Module 4
Reporting and
Analyzing Operating
Income
Revenue Recognition
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Revenue recognition refers to the
recording of revenue by a company
GAAP has two revenue recognition
criteria that must be met for revenue to be
recognized (and recorded on the income
statement)—revenue must be:
1. Realized or realizable
2. Earned
SEC Guidelines for Revenue
Recognition

SEC outlines its guidance for revenue
recognition in Staff Accounting Bulletin
(SAB) 101, where it states that revenue is
realized, or realizable, and earned when
each of the following criteria are met:
1.
2.
3.
4.
There is persuasive evidence that a sales agreement exists,
Delivery has occurred or services have been rendered,
Seller’s price to the buyer is fixed or determinable, and
Collectibility is reasonably assured.
Revenue Recognition Challenges
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Some serious revenue recognition challenges are:
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Revenue recognition upon delivery pending execution of
sales agreements.
Gross vs. Net.
Sales on consignment.
Failure to take delivery.
Nonrefundable fees.
Channel stuffing.
Mischaracterizing extraordinary or unusual transactions as
revenue.
Selling undervalued assets.
Percentage-of-Completion
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For certain industries requiring long-term
contacts, revenue is recognized using the
percentage-of-completion method, which
recognizes revenue by determining the costs
incurred to date compared with the
project’s total expected costs.
Percentage-of-completion method of
revenue recognition requires an estimate of
total anticipated costs.
Percentage-of-Completion Example
Stock Options
 Is
this compensation?
Up factor:
Down:
1.05
$52.09
0.125
1/1.05
Up prob:
50%
Down:
50%
$49.61
0.25
$47.25
0.50
$45.00
1.00
$47.25
0.375
$45.00
0.50
$42.86
0.50
$42.86
0.375
$40.82
0.25
$38.87
0.125
Outcome
Probability
Stock Price
Option Value
(Stock price $45, but not less
than $0)
A
12.5%
$52.09
$7.09
$0.89
B
37.5%
$47.25
$2.25
$0.84
C
37.5%
$42.86
$0.00
$0.00
D
12.5%
$38.87
$0.00
$0.00
Probability
x Option
Value
$1.73
Employee Stock Options

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Employee stock options are a form of
compensation.
Given to employees in lieu of cash payments
or salary.
Terms of these plans give employees the
right to purchase a fixed number of shares
of stock in the company at a fixed price for
a pre-determined period of time.
Employee Stock Options

Current GAAP either:

Intrinsic value based method:
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No compensation recorded if option’s exercise price is
equal to or greater than the optioned stock price at the
time both the number of shares optioned and their
exercise price are known.
Fair value based method:
Expenses fair value of options over their vesting period.
 Vesting means option can be exercised even if employee
leaves the company.

Cisco’s Stock Option “Expense” as
currently footnoted
Foreign Currency Translation
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Many companies conduct operations, not only in
countries outside of the US, but also in currencies
other than $US.
Many purchase assets in foreign currencies,
borrow in foreign currencies, and transact
business with their customers in foreign
currencies.
US corporations can have subsidiaries whose
entire balance sheets and income statements are
stated in foreign currencies.
Foreign Currency Translation
Adjustment at Ford Motor Company
Income Statement Effects of
Currency Swings
McDonald’s:
R&D Expenses
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R&D activities are a significant expenditure for
most firms, especially for those in technological
industries where R&D costs can range up to
10% of sales or higher.
These costs include employment costs for R&D
personnel, R&D related contract services and
PP&E costs.
Accounting standards relating to R&D
activities require: expense as incurred.
Cisco’s R&D Footnote
Income Tax Expense

Companies maintain two sets of books
1.
2.

