Module 5

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Module 5

• Reporting and Analyzing Operating Income

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Operating and Nonoperating Components in the
Income Statement
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Revenue Recognition

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

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Arguments Against Revenue Recognition

• Rights of return exist
• Consignment sales
• Continuing involvement by seller in product
  resale
• Contingency sales

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Pfizers Revenue Recognition Policy

• Pfizer recognizes its revenues as follows
• Revenue Recognitionwe 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.

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Oracles Revenue Recognition Policy
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Risks of Revenue Recognition

• Case 1 Channel stuffing
• Case 2 Barter transactions
• Case 3 Mischaracterizing transactions as
  arms-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

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Percentage-of-Completion

• The percentage-of-completion recognizes revenue
  by the proportion of costs incurred to date
  compared with total estimated costs.
• Assume that Abbott 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 Abbott
  recognizes.

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Percentage-of-Completion

• Revenue recognition policies for these types of
  contracts are disclosed in a manner typical to
  the following from the 2005 10-K report footnotes
  of Raytheon Company

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Johnson Controls Revenue Recognition
Percentage-of-Completion
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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.

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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 companys 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.

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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.

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

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Research and Development (RD) Expenses

• Expense all RD costs as incurred unless those
  assets have alternative future uses (in other RD
  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.

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Pfizers RD Accounting Footnote
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Cisco Systems RD
14 of sales
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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.

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Analysis of Restructuring Costs

• Asset write-downs - prior periods profits are
  arguably not as high as reported, and the current
  periods profit is not as low.
• Employee severance or relocation costs -
  overstatements are followed by a reversal of the
  restructuring liability, and understatements are
  followed by further accruals.

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Hewlett-Packards 2005 Restructuring Plan

• Of the 1.6 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.

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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.

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Income Tax Expenses
Assume the following facts
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Year 1
Year 2
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Year 3
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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.

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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.

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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.

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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.

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Pfizers Income Tax Footnote
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Pfizers Deferred Tax Footnote
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Another Illustration
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.
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Reconciliation of Statutory and Effective Tax
Rates - Pfizer
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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.
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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.

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Black Decker Discontinued Operations
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Raytheon Discontinued Operations
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Raytheon Discontinued Operations
Note other DOs reported a net loss of 5M,
yielding the 176 net income reported in the
income statement.
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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
• Costs incurred as a result of the September 11,
  2001, events

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Earnings Per Share
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Symantecs EPS Footnote
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Apples EPS Footnote
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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.

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Pfizers Foreign Currency Translation 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.

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BMYs Foreign Currency Translation
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BMYs FC Translation Solution

• 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.