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Financial Statement Analysis & ValuationThird Edition,Peter D. Mary LeaGregory A.Xiao-JunEastonMcAnallySommersZhang,Module 5: Revenue Recognition and Operating Income,Where we are,Module 5 Introduction,3,Operating and Nonoperating Components in the Income Statement,Module 5 Introduction,4,Pfizers Income Statement,Module 5 Introduction,5,Income Statement PresentationIFRS vs. GAAP,Module 5 Introduction,6,Learning Objectives,Module 5 Introduction,Explain revenue recognition criteria.Analyse accounting for operating expenses: R&D, restructuring.Analyse accounting for income tax.Explain how foreign currency fluctuations affect I/S.Compute EPS and explain the effect of dilutive securities.Explain accounting quality and identify areas for analysis.Understand the general difference between US GAAP and IFRS regarding revenue recognition & certain expense items.,7,Revenue Recognition,Revenue recognition criteriarealized or realizable, and earnedRealized 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.,Module 5 Objective 1,8,Arguments Against Revenue Recognition,Rights of return existConsignment salesContinuing involvement by seller in product resaleContingency sales,Module 5 Objective 1,9,Pfizers Revenue Recognition Policy,Pfizer recognizes its revenues as follows:,Module 5 Objective 1,10,Ciscos Income Statement,Module 5 Objective 1,11,MICHAEL HILL INTERNATIONAL LIMITED,(e) Revenue recognition(i) Sales of goods - retailSales of goods and services are recognised when a Group entity delivers a product or renders a service to the customer. Retail sales are usually in cash, payment plan or by credit card. The recorded revenue is the gross amount of sale (excluding taxes), including any fees payable for the transaction. It is the Groups policy to sell its products to the end customer with a right of return. Accumulated experience is used to estimate and provide for such returns at the time of sale.,12,Module 5 Objective 1,SKYCITY ENTERTAINMENT GROUP LIMITED,(e) Revenue RecognitionRevenue is recognised as summarised below.(i) Operating RevenueOperating revenues include casino, hotel, food and beverage, convention centre, tower admissions and other revenues. Gaming revenues represent the net gaming win to the casino from gaming activities, being the difference between amounts wagered and amounts won by casino patrons.Revenues exclude the retail value of rooms, food, beverage and other promotional allowances provided on a complimentary basis to customers.,13,Module 5 Objective 1,Risks of Revenue Recognition,Case 1: Channel stuffingCase 2: Barter transactionsCase 3: Mischaracterizing transactions as arms-lengthCase 4: Pending execution of sales agreementsCase 5: Gross versus net revenuesCase 6: Sales on consignmentCase 7: Failure to take deliveryCase 8: Nonrefundable fees,Module 5 Objective 1,14,Revenue Recognition under IFRS,Revenue is generally recognized under both U.S. GAAP and IFRS when the earning process is complete.There is extensive guidance under U.S. GAAP for specific industry transactions. That guidance is not present in IFRS.,Module 5 Objective 1,15,US GAAP:Apples Revenue Recognition Policy,Module 5 Objective 1,16,IFRS:Samsungs Revenue Recognition Policy,Module 5 Objective 1,17,Percentage-of-Completion,The percentage-of-completion recognizes revenue by the proportion of costs incurred to date to total estimated costs.Assume that Bayer Construction signs a $10 million contract to construct a building. Bayer 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.,Module 5 Objective 1,18,Module 5 Objective 1,Percentage-of-Completion,Revenue recognition policies for these types of contracts are disclosed in a manner typical to the following from the 2010 10-K report footnotes of Raytheon Company:,Module 5 Objective 1,20,FLETCHER BUILDING LIMITED,Income determinationSales recognitionSales are recognised in accordance with theterms of sale when the benefits of ownership and risk of loss passes to the customer. Construction contractsEarnings on construction contracts (including sub-contracts) are determined using the percentage-of-completion method. Earnings are not recognised until the outcome can be reliably estimated. .,21,Module 5 Objective 1,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.,Module 5 Objective 1,22,Percentage-of-Completion:US GAAP vs IFRS,For LT construction contract, the percentage-of-completion method is required under IFRSis preferred but not required under