Module 5

1. Module 5 Reporting and Analyzing Operating Income

2. Operating and Nonoperating Components in the Income Statement

3. Revenue Recognition • Revenue recognition criteria • realized or realizable, and • earned • Realized or realizablemeans that the seller’s net assets (assets less liabilities) increase. • Earnedmeans that the seller has performed its duties under the terms of the sales agreement.

4. Arguments Against Revenue Recognition • Rights of return exist • Consignment sales • Continuing involvement by seller in product resale • Contingency sales

5. Pfizer’s Revenue Recognition Policy • Pfizer recognizes its revenues as follows: • Revenue Recognition—we 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.

6. 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

7. 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.

8. 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:

9. 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.

10. 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.

11. 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.

12. Research and Development (R&D) Expenses • Expense all R&D costs as incurredunless 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.

14. Pfizer’s R&D Accounting Footnote

15. Cisco Systems’ R&D 14% of sales

16. 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.

17. Analysis of Restructuring Costs • Asset write-downs - prior periods’ profits are arguably not as high as reported, and the current period’s 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.

18. 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.

19. Income Tax Expenses Assume the following facts:

20. Year 1: Year 2:

21. Year 3:

22. Deferred Tax Liabilities and Assets • Deferred tax liabilitiesarise 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 assetsarise 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.

23. 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.

24. 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.

25. 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.

26. Operating Income “Below the Line” • Two categories of items are presented below-the-line: • Discontinued operationsNet 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 itemsGains or losses from events that are both unusual and infrequent.

27. Raytheon Discontinued Operations

28. Raytheon Discontinued Operations Note: other DOs reported a net loss of $5M, yielding the $176 net income reported in the income statement.

29. Extraordinary Items • The following items are generally not reportedas 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

30. Earnings Per Share

31. Symantec’s EPS Footnote

32. 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.