Financial

Statement
Analysis &
Valuation Sixth Edition

Peter D. Easton
Mary Lea McAnally
Gregory A. Sommers
Module 5
Revenues, Recognition, and
Operating Income

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Learning Objective 1
Apply revenue recognition
principles and assess results.

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Pfizer’s Income Statement

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Revenue Recognition Rule
General

 The general revenue recognition principle:

 Recognize revenue when the company transfers the good or service to the
customer
 When the customer obtains control of the good or service
 It is not necessary to receive cash to recognize revenue.

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Sales on Credit

 Many sales are on credit, meaning the customer has agreed to pay
the company in the future.
 The company recognizes revenue when the good or service is
transferred to the customer, and records an account receivable to
be collected later.
 Revenue recognition is unaffected by the delayed receipt of cash
if the company has fulfilled its performance obligation.

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Revenue Recognition Rule
5 Steps
1. Identify the contract(s) with the customer
 Parties to the contract should be identifiable.

 Terms of the sale should be specified.

2. Identify the performance obligation(s) in the contract

 Performance obligation is a contractual promise to transfer a good or service to the
customer.
 For contracts with more than one good or service, company must identify separate
performance obligations for each contractual promise.
3. Determine the transaction price
 If the purchase price is variable, estimate revenue using the expected purchase
price.

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Revenue Recognition Rule
5 Steps
4. Allocate the transaction price to the performance obligation(s)
 For contracts with more than one performance obligation, allocate the
transaction price to each performance obligation at its fair value (standalone
selling price).
 If standalone prices are not available, use a reasonable estimate of the selling
price.

5. Recognize revenue as/when each performance obligation is

satisfied
 Performance obligation is satisfied when the customer obtains control of the
goods or services.
 Performance obligations satisfied over a period of time should be recognized
as revenue over time.
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Revenue Recognition
Pfizer

Chargebacks, rebates, sales allowances and sales returns are

deducted from GROSS REVENUE.

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Complications
of Revenue Recognition
 Nonrefundable up-front fees―recognize as revenue when the goods
or services are provided
 Bill-and-hold arrangements―recognize when control of the goods
transfers to the customer
 Consignment sales―recognize commission when goods are sold
 Licenses―revenue recognition depends on the contract
 Right to use―recognize revenue when the customer can first use the licensed IP

 Promise of access―recognize over a period of time

 Franchises―recognize revenue as goods or services are delivered

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Learning Objective 2
Examine and evaluate
sales allowances.

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Sales Allowances

 Many companies offer customers a variety of sales allowances

 Rights of return
 Sales discounts for volume purchases
 Retailer promotions (point-of-sale price markdowns and other promotions)
 These reduce the amount of cash the company receives.
 Under GAAP companies must report amount of cash expected to
be received (NET sales).
 Companies must deduct from GROSS sales the expected sales
returns and other allowances.

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Sales Allowances
Example
Assume the following for Levi Strauss:
 Sells jeans to a customer for $130 on account; jeans cost $80
 Expects returns of 3% of sales

 Levi’s income statement reports the following:

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Reporting Sales Allowances

 Companies provide a reconciliation of their sales allowances

 Sales returns
 Sales discounts & incentives

 Levi’s disclosure is typical

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Analysis of Sales Allowances
Three metrics to analyze sales allowances:
1 Additions charged to Gross Sales
 Measures the income statement amount
 Reveals effects of the pricing pressure on net sales
 Expect the percentage of sales allowances to gross sales to increase (thus
reducing net sales) as pricing pressure increases
Allowance as Percentage of Gross Sales
2  Measures the balance sheet amount

Adequacy of the allowance amount

3
 Compares the dollar amount of the estimates for future sales returns to
the amount actually realized

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Three Analysis Metrics
Levi Strauss

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Analyst Adjustments 5.1
for Levi Strauss

 Estimate an “average” rate.

 Apply that average rate to determine adjusted amounts for the related
balance sheet and income statement accounts.

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Analyst Adjustments 5.1
for Levi Strauss

 Use the adjusted numbers to restate income statement numbers.

 Use the adjusted numbers to restate balance sheet numbers.

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Learning Objective 3
Analyze deferred revenue.

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Unearned (Deferred) Revenue

 In some industries, it is common to receive cash before recording

revenue.
 This creates a liability (Unearned Revenue) for the company’s
obligation to deliver a good or perform a service at a future date.
 When the good is provided or the service rendered, the unearned
revenue liability is reduced and revenue is recognized.

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Unearned (Deferred) Revenue

 Lowe’s Companies reports unearned (deferred) revenue details:

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Analysis of Unearned Revenue
 If deferred revenue liabilities decrease, we infer the company’s current
reported revenue was collected from customers in a prior accounting
period and there have been fewer new prepayments for which revenue
will be recognized in the future.
 Such a trend could predict future declines in revenue and profit.
 This is not the case for Lowe’s. The company reports a reconciliation of
the unearned (deferred) revenue account.

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Learning Objective 4
Evaluate how foreign currency exchange
rates affect revenue.

