Module 5
Reporting and
Analyzing
Operating Income
Revenue Recognition
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Revenue recognition criteria
1.
2.
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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.
Revenue may be questioned, when…
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Rights of return exist
Continuing involvement by seller in product
resale
Contingency sales
Revenue Recognition Challenges
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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
Percentage-of-Completion
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Method appropriate for sales made with long-term
contracts: construction, defense contracts
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.
Percentage-of-Completion
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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.
Research and Development (R&D) Expenses
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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.
How is R&D Reported by Cisco?
13% of
sales
Restructuring Expenses
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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.
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.
Income Tax Expenses
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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.
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Two sets of accounting records are necessary
because the U.S. tax code is different from
GAAP.
Deferred Tax Liabilities and Assets
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Deferred tax liabilities
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Arise when reported income is higher than taxable income.
Depreciation.
Deferred tax assets
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Arise when reported income is lower than taxable
income.
Unearned revenues, bad debt expenses.
Loss Carryforwards
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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.
Income Tax Footnotes
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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
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Pfizer’s Income Tax Footnote
Income tax expense is the sum of
1. Taxes currently payable
2. Deferred income taxes
Extraordinary Items
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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
Earnings Per Share
Global Accounting – R&D
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U.S. GAAP expenses all R&D costs
IFRS allows capitalization and subsequent amortization
of certain development costs that meet a list of
requirements.