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Class 7 - Module5


Income Statement Analysis

Topics
? Revenue Recognition
– Earned vs. Unearned – Percent completion

? R&D Expense ? Restructuring Costs ? Income Taxes

– Deferred Taxes and Valuation Allowance

? Below the line items
– Discontinued operations / Extraordinary items

? EPS Dilution ? Foreign Currency Translation

Revenue Recognition
? Revenue recognition criteria – realized or realizable, and – earned ? Realized or realizable means that the seller’s net assets (assets less liabilities) increase. ? Earned means that the seller has performed its duties under the terms of the sales agreement.

Pfizer’s Revenue Recognition Policy
? Pfizer recognizes its revenues as follows: – Revenue Recognition—we record revenue from product sales when the goods are shipped and title passes to the customer. At the time of sale, we also record estimates for a variety of sales deductions, such as sales rebates, discounts and incentives, and product returns. – This is a very typical policy, problems are unlikely

Cisco is much more complex:

Oracle’s Revenue Recognition Policy

? Microsoft reports $10.9 billion of unearned revenue in 2006. the company describes its recognition policy as follows:

Percentage-of-Completion
? The percentage-of-completion recognizes revenue by the proportion of costs incurred to date compared with total estimated costs. ? The percentage-of-completion method of revenue recognition requires an estimate of total costs. ? If total construction costs are underestimated, the percentageof-completion is overestimated (the denominator is too low) and revenue and gross profit to date are overstated. ? This uncertainty adds additional risk to financial statement analysis.

Johnson Controls Revenue Recognition

Revenue Recognition Summary
? Analyst needs to understand the revenue recognition policy that the firm is using. ? Read footnote 1 of the financial statements, which explains how the firm recognizes revenues ? Assess the reasonableness and conservatism of the firm’s policies. ? Compare the firm’s revenue recognition methods to other firms in the same industry. ? Be aware that specialized industries may have specialized revenue recognition practices. Examples: software, TV broadcasting and motion pictures, mortgage lending, membership businesses. Analyst needs to be an expert in the practices of the industries she follows. ? Be aware that revenue recognition problems account for over half of the restatements (and related stock impact) we observe.

Research and Development (R&D) Expenses
? Expense all R&D costs as incurred unless those assets have alternative future uses (in other R&D projects or otherwise). ? For example, a general research facility housing multi-use lab equipment is capitalized and depreciated like any other depreciable asset. ? However, project-directed research buildings and equipment with no alternate uses must be expensed.

Pfizer’s R&D Accounting Footnote

Restructuring Expenses
? Restructuring costs typically consists of two components: – Employee severance or relocation costs – Asset write-downs ? Accounting standard: – A company is required to have a formal restructuring plan that is approved by its board of directors before any restructuring charges are accrued. – Also, a company must identify the relevant employees and notify them of its plan. ? In each subsequent year, the company must disclose in its footnotes the original amount of the liability (accrual), how much of that liability is settled in the current period (such as employee payments), how much of the original liability has been reversed because of cost overestimation, any new accruals for unforeseen costs, and the current balance of the liability. ? This creates more transparent financial statements, which presumably deters earnings management.

Hewlett-Packard’s 2005 Restructuring Plan

? Of the $1.57 billion of expense recognized in 2005, $630 million was paid in that year, yielding an ending balance of approx. $1 billion. ? In fiscal year 2006, H-P paid out an additional $747 million. ? Is this a non-recurring item?

How much cash Did they use in 2008 And 2007 for Restructuring?

Income Tax Expenses
? Companies maintain two sets of accounting records, one for preparing financial statements for external constituents, including current and prospective shareholders, and another for reporting to tax authorities. ? Two sets of accounting records are necessary because the U.S. tax code is different from GAAP. ? The difference between the two sets of records means that: – Tax expense may be recorded before it is due to the IRS (results in deferred tax liability) – Tax may be paid to the IRS before it is recorded as an expense(results in a deferred tax assets) – Differences are referred to as ―timing differences‖ – Some book income is never subject to tax, and some book expenses are never deductable for tax. – Such differences are referred to as ―permanent differences‖

Deferred Tax Liabilities and Assets
? Deferred tax liabilities increase when pretax book income is greater than tax return income. ? Deferred tax assets increase when tax return income is greater than pretax book income.

