Module 4 Reporting and Analyzing Operating Income

Operating/Nonoperating and Core/Transitory Dimensions of Income

Operating Activities Operating activities refer to the main transactions and events of a company. Operating activities refer to the main transactions and events of a company. Results of operating activities are reported in the operating section of the income statement. Results of operating activities are reported in the operating section of the income statement.

Revenue Recognition Revenue recognition refers to the recording of revenue by a company Revenue recognition refers to the recording of revenue by a company GAAP has two revenue recognition criteria that must be met for revenue to be recognized (and recorded on the income statement)—revenue must be: GAAP has two revenue recognition criteria that must be met for revenue to be recognized (and recorded on the income statement)—revenue must be: 1. Realized or realizable 2. Earned

Cisco’s Revenue Recognition Policy

SEC Guidelines for Revenue Recognition SEC outlines its guidance for revenue recognition in Staff Accounting Bulletin (SAB) 101, where it states that revenue is realized, or realizable, and earned when each of the following criteria are met: SEC outlines its guidance for revenue recognition in Staff Accounting Bulletin (SAB) 101, where it states that revenue is realized, or realizable, and earned when each of the following criteria are met: 1. There is persuasive evidence that a sales agreement exists, 2. Delivery has occurred or services have been rendered, 3. Seller’s price to the buyer is fixed or determinable, and 4. Collectibility is reasonably assured.

Revenue Recognition Challenges Some serious revenue recognition challenges are: Some serious revenue recognition challenges are: Revenue recognition upon delivery pending execution of sales agreements. Revenue recognition upon delivery pending execution of sales agreements. Gross vs. Net. Gross vs. Net. Sales on consignment. Sales on consignment. Barter transactions. Barter transactions. Failure to take delivery. Failure to take delivery. Nonrefundable fees. Nonrefundable fees. Channel stuffing. Channel stuffing. Mischaracterizing extraordinary or unusual transactions as revenue. Mischaracterizing extraordinary or unusual transactions as revenue. Mischaracterizing transactions as “arm’s-length.” Mischaracterizing transactions as “arm’s-length.” Selling undervalued assets. Selling undervalued assets.

Percentage-of-Completion For certain industries requiring long-term contacts, revenue is recognized using the percentage-of-completion method, which recognizes revenue by determining the costs incurred to date compared with the project’s total expected costs. For certain industries requiring long-term contacts, revenue is recognized using the percentage-of-completion method, which recognizes revenue by determining the costs incurred to date compared with the project’s total expected costs. Percentage-of-completion method of revenue recognition requires an estimate of total anticipated costs. Percentage-of-completion method of revenue recognition requires an estimate of total anticipated costs.

Percentage-of-Completion Example

Raytheon Revenue Recognition Policy

Stock Options Is this compensation? Is this compensation?

Employee Stock Options Employee stock options are a form of compensation. Employee stock options are a form of compensation. Given to a select group of upper-level employees in lieu of cash payments or salary. Given to a select group of upper-level employees in lieu of cash payments or salary. Terms of these plans give employees the right to purchase a fixed number of shares of stock in the company at a fixed price for a pre-determined period of time. Terms of these plans give employees the right to purchase a fixed number of shares of stock in the company at a fixed price for a pre-determined period of time.

Employee Stock Options Current GAAP either: Current GAAP either: Intrinsic value based method: Intrinsic value based method: No compensation recorded if option’s exercise price is equal to or greater than the optioned stock price at the time both the number of shares optioned and their exercise price are known. No compensation recorded if option’s exercise price is equal to or greater than the optioned stock price at the time both the number of shares optioned and their exercise price are known. Fair value based method: Fair value based method: Expenses fair value of options over their vesting period. Expenses fair value of options over their vesting period. Vesting means option can be exercised even if employee leaves the company. Vesting means option can be exercised even if employee leaves the company.

Employee Stock Option Expense The FASB and IASB are both proposing new standards to require expensing in the income statement. The FASB and IASB are both proposing new standards to require expensing in the income statement.

Cisco’s Stock Option “Expense” as currently footnoted

Foreign Currency Translation Many companies conduct operations, not only in countries outside of the US, but also in currencies other than $US. Many companies conduct operations, not only in countries outside of the US, but also in currencies other than $US. Many purchase assets in foreign currencies, borrow in foreign currencies, and transact business with their customers in foreign currencies. Many purchase assets in foreign currencies, borrow in foreign currencies, and transact business with their customers in foreign currencies. US corporations can have subsidiaries whose entire balance sheets and income statements are stated in foreign currencies. US corporations can have subsidiaries whose entire balance sheets and income statements are stated in foreign currencies.

