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1、Financial Reporting, Financial Statement Analysis, and Valuation:A Strategic PerspectiveSixth EditionStickney/Brown/WahlenChapter 7Revenue Recognition and Related ExpensesRevenue Recognition Some Interesting SituationsnGlobal Crossing, Qwest Communications, and others have created worldwide fiber-op
2、tics networks in recent years. nFor example, Global Crossing might create a fiber-optics network in India, Qwest Communications might create a similar network in China, and each in turn might lease part of the capacity of the networks to each other.nThe leases often give the lessee an indefeasible r
3、ight of use to the capacity, essentially a legal transfer of title to the capacity. nEach company books the “sale” of the legal rights to the capacity as revenue in the year they sign the leases.nThey treat the “purchase” of the legal rights to the capacity as a capital expenditure, much like the pu
4、rchase of a long-lived asset. nDoes the swap of legal rights satisfy the revenue recognition criteria?nhow should the firms establish the value of the contract? (no cash is involved after all)nGAAP has not definitively answered how to account for these types of transactions.Revenue Recognition Some
5、Interesting SituationsnAOL, the Internet services division of AOL Time Warner, generates subscription revenues from subscribers to its online services, as well as advertising revenues for advertisements it places on various web sites.nIn the past, AOL entered into one such arrangement with eBay. Und
6、er the arrangement, AOL located firms that wished to advertise on the eBay web site. AOL sold the advertising space to various companies and then remitted a portion of this amount to eBay. nAOL bore no credit risk if the firms failed to pay for the advertising space. AOL guaranteed the sale of a cer
7、tain minimum amount of advertising space each month. Failure to sell the minimum space required AOL to make payments to eBay. nAOL booked the amount to be received from the various companies as revenues and the amount paid to eBay as an expense. In turn, eBay booked the net amount received from AOL
8、as revenue.nThe issue is whether AOL is a principal or an agent in purchasing and selling advertising space. The accounting described here considers AOL a principal, because it entails booking the full revenue and expense. nGAAP requires a firm to assume substantial product risk if it is to be consi
9、dered a principal, which does not appear to be the case here because AOL probably can sell sufficient advertising space each month to cover the minimum obligation to eBay. nIn this case, AOL bears little risk of unsold advertising space and should have accounted for its services as an agent and reco
10、gnized only the net amount as revenue. nRevenues often are a driver for assessing firms, particularly technology and Internet firms such as AOL.Revenue RecognitionnWhy we care about Revenue Recognition?nGoal of the business is to generate persistent profit and the only way to find profit is to gener
11、ate revenue, so when and how to recognize revenue is crucialnTendency of MGT: early recognitionnGAAP: when to recognize? (performed +measurable)n1. provision all or substantial portion of the servicesn2. receive either cash, A/R or some other asset whose cash equivalent can be measured with reasonab
12、le precision (credit giving and likelihood to receive cash)nTime of deliverymeasurement of cost (matching principle)nProblems with recognition on deliveryn uncertain of A/Rcredit standing of customersA/R turnover and days of A/R outstandingBad Debt expensesn uncertain of returned goodsstore returned
13、 goods in remote and independently owned warehousesn warranty expendituresrelated to matching principlenSales Stages: Customers Letter of Interestfirm customers orders completion of production physical delivery of productsExpense RecognitionnWhen to recognize expenses?n1. When revenue is recognizedc
14、osts directly associated with revenuesn Examples: Product costs (DM+DL+OH)n2. When expenses occur-costs not directly associated with revenuesn Examples: SAG+Insurance+property taxnEM: advertising, RD and maintenance expensesnot in the period when occurnBad Debt expensecredit lossesLong Term Contract
