©Cambridge Business Publishers, 2013 FINANCIAL STATEMENT ANALYSIS & VALUATION Third Edition Peter D. Mary LeaGregory A.Xiao-Jun EastonMcAnallySommersZhang

©Cambridge Business Publishers, 2013 Module 5: Revenue Recognition and Operating Income

©Cambridge Business Publishers, 2013 Operating and Nonoperating Components in the Income Statement

©Cambridge Business Publishers, 2013 Pfizer’s Income Statement

©Cambridge Business Publishers, 2013 Income Statement Presentation IFRS vs. GAAP

©Cambridge Business Publishers, 2013 Revenue Recognition Revenue recognition criteria Revenue recognition criteria 1. realized or realizable, and 2. earned Realized or realizable means that the seller’s net assets (assets less liabilities) increase. Realized or realizable means that the seller’s net assets (assets less liabilities) increase. Earned means that the seller has performed its duties under the terms of the sales agreement. Earned means that the seller has performed its duties under the terms of the sales agreement.

©Cambridge Business Publishers, 2013 Arguments Against Revenue Recognition Rights of return exist Rights of return exist Consignment sales Consignment sales Continuing involvement by seller in product resale Continuing involvement by seller in product resale Contingency sales Contingency sales

©Cambridge Business Publishers, 2013 Pfizer’s Revenue Recognition Policy Pfizer recognizes its revenues as follows:

©Cambridge Business Publishers, 2013 Cisco’s Income Statement

©Cambridge Business Publishers, 2013 Revenue Recognition under IFRS Revenue is generally recognized under both U.S. GAAP and IFRS when the earning process is complete. 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. There is extensive guidance under U.S. GAAP for specific industry transactions. That guidance is not present in IFRS. That guidance is not present in IFRS.

©Cambridge Business Publishers, 2013 Apple’s Revenue Recognition Policy

©Cambridge Business Publishers, 2013 Risks of Revenue Recognition Case 1: Channel stuffing Case 1: Channel stuffing Case 2: Barter transactions Case 2: Barter transactions Case 3: Mischaracterizing transactions as a rm’s-length Case 3: Mischaracterizing transactions as a rm’s-length Case 4: Pending execution of sales agreements Case 4: Pending execution of sales agreements Case 5: Gross versus net revenues Case 5: Gross versus net revenues Case 6: Sales on consignment Case 6: Sales on consignment Case 7: Failure to take delivery Case 7: Failure to take delivery Case 8: Nonrefundable fees Case 8: Nonrefundable fees

©Cambridge Business Publishers, 2013 Percentage-of-Completion The percentage-of-completion recognizes revenue by the proportion of costs incurred to date compared with total estimated costs. 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. 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. Assume that Bayer 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 Bayer recognizes. The following table summarizes construction costs incurred each year and the revenue Bayer recognizes.

©Cambridge Business Publishers, 2013 Percentage-of-Completion Revenue recognition policies for these types of contracts are disclosed in a manner typical to the following from the K report footnotes of Raytheon Company:

©Cambridge Business Publishers, 2013 Johnson Controls Revenue Recognition – Percentage-of-Completion Revenue Recognition The Company’s building efficiency business recognizes revenue from certain long-term contracts over the contractual period under the percentage-of-completion (POC) method of accounting. This method of accounting recognizes sales and gross profit as work is performed based on the relationship between actual costs incurred and total estimated costs at completion... The building efficiency business enters into extended warranties and long-term service and maintenance agreements with certain customers. For these arrangements, revenue is recognized on a straight-line basis over the respective contract term. The Company’s building efficiency business also sells certain heating, ventilating and air conditioning (HVAC) and refrigeration products and services in bundled arrangements, where multiple products and/or services are involved. In accordance with ASU No , “Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements – A Consensus of the FASB Emerging Issues Task Force,” the Company divides bundled arrangements into separate deliverables and revenue is allocated to each deliverable based on the relative selling price method… In all other cases, the Company recognizes revenue at the time title passes to the customer or as services are performed.

©Cambridge Business Publishers, 2013

Risks of Percentage-of-Completion The percentage-of-completion method of revenue recognition requires an estimate of total costs. 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. 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. This uncertainty adds additional risk to financial statement analysis.

©Cambridge Business Publishers, 2013 Recognition of Unearned Revenue Deposits or advance payments are not recorded as revenue until the company performs the services owed or delivers the goods. 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. 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.

