Understanding Financial Statements EIGHTH EDITION

Understanding Financial Statements EIGHTH EDITION Lyn M. Fraser Aileen Ormiston

A Guide to Earnings and Financial Reporting Quality This chapter considers the quality of reported financial information, which is a critical element in evaluating financial statement data (C) 2007 Prentice Hall, Inc.

A Guide to Earnings and Financial Reporting Quality (cont.) The higher the quality of financial reporting, the more useful the information is for business decision making (C) 2007 Prentice Hall, Inc.

A Guide to Earnings and Financial Reporting Quality(cont.) The earnings statement provides management with opportunities for influencing the outcome of reported earnings in ways that may not best represent economic reality or the future operating potential of a firm Potential areas include……. (C) 2007 Prentice Hall, Inc.

A Guide to Earnings and Financial Reporting Quality(cont.) • Accounting choices, estimates and judgments • Changes in accounting methods and assumptions • Discretionary expenditures • Nonrecurring transactions • Nonoperating gains and losses • Revenue and expense recognitions that do not match cash flow (C) 2007 Prentice Hall, Inc.

A Guide to Earnings and Financial Reporting Quality (cont.) The primary focus of this chapter is to provide the financial statement user with a step-by-step guide that links the items on an earnings statement with the key areas in the financial statement data that affect earnings quality (C) 2007 Prentice Hall, Inc.

A Guide to Earnings and Financial Reporting Quality (cont.) Another purpose is to provide the financial statement user with an approach to use in analyzing and interpreting the qualitative factors (C) 2007 Prentice Hall, Inc.

A Checklist for Earnings Quality Major areas on the checklist include: • Sales • Cost of Goods Sold • Operating Expenses • Nonoperating Revenue and Expense • Other Issues (C) 2007 Prentice Hall, Inc.

Sales Potential areas include: 1. Premature revenue recognition • Gross vs. net basis • Vendor financing • Allowance for doubtful accounts • Price vs. volume changes • Real vs. nominal growth (C) 2007 Prentice Hall, Inc.

Sales (cont.) 1. Premature revenue recognition: According to GAAP, revenue should not be recognized until there is evidence that a true sale has taken place Many firms have violated this accounting principle by recording revenue before the conditions for a true sale have been met (C) 2007 Prentice Hall, Inc.

Sales (cont.) 3. Vendor financing: Some companies use vendor financing to increase revenues by lending their customers (other companies) money to purchase their products (C) 2007 Prentice Hall, Inc.

Sales (cont.)3.Vendor financing Example of vendor financing disclosure in MDA section of a company’s 10K:* “Customer Financing Arrangements Outstanding Finance Receivables: The Company had net finance receivables of $260 million at December 31, ….., compared to $170 million at December 31, ….. These finance receivables are generally interest bearing, with rates ranging from 3% to 10%..... “ *Data from SEC website, www.sec.gov (C) 2007 Prentice Hall, Inc.

Cost of Goods Sold Potential areas include: • Cost-flow assumption for inventory • Base LIFO layer liquidations • Fulfillment costs • Loss recognitions on write-downs of inventories (C) 2007 Prentice Hall, Inc.

Cost of Goods Sold 7. Cost-flow assumption for inventory: LIFO results in the matching of current costs with current revenues and produces higher quality earnings than either FIFO or average cost (C) 2007 Prentice Hall, Inc.

Cost of Goods Sold (cont.) 8. Base LIFO layer liquidation: Base LIFO layer liquidations occur when companies are shrinking rather than increasing inventories Reduces the quality of earnings because there is an improvement in operating profit fromwhat would generally be considered anegative occurrence – inventory reductions (C) 2007 Prentice Hall, Inc.

Cost of Goods Sold (cont.) 9. Fulfillment costs: An expense account that some companies add to operating expenses to record costs that are typically classified as cost of goods sold, impacting their gross profit margin and lowering their quality of earnings (C) 2007 Prentice Hall, Inc.

Cost of Goods Sold (cont.) 10. Loss recognitions on write-downs of inventories: If the value of inventory falls below its original cost, the inventory is written down to market value. When the write-down is included in cost of goods sold, the gross profit margin is impacted (C) 2007 Prentice Hall, Inc.

Operating Expenses Potential areas include: • Discretionary expenses • Depreciation • Asset impairment • “Big bath” or restructuring charges • Reserves • In-process research and development • Pension accounting-interest rate assumptions (C) 2007 Prentice Hall, Inc.

Operating Expenses (cont.) 11. Discretionary expenses: If variable operating expenses such as repair and maintenance, research and development, and advertising and marketing are reduced primarily to benefit the current year’s reported earnings, the long-run impact on operating profit may be detrimental and lower the quality of those earnings (C) 2007 Prentice Hall, Inc.

Operating Expenses (cont.) 12. Depreciation: • straight-line method is lower in quality than an accelerated method • misclassification of operating expenses as capital expenditures creates poor quality of financial reporting on all financial statements • comparing companies is difficult when they use different depreciation methods and different estimates for the lives of their long-lived assets (C) 2007 Prentice Hall, Inc.

Operating Expenses (cont.) 13. Asset impairment: The write-down of asset values, following the principle of carrying assets at the lower of cost or market value, affects the comparability and thus the quality of financial data (C) 2007 Prentice Hall, Inc.

Operating Expenses (cont.) 14. “Big bath” or restructuring charges: Large charges classified as restructuring charges are sometimes used by companies to clean up their balance sheet Ongoing restructuring of a company can be a signal of underlying problems (C) 2007 Prentice Hall, Inc.

Operating Expenses (cont.) 15. Reserves: Often created to set aside funds today to cover some known future cost Abuse occurs when funds are set aside in good years (i.e., reducing net income) and then shifting the reserve amount to the income statement in poor years (C) 2007 Prentice Hall, Inc.

