Accounting MidTerm Topic 4

The major issues related to accounting for revenues are:

- Timing: when to recognize revenue - Amount: how much revenue to recognize for a given Period

What are the major issues/considerations with revenue recognition

- Timing: when to recognize revenue - Amount: how much revenue to recognize for a givenperiod

How do you calculate Earnings Per Share

An important financial performance indicator. Measures the dollars earned for each share of common stock. • Companies are also required to disclose fully diluted EPS. This adjusts for the effects on EPS of any outstanding securities that could potentially dilute shareholders' ownership claims (e.g., employee stock options) Calc: Net income - Preferred dividends DIVIDED BY Weighted average number of shares outstanding

Explain how management can shift income from one period into another by its estimation of uncollectible accounts.

Bad debts expense is recorded in the income statement when the allowance for uncollectible accounts is increased. If a company overestimates the allowance account, net income will be understated on the income statement and accounts receivable (net of the allowance account) will be underestimated on the balance sheet. In future periods, such a company will not need to add as much to its allowance account since it is already overestimated from that prior period (or, it can reverse the existing excess allowance balance). As a result, future net income will be higher. On the other hand, if a company underestimates its allowance account, then current net income will be overstated. In future periods, however, net income will be understated as the company must add to the allowance account and report higher bad debts expense.

Explain what comprehensive Income

Comprehensive income is defined as: all changes in equity during a period except those resulting from investments fromand distributions to owners Net Income + Other Comprehensive Income= Comprehensive income Other comprehensive income includes certain transactions that have income effects, but for various reasons the FASB decided to not include these items in net income (i.e., the income statement) Examples of transactions that are reported in other comprehensive income • Unrealized gains and losses on equity investments and • Gains and losses related to foreign exchange rate movements • Some gains and losses related to employee retirement plans

Identify the two typical categories of restructuring costs and their effects on the balance sheet and the income statement. Explain the concept of a big bath and why restructuring costs are often identified with this event.

Restructuring costs typically consist of two general categories: asset write-downs and accruals of liabilities. Asset write-downs reduce assets and are recognized in the income statement as an expense that reduces income and, thus, equity. Liability accruals create a liability, such as for anticipated severance costs and exit costs, and yield a corresponding expense that reduces income and equity. Big bath refers to an event in which companies are perceived as overestimating the amount of asset write-downs or liability accruals to deliberately reduce current period earnings so as to remove future costs from the balance sheet or to create 'reserves' that can be used to increase future period earnings

Explain the layout of a Income Statement

Revenue is first,Expenses are reported after revenue. Companies often report subtotals such as gross margin and operating income Several other reporting requirements that companies must follow include: Results of discontinued operations must be reported separately below those of continuing operations Affects of extraordinary items are reported separately just before net income. Rules for categorizing items as extraordinary are very strict, hence this category of items is rare Must report earnings per share after net income

Why are discontinued operations reported separately from continuing operations in the income statement?

Financial statement analysis is usually conducted for purposes of forecasting future financial performance of the company. Discontinued operations are, by definition, not expected to continue to affect the profits and cash flows of the company. Accordingly, the financial statements separately report discontinued operations from continuing operations to provide more useful measures of financial performance and financial income. For example, yielding an income measure that is more likely to persist into the future, and a net assets measure absent discontinued items

Discuss Timing or Revenue Recognition for Long Term Contracts

In general, revenue is recognized at time of sale or delivery One exception to this is long‐term contracts » In this case, companies typically recognize revenue prior to delivery and throughout the time during which the company is working on the construction project » The percentage‐of‐completion method is the required approach for recognizing revenue on longterm Contracts

Revenue Recognition: Amount

In general, the amount of revenue recognized is the fair value of the consideration received, usually cash or claim to cash (i.e.,accounts receivable). • When payment in cash is received at point‐of‐sale, recognition is straight‐forward: recognize the amount of cash received • When goods or services are sold in exchange for a promise to pay within a relatively short period of time (usually within a year), recognize the cash amount of the promise • Recognized on balance sheet as AR - When goods or services are sold in exchange for a promise to pay over a long‐term period of time (usually longer than a year), recognize revenue (income statement) and a note receivable (balance sheet) equal to the present value of the promised cash payments• Over the life of the note receivable, also recognize interest revenue • NOTE: we will not work specific problems for notes receivable

What are the criteria for categorizing an event as an extraordinary item? Provide an example of an event that would properly be categorized as an extraordinary item and one that would not.

