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 sellers 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--

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--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
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 periods 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-of-

date 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 Firms Tax Position

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 foreignsource income.
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Assessing a Firms 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

employees earnings into an investment

vehicle as specified by employee.

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Pensions and other Post retirement

benefits (Contd.)
Employers 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:

Pension Assets:
Funds

set aside by employers to make pension

payments.
Measured at fair market value (FMV) at the end of
each year:
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:

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

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Income Statement Effects of Pension

Plans

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Gain and Loss Recognition in Pension

Plans
Gains and losses occur when expectations turn

out to be different than realizations.

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:

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.

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