15、s Revenue RecognitionExamples of Long-term contracts: Building, Aircraft, ship builderFeatures: 1.Long term2.Contract in advance, including priceLegal3.Periodic payments as work progressesAccounting Methods:1.Percentage-of-completion: (match cost to revenue)Assumption: total costs can be estimatedEa
16、ch year, accumulated portion-previous portion(%=completion/total cost ) * total revenue If increased costs later years change of gross margin than predictedLoss: immediately recognized when identifiedAccounts: similar to A/R, we have Contracts in process accounts2.Completed-Contract Method:-time of
17、salesLong Term Contracts Revenue RecognitionExample 7: a firm agrees to construct a bridge for 5 M dollors. Estimated costs are Y1 1.5M Y2 2M Y3 0.5 M Total expected gross margin is 1m (=5-1.5-2-0.5)Example 8 if the y2 cost=2.2m and total expected cost is 4.2 mExample 9: if y2 the firm expects to re
18、alize a loss of the contract as 0.2 m, then y2 it must realize loss=575,000, it is used to offset the income of 375,000 in Y1Revenue Recognition when Cash Collectibility is UncertainnWhy? Uncertain of customers future financial condition or the right to return goodsnSolution: not on delivery but on
19、cash collectionnInstallment Method (consumer and land developer)nWhen: cash receivednRevenue and expenses are recognizednCost-Recovery-First Method (match cost to cash receipts and when cash receipts are higher than cost, firm recognize profit)nTax consideration: installment method is allowedExample
20、: TCC sold a computer costing 16 m to BOSTON for 20 m on 1/1/1, BOSTON agrees to pay annual 5,548195 on 12/31/1 to 12/31/4, the discount rate is 12%expense rate=16/20=0.8Installment Method and Cost-recovery-first methodnReporting revenues and expenses on ISnInstallment methodnStep1: for cash receive
21、d, decompose into interest revenue and principle reductionnStep2: for principle reduction, find the expense rate and then recognize revenue and expensenCost-recovery-first method:nSame step 1, but expense should be same as the revenue until the total cost has been recovered, then distribute the prof
22、itnReporting assets/liabilities on BSnInstallment methodnNotes receivable net=notes receivable-deferred gross margin (total gross margin 4m-each years differences in revenue and expenses)nCost-recovery-first method:nEach year, the notes receivable net is N/R-4M each year sameInventory DecodingnInven
23、toryFundamental issue for financial reporting purposes is determining the value of items in inventoryAffects balance sheet ue.g., ending balances of inventoryAffects net income ue.g., cost of goods soldAffects cash flows ue.g., some tax implicationsnSeparating Product Costs and Period CostsnWhat cos
24、ts should be assigned to inventory?nCarrying cost of inventory should include all costs required to obtain physical possession and to put the merchandise in saleable condition.nA lot of management judgment is required here.nWhat difference does it make?Product costs are added to inventory and do not
25、 reduce net income until the inventory is sold.Period costs are expensed in the current period and reduce net income in that period.Inventory Flow AssumptionsnFirms purchase or manufacture products at different times and different costsnWhich units were sold?nWhich units are still in inventory? nFou
26、r common approachesSpecific IdentificationLIFO (Last-In, First-Out for COGS)=FISH (First-In, Still-Here for Ending Inventory Values)FIFO (First-In, First-Out for COGS)=LISH (Last-In, Still-Here for Ending Inventory Values)Average costs (Accountants compromise when we dont like the result we get with
27、 other methods) uIf costs are not changing, the four approaches yield identical numbers. FIFO VS LIFOThe accounting method does not have to represent the physical flow of merchandise from the warehouse.General rule:In times of rising prices: LIFO tends to generate lower net income Corporate Tax pref
28、erence: LIFO low N/I, lower tax paid LIFO conformity rule tax code require that if you use LIFO for tax purposes, you must use it for financial accounting purposes.nWhich is the better method to use to assess the liquidity of a company? Which method gives us a balance sheet at current costs?nWhich i
29、s the better method to use to assess the current performance of a company?Which method gives us an income statement at current costs?FIFO vs LIFO:Current Ratio, Inventory turnover and impact on I/S, Cash and BSFIFO vs LIFO:Current Ratio, Inventory turnover and impact on I/S, Cash and BSSome Data on