©Cambridge Business Publishers, 2013 Recognition of Unearned Revenue Assume that Apple sells 60 iPads for $36,000 cash Assume that Apple sells 60 iPads for $36,000 cash

©Cambridge Business Publishers, 2013 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. 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. 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. 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. For construction projects the new rules will likely yield results similar to the percentage-of completion accounting method.

©Cambridge Business Publishers, 2013 Microsoft reports $14.8 billion of unearned revenue in 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 Programs Unearned revenue from volume licensing programs represents customer billings for multi- year licensing arrangements paid either at inception of the agreement or annually at the beginning of each billing coverage period and accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Undelivered Elements Undelivered 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.. Microsoft’s Revenue Recognition Policy for Unearned Revenue

©Cambridge Business Publishers, 2013 Pfizer’s R&D Accounting Footnote

©Cambridge Business Publishers, 2013 R&D Accounting Under IFRS

©Cambridge Business Publishers, 2013 How is R&D Reported by Cisco? 13% of sales

©Cambridge Business Publishers, 2013 Much of the R&D Expense is not Reported Separately 39.9% of sales

©Cambridge Business Publishers, 2013 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). 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. 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. However, project-directed research buildings and equipment with no alternate uses must be expensed.

©Cambridge Business Publishers, 2013 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. 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. Capitalizing and depreciating/amortizing R&D costs is not advisable as the depreciation or amortization period is arbitrary. Recommendations: Recommendations: Compare R&D/Sales for comparable companies Compare R&D/Sales for comparable companies Evaluate discussion of R&D effectiveness in the MD&A, financial press, and company communication. Evaluate discussion of R&D effectiveness in the MD&A, financial press, and company communication.

©Cambridge Business Publishers, 2013 Restructuring Expenses Restructuring costs typically consists of three components: Restructuring costs typically consists of three components: Employee severance or relocation costs Employee severance or relocation costs Asset write-downs Asset write-downs Other (i.e., contract termination costs, legal expenses, etc.) Other (i.e., contract termination costs, legal expenses, etc.) Accounting standard: 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. 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. 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. 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. This creates more transparent financial statements, which presumably deters earnings management.

©Cambridge Business Publishers, 2013 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. 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 period’s profit is not as low. Asset write-downs - prior periods’ profits are arguably not as high as reported, and the current period’s profit is not as low.

©Cambridge Business Publishers, 2013 Pfizer’s 2010 Restructuring Plan

©Cambridge Business Publishers, 2013 Income Tax Expenses Companies maintain two sets of accounting records, Companies maintain two sets of accounting records, one for preparing financial statements for external constituents, including current and prospective shareholders, and one for preparing financial statements for external constituents, including current and prospective shareholders, and another for reporting to tax authorities. another for reporting to tax authorities. Two sets of accounting records are necessary because the U.S. tax code is different from GAAP. Two sets of accounting records are necessary because the U.S. tax code is different from GAAP.

©Cambridge Business Publishers, 2013 Income Tax Expenses Example: straight-line depreciation for book and accelerated depreciation for tax

©Cambridge Business Publishers, 2013 Year 1:

©Cambridge Business Publishers, 2013 Year 2:

©Cambridge Business Publishers, 2013 Deferred Tax Liabilities and Assets Deferred tax liabilities 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 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.

©Cambridge Business Publishers, 2013 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. 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. 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. 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.

©Cambridge Business Publishers, 2013 Valuation Allowance deferred tax 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.

©Cambridge Business Publishers, 2013 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): 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 - Current tax expense - the amount payable (in cash) to tax authorities Deferred tax expense - the e Deferred tax expense - the effect on tax expense from changes in deferred tax liabilities and deferred tax assets

©Cambridge Business Publishers, 2013 Pfizer’s Income Tax Footnote Income tax expense is the sum of 1. Taxes currently payable 2. Deferred income taxes

©Cambridge Business Publishers, 2013 Pfizer’s Deferred Tax Footnote

©Cambridge Business Publishers, 2013 Caterpillar, Inc. ( CAT )

©Cambridge Business Publishers, 2013 Reconciliation of Statutory and Effective Tax Rates - Pfizer

©Cambridge Business Publishers, 2013 Reconciliation of Statutory and Effective Tax Rates – Caterpillar, Inc.

©Cambridge Business Publishers, 2013 Foreign Currency Translation A change in the strength of the $US vis-à-vis foreign currencies affects reported income in the following manner: 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. 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.

