Download Criteria for Revenue Recognition (Contd.)

Chapter 08
Operating Activities
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Criteria for Revenue Recognition
 Under US GAAP for accrual basis of
accounting:
 If firm has provided all or substantial portion of
product or service; and
 If firm has received an asset or satisfied a
liability with a value measurable with
reasonable precision.
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Criteria for Revenue Recognition (Contd.)
 Outlined by SEC for accurate reporting:
 If there is pervasive evidence that an
arrangement exists.
 If delivery has occurred or services have been
performed.
 If the seller’s price to the buyer is fixed or
determinable.
 If collectability is reasonably assured.
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Criteria for Revenue Recognition (Contd.)
 Provided by IFRS with respect to sale of
goods:
 If seller has transferred to buyer significant
risks and rewards of ownership of goods.
 If seller has not retained either effective control
or the kind of involvement associated with
ownership.
 If amount of revenue can be measured
reliably.
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Criteria for Revenue Recognition (Contd.)
 If probable that seller will obtain economic
benefits associated with transaction.
 If costs incurred or to be incurred can be
measured reliably.
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Revenue Recognition at time of Sale
 For most firms, occurs at time of product or
service delivery.
 Too early for a firm when below conditions
exist:
 Large and volatile uncollectible receivables.
 Unusually large return of goods.
 Excessive warranty expenditures.
 Substantial increase in collection periods.
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Revenue Recognition at time of Sale
(Contd.)
 Suffers from a more fundamental problem
when firms:
 Recognize revenue on firm order for goods
held in inventory.
 Recognize revenue earlier to physical delivery
and transfer of legal title to customer.
 Recognize revenue based on a mere
indication of interest by customer.
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Revenue Recognition delayed
 When firms do not meet some or all obligations
to the buyer. Examples:
 Sale of redeemable vouchers
 Insurance premiums paid in advance
 Advance collected from customers
Firms record a liability (often called deferred revenue, unearned revenue, or
advances from customers) for the amount of delayed revenue.
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Income Recognition under Long-Term (LT)
Contracts
 Operating cycle under LT contracts differ:
 Period of production may span many
accounting periods.
 Customers are identified, scope and price of
contract agreed upon in advance.
 Customers make periodic payments as work
progresses.
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Percentage-of-Completion method
 Recognizes revenue on completion of
milestones and customers invoiced for
partial completion based on:
 Total contract price
 Degree of completion
 Ratio of costs incurred till date to total
expected costs
 Recognizes proportion of expenses vis-à-
vis recognition of revenue.
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Completed-Contract method
 Recognizes revenue on completion of
contract.
 Contract price, costs, degree of completion
not easily estimable
 Method not permitted under IFRS if
percentage-of-completion method cannot be
used for reasons stated above.
 Recognizes loss on contract as soon as
evident; even if contract is incomplete.
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Reporting choices under LT Contracts
 Contractors:
 Should not use percentage-of-completion
method when substantial uncertainty exists
about costs.
 Can use either of two methods for contracts of
shorter duration.
 Must use the percentage-of-completion
method for income tax purposes
 Prefer to use the completed-contract method
to delay revenue and taxes for tax purposes.
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Revenue Recognition When Cash
Collectability is Uncertain
 When firm has completed delivery of the
product and customer is allowed to pay
over a long period of time.
 Recognizes revenue only when cash is
collected using either:
 Installment method
 Cost-Recovery method
 These methods are used only when amount of cash
firms will receive in future cannot be assessed.
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Installment method
 Recognizes revenue as and when portion
of selling price is collected in cash.
 Recognizes proportion of cost of goods
sold as an expense vis-à-vis recognition of
revenue.
 Often used by manufacturing firms selling
on extended payment plans.
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Cost-Recovery method
 Recognizes revenue not until cash is
received.
 Recognizes matching amount of expenses
each period until full cost recovery occurs.
 Shows profit only when cumulative cash
receipts exceed total costs.
 On full cost recovery, recognizes further
cash receipts as revenues with no
matching costs.
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Criteria for Expense recognition
 Under US GAAP and IFRS:
 Costs directly associated with revenues be
recognized as expenses in the period when
firm recognizes revenues (product costs).