30、Cost Flow AssumptionsSome Data on the Frequency of Each MethodnSource Accounting Trends and Techniques from 2002. Out of 600 Firms:417 used FIFO332 used LIFO181 used Average Cost37 used “Other”nOf those using LIFO:15 used it exclusively175 used it for more than 50% of inventory92 used it for less th
31、an 50% of inventory47 “indeterminable” 1.Firm choice of LIFO:When factor price increasingLower taxable incometax benefitVariability Inventory growthearnings smooth (income statement)Tax saving opportunitytax loss carryforwardsIndustryAssetbig firms2. Compensation consideration: LIFO lower income, so
32、 MGT focus less on earningsWhy Doesnt Everyone Use LIFO?The tax savings may be too small to make a difference. The differences between LIFO and FIFO could be very small.The firm may have large tax loss carryforwards and is not currently paying taxes.Firms in cyclical industries with extreme fluctuat
33、ions in physical inventory levels may avoid LIFO because of the high probability of frequent LIFO liquidations.IRS exerts some discretion over how often you can switch back and forth. Because of the LIFO conformity rule, lowering taxes also means lowering profits.Managers may avoid LIFO if they beli
34、eve it will lead to a lower stock price (the market is “fooled”) Managers may avoid LIFO if they believe it will lower compensation.Use of LIFO could trigger debt covenant violations.LIFO records are more complicated and costly to maintain (need to report LIFO reserve). LIFO Reserve- Reconciliation
35、of LIFO values to FIFO values nProblems with conversion between FIFO/LIFO is needed?nFIFO:nB/S current price of ending inventory-High accounting qualitynI/S historical COGS-low accounting qualityBut match to revenuenLIFO:nI/S current COGShigh accounting qualitynB/S historical price of ending invento
36、rylower accounting qualitySolution: IRS and GAAP require a reconciliation between FIFO/LIFO is neededn(balance sheet):Inventory LIFO + LIFO Reserve = Inventory FIFOn(income statement): Cost of Good Sold LIFO-Increase in LIFO reserve+Decrease in LIFO reserveCost of Goods Sold FIFOWhy? B/S and I/S Eff
37、ects Together Converting LIFO to FIFO-2905,11117,4615,583?Sometimes firms disclose the amount that FIFO beginning and ending inventory would have been, while other times, firms disclose the difference between FIFO and LIFO inventory balances. Take note of what is reported.290This column important fo
38、r I/S conversionThese columns important for B/S conversion Why is the LIFO Reserve Interesting?Impact on I/SThe LIFO reserve is the cumulative excess of LIFO Cost of Goods Sold over what would have been Cost of Goods Sold had the firm used FIFO.Current year:The increase in the reserve times the tax
39、rate equals the taxes saved this year (taxes postponed) by using LIFO.Balance of previous tax savings:The total reserve times the tax rate equals the cumulative taxes saved (postponed) by using LIFO.Taxes Saved by Some Actual FirmsnWe can see how much some companies have saved by using LIFO. Using a
40、n estimated marginal tax rate of 40%: Estimated 1998 Cumulative($ in millions)LIFO ReserveTax BenefitExxon $2,673.00$1,069.20General Motors 2,268.00 907.20Caterpillar 2,067.00 826.80Ford Motor 1,397.00 558.80General Electric 1,098.00 439.20Note: These were not picked at random. They are the firms wi
41、th the largest LIFO Reserves at the end of 1998.LIFO LiquidationLIFO Liquidation: Exception to General RuleWhen a firm sells purchasesCOGS is lower (including current purchases and previous LIFO inventory layers)Cash flow: lower cash outflowpurchase less goods higher cash outflowhigher income taxLIF
42、O can generate some very old “layers” of costs.Dipping into these layers can generate very high income uThis is when the quantity sold has exceeded quantity purchased during the period.Firms disclose when they dip into LIFO layersuThis actually more common than most people expectThe effect on net in
43、come might be disclosed pretax or after taxes:(after tax effect) = (pretax effect) *(1 marginal tax rate)LIFO LayersMore Facts on LIFO LiquidationsLIFO liquidation can occur when ending inventory is less than beginning inventory:Following declines in demandIncreases in competitionIntroduction of JIT