©Cambridge Business Publishers, 2013 Effects of Foreign Currency Translation for Pfizer

©Cambridge Business Publishers, 2013 MCD’s 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.

©Cambridge Business Publishers, 2013 Operating Income “Below the Line” Two categories of items are presented 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. 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. Extraordinary items Gains or losses from events that are both unusual and infrequent.

©Cambridge Business Publishers, 2013 Kraft’s Discontinued Operations

©Cambridge Business Publishers, 2013 Extraordinary Items The following items are generally not reported as extraordinary items: The following items are generally not reported as extraordinary items: Gains and losses on retirement of debt Gains and losses on retirement of debt Write-down or write-off of operating or nonoperating assets Write-down or write-off of operating or nonoperating assets Foreign currency gains and losses Foreign currency gains and losses Gains and losses from disposal of specific assets or business segment Gains and losses from disposal of specific assets or business segment Effects of a strike Effects of a strike Accrual adjustments related to long-term contracts Accrual adjustments related to long-term contracts Costs of a takeover defense Costs of a takeover defense

©Cambridge Business Publishers, 2013 Extraordinary Items under IFRS IFRS does not permit the reporting of income and expense items as “extraordinary.” IFRS does not permit the reporting of income and expense items as “extraordinary.” The IASB justified its position in IAS1 as follows: 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 entity’s future performance” (IAS1). “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 entity’s future performance” (IAS1).

©Cambridge Business Publishers, 2013 Earnings Per Share

©Cambridge Business Publishers, 2013 Caterpillar’s EPS Footnote

©Cambridge Business Publishers, 2013 Accounting Quality Relevance Relevance Reported earnings and cash flow numbers can be used to forecast the amount and timing of future earnings and cash flows. 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 qualitative information that is accurate and complete. Footnotes provide additional quantitative and qualitative information that is accurate and complete. Reliability Reliability Balance sheet numbers represent economic reality. Balance sheet numbers represent economic reality. Income statement numbers reflect economic earnings. 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. Reported cash flows accurately portray all of the cash that flowed in and out of the company during the period.

©Cambridge Business Publishers, 2013 Ways in Which Accounting Quality is Diminished Unintentional errors Unintentional errors One-time events One-time events Deliberate manager intervention Deliberate manager intervention Reliable numbers that are not predictive Reliable numbers that are not predictive

©Cambridge Business Publishers, 2013 Assessing and Remediating Accounting Quality Read both reports from the external auditor and take special note of any deviation from boilerplate language. 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 company’s policies to its industry peers. Peruse the footnote on accounting policies and compare the company’s policies to its industry peers. Examine changes in accounting policies. Examine changes in accounting policies. Compare key ratios over time. Compare key ratios over time. Identify nonrecurring items and separately assess their impact on company performance and position. Identify nonrecurring items and separately assess their impact on company performance and position. Recast financial statements as necessary to reflect an accounting policy(ies) that is more in line with competitors or one that better reflects economically relevant numbers. Recast financial statements as necessary to reflect an accounting policy(ies) that is more in line with competitors or one that better reflects economically relevant numbers.

©Cambridge Business Publishers, 2013 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. 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. 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 values of the elements. However, IFRS requires fair-value estimates that are less restrictive. For multiple-element contracts, both U.S. GAAP and IFRS allocate revenue based on relative fair values of the elements. However, IFRS requires fair-value estimates that are less restrictive.

©Cambridge Business Publishers, 2013 Global Accounting – R&D U.S. GAAP expenses all R&D costs U.S. GAAP expenses all R&D costs IFRS allows capitalization and subsequent amortization of certain development costs. IFRS allows capitalization and subsequent amortization of certain development costs.

©Cambridge Business Publishers, 2013 Global Accounting – Restructuring Expenses 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, 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, 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. 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. The U.S. GAAP estimate is at the most-likely outcome.

©Cambridge Business Publishers, 2013 Global Accounting – Income Taxes Both U.S. GAAP and IFRS recognize deferred tax assets for timing differences and unused tax losses. 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. 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.

©Cambridge Business Publishers, 2013 Global Accounting – Extraordinary Item Separate reporting of extraordinary items is not permitted under IFRS. Separate reporting of extraordinary items is not permitted under IFRS. US GAAP permits recognition of extraordinary items. 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. When comparing U.S. GAAP to IFRS, we include any extraordinary items with other expenses, according to their function.

©Cambridge Business Publishers, 2013 End Module 5