The company I chose for the analysis of Significant Accounting Policies is Verizon communications. It is a telecommunications company. Verizon is the largest service provider of communication services in the United States. Verizon Communications Inc. was formed after the merger with GTE corporation in 2000. It has operations in various parts of the world and has a work force which is approximately 222,900 employees.
Verizon's business is comprised of two reportable segments: 1.Verizon Domestic Wireless, provides wireless voice and data services and mobile phone equipment across the United States . It is a joint venture between Verizon (US wireless operations & services) and Vodafone Group. which was formed in June 2000. Verizon has a controlling stake of 55% in the unit while Vodafone has the remaining 45% stake. In 2009 the Domestic Wireless unit had revenues of $62,131 million dollars which was 58% of Verizon's aggregate revenue. 2. Wire line business provides customers with communications products and services, data and video broadband, network access and also operates and own one of the largest end-to-end global IP networks. These services are not only provided to consumers but to carriers, businesses and government customers in the United States and in 150 other countries. The Wire line segment is further sub-divided into four revenue-producing lines of business: Mass Markets, Global Enterprise, Global Wholesale and Other. For the year 2009,Wireline Business unit's revenue was $46,080 million which represented about 43% of the aggregate revenue of Verizon.
Verizon Communications also acts as Global Solution & Consulting company providing IT services & solutions to the major Fortune 500 companies in various sectors. For 2009 Verizon had consolidated revenues of $ 107.8 Billion dollars which was a 14 % increase compared to 2008 and this made Verizon one of the largest telecommunications companies in the United States as well as in the world.
This paper will discuss the some of the significant accounting policies being implemented by Verizon as described in their 10K report.
They are as follows:
Revenue Recognition policy: Verizon for its Domestic wireless unit earns its revenue by providing access to and usage of its network culminating in voice & data revenue. The access revenue of Verizon is billed one month in advance and recognized when its earned. Similarly the usage revenue is billed in arrears and recognized when the service is provided. The equipment sales revenue which is associated with any equipment which is sold through this business unit the revenue is recognized only when the equipment is delivered and accepted by the customer, as this is considered to be different from the services part of the Wireless Business unit. The other revenue associated with Equipment sale such as activation fee are charged and recorded at the time of acceptance of the equipment by the customer. For any third party transactions where Verizon is acting as the primary obligor in the agreement ,Verizon records the gross revenue when the sale is done. For the Wireline business unit of Verizon it earns its revenue from the usage of its network facilities and contract fees. In this unit for the video ,data ,voice and other services are billed one month in advance and recognized when they are earned. While revenues from these services are not fixed but which are based on the usage are generally billed in arrears and would be recognized when they are provided. In the Wire line Unit when an equipment is sold it is bundled with maintenance and monitoring services, the equipment revenue is recognized when the equipment is installed at the customer location. For the maintenance and monitoring services, revenue is recognized in monthly installments as per the contract specifications. Verizon undertakes turnkey project's here the long term contracts are accounted by the usage of the percentage completion method. If the costs for the project cannot be estimated easily then the completed contract method is employed. All the revenue producing transactions on which tax is imposed by the government are reported on a net basis. Now Verizon follows the fundamental principles of recognition of revenue Recognition Principle-i.e. Recognize revenue only when its earned. It does bill its customers for one month in advance for its different services but it recognizes all the revenue only when it has provided these services to the customer. Even while selling cellular units Verizon recognizes the revenue only when the product is delivered to the customer not when the sale is done. The method which is used by Verizon for Revenue Recognition is perfectly fine as it is under the GAAP guidelines so it follows good practice. It does not inflate its books by just recognizing the unearned revenue as earned revenue. Verizon does not recognize revenue for the gross selling price. Instead Verizon deducts the portion of gross sales that is likely to be refunded by customers,discounts,sales rebate and incentives.Now Verizon has to accurately estimate the likely cost of these deductions as per as the previous economic conditions as well as the current economic scenario.If Verizon does not estimate accurately the deduction then the data which is presented to the investors or creditors can be misinterpreted.