Rules for Foreign Currency Translation US GAAP and the SEC require that all financial statements prepared for US investors be in $US. US GAAP and the SEC require that all financial statements prepared for US investors be in $US. Financial statements of foreign subsidiaries must first be translated into $US before they can be consolidated with the US parent company and presented to US investors. Financial statements of foreign subsidiaries must first be translated into $US before they can be consolidated with the US parent company and presented to US investors. This translation process can dramatically affect both the income and the balance sheet. This translation process can dramatically affect both the income and the balance sheet.

Foreign Currency Translation Adjustment at Ford Motor Company

Income Statement Effects of Currency Swings McDonald’s:

R&D Expenses R&D activities are a significant expenditure for most firms, especially for those in technological industries where R&D costs can range up to 10% of sales or higher. R&D activities are a significant expenditure for most firms, especially for those in technological industries where R&D costs can range up to 10% of sales or higher. These costs include employment costs for R&D personnel, R&D related contract services and PP&E costs. These costs include employment costs for R&D personnel, R&D related contract services and PP&E costs. Accounting standards relating to R&D activities allow only one accounting procedure: expense as incurred. Accounting standards relating to R&D activities allow only one accounting procedure: expense as incurred.

Cisco’s R&D Footnote

Income Tax Expense Companies maintain two sets of books Companies maintain two sets of books 1. One for reporting to their shareholders 2. One for reporting to the IRS. This is perfectly legal as the tax Code is different from GAAP. This is perfectly legal as the tax Code is different from GAAP. This can result in dramatically different levels of pre-tax (financial reports to shareholders) and taxable (reported to the IRS) income. This can result in dramatically different levels of pre-tax (financial reports to shareholders) and taxable (reported to the IRS) income. These differences result in deferred tax liabilities (book income > taxable income) and deferred tax assets (book income taxable income) and deferred tax assets (book income < taxable income)

Components of Cisco’s Tax Expense

Cisco’s Deferred Tax Footnote

Intra-period Tax Allocation Taxes are disclosed in two ways on the I/S Taxes are disclosed in two ways on the I/S First is taxes on income from continuing operations First is taxes on income from continuing operations Second is to show remaining items net of taxes Second is to show remaining items net of taxes Gross amount x (1 - tax rate) Gross amount x (1 - tax rate)

Transitory Income Items & Core Earnings Estimation of stock prices entails forecasts of future earnings and cash flows. Estimation of stock prices entails forecasts of future earnings and cash flows. Forecasts are better when we can identify transitory items in reported earnings and cash flows and can eliminate those from our forecasts. Forecasts are better when we can identify transitory items in reported earnings and cash flows and can eliminate those from our forecasts. Our goal is to identify core earnings and cash flows of the company. Our goal is to identify core earnings and cash flows of the company. Core earnings and cash flows have the greatest persistence or predictive power and are, therefore, most useful for stock price estimation. Core earnings and cash flows have the greatest persistence or predictive power and are, therefore, most useful for stock price estimation.

Transitory Income Items Discontinued Operations Discontinued Operations Extraordinary Items Extraordinary Items Changes in Accounting Principle Changes in Accounting Principle

Disclosure and Presentation Operating revenues and Expenses: usual and frequent Operating revenues and Expenses: usual and frequent Other revenues and expenses: unusual or infrequent Other revenues and expenses: unusual or infrequent Disposal of a segment Disposal of a segment Extraordinary items: unusual and infrequent Extraordinary items: unusual and infrequent Changes in accounting principles Changes in accounting principles

Discontinued Operations Discontinued operations refer to any separately identifiable business operation that the company intends to sell. Discontinued operations refer to any separately identifiable business operation that the company intends to sell. Profits (loss) of the discontinued operations (net of tax), together with the gain (loss) on sale, of the segment are reported in a separate section of the income statement below income from continuing operations. Profits (loss) of the discontinued operations (net of tax), together with the gain (loss) on sale, of the segment are reported in a separate section of the income statement below income from continuing operations.

Example of Reporting for Discontinued Operations

Best Buy’s Reporting of Discontinued Operations

Extraordinary Items Extraordinary items represent transitory events that are both unusual and infrequent. Extraordinary items represent transitory events that are both unusual and infrequent. Extraordinary items are segregated from the rest of the income statement items and presented separately following income from continuing operations. Extraordinary items are segregated from the rest of the income statement items and presented separately following income from continuing operations. The company makes the determination of whether an event is unusual and infrequent. The company makes the determination of whether an event is unusual and infrequent.

