Module 5 Reporting and Analyzing Operating Income
Operating and Nonoperating Components in the Income Statement
Pfizer s Income Statement
Revenue Recognition Revenue recognition criteria 1. realized or realizable, and 2. earned Realized or realizable means that the seller s net assets (assets less liabilities) increase. Earned means that the seller has performed its duties under the terms of the sales agreement.
Arguments Against Revenue Recognition Rights of return exist Consignment sales Continuing involvement by seller in product resale Contingency sales
Pfizer s Revenue Recognition Policy Pfizer recognizes its revenues as follows:
Oracle s Revenue Recognition Policy
Risks of Revenue Recognition 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 The percentage-of-completion recognizes revenue by the proportion of costs incurred to date compared with total estimated costs. Assume that Bayer Construction signs a $10 million contract to construct a building. Abbott estimates construction will take two years and will cost $7,500,000. This means the contract yields an expected gross profit of $2,500,000 over two years. The following table summarizes construction costs incurred each year and the revenue Bayer recognizes.
Percentage-of-Completion Revenue recognition policies for these types of contracts are disclosed in a manner typical to the following from the 2007 10-K report footnotes of Raytheon Company: We generally use the cost-to-cost measure of progress for all of our long-term contracts Under the cost-to-cost measure of progress, the extent of progress towards completion is measured based on the ratio of costs incurred-to-date to the total estimated costs at completion of the contract. Contract costs include material, labor and subcontracting costs, as well as an allocation of indirect costs. Revenues, including estimated earned fees or profits, are recorded as costs are incurred. Due to the nature of the work required to be performed on many of our contracts, the estimation of total revenue and cost at completion is complex and subject to many variables.
Johnson Controls Revenue Recognition Percentage-of-Completion Revenue Recognition The Company recognizes revenue from long-term systems installation contracts of the building efficiency business over the contractual period under the percentage-of-completion (POC) method of accounting. Under this method, sales and gross profit are recognized as work is performed based on the relationship between actual costs incurred and total estimated costs at the completion of the contract Changes to the original estimates may be required during the life of the contract and such estimates are reviewed monthly. Sales and gross profit are adjusted prospectively for revisions in estimated total contract costs and contract values The use of the POC method of accounting involves considerable use of estimates in determining revenues, costs and profits and in assigning the amounts to accounting periods. The reviews have not resulted in adjustments that were significant to the Company s results of operations. The Company continually evaluates all of the issues related to the assumptions, risks and uncertainties inherent with the application of the POC method of accounting.
Risks of Percentage-of-Completion The percentage-of-completion method of revenue recognition requires an estimate of total costs. If total construction costs are underestimated, the percentage-of-completion is overestimated (the denominator is too low) and revenue and gross profit to date are overstated. This uncertainty adds additional risk to financial statement analysis.
Recognition of Unearned Revenue Deposits or advance payments are not recorded as revenue until the company performs the services owed or delivers the goods. Until then, the company s balance sheet shows the advance payment as a liability (called unearned revenue or deferred revenue) because the company is obligated to deliver those products and services.
Recognition of Unearned Revenue Assume that on January 1 a client pays Pfizer $360,000 for a guaranteed one year supply of a rare medicine.
Microsoft reports $15.3 billion of unearned revenue in 2008. the company describes its recognition policy as follows: Unearned revenue is comprised of the following items: Volume licensing programs Represents customer billings for multi-year licensing arrangements, paid either upfront or annually at the beginning of each billing coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Undelivered elements Represents free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis The amount recorded as unearned is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product s life cycle. The percentage of revenue recorded as unearned due to undelivered elements ranges from approximately 15% to 25% of the sales price for Windows XP Home and approximately 5% to 15% of the sales price for Windows XP Professional, depending on the terms and conditions of the license and prices of the elements. Product life cycles are currently estimated at three and one-half years for Windows operating systems.
Pfizer s R&D Accounting Footnote
Cisco Systems R&D Research and Development - We regularly seek to introduce new products and features in areas including routers, switches, advanced technologies, and other product technologies. Our research and development expenditures were $5.2 billion, $4.5 billion, and $4.1 billion in fiscal 2008, 2007, and 2006, respectively. All of our expenditures for research and development costs have been expensed as incurred. 13% of sales
Research and Development (R&D) Expenses 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.