 Costs not directly associated with revenues be
recognized as expenses in the period when
firm consumes the services or benefits of costs
in operations (period costs).
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Cost of Sales
 Single largest expense for most retail and
manufacturing firms.
 An expense is recognized when inventory
is consumed.
 Expense recognition becomes difficult
when unit costs are small and inventory
items similar:
 In such cases, cost of goods sold is measured
by making assumptions about the flow of costs
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Cost-flow assumptions
 Weighted average
 Determines the weighted average cost of all
inventory items available for sale.
 Assigns the cost to each unit sold and in the
ending inventory.
 Most recent purchase prices receive greater
weightage in cost.
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Cost-flow assumptions (Contd.)
 First-in, first-out (FIFO)
 Values inventory in balance sheet at prices
closest to current replacement cost of
inventory.
 Results in the highest net income and highest
balance sheet value for inventory of all three
methods in a period of rising prices.
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Cost-flow assumptions (Contd.)
 Last-in, first-out (LIFO)
 Assigns amounts to cost of goods sold closest
to current replacement cost of inventory.
 Results in the highest cost of goods sold and
lowest net-income of all three methods in a
period of rising prices.
 Is preferred by firms for income tax purposes.
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Cost-flow assumptions (Contd.)
 LIFO layer liquidation




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Is an exception to the generalization that LIFO produces
the lowest net income during periods of rising prices.
Occurs when a firm sells more units during a period than
it purchases.
LIFO assigns the cost of all current period’s purchases
plus costs assigned to the liquidated LIFO layers to
COGS.
During periods of rising prices, the liquidated layers of
LIFO may be lower than current costs, causing COGS to
be relatively low and net income relatively high.
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Why restate LIFO to FIFO?
 LIFO inventory valuation results in low out-ofdate inventory values, reflecting poor accounting
information quality.
 Inventory turnover ratio based on LIFO gives
poor indication of the actual inventory turnover.
 LIFO measure of the inventory turnover ratio
does not accurately portray the number of days
inventories are held if LIFO costs are very old.
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Reporting changes in Fair market value of
inventory
 Under U.S. GAAP and IFRS, inventory reported
at each balance sheet date is to be lower of cost
or market.
 Increases in market value is not reflected in the
financial statements until inventory is sold.
 Under U.S. GAAP and IFRS, losses due to
decline in market values of inventory below cost,
are reflected as decrease in inventory and
increase in cost of goods sold.
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Accounting Quality: Cost of Sales and
Inventory
 Following are considered for assessing
quality of information:
 Inventory cost-flow assumption.
 Price variation and inventory turnover ratio.
 Liquidation of LIFO inventory layers.
 Physical deterioration or obsolescence of
inventory.
 Financing of inventory acquisitions.
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Cost-Flow Assumptions by firms
 Should be ascertained by any analyst wrt:
 Rapid Inventory Turnover and Price Stability.
 Liquidation of LIFO Inventory Layers.
 Obsolete or Damaged Inventory.
 Inventory Financing Arrangements.
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Working Capital Investments
 Revenues and cash inflows are not necessarily equal.
 Cash inflows occurring after revenue is recognized
results in:
 Working capital asset or Accounts receivable.
 Cash inflows occurring before revenue is recognized
results in:
 Working capital liability or Deferred revenues.
 Inventory purchases affect Cash flow from operations
due to:
 Increase in Accounts Payable or
 Decrease in Cash.
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SG&A (Selling, General, and
Administrative) Costs
 Bear a less direct relationship with sales.
 Represent the consumption of assets and
incurrence of liabilities to carry on
corporate functions other than production.
 Examples: Advertising, Marketing,
Administration, Accounting, Information
systems, Warranty expense and Credit
functions.
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Operating Profit
 Sales revenue - Cost of sales + SG&A
expenses = Operating profit before tax
 Financial revenues and expenses along
with equity in the earnings of affiliates are
disclosed.
 Income tax expense is subtracted to obtain
Net Income.
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Income Tax Expense Computation
 Balance-sheet approach used to compute
income tax expense:
 Identify all differences between book and tax
basis of all assets, liabilities and tax loss
carry-forwards.