Depreciation :Now Verizon being a telecommunications company it invests a sizeable amount on plant, property and equipment such as telephones, network towers, cables, etc. Verizon for its PPE records the value of the assets in the balance sheet at historical cost, not at market value. Verizon also uses a straight line method for depreciation for Plant, Property & Equipment in its Wire Line and Wireless businesses. Verizon has a pre determined average useful life for all its different Plant, Property and Equipment so it calculates its depreciation based on a table which it has formed over the years of operation. Verizon provides the following table in their 10-K report:
Average Useful Lives (in years)
Buildings
15 - 45
Central office and other network equipment
3 - 15
Outside communications plant
Copper cable
15
Fiber cable (including undersea cable)
11 - 25
Poles, conduit and other
30 - 50
Furniture, vehicles and other
2 - 20
Once the good is replaced or retired then ,It deducts the carrying amount of the good from its respective account and shifts it to accumulated depreciation and any loss or gain on such transactions are reflected on the Income Sheet as an expense. Verizon capitalize and depreciate network software purchased or developed along with related plant assets. Capitalized interest is reported and depreciated as part of the cost of the network-related assets and as a reduction in interest expense.
Now Verizon uses a straight line depreciation for its PPE (i.e. the depreciation expense which is reported on the PPE is same over the useful life of the good. There are no fluctuations in the Depreciation Expense. Now Verizon uses the Straight Line method for Financial reporting to show less depreciation expense which would in turn increase its revenues to the shareholders. Now these methods are acceptable under GAAP a company can have two income sheets for different purposes such as one for Financial Reporting and one for Tax Reporting. So using a straight line method by Verizon for financial reporting is a correct approach for their business.
Inventory Management: Verizon's inventory management consists of sale of its wireless and wireline equipment, which is carried out through the FIFO method ( First-in, First -out basis) or the Average Cost method. Now Verizon states the FIFO method because it helps in the approximation of the actual cost, on a first in, first out basis. In the FIFO Method the costs from the inventory are transferred in the order they were initially recorded. The FIFO method helps Verizon show a bigger profit margin as compared to the LIFO method or the average cost method, As the Cost of Goods sold are the lowest compared to other methods. So if company needs to show higher gross profit to its stock holders then it uses its FIFO method.Verizon also separately reports the inventory costs such as (a) Raw materials & supplies:They are costs of direct materials which are used in the production process.(b)Work in process : Costs of partly finished goods. (c) Finished goods: These are the costs of the products that are completed and awaiting sale. Now in Verizon the inventories are reported also in the Lower Cost Method where the inventory book value is written down to current market value. Now this inventory write down is reflected as inventory expense and which reduces the gross profit and income. Since Verizon is in a technology- sensitive industry the risk of inventory losses are very high, due to technology getting out date or change in consumer tastes. So ensuring that inventory is not very high is very important for Verizon because it results in additional cost such as financing cost to hold inventories, storage cost(warehouse cost),handling costs & insurance cost for the inventory. The companies need to balance out the inventory so that there is no shortage which may lead to stock outs. This would lead to lost sales and production delays.
Earnings Per Common Share
The Earnings Per Share (EPS) is the most frequently discussed operating related number by the investors. It is the earnings that are available by the company to pay dividends to its common stockholders. There are two types of EPS Basic EPS & Diluted EPS. Basic earnings per common share are based on the weighted-average number of shares outstanding during the period. Diluted earnings per share include the lower bound of the year's EPS. In Verizon's case the dilution of the shares is due to the issuance of common stock out here the Diluted EPS is always less than the Basic EPS.
The Basic Earnings per share for Verizon for the year 2009 is $1.87.The Diluted Earnings per share is $ 1.29 for 2009.Verizon had approximately 112 million weighted-average shares for the years ended December 31, 2009. Verizon is authorized to issue up to 4.25 billion and 250 million shares of common stock and Series Preferred Stock, respectively. The Diluted earnings per share calculation presumes a scenario where all employees holding stock options exercise their right to purchase additional shares. So the Diluted EPS(1.29) for Verizon is less than its Basic EPS(1.87).Now EPS figures are used to compare the operating results for companies. The assumption being that the number of shares outstanding is proportional to the income level is not true because, A company twice the size of the another will report double the income and will have double the share outstanding than the EPS for both of the companies are the same. The company management controls the number of shares which are outstanding and different companies have different philosophies regarding the stock issuance and repurchase so investors should not judge a company from its Earnings Per Share. Even though the EPS for Verizon is low compared to other companies it still is doing much better than its competitors which provide a higher Earnings per share.
