Module 4Module 4

Reporting and Reporting and Analyzing Analyzing Operating Operating

IncomeIncome

Revenue RecognitionRevenue Recognition

Revenue recognitionRevenue recognition refers to the refers to the recording of revenue by a companyrecording of revenue by a company

GAAP has two revenue recognition GAAP has two revenue recognition criteria that must be met for revenue to be criteria that must be met for revenue to be recognized (and recorded on the income recognized (and recorded on the income statement)—revenue must be: statement)—revenue must be:

1.1. Realized or realizable Realized or realizable

2.2. EarnedEarned

SEC Guidelines for SEC Guidelines for Revenue RecognitionRevenue Recognition

SEC outlines its guidance for revenue SEC outlines its guidance for revenue recognition in Staff Accounting Bulletin recognition in Staff Accounting Bulletin (SAB) 101, where it states that revenue is (SAB) 101, where it states that revenue is realized, or realizable, and earned when realized, or realizable, and earned when each of the following criteria are met:each of the following criteria are met:

1.1. There is persuasive evidence that a sales agreement exists,There is persuasive evidence that a sales agreement exists,

2.2. Delivery has occurred or services have been rendered,Delivery has occurred or services have been rendered,

3.3. Seller’s price to the buyer is fixed or determinable, andSeller’s price to the buyer is fixed or determinable, and

4.4. Collectibility is reasonably assured.Collectibility is reasonably assured.

Revenue Recognition Revenue Recognition ChallengesChallenges

Some serious revenue recognition challenges are:Some serious revenue recognition challenges are: Revenue recognition upon delivery pending execution of Revenue recognition upon delivery pending execution of

sales agreements. sales agreements. Gross vs. Net. Gross vs. Net. Sales on consignment. Sales on consignment. Failure to take delivery. Failure to take delivery. Nonrefundable fees. Nonrefundable fees. Channel stuffing. Channel stuffing. Mischaracterizing extraordinary or unusual transactions as Mischaracterizing extraordinary or unusual transactions as

revenue. revenue. Selling undervalued assets. Selling undervalued assets.

Percentage-of-Percentage-of-CompletionCompletion

For certain industries requiring long-term For certain industries requiring long-term contacts, revenue is recognized using the contacts, revenue is recognized using the percentage-of-completion methodpercentage-of-completion method, which , which recognizes revenue by determining the costs recognizes revenue by determining the costs incurred to date compared with the incurred to date compared with the project’s total expected costs.project’s total expected costs.

Percentage-of-completion method of Percentage-of-completion method of revenue recognition requires an estimate of revenue recognition requires an estimate of total anticipated costs. total anticipated costs.

Percentage-of-Completion Percentage-of-Completion ExampleExample

Stock OptionsStock Options

Is this compensation?Is this compensation?

$45.001.00

$47.250.50

$45.000.50

$49.610.25

$42.860.50

$40.820.25

$38.870.125

$42.860.375

$47.250.375

$52.090.125

Up factor: 1.05

Down: 1/1.05

Up prob: 50%

Down: 50%

OutcomeOutcome ProbabiliProbabilityty

Stock Stock PricePrice

Option Option ValueValue

(Stock price (Stock price - $45, but - $45, but

not less than not less than $0)$0)

ProbabiliProbability x ty x

Option Option ValueValue

AA 12.5%12.5% $52.09$52.09 $7.09$7.09 $0.89$0.89

BB 37.5%37.5% $47.25$47.25 $2.25$2.25 $0.84$0.84

CC 37.5%37.5% $42.86$42.86 $0.00$0.00 $0.00$0.00

DD 12.5%12.5% $38.87$38.87 $0.00$0.00 $0.00$0.00

$1.73$1.73

Employee Stock OptionsEmployee Stock Options

Employee Employee stock optionsstock options are a form of are a form of compensation. compensation.

Given to employees in lieu of cash payments Given to employees in lieu of cash payments or salary. or salary.

Terms of these plans give employees the Terms of these plans give employees the right to purchase a fixed number of shares right to purchase a fixed number of shares of stock in the company at a fixed price for of stock in the company at a fixed price for a pre-determined period of time. a pre-determined period of time.

Employee Stock OptionsEmployee Stock Options

Current GAAP either:Current GAAP either: Intrinsic value based method:Intrinsic value based method:

No compensation recorded if option’s exercise No compensation recorded if option’s exercise price is equal to or greater than the optioned price is equal to or greater than the optioned stock price at the time both the number of shares stock price at the time both the number of shares optioned and their exercise price are known.optioned and their exercise price are known.

Fair value based method:Fair value based method: Expenses fair value of options over their vesting Expenses fair value of options over their vesting

period.period. Vesting means option can be exercised even if Vesting means option can be exercised even if

employee leaves the company.employee leaves the company.

Cisco’s Stock Option Cisco’s Stock Option “Expense” as currently “Expense” as currently

footnotedfootnoted

Foreign Currency Foreign Currency TranslationTranslation

Many companies conduct operations, not only in Many companies conduct operations, not only in countries outside of the US, but also in currencies countries outside of the US, but also in currencies other than $US. other than $US.