 Eliminate permanent differences between
book and tax basis.
 Compute deferred tax assets and liabilities
arising out of temporary differences and tax
credit carry-forwards.
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Income Tax Expense Computation
(Contd.)
 Assess the likelihood of benefits realizable
from deferred tax assets.
 Income taxes currently payable on taxable
income.
 Plus (minus) an increase (a decrease) in
deferred tax liabilities between the
beginning and the end of the period.
 Minus (plus) an increase (a decrease) in
deferred tax assets.
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Required Income Tax Disclosures (GAAP)
 Components of income tax expense
 Current expense
 Deferred expense
 Components of income before taxes
 Domestic operations
 Foreign operations
 Reconciliation of income taxes at statutory
rate with income tax expense
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Required Income Tax Disclosures (GAAP)
 Reconciling tax rate differences
 Permanent differences
 Components of deferred tax assets and
liabilities
 Uncollectible Accounts Receivable
 Warranties
 Pensions
 Leases
 Net operating losses
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Required Income Tax Disclosures (GAAP)
(Contd.)
 Net operating losses
 Depreciable assets
 Inventories
 Installment receivables
 Intangible Drilling and Development Costs
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Assessing a Firm’s Tax Position
Average Tax Rate =
Income Tax Expense
Book Income before Income Taxes
 Tax effective ways of operating:
 Shifting operations from higher tax regions to
lower tax regions.
 Adjusting transfer prices or cost-allocations to
shift income from high-tax to low-tax
jurisdictions.
 Shifting from domestic to foreign borrowing to
increase deductions for interest against
foreign-source income.
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Assessing a Firm’s Tax Position (Contd.)
 Shifting from equity to debt financing to
increase interest deductions.
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Pensions and other Post retirement
benefits
 Benefits provided by employers after
employees retire.
 ‘Pension Benefit’ plans are sponsored by
employers:
 Employers place a certain percentage of
employee’s earnings into an investment
vehicle as specified by employee.
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Pensions and other Post retirement
benefits (Contd.)
 Employer’s obligation under the plan is
satisfied once funds are placed into the
investment account.
 Fund balance at retirement depends on the
investing success of the investment company.
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Pension Accounting in a Defined Benefit
plan
 Key amounts in Defined Benefit Plan:
 Pension Obligation (Liability):
 Projected Benefit Obligation (PBO): Actuarially
determined present value of estimated retirement
payments to employees.
 Calculated according to the benefit formula (using
expected future salary levels).
 Discount rate used is the rate at which an outside
party would effectively settle the obligation.
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Pension Accounting in a Defined Benefit
plan (Contd.)

Pension Benefit formula:
Annual Benefits = Annual Credit x Years of Service x Salary at Retirement Date
 Pension Assets:
 Funds set aside by employers to make pension
payments.
 Measured at fair market value (FMV) at the end of
each year:

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Employers use Year-end FMV or an average FMV over a
period of time, usually five years in financial reporting.
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Economic Status of Pension Plan
 Determined by comparing two economic
amounts:
 Projected Benefit obligation
 Fair market value of Plan Assets
 Economic status of plan reflected on the balance
sheet:
If PBO > FMV of plan assets: Plan is underfunded (net obligation)
If PBO < FMV of plan assets: Plan is overfunded (net asset)
 Changes in the economic status of plan reported
in comprehensive income.
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What Changes the Economic Status of the
Plan?
 What Changes the PBO?
 Service cost
 Interest cost
 Prior service cost
 Actuarial gains and losses
 Benefit payments to retirees
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What Changes the Economic Status of the
Plan (Contd.)
 What Changes the FMV of Pension Plan
Assets?
 Cash contribution to Plan assets by
employers.
 Actual return on plan assets.
 Benefit payments to retirees.