44、 (Just In Time) systemsCan be avoided by purchasing sufficient quantities of inventory at year-end.nWhy would you want to avoid a LIFO liquidation? What actions could you take to avoid it?nWhy would you not take these actions to avoid a LIFO liquidation?nConsider the incentives facing the firm to bu
45、y more goods Avoid increased taxes due to the dip into old LIFO layers. USX ExampleWhat would net income have been in 1996 (approximately) if USX had used FIFO instead of LIFO Use Footnote 19? Assume that the marginal tax rate is equal to the U.S. statutory rate of 35%. Ignore the market valuation r
46、eserve adjustments. In footnote 19 of the 1996 10-K, USX notes the following:Current acquisition costs were estimated to exceed the above inventory values at December 31st by approximately $340 million and $320 million in 1996 and 1995, respectively.Difference between LIFO and FIFO COGSBeginning bal
47、ance LIFO Reserve $320 Ending balance LIFO Reserve $340 = - $20LIFO COGS higher than FIFO COGS by $20m Adjustment to obtain FIFO net income =Difference between LIFO and FIFO COGS * 1 - est. marginal tax rate$20 * 1 - .35 = $13Net income would have been approximately $13m higher under FIFO than under
48、 LIFO as reported by USX.USX LIFO LiquidationHow much was cost of goods sold changed in 1994 as a result of liquidations of LIFO inventory layers? What effect did this have on Earnings per Share (basically, what was the per share effect)? Assume that the marginal tax rate is equal to the U.S. statut
49、ory rate (35%) and that the weighted average number of common shares outstanding for 1994 is 286,594,000. Footnote 19 of the 1996 10-K states that, as a result of LIFO layer liquidations, cost of sales was not materially changed in 1996 and 1995, and decreased by $13 million in 1994. EPS Effect? I/S
50、 Effect of LIFO liquidations (after taxes) divided by the weighted average number of shares of common stock outstanding= $13 * (1 - .35) / 286,594,000 = $0.029 per shareThe approximate increase in 1994 Earnings per Share is $0.029 per share.So, Net Income increased as expected.Lower of Cost or Marke
51、t (LCM)nLower of Cost or Market (LCM)Inventory losses are typically recognized immediately and such losses reduce current period income. The idea is that when the replacement cost of inventory declines below its original cost, the potential value of the inventory has decline and a write-down/loss is
52、 warranted. :Note: Conservatism drives this convention, that is, LCM. Whats implied here is that inventory replacement cost and eventually selling price move together. The decline in replacement cost is presumed to signal that the price at which the inventory can be sold has declined. “Market” has a
53、 very particular meaning current replacement cost, subject to:Upper bound: realizable valueLower bound: market floornIts an old practice (around since the 1920s) and designed to protect securitized lending.Analyst Consideration on Inventoryn Inventory cost-flow assumption chosen by MGTnPrice variati
54、on and the speed at which inventory turns overnLiquidation of LIFO inventory layersnPhysical deterioration or obsolescence of inventorynFinancing of inventory acquisitionsAccounting for Fixed/Tangible AssetsnDepreciation of Fixed AssetsnB/S:nOriginal book value of PPE, nUseful life of assetsnDepreci
55、ation methodsnCarrying value of PPEnI/S: depreciation expensesnTax concern: where to find difference between GAAP method and Tax methodnDeferred tax liability-Tax notesnImpairment of PPEnWhen carrying amount=fair value and not recoverablenSum of undiscounted cash flows expected from the assets use a
56、nd disposalAverage Depreciable life to date and average total depreciable life calculationDepreciable life to date = accumulated depreciation/depreciation expenses =7,781/1,062=7.3 yearsTax concern: where to find difference between GAAP method and Tax methodDeferred tax liability-Tax notesAccounting
57、 for intangible AssetsnInternally developednExpense immediate in the period of occurnExternally purchasedobjectivity to find asset basisnFinite life-Trademarks, patent: similar to tangible assets, we can amortizenInfinite life-Goodwill from business combinationimpairment testnAccounting for R/D costsnAccounting for Software Development CostnThreshold: Technological Feasibility (TF)completion of a detailed program design or completion of a working modelnBefore TF: expensenAfter TF: capitalize and amortize nSoftware revision and improvement: MSWindows Series
