1. Peter D. Easton Mary Lea McAnally Greg Sommers Xiao-Jun Zhang ©Cambridge Business Publishers, 2015 M ODULE 5 Revenue Recognition and Operating Income

2. Operating and Nonoperating Components in the Income Statement 2 ©Cambridge Business Publishers, 2015

3. Pfizer’s Income Statement 3 ©Cambridge Business Publishers, 2015

4. IFRS Income Statement Format 4 ©Cambridge Business Publishers, 2015

5. Learning Objective 1 Explain revenue recognition criteria and identify transactions of special concern. ©Cambridge Business Publishers, 2015 5

6. Revenue Recognition  Revenue recognition criteria  realized or realizable, and  earned  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. ©Cambridge Business Publishers, 2015 6

7. Arguments Against Revenue Recognition  Rights of return exist  Consignment sales  Continuing involvement by seller  Contingency sales ©Cambridge Business Publishers, 2015 7

8. Pfizer’s Revenue Recognition Policy Pfizer recognizes its revenues as follows: 8 ©Cambridge Business Publishers, 2015

9. 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. ©Cambridge Business Publishers, 2015 9

10. Apple’s Revenue Recognition Policy 10 ©Cambridge Business Publishers, 2015 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 probable…The Company records deferred revenue when it receives payments in advance of the delivery of products or the performance of services…Revenue 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 product’s functionality, undelivered software elements that relate to the hardware product’s essential software, and undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices…The 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 product’s 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.

11. 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. ©Cambridge Business Publishers, 2015 11

12. Bayer Construction Entries 12 ©Cambridge Business Publishers, 2015

13. Percentage-of-Completion - Bayer Construction- 13 ©Cambridge Business Publishers, 2015

14. Revenue Recognition - Raytheon - 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 ©Cambridge Business Publishers, 2015

15. Revenue Recognition - Johnson Controls – Percentage-of-Completion 15 ©Cambridge Business Publishers, 2015

16. 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. ©Cambridge Business Publishers, 2015 16

17. 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. ©Cambridge Business Publishers, 2015 17

18. 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.” ©Cambridge Business Publishers, 2015 18

19. Microsoft’s Unearned Revenue Microsoft reports $22.4 billion of unearned revenue in 2013. the company describes its recognition policy as follows: 19 ©Cambridge Business Publishers, 2015 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.

20. 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. ©Cambridge Business Publishers, 2015 20

21. Learning Objective 2 Describe accounting for operating expenses, including research and development, and restructuring. ©Cambridge Business Publishers, 2015 21

22. Pfizer’s R&D Accounting Footnote 22 ©Cambridge Business Publishers, 2015

23. Pfizer R&D Costs vs. Peers 23 ©Cambridge Business Publishers, 2015

24. R&D Accounting Under IFRS 24 ©Cambridge Business Publishers, 2015

25. How is R&D Reported by Cisco? 25 ©Cambridge Business Publishers, 2015 12% of Sales

26. 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. ©Cambridge Business Publishers, 2015 26

27. 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. ©Cambridge Business Publishers, 2015 27

28. 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. ©Cambridge Business Publishers, 2015 28

29. Restructuring Expenses  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. ©Cambridge Business Publishers, 2015 29

30. 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 period’s profit is not as low.  Other restructuring costs – include items such as costs of vacating duplicative facilities and contract termination fees, for example. ©Cambridge Business Publishers, 2015 30

31. Pfizer’s 2010 Restructuring Plan 31 ©Cambridge Business Publishers, 2015

32. Learning Objective 3 Explain and analyze accounting for income taxes. ©Cambridge Business Publishers, 2015 32

33. 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. ©Cambridge Business Publishers, 2015 33

34. Income Tax Expenses Example: straight-line depreciation for book and accelerated depreciation for tax. 34 ©Cambridge Business Publishers, 2015

35. Year 1 Income Statements: Financial Reporting vs. Tax Reporting Year 1: 35 ©Cambridge Business Publishers, 2015

36. Year 2 Income Statements: Financial Reporting vs. Tax Reporting Year 2: 36 ©Cambridge Business Publishers, 2015

37. 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. ©Cambridge Business Publishers, 2015 37

38. 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. ©Cambridge Business Publishers, 2015 38

39. 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, 2015 39

40. 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 ©Cambridge Business Publishers, 2015 40

41. Pfizer’s Income Tax Footnote Income tax expense (provision) is the sum of: 1.Taxes currently payable 2.Deferred income taxes ©Cambridge Business Publishers, 2015 41

42. Pfizer’s Deferred Income Tax Footnote 42 ©Cambridge Business Publishers, 2015

43. Caterpillar, Inc. (CAT) 43 ©Cambridge Business Publishers, 2015

44. Reconciliation of Statutory and Effective Tax Rates - Pfizer - 44 ©Cambridge Business Publishers, 2015

45. Reconciliation of Statutory and Effective Tax Rates - Caterpillar, Inc. - 45 ©Cambridge Business Publishers, 2015

46. Learning Objective 4 Explain how foreign currency fluctuations affect the income statement. ©Cambridge Business Publishers, 2015 46

47. 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. ©Cambridge Business Publishers, 2015 47

48. Effects of Foreign Currency Translation - Pfizer - 48 ©Cambridge Business Publishers, 2015

49. MCD’s 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 ©Cambridge Business Publishers, 2015 49

50. 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. ©Cambridge Business Publishers, 2015 50

51. Pfizer’s Discontinued Operations 51 ©Cambridge Business Publishers, 2015

52. 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 ©Cambridge Business Publishers, 2015 52

53. 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 entity’s future performance” (IAS1). ©Cambridge Business Publishers, 2015 53

54. Learning Objective 5 Compute earnings per share and explain the effect of dilutive securities. ©Cambridge Business Publishers, 2015 54

55. Earnings Per Share 55 ©Cambridge Business Publishers, 2015

56. EPS Footnote - Virgin Media, Inc. - 56 ©Cambridge Business Publishers, 2015

57. Antidilutive Securities - Virgin Media, Inc. - 57 ©Cambridge Business Publishers, 2015

58. Learning Objective 6 Explain accounting quality and identify areas for analysis. ©Cambridge Business Publishers, 2015 58

59. 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 qualitative information that is accurate and complete. ©Cambridge Business Publishers, 2015 59

60. Ways in Which Accounting Quality is Diminished  Unintentional errors  One-time events and proforma disclosures  Deliberate manager intervention  Reliable numbers that are not predictive ©Cambridge Business Publishers, 2015 60

61. 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 company’s 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. ©Cambridge Business Publishers, 2015 61

62. 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 values of the elements. However, IFRS requires fair-value estimates that are less restrictive. ©Cambridge Business Publishers, 2015 62

63. Global Accounting - R&D -  U.S. GAAP expenses all R&D costs  IFRS allows capitalization and subsequent amortization of certain development costs. ©Cambridge Business Publishers, 2015 63

64. 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, 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. ©Cambridge Business Publishers, 2015 64

65. 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. ©Cambridge Business Publishers, 2015 65

66. Global Accounting - Extraordinary Items -  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. ©Cambridge Business Publishers, 2015 66

67. The End