US GAAP (completed contract method can be used as well)For revenue from services rendering, the percentage-of-completion method is required under IFRSis only applicable to software developers in specific circumstances.,Module 5 Objective 1,23,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.,Module 5 Objective 1,24,Recognition of Unearned Revenue,Assume that on Sept. 26, 2010, Apple sells 60 iPads for $36,000 cash.,Microsoft reports $14.8 billion of unearned revenue in 2010. the company describes its recognition policy as follows:,Unearned revenue comprises mainly unearned revenue from volume licensing programs, as well as payments for undelivered elements and for other offerings for which we earn the revenue when we provide the service or software or otherwise meet the revenue recognition criteria.Volume Licensing ProgramsUnearned revenue from volume licensing programs represents customer billings for multi- year licensing arrangements paid either atinception of the agreement or annually at the beginning of each billing coverage period and accounted for as subscriptions with revenuerecognized ratably over the billing coverage period.Undelivered ElementsUndelivered elements consist mainly of payments for unspecified upgrades or enhancements of Microsoft Internet Explorer on a when-and-if- available basis for Windows XP, and technology guarantee programs.,Microsofts Revenue Recognition Policy for Unearned Revenue,Module 5 Objective 1,26,AIR NEW ZEALAND LIMITED,Revenue recognitionAirline revenuePassenger and cargo sales revenue is recognised in revenue in advance at the fair value of the consideration received. Amounts are transferred to revenue in the Statement of Financial Performance when the actual carriage is performed. Unused tickets are recognised as revenue using estimates regarding the timing of recognition based on the terms and conditions of the ticket and historical trends.,27,Module 5 Objective 1,New Revenue Recognition Standard,In June 2010, the FASB and IASB published a joint exposure draft (ED) on revenue recognition, Revenue from Contracts with Customers. These new revenue recognition rules are similar to the rules for multi-element contracts. Companies must identify separate “performance obligations” within a contract and account for each individually.For construction projects the new rules will likely yield results similar to the percentage-of completion accounting method.,Module 5 Objective 1,28,Summary So Far,Separation of operating and nonoperating incomeRevenuesGeneral rules and risks of revenue recognitionPOCUnearned revenueNext, expenses,29,R&D Expenses,Module 5 Objective 2,Pfizers R&D Accounting Footnote:,30,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.,Module 5 Objective 2,31,How is R&D Reported?,32,R&D Accounting Under IFRS,Module 5 Objective 2,33,BLIS TECHNOLOGIES LIMITED,Internally-generated Intangible Assets Capitalised Development ExpenditureExpenditure on research activities is recognised as an expense in the period in which it is incurred. An internally-generated intangible asset arising from development (or from the development phase of an internal project) is recognised if, and only if, all of the following have been demonstrated: the technical feasibility of completing the intangible asset so that it will be available for use or sale; the intention to complete the intangible asset and use or sell it; the ability to use or sell the intangible asset; how the intangible asset will generate probable future economic benefits; the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and the ability to measure reliably the expenditure attributable to the intangible asset during its development.,34,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.Adjustment: capitalizing and depreciating/amortizing R&D costs?not advisable Reasons: 1. proportion of R&D with future benefits, and 2. the depreciation or amortization period and manner are arbitraryRecommendations:Compare R&D/Sales over time and across comparable companiesEvaluate discussion of R&D effectiveness in the MD&A, financial press, and company communication.,Module 5 Objective 2,35,Restructuring Expenses,Restructuring costs typically consists of three components:Employee severance or relocation costsAsset write-downsOther (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.,Module 5 Objective 2,36,Pfizers 2010 Restructuring Plan,Module 5 Objective 2,37,Telecom job cuts may hit 1230(NZH, 28 March 2013),As a result of its changes, Telecom