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

13% of

sales

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.

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

Another Illustration

Fortune Brands

Another Illustration

Fortune Brands

Reconciliation of Statutory and

Effective Tax Rates - Pfizer

Reconciliation of Statutory and

Effective Tax Rates Fortune Brands

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 Solution1. 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 below-

the-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