UNDERSTANDING
FINANCIAL STATEMENTS
Accounting Environment
and Financial Statements
Chapter 1
Timing of
Revenues/E
xpenses
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Financial statements are prepared on
an “accrual” basis, not “cash” basis.
Revenues reported when “earned” not
when received in cash
Matching Principle
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Matching process involves judgments by
management regarding recognition of
revenues and/or expenses
Usually the more conservative the approach
(usually lower income, higher expenses) the
higher the quality of earnings
Revenue
Recognition
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Although general rules and guidelines exist, the significant
variety of marketing methods for products and services make
it difficult to apply the rules consistently in all situations.
• Per FASB Statement of Financial Accounting Concepts No.5
Revenues generally are recognized when 2 criteria are met:
1. REALIZED OR REALIZABLE
2. EARNED
Revenue
Recognition
SEC Staff Accounting Bulletin (SAB) 101 – December
1999
•Persuasive evidence of an arrangement exists.
•Delivery has occurred or services have been
rendered.
•The seller’s price to the buyer is fixed or
determinable.
•Collectability is reasonably assured.
Revenue
Recognition
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Important issue with the SEC.
Research of accounting irregularities
shows that over ½ of fraudulent financial
reporting involves overstated revenue
(www.revenuerecognition.com)
Largest single issue involved in
restatement of financial statements
Results in larger drops in market capitalization than any other
type of restatement (based on SEC research)
Revenue
Recognition
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Revenue is recognized at the following time
depending on the circumstances:
A) At time of sale
B) During production
C) When production is complete
D) When cash is received
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Note that the PCAOB board is currently
studying revenue recognition issues.
Revenue
Recognition
A. At time of sale:
1) Revenue from selling products is recognized at the date of
sale…essentially time the goods are transferred to
customers.
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Need an allowance for estimate for uncollectible accounts.
May need an allowance for estimate for returns.
May need to recognize warranty expense/payable
2) Revenue from services rendered is recognized
when services are provided and are billable.
3) Gains or losses from disposing of assets
recognized at the date of sale.
Revenue
Recognition
B. During Production (over time):
1) Proportional revenue recognition
- Recognize revenue for amount of months
earned in a given year
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Interest,
rent, and
royalties income
- Revenue from multi-year contracts should be
recognized over the contract period (not when cash is
received)
Revenue
Recognition
B. During Production (over time):
2) Long-term Construction Contracts
(a)Percentage of Completion Method
- Revenue and expenses are recognized
as construction progresses.
(b) Completed Contract Method
-Revenue and expenses are recognized when the
contract is completed
Revenue
Recognition
A company must use of Percentage of Completion
method for L-T contracts when the following
conditions are met. Otherwise use Completed
Contract method.
(1) Reasonably costs estimates can be made
(2) Contract specifies legally enforceable rights,
the consideration, and the terms of settlement
(3) Buyer is expected to pay obligations under contract
(4) Contractor is expected to fulfill contractual
obligations
Revenue
Recognition
Percentage of Completion Method
(1) Input measures:
(a) Costs-to-date divided by
estimated total cost
(b) Efforts expended:
DLhours-to-date divided by
estimated total DL hrs
(2) Output measures:
(a) number miles completed to total miles contracted
(b) number of units completed to total units contracted
Revenue
Recognition
C. When Production is Complete (not waiting for
sale):
(1) Commodities - Agricultural products
& Precious metals
(2) Readily available market price
Recognize 100% revenue at the market price
and 100% cost of sales on the date that
production is completed.
At time of sale, recognize the difference between
the sales price and the previously recognized amount as a
“financing gain or loss” in Other Income.
Revenue
Recognition
D. When Cash is Received (after sales date):
(1) Installment Sales - Recognizes sales revenue
in the period the cash is collected rather than
the period of sale.
Defers/postpones revenue recognition.
(2) Cost of goods sold is deferred proportionally
to the deferred sales.
(3) Widespread use for tax accounting.
(4) Use installment method for financial stmt. purposes when:
(a) Periodic payments made over a lengthy time interval.
(b) There is significant uncertainty about the collectibility
Ways to
Increase Net
Income:
A. Use accounting principles that result in
higher revenue/sales/gains
1. percentage-of-completion method vs.
completed contract
B. Use estimates that increase revenues
1. use a higher estimate of the % completed
on a long-term project.
C. Engage in business decisions only to
increase revenues
1. sell major assets
Increase
revenues
Increase
revenues
D. Recognize revenue/sales/gains early (not GAAP)
1. sales for goods that are not transferred until after yearend
2. revenue recognized on multi-year contracts early (in first year
instead of over contract period)
3. not using installment sales method when required
4. Sales recognized even though it is not authorized
E. Recognize fictitious revenue/sales/gains
(not GAAP)
1. sham sales
F. Change in a revenue accounting principle that results in
a “cumulative income from the change” (GAAP)
Decrease
expenses
A. Use accounting principles that result in lower expenses
and/or losses (GAAP)
1.FIFO vs. LIFO
2. straight-line depreciation vs. accelerated depreciation
B. Use estimates that decrease expenses (GAAP, if
reasonable)
1.
2.
3.
4.
lower estimate of bad debt expense (lower % of sales)
longer useful lives for depreciable assets
lower estimate of warranty costs
lower estimate of pension costs
Decrease
expenses
C. Defer/decrease discretionary expenses (GAAP)
1. research and development expenditures
2. marketing costs
3. repairs and maintenance
Decrease
expenses
D. Under report valid expenses (not GAAP)
1. capitalizing costs versus expensing them
2. transfer expenses/losses and related liability to
another entity
3. failing to record expenses/losses and related liability
(a) purchases made near yearend that are paid after yearend
(b) contingency losses/liabilities
E. Changing an accounting principle that results in a
“cumulative income from the change” by recapturing
expenses (GAAP)
Changing from accelerated depreciation method to straight-line method
Nonrecurring/
Nonoperating
Items
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Nonrecurring and non-operating items are not part of
normal ongoing business
Earnings figure should reflect future operating potential
Therefore segregate such things as major asset sales,
asset impairments, discontinued
segment, accounting changes,
extraordinary items
Missing
Information
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Morale/efficiency/expertise of employees
Reputation/public perceptions of firm
Effectiveness of management team
Provisions for succession
Potential exposure to regulatory
changes