Goodwill and Intangible Assets:
Goodwill is the excess cost of acquisition for businesses over the fair value of the net assets which are acquired. Impairment testing at Verizon is done usually in the fourth quarter of every year. The tests for impairment uses a two-step approach, which would be performed at the unit level. Verizon have determined that in their case, the reporting units are operating segments since it is the lowest level at which reliable financial information is regularly reviewed by Verizon. The method for calculating Goodwill by Verizon is shown in the 10-K Report as First they compare the fair value of the reporting unit which is calculated using a market approach to its carrying value. If the carrying value exceeds the fair value, a potential impairment is present and the next step would be performed. In the next step comparison is made by the carrying value of the unit's goodwill to the unit's implied fair value. If the unit's implied fair value of goodwill is less than the carrying amount of goodwill, an impairment would be recognized.
Now Verizon calculates impairment only every fourth quarter so if a unit has some impairment during the first quarter of the year then Verizon would only come to know in the fourth quarter when it checks for impairment. This practice by Verizon is not right as for the first three quarters it portrays a picture that all units are working fine but in reality some units are impaired. GAAP suggest that a loss must be recorded whenever the impairment occurs. So Verizon must start testing for impairments every quarter to ensure that they record all the losses at the appropriate quarter and not wait till the end of the year as investors and creditors must have a correct financial picture.
Intangible Assets Not Subject to Amortization
A major portion of Verizon's assets that are intangible is wireless licenses which provide wireless operations the exclusive right to utilize designated radio frequency to provide cellular services. The licenses are issued for only ten years, such licenses are subject to renewal by the Federal Communications Commission. Verizon in its 10-K report states that Now due to this scenario Verizon again tests for the impairment of wireless license only once a year so any changes in the wireless license during that period would only be tested at the end of the year. Since wireless license is one of the important parts of Verizon's business they must regularly check for impairments so that they are able to take corrective measures.
Stock based compensation
Common stock is an important part of the executive compensation for a long time in Corporate America. The idea being that if the company executives own the stock then they would have an incentive to increase its value and this idea aligns with interests of the other shareholders also.As stated in the Verizon 10-K Report the Long Term Incentive Plan provided stock options,perfomance shares and other awards.The maximum b=number of shares from this program was 115 million shares.This suggests that Verizon uses Employee Stock options as a mean to compensate its employees. This option provides Verizon to ensure that its employees have same incentives as its shareholders to increase Verizon's Stock Price.Now such a proposition can have a downside as it also can create incentives for managers to increase the stock price at any means by fiddling with the earnings to inflate the stock price.This is also known as managerial myopia where managers inflate the stock price till they can exercise their options.Now till some time back Verizon was not recording the stock options as part of the compensation expense because previous GAAP rules suggested that options had value only when options purchase price was less than the market stock price.So if Verizon provided stock options equal to the market stock price than it was viewed as nothing of value had being given to its employees. Earlier Verizon did not report compensation expense on these employee stock options as it used to provide it on market value. So this reduced the quality of reported earnings due to the accounting stock options and the amount of unrecorded compensation expense.
Now Verizon provides its employees with restricted stock units rather than stock options. In the restricted stock plan Verizon transfers shares to its employees but the employees cannot sell the shares until the end of the vesting period. In Verizon the Human Resources team determines the number of RSUs an employee can earn based on the extent to which the corresponding goals have been achieved over the three-year performance cycle. The Restricted Stock Units in Verizon are classified as a liability because the Restricted Stock Units will be paid in cash on vesting. The liability of the RSU is measured in a fair value at the end of reporting period because there would be fluctuations based on the performance of Verizon. The outstanding restricted stock units of Verizon for December 31,2009 was 19,443 units at a market price of $35.50.
Providing stock compensation for it employees Verizon is doing the right thing by ensuring that there is enough incentive for its employees to perform well. It must but keep a close watch on the managers to whom they are providing these options as they may take risky methods to inflate the stock price and cause problems in the long run for Verizon's stockholders. Verizon's earlier method of not reporting the stock options as a compensation expense was a method which used to not provide a clear picture of the earnings. So Verizon must ensure that the stock options are accounted as an income expense whenever they provide stock options to its executives.