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Reporting Income Effects of Pension
Plans
Type of Change in Pension Plan
Changes in PBO:
Service cost
Interest cost on PBO
Prior service cost
Liability gains/losses on PBO
Treatment in Reporting Income
Increase pension expense (decrease net income)
Increase pension expense (decrease net income)
Decrease other comprehensive income
Increase/decrease other comprehensive income
Changes in FM V of plan assets:
Actual return on plan assets:
Expected return on plan assets Decrease pension expense (increase net income)
Asset gains/losses
Increase/decrease other comprehensive income
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Income Statement Effects of Pension
Plans
Computation of Net Pension Expense
Service cost
Add Interest on PBO
Less Expected return on assets
Add Amortization of Prior Service cost
Add Amortization of gain/loss
Net pension expense
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Gain and Loss Recognition in Pension
Plans
 Gains and losses occur when expectations turn
out to be different than realizations.
Expected PBO ≠ Actual PBO, results in liability gains or losses
Expected FMV ≠ Actual FMV, results in asset gains or losses
 Net deferred gain/loss is amortized only if very
large:
 corridor amount set as threshold for deferred gain or
loss amortization by FASB.
 corridor is defined as 10 percent of the greater of
actual PBO or actual FMV.
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Actuarial Assumptions under Pension
Plans
 To be disclosed in notes to financial
statements:
 Discount rate used to compute the pension
benefit obligation.
 Expected rate of return on pension
investments.
 Rate of compensation increase, which affects
the amount of the PBO.
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Other Postretirement Benefits
 Benefits provided to employees other than
pension (eg; health care).
 Expected obligation computed as the
actuarially determined present value of
future payments.
 Accounting framework different from that of
Pensions wrt following:
 Payments are made as and when claims are
made with no dedicated plan assets, and
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Other Postretirement Benefits (Contd.)
 Additional disclosures for Postretirement
Benefits other than Pensions:


Chapter: 08
Assumed health care cost trend rate in actuarial
computations.
Effect of a one-percentage-point change in health
care cost trend rate on accumulated PBO and
aggregate of service and interest cost of Health care
benefits.
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Signals about Earnings Persistence
 Sharp swings in market values of
investments can impact pension expense
and earnings.
 Firms use long-term expected returns on
investments to compute expected return
on assets each period.
 Impact of changing stock prices is to be
considered to forecast future earnings
based on current earnings.
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Derivative Instruments
 Help a firm mitigate the following risks:
 Interest rate risk.
 Foreign currency exchange rate risk.
 Commodity price risk.
 Nature and use
 Derive value from some other financial
instrument.
 Typically used to hedge against losses from
above mentioned risks.
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Derivative Instruments (Contd.)
 Their change in value offset changes in value
of an asset or a liability or changes in future
cash flows, thereby neutralizing losses.
 Reported as assets or liabilities depending
on rights and obligations under a contract.
 Must be revalued to fair value each period
with revaluation amount affecting net
income or other comprehensive income.
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Derivative Instruments (Contd.)
 Classified under US GAAP and IFRS as:
 Speculative investments
 Fair value hedges
 Cash flow hedges
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Treatment of Hedging Gains and Losses
 Under Fair Value hedges:
 Gains and losses recognized in net income.
 Asset or liability revalued with a corresponding
amount.
 Under Cash Flow hedges:
 Gains and losses recognized in Other
Comprehensive income.
 Gain or loss out of ineffective hedges
included in Net income.
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Treatment of Hedging Gains and Losses
(Contd.)
 Accumulated amount in Other
Comprehensive income is transferred to
net income periodically.
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Disclosures Related to Derivative
Instruments (FASB Statement 133)
 Risk management strategy of the firm
distinguishing the derivative instruments
used.
 Net gains or losses under Fair Value and
Cash Flow hedges due to ineffective
hedging.
 Transactions resulting in re-classification of
gains and losses from Other
Comprehensive income to net income.
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Disclosures Related to Derivative
Instruments (FASB Statement 133) (Contd.)
 Net gains or losses when a:
 hedged firm commitment no longer qualifies as
a fair value hedge or
 hedged forecasted transaction no longer
qualifies as a cash flow hedge.
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Accounting Quality Issues and
Derivatives
 Fair market values reported for derivative
instruments not reliable when active
markets do not exist.
 Classification of derivatives as ‘fair value’
hedges versus ‘cash flow’ hedges by firms
questionable.
 Different impact on earnings due to gains or
losses from each kind of hedge.
Chapter: 08
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