Chapter 5 Slides-2

FINANCIAL &
MANAGERIAL
ACCOUNTING for MBAs
Peter D. Easton
Robert F. Halsey
Mary Lea McAnally
Al L. Hartgraves
Fourth Edition
MODULE 5
Reporting and Analyzing

Operating Income
Cambridge Business Publishers, 2015
Wayne J. Morse
Operating and Nonoperating

Components in the Income Statement
Pfizers
Income
Statement
IFRS
Income
Statement
Format
Learning Objective 1
Explain revenue recognition criteria

and identify transactions of
special concern.
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.
Arguments Against
Revenue Recognition
Rights of return exist

Consignment sales
Continuing involvement by seller
Contingency sales
Pfizers Revenue Recognition Policy

Pfizer recognizes its revenues as follows:
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.
In addition, public companies in the
U.S. must follow additional guidance
set by the SEC
Apples Revenue Recognition Policy

Net sales consist primarily of revenue from the sale of hardware, software, digital content
and applications, peripherals, and service and support contracts. The Company recognizes
revenue when persuasive evidence of an arrangement exists, delivery has occurred, the
sales price is fixed or determinable, and collection is probableThe Company records
deferred revenue when it receives payments in advance of the delivery of products or the
performance of servicesRevenue from AppleCare service and support contracts is
deferred and recognized over the service coverage periods.
Revenue Recognition for Arrangements with Multiple Deliverables
For multi-element arrangements that include hardware products containing software
essential to the hardware products functionality, undelivered software elements that relate
to the hardware products essential software, and undelivered non-software services, the
Company allocates revenue to all deliverables based on their relative selling pricesThe
Company has identified up to three deliverables regularly included in arrangements
involving the sale of these devices. The first deliverable is the hardware and software
essential to the functionality of the hardware device delivered at the time of sale. The
second deliverable is the embedded right included with the purchase of iOS devices, Mac
and Apple TV to receive on a when-and-if-available basis, future unspecified software
upgrades and features relating to the products essential software. The third deliverable is
the non-software services to be provided to qualifying versions of iOS devices and Mac.
The Company allocates revenue between these deliverables using the relative selling price
method.
10
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.
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.
11
Bayer
Construction
Entries
12
Percentage-of-Completion - Bayer
13
Raytheon Revenue Recognition

Revenue recognition policies for these types
of contracts are disclosed in a manner
typical to the following from the 2012 10-K
report footnotes of Raytheon Company:
14
Johnson Controls Revenue Recognition

Percentage-of-Completion
15
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-ofcompletion 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.
16
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.
17
Recognition of Unearned Revenue

Assume that
Apple sells 60 iPads for $36,000 cash
Of the $36,000 in cash that Apple receives, it
deems that $600 should be allocated to the next
24-month period because it relates to unspecified
and specified software upgrade rights.
18
Microsofts Unearned Revenue

Microsoft reports $22.4 billion of unearned
revenue in 2013. the company describes its
recognition policy as follows:
Revenue is recognized when persuasive evidence of an arrangement exists, delivery has
occurred, the fee is fixed or determinable, and collectibility is probable. Revenue generally
is recognized net of allowances for returns and any taxes collected from customers and
subsequently remitted to governmental authorities.
Certain volume licensing arrangements include a perpetual license for current products
combined with rights to receive unspecified future versions of software products
(Software Assurance), which we have determined are additional software products and
are therefore accounted for as subscriptions, with billings recorded as unearned revenue
and recognized as revenue ratably over the coverage period.
Revenue from cloud-based services arrangements that allow for the use of a hosted
software product or service over a contractually determined period of time without taking
possession of software are accounted for as subscriptions with billings recorded as
unearned revenue and recognized as revenue ratably over the coverage period beginning
on the date the service is made available to customers.
19
New Revenue Recognition Standard

The FASB has proposed a new revenue recognition
standard that will become effective in 2017.
Under the proposed standard, revenue recognition
should occur when (or as) a good or service is
transferred to the customer and the customer obtains
control of that good or service.
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.
20
Describe accounting for

operating expenses, including
research and development,
and restructuring.
21
Pfizers R&D Accounting Footnote
22
Pfizer R&D Costs vs. Peers
23
R&D Accounting Under IFRS
24
How is R&D Reported by Cisco?
12% of
sales
25
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.
26
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.
27
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.
28
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.
29
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.
30
Pfizers 2010 Restructuring Plan
31
Explain and analyze

accounting for income taxes.
32
Income Tax Expense

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.
33
Income Tax Expenses

Example: straight-line depreciation for
book and accelerated depreciation for
tax
34
Year 1 Income Statements:

Financial Reporting vs. Tax Reporting
Year 1:
35
Year 2 Income Statements:

Financial Reporting vs. Tax Reporting
Year 2:
36
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.
37
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.
38
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.
39
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
40
Pfizers Income Tax Footnote
Income tax expense (provision) is the sum of

1. Taxes currently payable
2. Deferred income taxes
41
Pfizers Deferred Income Tax Footnote
42
Caterpillar, Inc. (CAT)
43
Reconciliation of Statutory and