Foreign Currency Translation
Verizon operates in 150 different countries all over the world.The currency of Verizon's foreign operations are usually the local currencies in which countries they operate . For the foreign subsidiaries, Verizon ensures that the income statement is modified at the average exchange rates for that year, and Verizon would ensure that it modifies the assets and liabilities during the same period of time. Verizon would enter these entries in Accumulated gain/loss, a different component of Equity, in Verizon's balance sheets. Long term exchange gains and losses on intercompany foreign currency transactions are reported in Accumulated other comprehensive gain/loss. The other gains or losses are usually reported in the income statement. Now since Verizon has many subsidiaries it might purchase assets in foreign currencies, borrow money in foreign currencies, and do business with their customers and suppliers in foreign currencies. GAAP ensures that the financial statements must be prepared in terms of US Dollars and for foreign subsidiary if balance sheet is made in foreign currency it must be converted to US dollars.Now whenever the US $ weakens compared to ther foreign currency then the value of its Assets, Liablities & Equity must increase. Similarly if the US $ strengthens compared to the foreign currency then the Assets, Liablities & Equity would decrease in its value.The amount required to balance the accounting equation is called the foreign currency translation adjustment. The adjustment for the year 2009 it was $1014 million dollars and for the year 2008 it was $ 936 million dollars now this increase in the adjustment was due to the devaluation of the U.S. dollar against the Euro. Since most of Verizon's foreign operations was in Europe. Verizon acknowledged the loss in its books by showing the adjustment for the years 2008 and 2009 in accumulated comprehensive income loss. So Verizon correctly reported the loss in its books for the shareholders to analyse its performance for the year 2009.
Analysis of Key Financial Ratios
We analyze the impact of these significant accounting policies on the key financial ratios. These ratios gives the investor information about the strength and weakness of the company.The analysis of the profitablity ratio of Verizon to measure its ability to make a profit.The Gross Profit Margin is measured by the gross income divided by revenue.The Gross Income of Verizon was 13.01 and the industry average was 20.32.The gross income of Verizon has been declining for the last 2 years due to the economic envoirnment.The drop in the profit margin is due to the increase in the cost of sales.So if Verizon wants to increase its profit margin. It can also start recognizing revenue unearned revenue which would be wrong and lead to wrong financial information to the investors. The Net Profit Margin is measured as the net income divided by the revenue. Verizon's net profit margin was 3.39 and was less than it was in 2008 (6.60).Now net profit could be increased by reducing the expenses or by increasing the gross profit. Now if Verizon does not classify its expenses properly and does not report them on time. Then the net profit which would be calculated would be skewed and this would give inappropriate financial statements to the investors or creditors.So it is very important for Verizon to ensure that it follows the Revenue Recognition principle as specified by the GAAP for proper financial statements.
The Asset turnover ratio of Verizon is 0.5(total revenue/average total assets) and the Inventory turnover is 26.2(cost of goods sold/inventory).Now in the case of asset turnover ratio if the expenses are not recorded properly then the asset would increase or decrease its value resulting in the asset turnover ratio being high or low. The correct reporting of expense or recognition of revenue is very important as it also effects the Return of Asset(ROA) & Return on Equity(ROE). Return on Assets(ROA) : It is the ratio calculated by net income divided by the total assets of the company. The ROA of Verizon for 2009 was 1.61% it had reduced from the last year 2008 when it was 3.18% this was due to the unfavorable economic conditions. ROA tells us how Verizon is using its assets to generate revenue. Return on Equity(ROE): It is the ratio calculated by the net income divided by the stockholders equity.The ROE of Verizon for 2009 was 8.78 % which had reduced from year 2008 when it was 15.41 %.It was mainly due to the economic conditions.ROE helps to understands how much did the investors earn.
Thus, looking at the above observations on the accounting policies and impact of the same on ratio analysis, it seems that what a vital role these accounting policies play in a financial reporting of Verizon.
Conclusion
After the analysis of the 10-K report of Verizon,I come to the primary conclusion that the company is financially sound due to its increasing revenue, cash flow & income. It is one of the largest companies in the telecommunications industry with market share of about 26.6%. It has a credit rating from Standard & Poor of A-1. The nature of industry in which Verizon participates, there are many technological innovations and diverse needs of the people as well as the markets so it is highly competitive and fluctuating. Though it shows that Verizon has grown in terms of revenue and income but when analyzed deeply the net profit margin has been reducing this is due to the current economic conditions and the increasing cost. This is one area of concern for the investors. Verizon's management must choose the correct accounting methods with a lot of thought as Verizon must be able to provide the correct financial information to the stockholder. Once the current economic scenario improves and Verizon makes small changes into its accounting practices then it would be much more profitable and a stable company in the future.