expects its payroll costs will go down by $90 million to $110 million each year.It said the one-off costs associated with restructuring are expected to be between $70-80 million.,38,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 periods profit is not as low.,Module 5 Objective 2,39,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 tax code is different from GAAP. GAAP PBT vs TAX PBTTax expense= Current tax + Deferred tax,Module 5 Objective 3,40,Income Tax Expenses,Example: straight-line depreciation for book and accelerated depreciation for tax,Module 5 Objective 3,41,Year 1:,Module 5 Objective 3,42,Year 2:,Module 5 Objective 3,43,Deferred Tax Liabilities and Assets,Deferred tax liabilities (DTL) 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 (DTA) 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.,Module 5 Objective 3,44,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.,Module 5 Objective 3,45,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.,Module 5 Objective 3,46,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 authoritiesDeferred tax expense - the effect on tax expense from changes in deferred tax liabilities and deferred tax assets,Module 5 Objective 3,47,Pfizers Income Tax Footnote,Income tax expense is the sum of Taxes currently payableDeferred income taxes,48,Pfizers Deferred Tax Footnote,Module 5 Objective 3,49,Caterpillar, Inc. ( CAT ),Module 5 Objective 3,50,Reconciliation of Statutory and Effective Tax Rates - Pfizer,Module 5 Objective 3,51,Reconciliation of Statutory and Effective Tax Rates Caterpillar, Inc.,Module 5 Objective 3,$3752: pretax profit for 2010,52,Analysis of Income Tax,Increases in DTL indicate a companys GAAP income is higher than taxable incomepotential upwards earnings management Adequacy of DTA valuation allowancefuture benefits realisable?a percentage of the DTAChange in valuation allowance regarding DTAdeceases boost net income,Module 5 Objective 3,53,Summary So Far,RevenuesExpenses: R&D, Restructuring, Income TaxNextForeign currency translation effectsDiscontinued operations / Extraordinary itemsEPS (basic vs diluted)Accounting qualityGlobal accounting: US GAAP vs IFRS,54,Foreign Currency Translation,A change in the strength of the $US vis-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.,Module 5 Objective 4,55,Effects of Foreign Currency Translation for Pfizer,Module 5 Objective 4,56,MCDs Foreign Currency Translation,Footnotes:In 2010, foreign currency translation had a positive impact on consolidated operating results driven by stronger global currencies, primarily the Australian Dollar and Canadian Dollar, partly offset by the weaker Euro. In 2009, foreign currency translation had a negative impact on consolidated operating results, primarily driven by the Euro, British Pound, Russian Ruble, Australian Dollar and Canadian Dollar. In 2008, foreign currency translation had a positive impact on consolidated operating results, driven by the stronger Euro and most other currencies, partly offset by the weaker British Pound.,Module 5 Objective 4,57,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 (in two slides).,Treated as nonoperating!,58,Krafts Discontinued Operations,59,Extraordinary Items,Extraordinary items Gains or losses from events that are both unusual and infrequent. The following items are generally not reported as extraordinary items:Gains and losses on retirement of debtWrite-down or write-off of operating or nonoperating assetsForeign currency gains and lossesGains and losses from disposal of specific assets or business segmentEffects of a strikeAccrual adjustments related to long-term contractsCosts of a takeover defense,60,Extraordinary Items under IFRS,IFRS does not permit the reporting of income and expense items as “extraordinary.” The IASB justified its position in IAS1 as follows: “The Board decided that items treated as extraordinary result from the normal business risks faced by an entity and do not warrant presentation in a separate component of the income statement. The nature or function of a transaction or other event, rather than its frequency, should determine its presentation within the income statement. Items currently classified as extraordinary are only a subset of the items of income and expense that may warrant disclosure to assist users in predicting an entitys future performance” (IAS1).,61,Earnings Per Share,Module 5 Objective 5,62,Caterpillars EPS Footnote,Module 5 Objective 5,63,Accounting Quality,Relevanc