understanding financial statements eighth edition lyn m. fraser aileen ormiston

Understanding Understanding Financial Statements Financial Statements

EIGHTHEIGHTH EDITION EDITION

Lyn M. Fraser Lyn M. Fraser

Aileen OrmistonAileen Ormiston

(C) 2007 Prentice Hall, Inc.(C) 2007 Prentice Hall, Inc.

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A Guide to Earnings and A Guide to Earnings and Financial Reporting Financial Reporting QualityQuality

This chapter considers the quality of reported financial information,

which is a critical element in evaluating financial statement data


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A Guide to Earnings and A Guide to Earnings and Financial Reporting QualityFinancial Reporting Quality (cont.)(cont.)

The higher the quality of financial reporting, the more useful the information is for business

decisionmaking


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A Guide to Earnings and A Guide to Earnings and Financial Reporting QualityFinancial Reporting Quality

(cont.)(cont.)

The earnings statement providesmanagement with opportunities

forinfluencing the outcome of

reportedearnings in ways that may not

bestrepresent economic reality or

thefuture operating potential of a

firm

Potential areas include…….


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Accounting choices, estimates and Accounting choices, estimates and judgmentsjudgments

Changes in accounting methods and Changes in accounting methods and assumptionsassumptions

Discretionary expendituresDiscretionary expenditures Nonrecurring transactionsNonrecurring transactions Nonoperating gains and lossesNonoperating gains and losses Revenue and expense recognitions that do Revenue and expense recognitions that do

not match cash flownot match cash flow


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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


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Another purpose is to provide the financial statement user with an

approach to use in analyzing and

interpreting the qualitative factors


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A Checklist for Earnings A Checklist for Earnings QualityQuality

I.I. SalesSales

II.II. Cost of Goods SoldCost of Goods Sold

III.III. Operating ExpensesOperating Expenses

IV.IV. Nonoperating Revenue and Nonoperating Revenue and ExpenseExpense

V.V. Other IssuesOther Issues

Major areas on the checklist include:


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SalesSales

1.1. Premature revenue recognitionPremature revenue recognition

2.2. Gross vs. net basisGross vs. net basis

3.3. Vendor financingVendor financing

4.4. Allowance for doubtful accountsAllowance for doubtful accounts

5.5. Price vs. volume changesPrice vs. volume changes

6.6. Real vs. nominal growthReal vs. nominal growth

Potential areas include:


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Sales Sales (cont.)(cont.)

1. Premature revenue recognition:

According to GAAP, revenue should notAccording to GAAP, revenue should not

be recognized until there is evidencebe recognized until there is evidence

that a true sale has taken placethat a true sale has taken place

Many firms have violated this accounting Many firms have violated this accounting

principle by recording revenue principle by recording revenue before the conditions for a true sale before the conditions for a true sale have been met have been met


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2. Gross vs. net basis:

Another tactic to boost revenues is Another tactic to boost revenues is to record sales at the gross to record sales at the gross rather than the net pricerather than the net price


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3. Vendor financing:

Some companies use vendor Some companies use vendor financing to increase revenues financing to increase revenues by lending their customers (other by lending their customers (other companies) money to purchase companies) money to purchase their productstheir products


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3.3. Vendor financingVendor financing

Example of vendor financing disclosure in MDA section of a company’s 10K:*

““Customer Financing ArrangementsCustomer Financing Arrangements

Outstanding Finance Receivables:Outstanding Finance Receivables: The Company had net The Company had net

finance receivables of $260 million at December 31, ….., finance receivables of $260 million at December 31, …..,

compared to $170 million at December 31, ….. These compared to $170 million at December 31, ….. These

finance receivables are generally interest bearing, with finance receivables are generally interest bearing, with

rates ranging from 3% to 10%..... “rates ranging from 3% to 10%..... “

*Data from SEC website, *Data from SEC website, www.sec.govwww.sec.gov


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4. Allowance for doubtful accounts:

This is a type of reserve account that This is a type of reserve account that cancan

be manipulated by under- or be manipulated by under- or overestimating bad debt overestimating bad debt expensesexpenses


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5. Price vs. volume changes:

In general, higher quality earnings In general, higher quality earnings would be the product of both would be the product of both volume and price increases volume and price increases (during inflation)(during inflation)


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6. Real vs. nominal growth:

