Understanding Financial Reports and the Income Statement

Chapter 2

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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:

• 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 MattersAPPENDIX•  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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(millions, except per share data)2001 2000 1999

Net Sales 30,004 37,580 33,075 Costs and ExpensesManufacturing 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 (1.78) 0.61 0.42 Diluted Earnings (loss) per common share (1.78) 0.58 0.41 Basic wgtd avg common shares outstanding 2213.3 2170.1 2119.5Diluted wgtd avg common shares outstanding 2213.3 2256.6 2202.0

Year ended December, 31

Motorola, Inc. and SubsidiariesConsolidated Statements of Operations

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Nokia Consolidated profit and loss (IAS)2001 2000 1999

EURm EURm EURmNet sales 31,191 30,376 19,772 Cost of goods sold (19,787) (19,072) (12,227) Research and development expenses (2,985) (2,584) (1,755) Selling, general and administrative expenses (3,443) (2,804) (1,811) One-time customer finance charges (714) - - Impairment of minority investments (80) - - Impairment of goodwill (518) - - Amortization of goodwill (302) (140) (71) Operating profit 3,362 5,776 3,908 Share of results of associated companies (12) (16) (5) Financial income and expenses 125 102 (58) Profit before tax and minority interests 3,475 5,862 3,845 Tax (1,192) (1,784) (1,189) Minority interests (83) (140) (79)

Net profit 2,200 3,938 2,577 Earnings per share

Basic 0.47 0.84 0.56 Diluted 0.46 0.82 0.54

Average number of shares (thousands) Basic 4,702,852 4,673,162 4,593,761 Diluted 4,787,219 4,792,980 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

• 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.