Analysis of R&D Expense R&D costs for wages and general purpose PPE are accounted for as they normally are. Only the expensing of PPE with no alternate use differs. Capitalizing and depreciating/amortizing R&D costs is not advisable as the depreciation or amortization period is arbitrary. Recommendations: Compare R&D/Sales for comparable companies Evaluate discussion of R&D effectiveness in the MD&A, financial press, and company communication.
Restructuring Expenses 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. This creates more transparent financial statements, which presumably deters earnings management.
Analysis of Restructuring Costs Employee severance or relocation costs - overstatements are followed by a reversal of the restructuring liability, and understatements are followed by further accruals. Asset write-downs - prior periods profits are arguably not as high as reported, and the current period s profit is not as low.
Pfizer s 2007 Restructuring Plan
Income Tax Expenses 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. Two sets of accounting records are necessary because the U.S. tax code is different from GAAP.
Income Tax Expenses Example: straight-line depreciation for book and accelerated depreciation for tax
Year 1:
Year 2:
Deferred Tax Liabilities and Assets Deferred tax liabilities arise when the net book value of liabilities is less for financial reporting than for tax reporting, or when the net book value of assets is greater for financial reporting than for tax reporting. Deferred tax assets arise when the net book value of liabilities is greater for financial reporting than for tax reporting, or when the net book value of assets is smaller for financial reporting than for tax reporting.
Loss Carryforwards 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.
Valuation Allowance Companies are required to establish a deferred tax valuation allowance for deferred tax assets when the future realization of their benefits is uncertain. The effect on financial statements is to reduce reported assets, increase tax expense, and reduce equity. These effects are reversed if the allowance is reversed in the future when realization of these tax benefits becomes more likely.
Income Tax Footnotes 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 effect on tax expense from changes in deferred tax liabilities and deferred tax assets.
Pfizer s Income Tax Footnote Income tax expense is the sum of 1. Taxes currently payable 2. Deferred income taxes
Pfizer s Deferred Tax Footnote
Fortune Brands Another Illustration
Fortune Brands Another Illustration
Reconciliation of Statutory and Effective Tax Rates - Pfizer
Fortune Brands Reconciliation of Statutory and Effective Tax Rates Pretax income $188.4 $1,120.2 1,179.3 Effective tax rate 50.7% 30.9% 24.5%
Foreign Currency Translation A change in the strength of the $US vis-à-vis foreign currencies affects reported income in the following manner: changes in foreign currency exchange rates have a direct effect on the $US equivalent for revenues, expenses, and income of the foreign subsidiary because revenues and expenses are translated at the average exchange rate for the period.
Pfizer s Foreign Currency Translation Footnote The $US weakened against many foreign currencies for several years preceding and including 2007. Thus, each unit of foreign currency purchased more $US. Therefore, revenues and expenses denominated in foreign currencies were translated to higher $US equivalents, yielding increased revenues and profits even when unit volumes remained unchanged.
BMY s Foreign Currency Translation 1. Did the $US strengthen or weaken vis-à-vis other world currencies in which BMY conducts its business 2. Did the $99 million other comprehensive income affect cash flow in 2007? Explain. If not, are there other currency-related transactions that did affect cash flow?
BMY s FC Translation Solution 1. The translation adjustment is related to the conversion of balance sheets denominated in foreign currencies into $US. For solvent companies, assets exceed liabilities. Therefore, a positive foreign currency translation adjustment would be consistent with a weakening of the $US. As foreign currencies strengthen vis-à-vis the $US, the $US value of assets denominated in those currencies increases as does the value of liabilities. And, since assets exceed liabilities for solvent companies, the asset adjustment exceeds the liability adjustment, yielding a positive foreign currency translation adjustment. 2. The $99 million other comprehensive income is related to the restatement of foreign currency-denominated balance sheets for BMY s subsidiaries into $US. There is no cash flow effect. The sales and expenses of those subsidiaries were also translated into higher $US in BMY s consolidated income statement. There is no cash flow effect here either unless foreign profits are repatriated to the US parent.
Operating Income Below the Line Two categories of items are presented belowthe-line: Discontinued operations Net income (loss) from business segments that have been or will be sold, and any gains (losses) on net assets related to those segments sold in the current period. Extraordinary items Gains or losses from events that are both unusual and infrequent.
Home Depot Discontinued Operations
Home Depot Discontinued Operations
Raytheon Discontinued Operations
Raytheon Discontinued Operations
Extraordinary Items 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
Autodesk s EPS Footnote
Apple s EPS Footnote