Important to determine if sales are Important to determine if sales are growing in “real” (inflation-growing in “real” (inflation-adjusted) as well as “nominal” adjusted) as well as “nominal” (as reported) terms(as reported) terms


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Cost of Goods SoldCost of Goods Sold

7.7. Cost-flow assumption for inventoryCost-flow assumption for inventory

8.8. Base LIFO layer liquidationsBase LIFO layer liquidations

9.9. Fulfillment costsFulfillment costs

10.10. Loss recognitions on write-downs of Loss recognitions on write-downs of inventoriesinventories



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Cost of Goods SoldCost of Goods Sold

7. Cost-flow assumption for inventory:

LIFO results in the matching of LIFO results in the matching of current costs with current current costs with current revenues and produces higher revenues and produces higher quality earnings than either FIFO quality earnings than either FIFO or average costor average cost


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Cost of Goods SoldCost of Goods Sold (cont.) (cont.)

8. Base LIFO layer liquidation:

Base LIFO layer liquidations occur when Base LIFO layer liquidations occur when companies are shrinking rather than companies are shrinking rather than increasing inventoriesincreasing inventories

Reduces the quality of earnings because Reduces the quality of earnings because there is an improvement in operating there is an improvement in operating profit fromprofit from what would generally be what would generally be considered aconsidered a negative occurrence – negative occurrence – inventory reductionsinventory reductions


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Cost of Goods Sold Cost of Goods Sold (cont.)(cont.)

9. Fulfillment costs:

An expense account that some An expense account that some companies add to operating companies add to operating expenses to record costs that are expenses to record costs that are typically classified as cost of typically classified as cost of goods sold, impacting their gross goods sold, impacting their gross profit margin and lowering their profit margin and lowering their quality of earningsquality of earnings


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Cost of Goods Sold Cost of Goods Sold (cont.)(cont.)

10. Loss recognitions on write-downs of inventories:

If the value of inventory falls below its If the value of inventory falls below its original cost, the inventory is original cost, the inventory is written down to market value.written down to market value.

When the write-down is included in When the write-down is included in cost of goods sold, the gross cost of goods sold, the gross profit margin is impactedprofit margin is impacted


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Operating ExpensesOperating Expenses

11.11. Discretionary expensesDiscretionary expenses

12.12. DepreciationDepreciation

13.13. Asset impairmentAsset impairment

14.14. ““Big bath” or restructuring chargesBig bath” or restructuring charges

15.15. ReservesReserves

16.16. In-process research and developmentIn-process research and development

17.17. Pension accounting-interest rate Pension accounting-interest rate assumptionsassumptions



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Operating Expenses Operating Expenses (cont.)(cont.)

11. Discretionary expenses:

If variable operating expenses such as repair If variable operating expenses such as repair and maintenance, research and and maintenance, research and development, and advertising and development, and advertising and marketing are reduced primarily to marketing are reduced primarily to benefit the current year’s reported benefit the current year’s reported earnings, the long-run impact on earnings, the long-run impact on operating profit may be detrimental and operating profit may be detrimental and lower the quality of those earningslower the quality of those earnings


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12. Depreciation: straight-line method is lower in quality straight-line method is lower in quality

than an accelerated methodthan an accelerated method misclassification of operating expenses misclassification of operating expenses

as capital expenditures creates poor as capital expenditures creates poor quality of financial reporting on all quality of financial reporting on all financial statementsfinancial statements

comparing companies is difficult when comparing companies is difficult when they use different depreciation methods they use different depreciation methods and different estimates for the lives of and different estimates for the lives of their long-lived assetstheir long-lived assets


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13. Asset impairment:

The write-down of asset values, The write-down of asset values, following the principle of carrying following the principle of carrying assets at the lower of cost or assets at the lower of cost or market value, affects the market value, affects the comparability and thus the quality comparability and thus the quality

of financial dataof financial data


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14. “Big bath” or restructuring charges:

Large charges classified as restructuring Large charges classified as restructuring charges are sometimes used by charges are sometimes used by companies to clean up their balance companies to clean up their balance sheetsheet

Ongoing restructuring of a company can be Ongoing restructuring of a company can be a signal of underlying problemsa signal of underlying problems


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15. Reserves:

Often created to set aside funds today to Often created to set aside funds today to cover some known future costcover some known future cost