Effective Tax Rates - Pfizer
44
Reconciliation of Statutory and

Effective Tax Rates Caterpillar, Inc.
45
Explain how foreign currency

fluctuations affect the
income statement.
46
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.
47
Effects of Foreign Currency Translation

for Pfizer
48
MCDs Foreign Currency Translation
Footnotes:
In 2012, foreign currency translation had a negative impact
on consolidated operating results driven by stronger $US.
In 2011, foreign currency translation had a positive impact
on consolidated operating results, driven by weaker $US
49
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.
50
Pfizers Discontinued Operations
51
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
52
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).
53
Compute earnings per share

and explain the effect of
dilutive securities.
54
Earnings Per Share
55
Virgin Media, Inc.s EPS Footnote
56
Virgin Media, Inc.s

Antidilutive Securities
57
Explain accounting quality

and identify areas for analysis.
58
Accounting Quality
Reliability
Balance sheet numbers represent economic
reality.
Income statement numbers reflect economic
earnings.
Reported cash flows accurately portray all of the
cash that flowed in and out of the company during
the period.
Relevance
Reported earnings and cash flow numbers can be
used to forecast the amount and timing of future
earnings and cash flows.
Footnotes provide additional quantitative and
59
qualitative information that is accurate and
Ways in Which Accounting Quality

is Diminished
Unintentional errors
One-time events and proforma
disclosures
Deliberate manager intervention
Reliable numbers that are not
predictive
60
Assessing and Remediating

Accounting Quality
Read both reports from the external auditor and take
special note of any deviation from boilerplate language.
Peruse the footnote on accounting policies and
compare the companys policies to its industry peers.
Examine changes in accounting policies.
Compare key ratios over time.
Review ratios of competitors
Identify nonrecurring items and separately assess their
impact on company performance and position.
Recast financial statements as necessary to reflect an
accounting policy that is more in line with competitors
or one that better reflects economically relevant
numbers.
61
Global Accounting
Revenue Recognition
U.S. GAAP has specific guidance about what
constitutes revenue, how revenue is measured,
and the timing of its recognition. IFRS is not
specific about the timing and measurement of
revenue recognition and does not provide
industry-specific guidance.
A U.S. GAAP revenue-recognition criterion is that
the sales price be fixed or determinable. IFRS
considers the probability that economic benefits
will flow to the seller and records such benefits
as revenue if they can be reliably measured.
For multiple-element contracts, both U.S. GAAP
and IFRS allocate revenue based on relative fair
62
Global Accounting
R&D
U.S. GAAP expenses all R&D costs
IFRS allows capitalization and
subsequent amortization of certain
development costs.
63
Global Accounting
Under IFRS, restructuring expense is recognized
when there is a binding contract or a plan for
the restructuring and if the affected employees
expect the plan to be implemented.
Under IFRS, compensation for employees who
will be terminated is recognized when
employees are deemed redundant.
Under IFRS, a restructuring provision is recorded
at its best estimate. This is usually the expected
value.
The U.S. GAAP estimate is at the most-likely
outcome
64
Global Accounting
Income Taxes
Both U.S. GAAP and IFRS recognize
deferred tax assets for timing
differences and unused tax losses.
Under IFRS, deferred tax assets on
employee stock options are computed
based on the options intrinsic value at
each reporting date. In contrast, GAAP
uses historical value.
65
Global Accounting
Extraordinary Item
Separate reporting of extraordinary
items is not permitted under IFRS.
US GAAP permits recognition of
extraordinary items.
When comparing U.S. GAAP to IFRS, we
include any extraordinary items with
other expenses, according to their
function.
66
The End

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Chapter 5 Slides-2

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FINANCIAL &

Mary Lea McAnally

Reporting and Analyzing

Operating and Nonoperating

Cambridge Business Publishers, 2015

Cambridge Business Publishers, 2015

Cambridge Business Publishers, 2015

Explain revenue recognition criteria

Cambridge Business Publishers, 2015

realized or realizable, and

Realized or realizable means that

Cambridge Business Publishers, 2015

Rights of return exist

Cambridge Business Publishers, 2015

Pfizers Revenue Recognition Policy

Cambridge Business Publishers, 2015

Revenue Recognition Under IFRS

Apples Revenue Recognition Policy

The following table summarizes construction

Cambridge Business Publishers, 2015

Cambridge Business Publishers, 2015

Raytheon Revenue Recognition

Cambridge Business Publishers, 2015

Johnson Controls Revenue Recognition

Cambridge Business Publishers, 2015

Recognition of Unearned Revenue

Recognition of Unearned Revenue

Cambridge Business Publishers, 2015

Microsofts Unearned Revenue

New Revenue Recognition Standard

Describe accounting for

Cambridge Business Publishers, 2015

Pfizers R&D Accounting Footnote

Cambridge Business Publishers, 2015

Pfizer R&D Costs vs. Peers

Cambridge Business Publishers, 2015

R&D Accounting Under IFRS

Cambridge Business Publishers, 2015

How is R&D Reported by Cisco?

Cambridge Business Publishers, 2015

Research and Development (R&D)

Cambridge Business Publishers, 2015

Analysis of R&D Expense

Employee severance or relocation costs

the original amount of the liability (accrual),

This creates more transparent financial

Analysis of Restructuring Costs

Pfizers 2010 Restructuring Plan

Cambridge Business Publishers, 2015

Explain and analyze

Cambridge Business Publishers, 2015

Income Tax Expense

Two sets of accounting records are

Income Tax Expenses

Cambridge Business Publishers, 2015

Year 1 Income Statements:

Cambridge Business Publishers, 2015

Year 2 Income Statements:

Cambridge Business Publishers, 2015

Deferred Tax Liabilities and Assets

Deferred tax assets arise when

Cambridge Business Publishers, 2015

Income Tax Footnotes