Many purchase assets in foreign currencies, Many purchase assets in foreign currencies, borrow in foreign currencies, and transact borrow in foreign currencies, and transact business with their customers in foreign business with their customers in foreign currencies. currencies.

US corporations can have subsidiaries whose US corporations can have subsidiaries whose entire balance sheets and income statements are entire balance sheets and income statements are stated in foreign currencies. stated in foreign currencies.

Foreign Currency Foreign Currency Translation Adjustment at Translation Adjustment at

Ford Motor CompanyFord Motor Company

Income Statement Effects Income Statement Effects of Currency Swingsof Currency Swings

McDonald’s:

R&D ExpensesR&D Expenses R&DR&D activities are a significant expenditure activities are a significant expenditure

for most firms, especially for those in for most firms, especially for those in technological industries where R&D costs can technological industries where R&D costs can range up to 10% of sales or higher. range up to 10% of sales or higher.

These costs include employment costs for R&D These costs include employment costs for R&D personnel, R&D related contract services and personnel, R&D related contract services and PP&E costs. PP&E costs.

Accounting standards relating to R&D Accounting standards relating to R&D activities require: activities require: expense as incurredexpense as incurred. .

Cisco’s R&D FootnoteCisco’s R&D Footnote

Income Tax ExpenseIncome Tax Expense Companies maintain two sets of booksCompanies maintain two sets of books

1.1. One for reporting to their shareholdersOne for reporting to their shareholders2.2. One for reporting to the IRS. One for reporting to the IRS.

This is perfectly legal as the tax Code is different This is perfectly legal as the tax Code is different from GAAP. from GAAP.

This can result in dramatically different levels of This can result in dramatically different levels of pre-tax (financial reports to shareholders) and pre-tax (financial reports to shareholders) and taxable (reported to the IRS) income. taxable (reported to the IRS) income.

These differences result in deferred tax liabilities These differences result in deferred tax liabilities (book income > taxable income) and deferred tax (book income > taxable income) and deferred tax assets (book income < taxable income)assets (book income < taxable income)

Components of Cisco’s Tax Components of Cisco’s Tax ExpenseExpense

Cisco’s Deferred Tax Cisco’s Deferred Tax FootnoteFootnote

Intra-period Tax Intra-period Tax AllocationAllocation

Taxes are disclosed in two ways on Taxes are disclosed in two ways on the I/Sthe I/S

First is taxes on income from First is taxes on income from continuing operationscontinuing operations

Second is to show remaining items Second is to show remaining items net of taxesnet of taxes Gross amount x (1 - tax rate)Gross amount x (1 - tax rate)

Transitory Income Items & Core Transitory Income Items & Core EarningsEarnings

Estimation of stock prices entails forecasts of Estimation of stock prices entails forecasts of future earnings and cash flows. future earnings and cash flows.

Forecasts are better when we can identify Forecasts are better when we can identify transitory items in reported earnings and cash transitory items in reported earnings and cash flows and can eliminate those from our forecasts.flows and can eliminate those from our forecasts.

Our goal is to identify Our goal is to identify corecore earnings and cash earnings and cash flows of the company. flows of the company.

Core earnings and cash flows have the greatest Core earnings and cash flows have the greatest persistence or predictive power and are, therefore, persistence or predictive power and are, therefore, most useful for stock price estimation. most useful for stock price estimation.

Disclosure and Disclosure and PresentationPresentation

Operating revenues and Expenses: Operating revenues and Expenses: usual and frequentusual and frequent

Other revenues and expenses: Other revenues and expenses: unusual or infrequentunusual or infrequent

Disposal of a segmentDisposal of a segment Extraordinary items: unusual and Extraordinary items: unusual and

infrequentinfrequent Changes in accounting principlesChanges in accounting principles

Transitory Income ItemsTransitory Income Items

Discontinued OperationsDiscontinued Operations Extraordinary ItemsExtraordinary Items Changes in Accounting PrincipleChanges in Accounting Principle

Discontinued OperationsDiscontinued Operations

Discontinued operations refer to any Discontinued operations refer to any separately identifiable business operation separately identifiable business operation that the company intends to sell. that the company intends to sell.

Profits (loss) of the discontinued operations Profits (loss) of the discontinued operations (net of tax), together with the gain (loss) on (net of tax), together with the gain (loss) on sale, of the segment are reported in a sale, of the segment are reported in a separate section of the income statement separate section of the income statement below income from continuing operations. below income from continuing operations.

Best Buy’s Best Buy’s Reporting of Discontinued Reporting of Discontinued

OperationsOperations

Best Buy’s Best Buy’s Reporting Reporting

of of DiscontinDiscontin

ued ued OperationOperation

ss

Extraordinary ItemsExtraordinary Items

Extraordinary items represent transitory Extraordinary items represent transitory events that are both unusual and events that are both unusual and infrequent. infrequent.

Extraordinary items are segregated Extraordinary items are segregated from the rest of the income statement from the rest of the income statement items and presented separately following items and presented separately following income from continuing operations. income from continuing operations.