GAAP Guidelines for Extraordinary Items GAAP provides the following guidance for the determination of extraordinary item status: Unusual nature - Event or transaction is abnormal and unrelated to the ordinary activities of the company Infrequent – Event is not reasonably expected to recur

Examples of Extraordinary Items (Not) Write-down or write-off of assets Write-down or write-off of assets Foreign currency gains and losses Foreign currency gains and losses Gains and losses form disposal of specific assets or business segments Gains and losses form disposal of specific assets or business segments Effects of a strike Effects of a strike Accrual adjustments related to long-term contracts Accrual adjustments related to long-term contracts Costs of defense against a takeover Costs of defense against a takeover Costs incurred as a result of the September 11, 2001 events. Costs incurred as a result of the September 11, 2001 events.

Change in Accounting Principle A change in accounting principle results from adoption of a generally accepted accounting principle different from the one previously used for reporting purposes. A change in accounting principle results from adoption of a generally accepted accounting principle different from the one previously used for reporting purposes.

Steps to Account for a Change in Accounting Principle Note: FASB has issued an Exposure Draft under which Changes in Accounting Principle will no longer be recognized as a cumulative effect adjustment. Instead, the effect of the change will be recognized retrospectively for all periods for which the effect can be estimated. 1.Financial statements are not restated 2.Cumulative effect of the change is included in net income in the period of change 3.The nature of the change and its effects are disclosed in the footnotes 4.Income for prior periods is reported on a proforma basis as if the new accounting principle had been applied to all periods reported.

Changes in Accounting Principles Shown in the “sunshine” Shown in the “sunshine” Current year operating income reflects current year under new method Current year operating income reflects current year under new method Separate line for prior year catch-up Separate line for prior year catch-up Pro-forma for prior year Pro-forma for prior year Auditor’s report Auditor’s report Different from a change in estimate or the correction of an error. Different from a change in estimate or the correction of an error.

Recognition of Gains on Assets Sales When assets are purchased they are recorded at their purchase price. Subsequently, they are carried at their historical cost, even if they appreciate in value, and are written down only if they suffer a permanent decline in value. When assets are purchased they are recorded at their purchase price. Subsequently, they are carried at their historical cost, even if they appreciate in value, and are written down only if they suffer a permanent decline in value. When they are sold, the company recognizes a gain (loss) equal to the difference between their selling price and the amount at which they are carried on the balance sheet: When they are sold, the company recognizes a gain (loss) equal to the difference between their selling price and the amount at which they are carried on the balance sheet: Selling price of asset – Asset carrying amount from balance sheet = Gain (loss) on sale Selling price of asset – Asset carrying amount from balance sheet = Gain (loss) on sale

Gains (Losses) on Asset Sales Gain (loss) = sale proceeds – asset book value Gain (loss) = sale proceeds – asset book value Assume that a company sells a machine for $10,000 that it carries on its balance sheet for $8,000 (historical cost of $12,000 less accumulation depreciation of $4,000). Assume that a company sells a machine for $10,000 that it carries on its balance sheet for $8,000 (historical cost of $12,000 less accumulation depreciation of $4,000). The company reports a gain of $2,000 ($10,000-$8,000). The company reports a gain of $2,000 ($10,000-$8,000). This gain is reported in income from continuing operations. This gain is reported in income from continuing operations.

Restructuring Charges: Employee Severance Employee severance costs represent the accrual of estimated costs relating to the termination of employees as a result of a restructuring program. Employee severance costs represent the accrual of estimated costs relating to the termination of employees as a result of a restructuring program. “Accrual” means the following: “Accrual” means the following: The company has estimated the total costs of terminating or relocating a targeted group of employees. This cost might include severance pay, outplacement costs, relocation or retraining costs for those employees who remain with the company, and so forth. The company has estimated the total costs of terminating or relocating a targeted group of employees. This cost might include severance pay, outplacement costs, relocation or retraining costs for those employees who remain with the company, and so forth. Once costs are estimated, the company must record this total estimated cost as an expense in the period that costs are estimated and the restructuring program announced to employees. Once costs are estimated, the company must record this total estimated cost as an expense in the period that costs are estimated and the restructuring program announced to employees.