Operating Expenses (cont.) 16. In-process research and development: One-time charges taken at the time of an acquisition Can be problematic if companies write-off significant amounts of research and development in the year of acquisition in order to boost earnings in later years (C) 2007 Prentice Hall, Inc.

Operating Expenses (cont.) 17. Pension accounting-interest rate assumptions: A change in the pension interest rate assumption can impact earnings equality • if the rate is decreased, the annual pension cost and the present value of the benefits will increase • if the rate is increased, the annual pension cost and the present value of the benefits will decrease (C) 2007 Prentice Hall, Inc.

Nonoperating Revenue and Expense Potential areas include: • Gains (losses) from sales of assets • Interest income • Equity income • Income taxes • Unusual items • Discontinued operations • Accounting changes • Extraordinary items (C) 2007 Prentice Hall, Inc.

Nonoperating Revenue and Expense (cont.) 18. Gains (losses) from sales of assets: The sale of a major asset is sometimes made to increase earnings and/or to generate needed cash when the firm is performing poorly. Such transactions are not part of the normal operations of the firm and should be excluded from net income when considering the future operating potential of the company (C) 2007 Prentice Hall, Inc.

Nonoperating Revenue and Expense (cont.) 19. Interest income: In assessing earnings quality, the analyst should be alert to the materiality and variability in the amount of interest income because it is not part of operating income (C) 2007 Prentice Hall, Inc.

Nonoperating Revenue and Expense (cont.) 20. Equity income: The net effect of using this method is that the investor, in most cases, records more income than is received in cash (C) 2007 Prentice Hall, Inc.

Nonoperating Revenue and Expense (cont.) 21. Income taxes: • Provision for income tax expense on the income statement differs from the tax actually paid • Important to differentiate between increases and decreases to net earnings caused by tax events (C) 2007 Prentice Hall, Inc.

Nonoperating Revenue and Expense (cont.)21. Income taxes Examples of income tax expense compared to income taxes paid from a selection of 10Ks* $ in millionsIncome Tax Income Taxes Expense Paid Communications mfg. $ 1,921 $ 693 Pharmaceutical mfg. 2,733 1,700 Restaurant chain 55 45 Retailer 504 482 *Data from SEC website, www.sec.gov (C) 2007 Prentice Hall, Inc.

Nonoperating Revenue and Expense (cont.) 22. Unusual items: Analyst should always investigate these items by reading the notes and the MD&A to determine if these items are nonoperating and/or nonrecurring Also called special charges (C) 2007 Prentice Hall, Inc.

Nonoperating Revenue and Expense (cont.) 23. Discontinued operations: Should be excluded in considering future earnings Appropriate to deduct the income on discontinued operations each year from earnings for comparative purposes (C) 2007 Prentice Hall, Inc.

Nonoperating Revenue and Expense (cont.) 24. Accounting changes: • SFAS #154, “Accounting Changes and Error Corrections”, makes comparability and consistency better • Users of financial statements should carefully read any footnote disclosures regarding accounting changes • A quality of earnings issue exists if a firm is changing accounting methods to boost earnings in the short-term (C) 2007 Prentice Hall, Inc.

Nonoperating Revenue and Expense (cont.) 25. Extraordinary items: Gains and losses that are both unusual and infrequent in nature Amounts should be eliminated from earnings when evaluating a firm’s future earnings potential (C) 2007 Prentice Hall, Inc.

Other Issues (cont.) 26. Material changes in number of shares outstanding: • Changes can result from treasury stock purchases and the purchase and retirement of a firm’s own common stock • Reasons for the repurchase of common stock should be determined if possible to see if firm is spending scarce resources to merely increase earnings per share (EPS) (C) 2007 Prentice Hall, Inc.

Other Issues (cont.) • Operating earnings, a.k.a. core earnings, • pro forma earnings, or EBITDA: Operating earnings are important for assessing the ongoing potential of a firm Variety of “company created” numbers have been created for users to review Core earnings Pro forma earnings OperatingEarningsBeforeInterest, Tax, DepreciationandAmortization(EBITDA) (C) 2007 Prentice Hall, Inc.

What are the Real Earnings? Each individual user of financial statements should adjust the earnings figure to reflect what they believe is relevant to the decision at hand (C) 2007 Prentice Hall, Inc.

Quality of Financial Reporting-The Balance Sheet Items discussed in the earnings quality section such as the value attached to accounts receivable, inventory and long-term assets also impact balance sheet quality Other items to assess and evaluate include….. (C) 2007 Prentice Hall, Inc.

Quality of Financial Reporting-The Balance Sheet (cont.) • Type of debt used to finance assets should generally be matched (short-term debt for current assets and long-term debt/equity for long-term assets) • “Commitments and Contingencies” disclosures in the notes should be carefully evaluated as information on off-balance-sheet financing and other complex financing arrangements are located here (C) 2007 Prentice Hall, Inc.

Quality of Financial Reporting-The Balance Sheet (cont.) • “Commitments and Contingencies” also contain information on Operating leases Capital leases Environmental matters Guarantees Legal proceedings (C) 2007 Prentice Hall, Inc.

Quality of Financial Reporting-The Statement of Cash Flows The cash flows from operations (CFO) figure, while highly useful, can be manipulated by • Recording operating expenses as capital expenditures • Managing current asset and liability accounts to cause increases to CFO (C) 2007 Prentice Hall, Inc.

Quality of Financial Reporting-The Statement of Cash Flows (cont.) Cash flows from the following types of items should be removed from CFO for analytical purposes: • Investments in trading securities • Discontinued operations • Nonrecurring expenses or income (C) 2007 Prentice Hall, Inc.

Understanding Financial Statements EIGHTH EDITION