sales
30,004
37,580
33,075
Costs and Expenses
Manufacturing and other costs of sales
21,445
23,628
20,631
Selling, general and administrative expenses
3,703
5,141
5,220
Research and development expenditures
4,318
4,437
3,560
Depreciation expense
2,357
2,352
2,243
Reorganizations of businesses
1,858
596
(226)
Other charges
3,328
517
1,406
Interest expense, net
437
248
138
Gains on sales of invesements and businesses
(1,931)
(1,570)
(1,180)
Total costs and expenses
35,515
35,349
31,792
Earnings (loss) before income taxes
(5,511)
2,231
1,283
Income tax provision (benefit)
(1,574)
913
392
Net earnings (loss)
(3,937)
1,318
891
Basic Earnings (loss) per common share
Diluted Earnings (loss) per common share
Basic wgtd avg common shares outstanding
Diluted wgtd avg common shares outstanding
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(1.78)
(1.78)
2213.3
2213.3
0.61
0.58
2170.1
2256.6
0.42
0.41
2119.5
2202.0
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Nokia Consolidated profit and loss (IAS)
Net sales
Cost of goods sold
Research and development expenses
Selling, general and administrative expenses
One-time customer finance charges
Impairment of minority investments
Impairment of goodwill
Amortization of goodwill
Operating profit
Share of results of associated companies
Financial income and expenses
Profit before tax and minority interests
Tax
Minority interests
Net profit
Earnings per share
Basic
Diluted
Average number of shares (thousands)
Basic
Diluted
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EURm
31,191
(19,787)
(2,985)
(3,443)
(714)
(80)
(518)
(302)
3,362
(12)
125
3,475
(1,192)
(83)
2,200
2000
EURm
30,376
(19,072)
(2,584)
(2,804)
(140)
5,776
(16)
102
5,862
(1,784)
(140)
3,938
1999
EURm
19,772
(12,227)
(1,755)
(1,811)
(71)
3,908
(5)
(58)
3,845
(1,189)
(79)
2,577
0.47
0.46
0.84
0.82
0.56
0.54
4,702,852
4,787,219
4,673,162
4,792,980
4,593,761
4,743,184
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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
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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
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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)
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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%
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Selling, General and Administrative
(SG&A) Expenses
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•
•
•
•
•
•
•
•
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Operating expenses including
Salaries
Pension costs
Marketing costs
Insurance
Rent
Depreciation
Other
Generally reported as a single line item
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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
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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
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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
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Operating income
• Results of primary operations, independent of
investment, financing and tax expenses
Sales
(Cost of sales)
Gross profit
(S G & A)
Operating income
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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
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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
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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, 2005.
• To be consistent with IAS
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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
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Special revenue recognition methods
• Long-term contract
– Completed contract
– Percentage of completion
• Warranty contracts
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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
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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.
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