Abuse occurs when funds are set aside in Abuse occurs when funds are set aside in good years (i.e., reducing net income) good years (i.e., reducing net income) and then shifting the reserve amount and then shifting the reserve amount to the income statement in poor yearsto the income statement in poor years


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16. In-process research and development:

One-time charges taken at the time of an One-time charges taken at the time of an acquisitionacquisition

Can be problematic if companies write-off Can be problematic if companies write-off significant amounts of research and significant amounts of research and development in the year of acquisition development in the year of acquisition in order to boost earnings in later yearsin order to boost earnings in later years


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17. Pension accounting-interest rate assumptions:

A change in the pension interest rate A change in the pension interest rate assumption can impact earnings equalityassumption can impact earnings equality

if the rate is decreased, the annual if the rate is decreased, the annual pension cost and the present value of the pension cost and the present value of the benefits will increasebenefits will increase

if the rate is increased, the annual if the rate is increased, the annual pension cost and the present value of the pension cost and the present value of the benefits will decreasebenefits will decrease


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Nonoperating Revenue and Nonoperating Revenue and ExpenseExpense

18.18. Gains (losses) from sales of assetsGains (losses) from sales of assets

19.19. Interest incomeInterest income

20.20. Equity incomeEquity income

21.21. Income taxesIncome taxes

22.22. Unusual itemsUnusual items

23.23. Discontinued operationsDiscontinued operations

24.24. Accounting changesAccounting changes

25.25. Extraordinary itemsExtraordinary items



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Nonoperating Revenue and Nonoperating Revenue and Expense Expense (cont.)(cont.)

18. Gains (losses) from sales of assets:

The sale of a major asset is sometimes The sale of a major asset is sometimes made to increase earnings and/or to made to increase earnings and/or to generate needed cash when the firm is generate needed cash when the firm is performing poorly. Such transactions performing poorly. Such transactions are not part of the normal operations are not part of the normal operations of the firm and should be excluded of the firm and should be excluded from net income when considering the from net income when considering the future operating potential of the future operating potential of the companycompany


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19. Interest income:

In assessing earnings quality, the In assessing earnings quality, the analyst should be alert to the analyst should be alert to the materiality and variability in the materiality and variability in the amount of interest income because amount of interest income because it is not part of operating incomeit is not part of operating income


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20. Equity income:

The net effect of using this method is The net effect of using this method is that the investor, in most cases, that the investor, in most cases, records more income than is records more income than is received in cashreceived in cash


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21. Income taxes:

Provision for income tax expense Provision for income tax expense on the income statement differs on the income statement differs from the tax actually paidfrom the tax actually paid

Important to differentiate between Important to differentiate between increases and decreases to net increases and decreases to net earnings caused by tax eventsearnings caused by tax events


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21. Income taxes21. Income taxes

Examples of income tax expense compared to income taxes paid from a selection of 10Ks*

$ in millions$ in millions Income Tax Income Income Tax Income TaxesTaxes

Expense Expense PaidPaid

Communications mfg.Communications mfg. $ 1,921$ 1,921 $ 693 $ 693

Pharmaceutical mfg.Pharmaceutical mfg. 2,733 2,733 1,700 1,700

Restaurant chainRestaurant chain 55 55 45 45

RetailerRetailer 504 504 482 482*Data from SEC website, *Data from SEC website, www.sec.govwww.sec.gov


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22. Unusual items:

Analyst should always investigate these Analyst should always investigate these items by reading the notes and the items by reading the notes and the MD&A to determine if these items MD&A to determine if these items are nonoperating and/or are nonoperating and/or nonrecurringnonrecurring

Also called special chargesAlso called special charges


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23. Discontinued operations:

Should be excluded in considering Should be excluded in considering future earningsfuture earnings

Appropriate to deduct the income on Appropriate to deduct the income on discontinued operations each year discontinued operations each year from earnings for comparative from earnings for comparative purposespurposes


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24. Accounting changes: SFAS #154, “Accounting Changes and SFAS #154, “Accounting Changes and

Error Corrections”, makes Error Corrections”, makes comparability and consistency bettercomparability and consistency better

Users of financial statements should Users of financial statements should carefully read any footnote disclosures carefully read any footnote disclosures regarding accounting changesregarding accounting changes

A quality of earnings issue exists if a A quality of earnings issue exists if a firm is changing accounting methods to firm is changing accounting methods to boost earnings in the short-termboost earnings in the short-term