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Accounting for
Foreign Currency Effects
 Companies’ foreign subsidiaries maintain their accounting records
in foreign currencies (other than the $US).
 Before the subsidiaries’ financial statements are consolidated,
they must be translated into $US.
 As the $US weakens vis-à-vis other world currencies each unit of foreign
currency buys more $US.
 When the income statement of a foreign subsidiary is translated into $US,
the income statement grows.
 Reported revenues and expenses are larger than before the $US weakened.
 The balance sheet also grows, resulting in a higher $US value for assets,
liabilities, and equity.

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Foreign Currency Effects
Pfizer

 Revenues “increased” in 2018 due to foreign currency changes.

 We can infer that the $US dollar weakened during the year.

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Foreign Currency and Cash Flows

Consider three examples of how foreign currency gains and losses may
affect cash flow:

1. $US company transacts business in foreign currencies

 For example, a U.S. company might write a sales contract in Euros.
 If the $US weakens between the date of the sale and the collection of a Euro-
denominated account receivable, the U.S. company realizes a foreign currency
transaction gain.
 Conversely, If a U.S. company purchases goods, and the $US weakens, the foreign
currency denominated account payable would grow and more $US would be
required to settle the obligation, the U.S. company realizes a foreign currency
transaction loss.

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Foreign Currency and Cash Flows

Consider three examples of how foreign currency gains and losses may
affect cash flow:

2. $US company borrows in a foreign currency

 If a U.S. parent company borrows in foreign currencies and the $US weakens, the
parent company will realize a loss as it repays more $US to settle the foreign
currency-denominated loan.

3. Foreign subsidiary’s cash is repatriated

 If the U.S. parent repatriates cash from foreign subsidiaries by means of a cash
dividend, the parent company will realize a foreign currency transaction gain if the
$US weakens before the dividend is converted into $US.

These transactions describe realized gains/losses,

whereas translation effects are unrealized gains/losses.
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Foreign Profits and Repatriation
 Using the income statement as reported implicitly includes the foreign
currency effects.
 10-K disclosures report foreign currency effects, which allows analysts
to isolate the effects. For example, Pfizer reports:

 Good analysis computes ratios WITH and WITHOUT the effect of

foreign currency.
 Because foreign currency effects are unpredictable and out of the
company’s direct control, good analysis exclude foreign currency effects
to better forecast operating cash flow.

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Learning Objective 5
Analyze accounts receivable and
uncollectible amounts.

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Accounts Receivable
 Accounts receivable are reported on the balance sheet net of the
allowance for doubtful (uncollectible) accounts:

 Firms use aging analysis to estimate uncollectible accounts.

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Accounting for Accounts Receivable
 Assume a company
 Sells goods on account for $100,000
 Establishes an allowance for uncollectible accounts of $2,900

 The financial statement effects are as follows:

 The company reports the following on its balance sheet:

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Write-Off of Uncollectible Account
 Assume a customer who owes $500 files for bankruptcy.
 If the company determines the receivable is now uncollectible, the
company records a “write off” and adjusts the allowance.

 The company reports the following balances at period end:

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Analysis of (A/R)—Magnitude

 The magnitude of accounts receivable is measured with the

following two ratios:
1. Accounts receivable turnover = Sales .

Average A/R

2. Days sales outstanding (DSO) = 365 .

A/R Turnover
 For Pfizer:

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Interpretation of A/R Ratios

 When accounts receivable have grown more quickly than sales,

we observe:
 Lower accounts receivable turnover ratio
 Higher percentage of accounts receivable to sales
 Lengthening of the DSO

 Generally, such a trend is not favorable for two possible reasons

 The company is becoming more lenient in granting credit to its customers
 Credit quality is deteriorating

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A/R Turnover and DSO
Pfizer

 Pfizer’s A/R turnover ratio increased over the past five years—a good
sign
 DSO declined by 10 days from 2014 to 2018
 Collecting A/R more quickly increases operating cash flow

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Analysis of A/R—Quality
 10-K Schedule II reports a “roll forward” of the allowance that shows
movements in the account.

 Over the 3-year period, the company wrote off $7,112 ($3,973 + $1,893
+ $1,246) but only increased the allowance by $6,124 ($2,284 + $1,645
+ $2,195).
 Allowance / Gross Receivables has declined:

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Analysis of A/R—Quality

There are two possible interpretations for the Levi Strauss trend:
1. Credit quality has improved
 If Levi Strauss feels that the collectability of its remaining receivables has
improved, it can feel confident in allowing the allowance for uncollectible
accounts to decline.

2. Levi Strauss is underestimating the allowance account

 This is the more troubling of the two possibilities.
 Levi Strauss might be attempting to increase its profitability by not adding to the
allowance account, and thus, avoiding more bad debt expense.

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Analyst Adjustments 5.2

 Allowance for doubtful accounts is an estimate, managers can (and do) use the
allowance account to help the company meet net sales or earnings targets (via
bad debt expense.)
 Analyst seek to adjust numbers to “undo” any deliberate variation across years.
 To adjust our numbers, we estimate an “average” rate of the allowance to
Accounts receivable, gross.
 Apply that average rate to determine adjusted amounts for the related balance
sheet and income statement accounts.