Exercise (True/False)
? 1. According to GAAP revenue recognition criteria, in order for revenue to be recognized on the income statement, it must be either realized (realizable) or earned. ? 2. In 2007, Abbot Laboratories Inc. began a research and development project, incurring expenses of $10 million for the research facility and lab equipment. When this project is completed in 2010, the facility and lab equipment will be used for general research work indefinitely. Under GAAP, Abbot must expense the $10 million in 2007. ? 3. Employee severance costs, as part of restructuring costs, are not reported in the income statement until the actual payment for these costs occurs. ? 4. Income tax expense is recorded at the amount owing to the tax authorities because this is the most objectively measured amount.

Loss Carryforwards
? When a company reports a loss for tax purposes, it can carry back that loss for up to two years to recoup previous taxes paid. ? Any unused losses can be carried forward for up to twenty years to reduce future taxes. ? This creates a benefit (an ―asset‖) on the tax reporting books for which there is no corresponding financial reporting asset and thus the company records a deferred tax asset.

Valuation Allowance
? Companies are required to establish a deferred tax valuation allowance for deferred tax assets if it is more likely than not that some or all of the deferred tax asset will not be realized. ? The effect on financial statements is to reduce reported assets, increase tax expense, and reduce equity. ? These effects are reversed if the allowance is reversed in the future when realization of these tax benefits becomes more likely.

Income Tax Footnotes
? Income tax expense reported in its income statement (called the provision) consists of the following two components (organized by federal, state and foreign):
– Current tax expense - the amount payable (in cash) to tax authorities – Deferred tax expense - the effect on tax expense of timing differences

Pfizer’s Income Tax Footnote

Pfizer’s Deferred Tax Footnote

Another Illustration Black and Decker Income Taxes Footnote
NOTE: While Black & Decker has an overall 2005 net deferred tax asset of $116.2 million, that amount is composed of tax assets and liabilities arising from a variety of tax reporting/financial reporting differences.

Reconciliation of Statutory and Effective Tax Rates - Pfizer

Reconciliation of Statutory and Effective Tax Rates – Dell, Inc.

Notice the fluctuation in effective tax rate from 21.9% to 31.5% in the past two years.

Key Things to Look For - Taxes
? Difference between statutory and effective rates: – Are differences transitory or persistent? – Try to figure out what next year’s effect tax rate is likely to be. ? Valuation allowance: – Effect of changes in allowance on income – Any evidence that it is being manipulated

Operating Income “Below the Line”
? Two categories of items are presented belowthe-line: – Discontinued operations Net income (loss) from business segments that have been or will be sold, and any gains (losses) on net assets related to those segments sold in the current period. – Extraordinary items Gains or losses from events that are both unusual and infrequent.

Raytheon Discontinued Operations

Raytheon Discontinued Operations

Note: other DOs reported a net loss of $5M, yielding the $176 net income reported in the income statement.

Extraordinary Items
? The following items are generally not reported as extraordinary items: – Gains and losses on retirement of debt – Write-down or write-off of operating or nonoperating assets – Foreign currency gains and losses – Gains and losses from disposal of specific assets or business segment – Effects of a strike – Lawsuit settlements – Costs of a takeover defense – Costs incurred as a result of the September 11, 2001, events or Hurricane Katrina

Verizon

Exercise (True/False)
? 1. Revenues from discontinued operations of a company are reported separately from revenues from continuing operations in the income statement.

? 2. For an item to be classified as extraordinary, it needs to be either unusual or infrequent. ? 3. When a company reports a deferred tax asset it means that the company will more likely than not receive a tax benefit in the future.

Earnings Per Share

Diluted EPS
? Concept: To show how much each common shareholder would ―own‖ with respect to earnings IF all dilutive securities had been exercised or converted at the beginning of the year. Numerator and denominator are adjusted as follows: – convertible preferred stock: ? numerator: eliminate pf dividend (not be paid if converted) ? denominator: increase shares OS (would increase if converted) – convertible bonds: ? numerator: eliminate interest expense (not paid if converted) ? denominator: increase shares outstanding (larger if converted) – stock options: ? no numerator effect ? denominator: increase shares outstanding using ―Treasury Stock Method‖ ? Only dilutive securities are used in adjusting the diluted calculation.

