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Chapter 7
Expense Analysis
1
Preliminary concepts of expense
• Expense is the cost of doing business (making profit)
during an accounting year.
• Managers have incentives to understate operating
expenses for two reasons:
– Report higher net income to influence investors
behavior
– Exhibit more efficiency of the managers that they
have been able to earn certain profit at less
operating expense.
• Managers have incentives to overstate certain
expenses for two reasons:
– To reduce corporate tax burden
– To have cash flow and financing advantage
2
Relevant Accounting Principles
•
•
Recording of firm’s expenses is governed by two
principles:
Matching principle: This implies that expenses should
be consistent with the revenues. It allows investors to
analyze expenses as a percentage of revenues, and
thereby to arrive at the profit margin.
Conservatism principle: This implies that a
conservative approach should be taken to record
expenses like to write-off the value of assets as soon
as the impairment is noticed. The same method is not
appropriate for probable revenues.
3
Recognition of Expenses
1.
2.
3.
Cost of resources consumed that have a clear
cause and effect relationship on profit and can be
perfectly matched against revenues of the period –
labor cost, material expense
Cost of resources that have no clear cause and
effect relationship to revenues are recorded only
when they are consumed – utilities expense,
advertising expense
Costs that arise from decline in future benefits of
resources (assets) – depreciation, loss on sale of
fixed assets, inventory damaged on fire, accidents
or in market value
4
Reporting Challenges for Expenses:
1. Resources providing benefits over multiple periods
Fixed assets like plant & building, R & D, advertising, goodwill, some
operating assets like inventory, and marketing expenses refer to benefits
over multiple period.
•
How to allocate the cost of such resources? How to follow the matching
principle? Spread out the cost of resource over its expected life when
there is clear cause-and-effect relationship between expense and
revenue. When cause-and-effect relation is not clear, recognize it as an
expense in the period incurred.
•
Depreciation: Fixed assets include plant, buildings, manufacturing
equipment, computer equipment, automobiles, and furnishings. GAAP
requires managers to make estimate of the expected useful lives of such
assets and the expected salvage value at the end of the lives. The
principle is to spread benefit over economic useful life considering
technological obsolescence and use. Not so easy as it depends on
business strategy and experience. (Case: Delta Airlines vs. Singapore
Airlines)
•
Good will: The cause-and-effect relation between purchased goodwill
resources and future revenues is less obvious than fixed assets, Firstly,
because, the course of benefit is less clear than fixed assets. Secondly,
goodwill can represent any over payment by the acquirer for target’s
business as well as payment for intangibles. (Case: Walt Disney
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acquisition of Capital Cities, last chapter)
Reporting Challenges for Expenses:
1. Resources providing benefits over multiple periods
(Contd..)
• Research and Development Outlays: It is logical that R&D expenses
should be recorded when the new product revenues are expected to
generate. However, success of R&D is highly uncertain, so
accounting rules of most countries suggest to record as soon as the
expense incurred. Exceptions: purchase from another company
should be amortized over useful life. Software development cost
should be capitalized upon completion of a detailed program design
and amortized in proportion to benefit received. This gives
considerable management discretion to record the expense.
• Advertising outlays: There is no clear link between advertising
outlays in a period and future revenues. Example: Microsoft
expended $220 million campaign to launch Windows 95. The role of
campaign in the success of the new product is difficult to estimate.
Because of the company’s dominant position in the market, there
was widespread public interest in the product even before the
advertisement was made. This suggests that the success of the
product can not be completely attributed to market campaign.
6
How depreciation method reflects organizational strategy:
Case of Delta Air Lines & Singapore Airlines
• In 1998 Delta Air Lines depreciated new aircraft over 25 years and
estimated salvage values at 5% of cost. In contrast, Singapore
Airlines estimated the life of aircraft at 10 years and salvage values
at 20% of cost. These estimates reflect differences in two airlines’
business strategies. Singapore airlines targets business travelers
who are less price conscious and demand reliable service. In
contrast, Delta focuses more on economy travelers who are highly
price-sensitive and for whom on-time arrival is less crucial.
Singapore Airlines reduces the risk of flight delays and ensures on
time arrival. Delta reduces equipment outlays but at the cost of high
increased maintenance and lower on time arrival rates. Ownership
pattern may be related as well. Delta is 100% publicly owned and
Singapore Airlines is majority owned by the Singapore govt.