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One for reporting to their shareholders
One for reporting to the IRS.
This is perfectly legal as the tax Code is different
from GAAP.
This can result in dramatically different levels of
pre-tax (financial reports to shareholders) and
taxable (reported to the IRS) income.
These differences result in deferred tax liabilities
(book income > taxable income) and deferred
tax assets (book income < taxable income)
Components of Cisco’s Tax Expense
Cisco’s Deferred Tax Footnote
Intra-period Tax Allocation
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Taxes are disclosed in two ways on the I/S
First is taxes on income from continuing
operations
Second is to show remaining items net of taxes
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Gross amount x (1 - tax rate)
Transitory Income Items & Core Earnings
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Estimation of stock prices entails forecasts of
future earnings and cash flows.
Forecasts are better when we can identify
transitory items in reported earnings and cash
flows and can eliminate those from our forecasts.
Our goal is to identify core earnings and cash
flows of the company.
Core earnings and cash flows have the greatest
persistence or predictive power and are, therefore,
most useful for stock price estimation.
Disclosure and Presentation
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Operating revenues and Expenses: usual and
frequent
Other revenues and expenses: unusual or
infrequent
Disposal of a segment
Extraordinary items: unusual and infrequent
Changes in accounting principles
Transitory Income Items
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Discontinued Operations
Extraordinary Items
Changes in Accounting Principle
Discontinued Operations
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Discontinued operations refer to any
separately identifiable business operation
that the company intends to sell.
Profits (loss) of the discontinued operations
(net of tax), together with the gain (loss) on
sale, of the segment are reported in a
separate section of the income statement
below income from continuing operations.
Best Buy’s
Reporting of Discontinued
Operations
Best Buy’s
Reporting of
Discontinued
Operations
Extraordinary Items
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Extraordinary items represent transitory
events that are both unusual and infrequent.
Extraordinary items are segregated from
the rest of the income statement items and
presented separately following income from
continuing operations.
The company makes the determination of
whether an event is unusual and infrequent.
Examples of Extraordinary Items
(Not)
• Write-down or write-off of assets
• Foreign currency gains and losses
• Gains and losses form disposal of specific assets or
business segments
• Effects of a strike
• Accrual adjustments related to long-term contracts
• Costs of defense against a takeover
• Costs incurred as a result of the September 11, 2001 events.
Change in Accounting Principle

A change in accounting principle results
from adoption of a generally accepted
accounting principle different from the one
previously used for reporting purposes.
Changes in Accounting
Principles

Shown in the “sunshine”
Current year operating income reflects current year
under new method
 Separate line for prior year catch-up
 Pro-forma for prior year
 Auditor’s report
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Different from a change in estimate or the
correction of an error.
Recognition of Gains on Assets Sales
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When assets are purchased they are recorded at
their purchase price. Subsequently, they are
carried at their historical cost, even if they
appreciate in value, and are written down only if
they suffer a permanent decline in value.
When they are sold, the company recognizes a
gain (loss) equal to the difference between their
selling price and the amount at which they are
carried on the balance sheet:
Selling price of asset – Asset carrying amount
from balance sheet = Gain (loss) on sale
Gains (Losses) on Asset Sales
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Gain (loss) = sale proceeds – asset book value
Assume that a company sells a machine for $10,000
that it carries on its balance sheet for $8,000
(historical cost of $12,000 less accumulation
depreciation of $4,000).
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The company reports a gain of $2,000 ($10,000-$8,000).
This gain is reported in income from continuing
operations.
Restructuring Charges: Employee
Severance
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Employee severance costs represent the accrual of
estimated costs relating to the termination of
employees as a result of a restructuring program.
Asset write-downs: restructuring activities that
usually encompass closure or relocation of
manufacturing or administrative facilities.
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Inventory
LT Assets
Goodwill
Pro Forma Earnings
Earnings per Share (EPS)
Earnings per Share (EPS)
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Basic EPS is computed as (Net income – Dividends on
preferred stock) / Weighted average number of
common shares outstanding during the year.
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Since net income already includes interest expense, but not
dividends (dividends are not treated as an expense under
GAAP), subtraction of dividends on preferred stock yields
the amount of profit per common share available for
payment of dividends to common shareholders.
Diluted EPS reflect the additional shares that would
have been issued had all stock options and convertible
securities been exercised at the beginning of the year.
Comprehensive Income

Changes in net assets of an entity during a
period from transactions and other events from
non-owner sources
Includes all changes in equity during a period except
those resulting from investment by owners and
distributions to owners
 Example – mark to market for available for sale
securities
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