In order for an event to be classified as an extraordinary item, its occurrence must be both unusual and infrequent. Items that are considered to be both unusual and infrequent might be the destruction of property by natural disaster or the expropriation of assets by a foreign government in which the company operates. Gains and losses on early retirement of long-term bonds, once comprising the majority of extraordinary items, are no longer considered as such unless they meet the tests outlined above. Other events not likely to be included as extraordinary items include asset write-downs, gains and losses on the sales of assets, and costs related to an employee strike

When is revenue recognized

realizable Earned - Revenue is earned when a company has substantially accomplished what it must do to be entitled to the benefits represented by the revenue Realized or realizable - Revenue is realized when goods and services are exchanged for cash or claims to cash (receivable) - Revenue is realizable when assets received in exchange are readily convertible to known amounts of cash or claim to cash

Earnings Management: What are the causes of low earnings quality and What are managements' incentives regarding the reporting of earnings?

• Weak accounting standards (or the inherent limitations of accounting) • Unintentional errors by managers in applying accounting standards • Intentional manipulation of accounting standards by managers What are managements' incentives regarding the reporting of earnings? • Report smooth earnings increases from year‐to‐year • Report earnings that meet or exceed important benchmarks (Analysts, earnings, internal Targets)

What are some techniques used by companies to manage earnings

1. Shift income from one period to another period - Accomplished by accelerating or delaying the recognition of revenues (gains) or expenses (losses) 2. Shift the classification of income items within the income statement for a given period Income Shifting: revenue recognition Accelerated recognition of revenue • Recognize revenue before product or service is delivered • Recognize revenue when right of return exists and is likely Smoothing of revenue from period to period • Slow down recognition of revenue in good years, and then accelerate recognition in bad years Income Shifting: expense recognition Under-reporting of expenses • Capitalizing (recording as an asset) expenditures that should be recorded as expenses • Under estimating accrued expenses (warranties, legal liabilities, etc.) Common areas where management estimates can result in manipulation of expenses • Uncollectible accounts, • Inventory write-downs, • Warranty costs, • Legal liabilities Earnings Quality & Earnings Management Income Shifting: expense recognition Accelerated recognition of expenses • 'Big bath' techniques: in bad years, companies often are aggressive in writing-down assets and taking large liability reserves in the belief that if your going to report bad news, you might as well report really bad news• This over-reports expenses in the current year and sets up future years for lower expenses related to the reversal of liability reserves Other techniques to produce one-time gains • Sale of assets that have appreciated in value: Examples - Real estate, - Investments in equity securities Income statement classification: Some companies will try to classify ongoing expenses as unusual or infrequent, Companies may also attempt to categorize unusual or infrequent gains within

What are the criteria that guide firms in recognition of revenue? What does each of the criteria mean? How are the criteria met for a company like Abercrombie & Fitch Co., a clothing retailer? How are the criteria met for a construction company that builds offices under long-term contracts with developers

Revenue must be realized or realizable and earned before it can be reported in the income statement. Realized or realizable means that the company's net assets have increased, that is, the company has received an asset (for example, cash or accounts receivable) or satisfied a liability as a result of the transaction. Earned means that the company has satisfied its obligation to the customer under the terms of the sale. For retailers, like Abercrombie & Fitch, revenue is generally earned when title to the merchandise passes to the buyer (e.g., when the buyer takes possession of the merchandise), because returns can be estimated. For companies operating under long-term contracts, the earning process is typically measured using the percentage-of-completion method, that is, by the percentage of costs incurred relative to total expected costs.

Explain considerations for valuation of receivables

Short‐term accounts receivable are reported at net realizable value » The net amount they expect to receive in cash » This requires accounting for uncollectible amounts - Companies must estimate amounts that will likely be uncollectible and report accounts receivable net of the uncollectible amount » This is called the allowance method

How do you report comprehensive income

The FASB has allowed companies to choose one of three ways to report components of comprehensive income • As part of the income statement (i.e., a combined statement of comprehensive income) • As a statement of comprehensive income separate from the primary income statement • As part of the statement of stockholders' equity (no longer allowed beginning in 2012 [ASU 2011‐05]) Note: beginning in 2012, companies are only allowed to choose from the first two options.