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Analyst Adjustments 5.2
for Pfizer

 Estimate an “average” rate.

 Apply that average rate to determine adjusted amounts for the related
balance sheet and income statement accounts.

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Analyst Adjustments 5.2
for Pfizer

 Use the adjusted numbers to restate income statement numbers.

 Use the adjusted numbers to restate balance sheet numbers.

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Learning Objective 6
Evaluate operating expenses and
discontinued operations.

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Deductions From Income
Pfizer

 Cost of sales―The cost Pfizer incurred to make or buy the products it

sold during the year
 Selling, informational and administrative expense―Usually, this
expense category is labelled Selling, general and administrative
(SG&A) expense, and includes a number of general overhead expense
categories, such as Salaries, Marketing, IT, Legal, etc.
 Research and development expense―This is the amount Pfizer incurs
to conduct research for new products
 Amortization of intangible assets―Amortization expense is a noncash
expense, similar to depreciation expense

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Deductions From Income
Pfizer
 Restructuring charges―The cost Pfizer incurred (and expects to
incur) to restructure its operations
 Provision for taxes on income―Taxes to federal and state tax
authorities as well as income taxes levied by foreign governments
 Discontinued operations―The operating profit (or loss) on businesses
that Pfizer has decided to divest plus the gain (or loss) on the sale of
those businesses
 Income attributable to noncontrolling interest―The portion of the
subsidiaries’ income that is owned by the noncontrolling shareholders,
that is, the portion NOT attributable to Pfizer’s shareholders (who own
the controlling interest)

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Research and Development Expense

 R&D costs broadly consist of the following:

 Salaries and benefits for researchers and developers
 Supplies needed to conduct the research
 Licensing fees for intellectual property or software used in the R&D process
 Third-party payments to collaborators at other firms and universities
 Laboratory and other equipment
 Property and buildings to be used as research facilities

 R&D costs are expensed as incurred except for general purpose

PPE assets which are capitalized and depreciated as usual.

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Median S&P 500 Firm R&D/Revenue
2018

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Analysis of R&D

 To analyze R&D:
 Compare R&D expense ($ and as a % of revenue) over time
 Compare the company’s R&D spending to peers

 Financial analysts aim to develop forward-looking predictions of

a company’s income and cash flow.
 Monitor new products in the pipeline
 Develop estimates of their ultimate commercial feasibility
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Discontinued Operations
 Companies often divest of business segments.
 When this occurs, the company reports the event at the bottom of the
income statement by segregating income from continuing versus
discontinued operations.
 The discontinued operations line item has two components:
 Net income (or loss) from the segment’s business activities prior to the divestiture
 Any gain (or loss) on the sale of the business

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Why Segregate
Discontinued Operations?

 Discontinued operations are segregated in the income statement because

they represent a transitory item.
 Transitory items won’t recur and thus, they are largely irrelevant to
predicting future performance.
 Investors tend to focus on income from continuing operations because
that is the level of profitability that is likely to persist (continue) into the
future.
 In order to be classified as a discontinued operation, the disposal of the
business unit must:
 Represent a strategic shift for the company
 Have a major effect on the company’s financial results

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Analyst Adjustments 5.3

 To analyze return for 2018 (ROE and ROA) and to compare to the two prior
years, the appropriate earnings number is “Income from continuing
operations”.

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Learning Objective 7
Interpret pro forma
and non-GAAP disclosures.

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Pro Forma Income Reporting

 Pro forma income statements are non-GAAP numbers that company

management believes provide a better measure of their financial
performance.
 The Securities and Exchange Commission (SEC) requires that
companies reconcile non-GAAP information to GAAP numbers
(Regulation G).
 Remember that a company’s purpose for making a non-GAAP
disclosure is to portray its financial performance the way that
management would like us to analyze it.
 Unscrupulous companies might attempt to present financial results in
the best possible light (opportunism).

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Pro Forma Disclosure
Pfizer

 Adjusted diluted EPS is not a GAAP metric.

 Analysts may or maynot agree with Pfizer’s adjustments that excludes
costs relating to acquisitions, discontinued operations, and other one-
time nonrecurring items.
 Must examine disclosure carefully and consider the company’s
incentives for reporting “adjusted” numbers.
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SEC Warning

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Disclosures and Market Assessments
For a thorough reading of the GAAP financials:
 Read the external audit report and note any deviation from boilerplate language.

 Peruse accounting policy footnote and compare to peers.

 Examine changes in accounting policies.

 Compare key ratios over time.

 Review competitors’ ratios and consider how macroeconomic conditions have

shifted ratios over time.
 Identify nonrecurring items and separately assess their impact on company
performance and position.
 Recast financial statements as necessary to reflect accounting policies more in line
with competitors or that better reflect economically relevant numbers.

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Financial
Statement
Analysis &
Valuation Sixth Edition

Cambridge Business Publishers

www.cambridgepub.com