Restructuring Charges: Employee Severance In the same period, the company must also record a liability on its balance sheet for the total amount of cost recognized in the income statement as expense. In the same period, the company must also record a liability on its balance sheet for the total amount of cost recognized in the income statement as expense. When paid, the payments reduce the liability previously recognized and, as a result, do not result in any additional expense in the income statement. When paid, the payments reduce the liability previously recognized and, as a result, do not result in any additional expense in the income statement.

Restructuring Charges: Asset Write- downs Asset write-downs: restructuring activities that usually encompass closure or relocation of manufacturing or administrative facilities. Asset write-downs: restructuring activities that usually encompass closure or relocation of manufacturing or administrative facilities. This can entail the write-offs of long-term assets (such as plant assets), write-downs of inventories that are no longer salable at current carrying costs or greater, and the write-offs of goodwill. This can entail the write-offs of long-term assets (such as plant assets), write-downs of inventories that are no longer salable at current carrying costs or greater, and the write-offs of goodwill.

Restructuring Charges: Asset Write- downs Recall that the cost of an asset is first recorded on the balance sheet and is, subsequently, removed from the balance sheet and transferred to the income statement as expense when the asset is used up. Recall that the cost of an asset is first recorded on the balance sheet and is, subsequently, removed from the balance sheet and transferred to the income statement as expense when the asset is used up. Write-down (write-off) of an asset accelerates this process for a portion of (all of) the asset’s cost. Write-down (write-off) of an asset accelerates this process for a portion of (all of) the asset’s cost. It is an entry made into the company’s books and does not involve any cash flow effects, other than any potential tax benefits. It is an entry made into the company’s books and does not involve any cash flow effects, other than any potential tax benefits.

Goodwill Write-Down Goodwill is the excess of the purchase price paid for a company over the fair market value of its net assets (assets less liabilities assumed in the acquisition). Goodwill is the excess of the purchase price paid for a company over the fair market value of its net assets (assets less liabilities assumed in the acquisition). Under current accounting standards, goodwill is carried on the books as an asset at its original (historical) cost and its carrying amount on the balance sheet is not reduced unless it is deemed to be impaired, at which time it is written down or written off in its entirety. Under current accounting standards, goodwill is carried on the books as an asset at its original (historical) cost and its carrying amount on the balance sheet is not reduced unless it is deemed to be impaired, at which time it is written down or written off in its entirety. Goodwill charge-offs refer to the immediate transfer of some or all of the goodwill cost from the balance sheet to the income statement as expense. Goodwill charge-offs refer to the immediate transfer of some or all of the goodwill cost from the balance sheet to the income statement as expense.

Pro Forma Earnings

Summary: Operating/Nonoperating vs. Core/Transitory

Earnings per Share (EPS)

Basic EPS is computed as (Net income – Dividends on preferred stock) / Weighted average number of common shares outstanding during the year. Basic EPS is computed as (Net income – Dividends on preferred stock) / Weighted average number of common shares outstanding during the year. Since net income already includes interest expense, but not dividends (dividends are not treated as an expense under GAAP), subtraction of dividends on preferred stock yields the amount of profit per common share available for payment of dividends to common shareholders. Since net income already includes interest expense, but not dividends (dividends are not treated as an expense under GAAP), subtraction of dividends on preferred stock yields the amount of profit per common share available for payment of dividends to common shareholders. Diluted EPS reflect the additional shares that would have been issued had all stock options and convertible securities been exercised at the beginning of the year. Diluted EPS reflect the additional shares that would have been issued had all stock options and convertible securities been exercised at the beginning of the year.

Cisco’s Earnings Per Share

Earnings Per Share Disclosure Separate EPS disclosure for: Separate EPS disclosure for: Net income from continuing operations after tax Net income from continuing operations after tax Disposals of business segments Disposals of business segments Extraordinary items Extraordinary items Changes in accounting principles Changes in accounting principles Calculation Calculation Separate dollar amount from above divided by number of common shares outstanding Separate dollar amount from above divided by number of common shares outstanding Fully diluted earnings per share Fully diluted earnings per share

Comprehensive Income Changes in net assets of an entity during a period from transactions and other events from non-owner sources Changes in net assets of an entity during a period from transactions and other events from non-owner sources Includes all changes in equity during a period except those resulting from investment by owners and distributions to owners Includes all changes in equity during a period except those resulting from investment by owners and distributions to owners Example – mark to market for available for sale securities Example – mark to market for available for sale securities