Accordingly, Delta is more profit driven than Singapore Airlines.
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Resources providing benefits over multiple periods
(Contd.)
Key analysis questions:
1.
2.
3.
4.
5.
What assumptions are made by management to amortize
resources? Is it consistent with the strategy of the firm? Is it
consistent with the industry? If not, why?
Has the firm changed its amortization assumptions over time?
Why?
Is there any evidence that the firms consistently over- or underamortized long-lived assets?
What is the value and reliability of benefits expected from
capitalized current period outlays. (ex: goodwill)
Does the firm have a track record of creating new products through
its R&D labs, brand names in marketing campaign?
8
Reporting Challenges for Expenses
2. Timing and Amount of Payment for resources is
Uncertain
• Long–term commitment but no direct long term benefits in future –
pension, environmental hazard cleanup costs
• Should expected obligation be reported at their present value? Then
how would the errors in management's forecast of expected
obligation and change in interest rate be accommodated?
• Post retirement benefits: Managers have to forecast current
employees’ future working lives with the firm, their life expectancies,
retirement ages, and the expected cost of future benefits. These
data are used to estimate the present value of the expected future
benefits for current employees. The value is amortized as a benefit
expense by using straight line method over the employees’ expected
working lives with the firm. The benefit expense increases as the
retirement time becomes closer due to (accumulated) interest effect;
and decreases as any assets invested by the company to fund the
benefit plan increases the value.
• Environmental cleanup costs: one time or spread over the years
of cleanup?
9
2. Timing and Amount of Payment for resources is
Uncertain (Contd.)
Key analysis questions:
• What assumptions are made by the management to
recognize the cost of uncertain future obligations? Is
there any change from prior years? What are the reasons
behind the change?
• Are there any difference in the assumptions of the firms
from that of other firms of the industry? What is the
justification of the differences? Does the firm has unique
relation with the suppliers of these resources?
• Does the firm has a long term record of overestimation or
underestimation of expenses?
• Does the accounting standard affect the true expense of
the firm on the ground of uncertainty in estimating future
obligation? What is the associated risk? How does the
firm manage these risks?
10
Reporting Challenges for Expenses
3. Difficulty in determining the value of
resources consumed
•
1.
2.
3.
Resource purchased at different times but their costs cannot be
identified with each individual unit (unlike automobile case). To
ascertain the cost of goods sold is difficult if there is:
 1. inflation in the economy,
 2. demand or supply shock for the input, and
 3. variation in input usage due to different operating scale.
There are 3 techniques:
LIFO: Its merit is that it gives an indication of the future profit
margin of the firm. The demerit is the outdated valuation of
inventories as the closing stock is made of earliest stock.
FIFO: The merit is that inventories are valued at recent cost.
Demerit is poor estimation of profit margin.
Average cost Method is a compromise in between.
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3. Difficulty in determining the value of resources
consumed (Contd.)
Key analysis questions:
1.
2.
What method does the firm take for asset
valuation? Any recent change in it? What and
why?
What are the earning effects of the valuation
method? Does it have any effect in future? What
would be the nature of effects?
12
Reporting Challenges for Expenses
4. Unused resources decline in value
• Decline in market value of asset should be recorded as
expense but increase in asset value should not be recorded.
As an application of conservatism principle permanent
decline in resource values should be recorded as a loss.
According to SFAS, firms are required to review the assets
for impairment whenever there is a change in the firm’s
circumstances or an indication that book values can not be
recovered.
• Financial instruments
– Instrument held as a store of cash: show unrealized
gain/loss
– Ready for sale : show only realized gain/loss
– Instrument held to maturity: show at historical cost and
realized gain/loss
– Instruments held for hedging: fair values
13
4. Unused resources decline in value (Contd.)
Key analysis questions:
1.
2.
3.
4.
5.
For operating assets impairment charge taken by the
management: Is the timing and amount consistent with the
changes in operating performances of the firm and other related
firms? Is there any delay in recording the loss?
What is the past tendency of the firm to over-state and understate the operating assets?
What is the basis of the estimation of the fair value of the
impaired operating assets. Is it done by independent appraisal or
by management estimate?
For financial instruments: What is management’s purpose for
owning the instruments? Is the purpose consistent with
shareholders’ interest?
What is the unrealized gains or losses on holding financial
instruments, regardless whether it is reported in the income
statement?
14
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