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25. Extraordinary items:

Gains and losses that are both unusual Gains and losses that are both unusual and infrequent in natureand infrequent in nature

Amounts should be eliminated from Amounts should be eliminated from earnings when evaluating a firm’s earnings when evaluating a firm’s future earnings potentialfuture earnings potential


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Other IssuesOther Issues

26.26. Material changes in number of sharesMaterial changes in number of shares

outstandingoutstanding

27.27. Operating earnings, a.k.a. core Operating earnings, a.k.a. core earnings,earnings,

pro forma earnings, or EBITDApro forma earnings, or EBITDA



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Other Issues Other Issues (cont.)(cont.)

26. Material changes in number of shares outstanding: Changes can result from treasury Changes can result from treasury

stock purchases and the purchase and stock purchases and the purchase and retirement of a firm’s own common retirement of a firm’s own common stockstock

Reasons for the repurchase of Reasons for the repurchase of common stock should be determined common stock should be determined if possible to see if firm is spending if possible to see if firm is spending scarce resources to merely increase scarce resources to merely increase earnings per share (EPS)earnings per share (EPS)


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Other Issues Other Issues (cont.)(cont.)

27.Operating earnings, a.k.a. core earnings,

pro forma earnings, or EBITDA:Operating earnings are important for assessing Operating earnings are important for assessing

the ongoing potential of a firmthe ongoing potential of a firm

Variety of “company created” numbers have Variety of “company created” numbers have been created for users to reviewbeen created for users to review

Core earningsPro forma earnings

Operating Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA)


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What are the Real Earnings?What are the Real Earnings?

Each individual user of financial statements Each individual user of financial statements should adjust the earnings figure to should adjust the earnings figure to reflect what they believe is relevant to reflect what they believe is relevant to the decision at handthe decision at hand


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Quality of Financial Quality of Financial Reporting-The Balance Reporting-The Balance SheetSheet

Items discussed in the earnings quality section Items discussed in the earnings quality section such as the value attached to accounts such as the value attached to accounts receivable, inventory and long-term receivable, inventory and long-term assets also impact balance sheet qualityassets also impact balance sheet quality

Other items to assess and evaluate include…..Other items to assess and evaluate include…..


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Quality of Financial Quality of Financial Reporting-The Balance Reporting-The Balance Sheet Sheet (cont.)(cont.)

Type of debt used to finance assets should Type of debt used to finance assets should generally be matched (short-term debt for generally be matched (short-term debt for current assets and long-term debt/equity current assets and long-term debt/equity for long-term assets)for long-term assets)

““Commitments and Contingencies” Commitments and Contingencies” disclosures in the notes should be carefully disclosures in the notes should be carefully evaluated as information on off-balance-evaluated as information on off-balance-sheet financing and other complex sheet financing and other complex financing arrangements are located herefinancing arrangements are located here


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Quality of Financial Quality of Financial Reporting-The Balance Reporting-The Balance Sheet Sheet (cont.)(cont.)

““Commitments and Contingencies” Commitments and Contingencies” also contain information onalso contain information on

Operating leasesOperating leases

Capital leasesCapital leases

Environmental mattersEnvironmental matters

GuaranteesGuarantees

Legal proceedingsLegal proceedings


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Quality of Financial Reporting-Quality of Financial Reporting-The Statement of Cash FlowsThe Statement of Cash Flows

Recording operating expenses as Recording operating expenses as capital expenditurescapital expenditures

Managing current asset and liability Managing current asset and liability accounts to cause increases to CFOaccounts to cause increases to CFO

The cash flows from operations (CFO) from operations (CFO) figure, while highly useful, can be figure, while highly useful, can be manipulated bymanipulated by


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Quality of Financial Reporting-Quality of Financial Reporting-The Statement of Cash FlowsThe Statement of Cash Flows (cont.)(cont.)

Investments in trading securitiesInvestments in trading securities Discontinued operationsDiscontinued operations Nonrecurring expenses or incomeNonrecurring expenses or income

Cash flows from the following types of items should be removed from CFO for analytical purposes:


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The Journey The Journey Through the Maze Through the Maze ContinuesContinues

Ch. 6:Ch. 6: The Analysis of Financial The Analysis of Financial StatementsStatements

understanding financial statements eighth edition lyn m. fraser aileen ormiston

Documents

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