1. Reporting and Analyzing Operating Income
Module 5
Reporting and Analyzing
Operating Income

2. Revenue Recognition Revenue recognition criteria
realized or realizable, and
earned
Realized or realizable means primarily that cash is collected or a receivable is collectible.
Earned means that the seller has performed its duties under the terms of the sales agreement.

3. Revenue may be questioned, when…
Rights of return exist
Continuing involvement by seller in product resale
Contingency sales

4. Revenue Recognition Challenges
Case 1: Channel stuffing
Case 2: Barter transactions
Case 3: Mischaracterizing transactions as
arm’s-length
Case 4: Pending execution of sales agreements
Case 5: Gross versus net revenues
Case 6: Sales on consignment
Case 7: Failure to take delivery
Case 8: Nonrefundable fees

5. Percentage-of-Completion
Method appropriate for sales made with long-term contracts: construction, defense contracts, project services
The percentage-of-completion recognizes revenue by the proportion of costs incurred to date compared with total estimated costs.
Subject to manipulation of the estimated costs.

6. Percentage-of-Completion
Assume that Bayer Construction signs a $10 million contract to construct a building. Bayer estimates construction will cost $4,500,000 the first year and $3,000,000 for the second year.

7. 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.

8. How is R&D Reported by Cisco?
13% of sales

9. 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 requires:
formal restructuring plan approved by its board of directors
identify the relevant employees and notify them of the plan.
Each year, the company must disclose in its footnotes liability (accrual), liability amount settled this period and any changes in estimates.

10. Income Tax Expenses Companies maintain two sets of accounting records,
one for preparing external financial statements
another for reporting to tax authorities.
Two sets of accounting records are necessary because the U.S. tax code is VERY different from GAAP.

11. Income Tax Differences
Timing Differences
Depreciation
Bad debts expense
Warranties
% completion vs completed contract on revenues
Permanent Differences
Life insurance of officers
Entertainment above limits
Income from state and local bonds

12. Deferred Tax Liabilities and Assets
Arise when reported income is higher than taxable income.
Example: Depreciate faster for tax return than fin. report
Deferred tax assets
Arise when reported income is lower than taxable income.
Unearned revenues are revenues for tax return
Bad debt expenses are projected in fin. report, but only write-offs allowed for tax return

13. 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.

14. 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 effects on tax expense from changes in deferred tax liabilities and deferred tax assets

15. Pfizer’s Income Tax Footnote
Income tax expense (provision) is the sum of
Taxes currently payable
Deferred income taxes

16. Earnings Per Share

17. Global Accounting – R&D
U.S. GAAP expenses all R&D costs
IFRS allows capitalization and subsequent amortization of certain development costs that meet a list of requirements.