Treasury Stock Method
? Applies to dilutive outstanding options and warrants. ? No distinction is made regarding vesting or exercisability. ? Assumption is that in-the-money (dilutive) options are exercised, and proceeds from exercise are used by the firm to repurchase shares on the open market at the average market price during the year. ? Example: 25,000 options outstanding with exercise price of $25 per share. Average stock price is $27.50. – Assumed exercise would bring in $625,000, – Preceeds assumed to be used to repurchase $625,000/$27.50 = 22,727 shares. – So Incremental shares added to denominator for options are 25,000-22,727=2,273

Example EPS Calculation
? Net Income $500,000 ; Tax rate 40% ? Average Common Shares Outstanding 100,000 ? $1,000,000 face value 8% convertible bond; conversion option 25 shares per 1,000 bond; issued July 1 of current year ? 25,000 options outstanding, exercise price $25 per share ? Average stock price during the year was $27.5 $500,000 Basic EPS ? ? $5 / share 100,000 ? For diluted, assume exercise of convertible bond: ? x[ $1,000,000/$40] = 12,500 to denominator; add [$1,000,000 x 8% x (1-.40)]x? = $24,000 to numerator

$500,000? $24,000 Diluted EPS ? ? $4.57 / share 100,000? 12,500? 2,273

EPS Disclosure Requirements
? If the company has potentially dilutive securities, both basic and diluted EPS must be shown. ? Separate EPS disclosure for: – Net income from continuing operations (after tax) – Disposals of business segments – Extraordinary items ? If diluted EPS is required, it should be shown for each level of presentation.

Symantec’s EPS Footnote

Apple’s EPS Footnote

Which company is better?
Berkshire-Hathaway

Exxon-Mobil

Foreign Currency Translation
? A change in the strength of the $US vis-à-vis foreign currencies affects reported income in the following manner:
– Changes in foreign currency exchange rates have a direct effect on the $US equivalent for revenues, expenses, and income of a foreign subsidiary because revenues and expenses are translated at the average exchange rate for the period. – Changes in year-end exchange rates also affect the US dollar carrying value of foreign subsidiary assets and liabilities; the net effect of this may appear in income (if subsidiary’s functional currency is US$) or in equity ((if subsidiary’s functional currency is its local currency).

Pfizer’s Foreign Currency Footnote

? The $US weakened against many foreign currencies for several years preceding and including 2005. ? Thus, each unit of foreign currency purchased more $US. Therefore, revenues and expenses denominated in foreign currencies were translated to higher $US equivalents, yielding increased revenues and profits even when unit volumes remained unchanged.

BMY’s Foreign Currency Translation
Bristol-Myers Squibb reports its accumulated and other comprehensive income (loss) as part of its statement of shareholders’ equity as reported in the following footnote from its 10 -K report:
Dollars in millions Foreign Currency Translation Available for sale securities Deferred loss of Effective Hedges Minimum pension liability Adjustment Accumulated other Comprehensive Income/Loss

Balance at December 31, 2002 Other comprehensive income (loss) Balance at December 31, 2003

$(724) 233 $(491)

$1 23 $24

$(87) (171) $(258)

$(94) (36) $(130)

$(904) 49 $(855)

a. What effect(s) does the $233 million foreign currency translation amount have on BristolMyers Squibb’s stockholders’ equity? b. Describe the exchange rate environment ($US vis-à -vis other world currencies) that gives rise to the effect identified in part a.

BMY’s FC Translation
? The $233 million foreign currency translation adjustment is a positive amount that reduces the negative cumulative foreign currency translation adjustment. As a result, stockholders’ equity increases by $233 million. The translation adjustment is related to the conversion of balance sheets denominated in foreign currencies into $US. For solvent companies, assets exceed liabilities. Therefore, a positive foreign currency translation adjustment would be consistent with a weakening of the $US. As foreign currencies strengthen vis-à-vis the $US, the $US value of assets denominated in those currencies increases as does the value of liabilities. And, since assets exceed liabilities for solvent companies, the asset adjustment exceeds the liability adjustment, yielding a positive foreign currency translation adjustment.

?

Exercise (True/False)
? 1. Because diluted EPS include dilutive securities such as convertible securities and employee stock options, it must always be less than or equal to basic EPS.

? 2. A company with outstanding employee stock options will report a diluted EPS that is lower than basic EPS. ? 3. Revenue from a foreign subsidiary will be larger in U.S. dollars when the dollar weakens relative to the foreign currency.


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