The company makes the determination The company makes the determination of whether an event is unusual and of whether an event is unusual and infrequent. infrequent.

Examples of Examples of Extraordinary Items Extraordinary Items

(Not)(Not)• Write-down or write-off of assetsWrite-down or write-off of assets

• Foreign currency gains and lossesForeign currency gains and losses

• Gains and losses form disposal of specific assets or Gains and losses form disposal of specific assets or business segmentsbusiness segments

• Effects of a strikeEffects of a strike

• Accrual adjustments related to long-term contractsAccrual adjustments related to long-term contracts

• Costs of defense against a takeoverCosts of defense against a takeover

• Costs incurred as a result of the September 11, 2001 events.Costs incurred as a result of the September 11, 2001 events.

Change in Accounting Change in Accounting PrinciplePrinciple

A A change in accounting principlechange in accounting principle results results from adoption of a generally accepted from adoption of a generally accepted accounting principle different from the one accounting principle different from the one previously used for reporting purposes. previously used for reporting purposes.

Changes in Accounting Changes in Accounting PrinciplesPrinciples

Shown in the “sunshine”Shown in the “sunshine” Current year operating income reflects Current year operating income reflects

current year under new methodcurrent year under new method Separate line for prior year catch-upSeparate line for prior year catch-up Pro-forma for prior yearPro-forma for prior year Auditor’s reportAuditor’s report

Different from a change in estimate Different from a change in estimate or the correction of an error.or the correction of an error.

Recognition of Gains on Assets Recognition of Gains on Assets SalesSales

When assets are purchased they are recorded at When assets are purchased they are recorded at their purchase price. Subsequently, they are their purchase price. Subsequently, they are carried at their historical cost, even if they carried at their historical cost, even if they appreciate in value, and are written down only if appreciate in value, and are written down only if they suffer a permanent decline in value. they suffer a permanent decline in value.

When they are sold, the company recognizes a When they are sold, the company recognizes a gain (loss) equal to the difference between their gain (loss) equal to the difference between their selling price and the amount at which they are selling price and the amount at which they are carried on the balance sheet:carried on the balance sheet:

Selling price of asset – Asset carrying amount Selling price of asset – Asset carrying amount from balance sheet = Gain (loss) on salefrom balance sheet = Gain (loss) on sale

Gains (Losses) on Asset Gains (Losses) on Asset SalesSales

Gain (loss) = sale proceeds – asset book Gain (loss) = sale proceeds – asset book valuevalue

Assume that a company sells a machine for Assume that a company sells a machine for $10,000 that it carries on its balance sheet $10,000 that it carries on its balance sheet for $8,000 (historical cost of $12,000 less for $8,000 (historical cost of $12,000 less accumulation depreciation of $4,000). accumulation depreciation of $4,000). The company reports a gain of $2,000 ($10,000-The company reports a gain of $2,000 ($10,000-

$8,000).$8,000). This gain is reported in income from continuing This gain is reported in income from continuing

operations.operations.

Restructuring Charges: Restructuring Charges: Employee SeveranceEmployee Severance

Employee severanceEmployee severance costs represent the accrual of costs represent the accrual of estimated costs relating to the termination of estimated costs relating to the termination of employees as a result of a restructuring program.employees as a result of a restructuring program.

Asset write-downsAsset write-downs: restructuring activities that : restructuring activities that usually encompass closure or relocation of usually encompass closure or relocation of manufacturing or administrative facilities.manufacturing or administrative facilities. InventoryInventory LT AssetsLT Assets GoodwillGoodwill

Pro Forma EarningsPro Forma Earnings

Earnings per Share (EPS)Earnings per Share (EPS)

Earnings per Share (EPS)Earnings per Share (EPS) Basic EPSBasic EPS is computed as (Net income – Dividends on is computed as (Net income – Dividends on

preferred stock) / Weighted average number of preferred stock) / Weighted average number of common shares outstanding during the year. common shares outstanding during the year. Since net income already includes interest expense, but not Since net income already includes interest expense, but not

dividends (dividends are not treated as an expense under dividends (dividends are not treated as an expense under GAAP), subtraction of dividends on preferred stock yields GAAP), subtraction of dividends on preferred stock yields the amount of profit per common share available for the amount of profit per common share available for payment of dividends to common shareholders. payment of dividends to common shareholders.

Diluted EPSDiluted EPS reflect the additional shares that would reflect the additional shares that would have been issued had all stock options and convertible have been issued had all stock options and convertible securities been exercised at the beginning of the year.securities been exercised at the beginning of the year.

Comprehensive IncomeComprehensive Income

Changes in net assets of an entity Changes in net assets of an entity during a period from transactions and during a period from transactions and other events from non-owner sourcesother events from non-owner sources Includes all changes in equity during a Includes all changes in equity during a

period except those resulting from period except those resulting from investment by owners and distributions investment by owners and distributions to ownersto owners

Example – mark to market for available Example – mark to market for available for sale securitiesfor sale securities