Reporting and Analyzing Operating Income - Amazon S3s3.amazonaws.com/zanran_storage/ of Revenue...
Transcript of Reporting and Analyzing Operating Income - Amazon S3s3.amazonaws.com/zanran_storage/ of Revenue...
Revenue Recognition
Revenue recognition criteria
1. realized or realizable, and
2. 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.
Arguments Against Revenue Recognition
Rights of return exist
Consignment sales
Continuing involvement by seller in product
resale
Contingency sales
Risks of Revenue Recognition
Case 1: Channel stuffing
Case 2: Barter transactions
Case 3: Mischaracterizing transactions as
arm’s-length
Case 4: Pending execution of sales agreements
Case 5: Gross versus net revenues
Case 6: Sales on consignment
Case 7: Failure to take delivery
Case 8: Nonrefundable fees
Percentage-of-Completion
The percentage-of-completion recognizes revenue by the proportion of costs incurred to date compared with total estimated costs.
Assume that Bayer Construction signs a $10 million contract to construct a building. Abbott estimates construction will take two years and will cost $7,500,000. This means the contract yields an expected gross profit of $2,500,000 over two years.
The following table summarizes construction costs incurred each year and the revenue Bayer recognizes.
Percentage-of-Completion
Revenue recognition policies for these types of contracts
are disclosed in a manner typical to the following from the
2007 10-K report footnotes of Raytheon Company:
“We generally use the cost-to-cost measure of progress for all of our long-term
contracts… Under the cost-to-cost measure of progress, the extent of progress
towards completion is measured based on the ratio of costs incurred-to-date to
the total estimated costs at completion of the contract. Contract costs include
material, labor and subcontracting costs, as well as an allocation of indirect
costs. Revenues, including estimated earned fees or profits, are recorded as
costs are incurred. Due to the nature of the work required to be performed on
many of our contracts, the estimation of total revenue and cost at completion is
complex and subject to many variables.”
Johnson Controls Revenue Recognition –
Percentage-of-Completion
Revenue Recognition
The Company recognizes revenue from long-term systems installation contracts
of the building efficiency business over the contractual period under the
percentage-of-completion (POC) method of accounting. Under this method, sales
and gross profit are recognized as work is performed based on the relationship
between actual costs incurred and total estimated costs at the completion of the
contract…Changes to the original estimates may be required during the life of the
contract and such estimates are reviewed monthly. Sales and gross profit are
adjusted prospectively for revisions in estimated total contract costs and contract
values…The use of the POC method of accounting involves considerable use of
estimates in determining revenues, costs and profits and in assigning the
amounts to accounting periods. The reviews have not resulted in adjustments that
were significant to the Company’s results of operations. The Company continually
evaluates all of the issues related to the assumptions, risks and uncertainties
inherent with the application of the POC method of accounting.
Risks of Percentage-of-Completion
The percentage-of-completion method of revenue
recognition requires an estimate of total costs.
If total construction costs are underestimated, the
percentage-of-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.
Recognition of Unearned Revenue
Deposits or advance payments are not recorded
as revenue until the company performs the
services owed or delivers the goods.
Until then, the company’s balance sheet shows
the advance payment as a liability (called
unearned revenue or deferred revenue) because
the company is obligated to deliver those
products and services.
Recognition of Unearned Revenue
Assume that on January 1 a client pays Pfizer
$360,000 for a guaranteed one year supply of a rare
medicine.
Microsoft reports $15.3 billion of unearned revenue in 2008. the company describes its recognition policy as follows:
Unearned revenue is comprised of the following items:
Volume licensing programs – Represents customer billings for multi-year
licensing arrangements, paid either upfront or annually at the beginning of each
billing coverage period, which are accounted for as subscriptions with revenue
recognized ratably over the billing coverage period.
Undelivered elements – Represents free post-delivery telephone support and
the right to receive unspecified upgrades/enhancements of Microsoft Internet
Explorer on a when-and-if-available basis…The amount recorded as unearned
is based on the sales price of those elements when sold separately and is
recognized ratably on a straight-line basis over the related product’s life cycle.
The percentage of revenue recorded as unearned due to undelivered elements
ranges from approximately 15% to 25% of the sales price for Windows XP
Home and approximately 5% to 15% of the sales price for Windows XP
Professional, depending on the terms and conditions of the license and prices of
the elements. Product life cycles are currently estimated at three and one-half
years for Windows operating systems.
Cisco Systems’ R&D
13% of
sales
Research and Development - We regularly seek to introduce new products and features in
areas including routers, switches, advanced technologies, and other product technologies.
Our research and development expenditures were $5.2 billion, $4.5 billion, and $4.1 billion in
fiscal 2008, 2007, and 2006, respectively. All of our expenditures for research and
development costs…have been expensed as incurred.
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.
Analysis of R&D Expense
R&D costs for wages and general purpose PPE are
accounted for as they normally are. Only the
expensing of PPE with no alternate use differs.
Capitalizing and depreciating/amortizing R&D
costs is not advisable as the depreciation or
amortization period is arbitrary.
Recommendations:
Compare R&D/Sales for comparable companies
Evaluate discussion of R&D effectiveness in the
MD&A, financial press, and company communication.
Restructuring Expenses Restructuring costs typically consists of three components:
Employee severance or relocation costs
Asset write-downs
Other (i.e., contract termination costs, legal expenses, etc.)
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.
Analysis of Restructuring Costs
Employee severance or relocation costs -
overstatements are followed by a reversal of the
restructuring liability, and understatements are
followed by further accruals.
Asset write-downs - prior periods’ profits are
arguably not as high as reported, and the current
period’s profit is not as low.
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.
Income Tax Expenses
Example: straight-line depreciation for book and
accelerated depreciation for tax
Deferred Tax Liabilities and Assets
Deferred tax liabilities arise when the net book value
of liabilities is less for financial reporting than for tax
reporting, or when the net book value of assets is
greater for financial reporting than for tax reporting.
Deferred tax assets arise when the net book value
of liabilities is greater for financial reporting than
for tax reporting, or when the net book value of
assets is smaller for financial reporting than for tax
reporting.
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 when the future realization of their benefits is uncertain.
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
from changes in deferred tax liabilities and deferred
tax assets.
Pfizer’s Income Tax Footnote
Income tax expense is the sum of
1. Taxes currently payable
2. Deferred income taxes
Reconciliation of Statutory and
Effective Tax Rates Fortune Brands
Pretax income $188.4 $1,120.2 1,179.3
Effective tax rate 50.7% 30.9% 24.5%
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 the foreign
subsidiary because revenues and expenses are translated at the
average exchange rate for the period.
Pfizer’s Foreign Currency Translation Footnote
The $US weakened against many foreign currencies for
several years preceding and including 2007.
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
1. Did the $US strengthen or weaken vis-à-vis other world currencies in which
BMY conducts its business
2. Did the $99 million other comprehensive income affect cash flow in 2007?
Explain. If not, are there other currency-related transactions that did affect cash
flow?
BMY’s FC Translation Solution1. 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.
2. The $99 million other comprehensive income is related to the restatement of foreign currency-denominated balance sheets for BMY’s subsidiaries into $US. There is no cash flow effect. The sales and expenses of those subsidiaries were also translated into higher $US in BMY’s consolidated income statement. There is no cash flow effect here either unless foreign profits are repatriated to the US parent.
Operating Income “Below the Line”
Two categories of items are presented below-
the-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.
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
Accrual adjustments related to long-term contracts
Costs of a takeover defense