Accounting & Financial Reporting

Accounting & Financial Reporting

BUSG 503Michael Dimond

Michael DimondSchool of Business Administration

• Exercises E5-22, 23, 24, 27, 28, 31

For next week…


E5-22Company Revenue Recognition

a. The Limited

When the customer takes the merchandise and the right of return period has expired or costs of returns can be reasonably estimated.

b. Boeing Corporation

Revenue is recognized under long-term contracts under the percentage-of-completion method.

c. Supervalu When the customer takes the merchandise and payment is received.

d. MTV When the content is aired by the TV stations.

e. Real estate developer

When title to the houses is transferred to the buyers.

f. Bank of America

Interest is earned by the passage of time. Each period, Bank of America accrues income on each of its loans and establishes an account receivable on its balance sheet.

g. Harley-Davidson

When title to the motorcycles is transferred to the buyer. Harley will also set up a reserve for anticipated warranty costs and recognize the expected warranty cost expense when it recognizes the sales revenue.

h. Time-Warner When the magazines are sent to subscribers. Subscriptions received in advance are deferred revenue (a liability) until the magazines are mailed.


E5-23

Company Revenue Recognition

a. Real Money The recognition of revenue is dependent upon Real Money providing updates. Thus, the company should recognize revenue ratably over the period of time that customers can access its Website, not when the cash is received.

b. Oracle The fee to purchase the right to use the software can be recorded as revenue when the software is installed. Service revenue can only be recognized ratably over the period of time covered by the service contract.

c. Intuit Recognize revenue when the software is sent to customers. The company must estimate potential warranty claims and establish a reserve for them when revenue is recorded.

d. Computer- game developer

Recognize revenue after the 10-day right of return period expires.


E5-24 ($ millions) Percentage-of-Completion Method Completed Contract

Year

Costs incurred

Percent of total

expected costs

Revenue recognized

(percentage of costs incurred

total contract amount)

Income (Revenue – Costs

incurred)

Revenue recognized

Income

2011 $100 25% $125 $ 25 $ 0 $ 0

2012 300 75% 375 75 500 100

$400 $500 $100 $500 $100


E5-27The following items are considered to be operating items on the income statement:

Net sales Cost of sales and the special inventory charge Selling general and administrative expense Research and development Merger and acquisition costs In-process research and development Litigation settlement Gain on disposal of fixed assets

Note: “Other expense” is assumed to be operating unless information is provided in the

footnotes that indicates otherwise OR the company shows it explicitly as non-operating. This is the case with Apollo – by showing the item after operating profit, the company is reporting that the item is not part of operations.


E5-28The following items are operating:

Net sales Finance and interest income Other income Cost of sales Research and development expenses Selling, administrative and general expenses Other operating expenses Provision for income taxes (the portion that relates to operating

profit) Equity in income of unconsolidated affiliates; this relates to Deere’s

investments in companies over which it exerts significant influence, but does not control. This income is viewed as operating so long as the related investment is considered an operating asset.

Interest expense is the only nonoperating item.


a. Sales dropped at two segments: North American (1.9%) and Europe (2.7%). The other two segments had sales increases: Latin America (4.8%) and Asia (2%).

b. On a consolidated basis, foreign currency exchange rates had a negligible impact on Kellogg’s sales (0.1%). Segment level analysis reveals a different story. In Europe and Latin America, sales were negatively affected by currency rate changes – Europe’s sales in U.S. dollars decreased by 2.8% and Latin American sales (again, in USD) dropped by a significant 8.9%. In contrast, sales in Asia, when converted to dollars, increased by 11.7%. From these effects, we can conclude that during 2010, the U.S. dollar strengthened with respect to the euro and Latin American currencies and weakened with respect to Asian currencies.

c. Before the effects of foreign currency, North America experienced a small decline in profits, 1.7% which was moderated by a positive impact of foreign currency rate changes. Europe had 8.2% profit growth but the stronger dollar reduced the growth by 3.4 percentage points to 4.8%. Latin American profits were down slightly (-2.4%) but a significantly stronger dollar vis-à-vis Latin American currencies further reduced profits by 12.3 percentage points to an overall decline of 14.7%. Asian profits were down by a significant 29.5% but because of a weaker dollar, the net effect was only 14.3% decline.

d. U.S. public companies are required to report their financial statements in $US. This means that all foreign currency transactions must by translated into $US. As the $US weakens, each foreign currency unit is worth more in dollar terms. Consequently, sales and expenses denominated in a foreign currency have a higher $US equivalent. Indeed, each income statement item is greater, thus increasing reported profits or losses. Companies with significant foreign-currency based transactions can experience large swings in reported numbers when currencies change dramatically.

e. Kellogg uses derivatives such as foreign currency exchange contracts, options and currency swaps, to hedge its known foreign exchange exposure. Gains and losses resulting from hedging instruments offset the foreign exchange gains or losses on the underlying (hedged) items (assets, liabilities, revenues and expenses). Realized and unrealized gains and losses on these contracts are recognized in the same period as gains and losses on the hedged items.

E5-31


Cisco Systems, Inc. Current Assets

Note: Cisco’s Accounts Receivable are reported net of a $235 million allowance

for uncollectible accounts.


Allowance for Uncollectible Accounts

• The amount of expected uncollectible accounts is usually computed based on an aging analysis.

• Each customer’s account balance is categorized by the number of days or months the underlying invoices have remained outstanding.

• Based on prior experience or on other available statistics, bad debts percentages are applied to each of these categorized amounts, with larger percentages being applied to older accounts.


Aging Analysis Example

• GAAP requires companies to disclose the amount of the allowance for uncollectible accounts, either on the face of the balance sheet or in the notes.

• Companies are also required to disclose their accounting policies with respect to receivables.


Reporting Accounts Receivable

Given our gross balance of $100,000 and estimated uncollectible accounts of $2,900, accounts receivable will be reported as follows:


Write-off of Uncollectible Accounts

• The write-off of an uncollectible account does not affect income. The amount written-off is reflected as a reduction of the account receivable balance and the allowance for uncollectible accounts:


Income Shifting

• By underestimating the provision, expense is reduced in the income statement, thus increasing current period income.

• In one or more future periods, when write-offs occur for which the company should have provisioned earlier, it must then increase the provision to make up for the underestimated provision for the earlier period.

• This reduces income in one or more subsequent periods. Income has, thus, been shifted (borrowed) from a future period into the current period.


Receivables Turnover & Days Sales in Receivables

• The accounts receivables turnover (ART) rate is defined as

• The accounts receivable turnover rate reveals how many times receivables have turned (been collected) during the period.

• More turns indicate that receivables are being collected quickly.

• A companion ratio is the Average Collection Period:


• FIFO, LIFO & Average Cost are three methods of computing inventory value

Computing COGS


Inventory Turnover Rates


Long-Term Assets

• Long-term assets mainly consist of property, plant, and equipment (PPE).

• These assets often makeup the largest asset amounts. • Future expenses arising from these long-term assets

often makeup the larger expense amounts—typically reflected in depreciation expense and asset write-downs.


• Exercises E6-22-30 & 36. We will go through these in class• Read Chapter 7 & preview the Mini Exercises

For next week…

Accounting & Financial Reporting

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