MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING

REPORTS

Baginski & Hassell

Electronic presentation adaptation byDr. Barbara L. Hassell & Dr. Harold O. Wilson

Chapter 10

Operating Activities (Revenue and Expense Recognition) Topics

– Revenue recognition– Sales returns– Matching expenses incurred to revenues earned– Product cost versus period costs– Exceptions in revenue recognition– Structural changes in operations– Changes in measurement (accounting changes)– Earnings per share (EPS)– Statement of Cash Flows, indirect method

Revenue Recognition

• Revenue is recognized (recorded) when ...– Realized and– Earned (and realization highly probable).

• General rule of revenue recognition:– Recognize revenue at the point of delivery

of goods (manufacturing and merchandise firms) and/or rendering of services.

Revenue Recognition and Critical Events

• A “critical event” normally triggers revenue recognition (e.g., physical delivery,

or service substantially completed).

• Critical events tend to be industry specific.

• Note: The probability of a “sales return” must be low!

• GAAP requires six conditions for revenue recognition if a right of return exists.

Sales Returns

• Sales returns are recorded separately.• Estimated sales returns should be recorded

in the same period as the related sales.• The Six GAAP Conditions are met in most

arms-length transactions.• No significant uncertainties.

• When goods pass the F.O.B. shipping point, legal title changes, creating an

excellent time to record a sale/purchase!• Practical decision: Recognize the sale when

the goods leave the premises and recognize a purchase when the goods arrive.

• Inventory counting cutoffs must the consistent with the above practices.

F.O.B. Points

EXPENSES DEFINED

EXPENSES: Expired costs having no measurable benefits in future revenue producing activities.

Matching Expenses (Efforts) to Revenues (Accomplishments)

• Three justifications for expense recognition– Direct cause and effect (e.g., sales and cost of

goods sold).– Lack of measurable future economic benefit

(e.g., administrative costs).– Systematic and rational allocation of expiring

costs (e.g., depreciation, insurance).

Product Costs versus Period Costs

• In manufacturing firms, all costs are labeled as either “product” or “period:”– Product costs are clearly traceable to the

production of assets (specific inventory units).• Direct materials, Direct Labor, FOH!

– Period costs are not traceable to specific inventory units or production, per se.• Home office expenses, advertising.

Three Exceptions to General Rule of Revenue Recognition

Revenue recognition at end of production, before sale and delivery (e.g., precious

metals)Revenue recognition during production

(e.g., percentage-of-completion for long-term construction contracts).

Revenue recognition subsequent to delivery (e.g., sales with right of return that

do not meet the 6 GAAP criteria).

Interest Costs

• General rule: Expense interest as incurred

• Exception: When a company self-constructs a long-lived asset– Interest is capitalized as part of the asset’s cost

FAQ?

Should interest costs be expensed or capitalized?

In general, expensed! But many theorists believe that interest incurred on self-constructed assets should be capitalized!

Accelerated Cash Flows• Some firms generate cash flows “up front” for

services/products to be provided later (e.g., health clubs, magazine publishers, and franchisors).

• Revenues should be recorded when earned

• Passage of time is critical event for health clubs.

• Shipping each magazine is critical event for magazines.

• Pre-collected income (unearned revenue, (deferred revenue) is a liability until earned.

Structural Changes in Operations

• Voluntary structural changes– Restructurings

• Reported as part of income from continuing operations.

• Usually reported as part of other income (expense), and gains (losses).

• May be reported separately in income statement

– Discontinued operations• Reported net of tax, below income

from continuing operations, in two amounts:

– Operating income(loss)» Income(loss) prior to measurement

date– Gain(loss) on sale/disposition

» Income(loss) from operations subsequent to measurement date

» Gain(loss) at disposal

• Involuntary structural change (e.g., expropriation by governmental entity)

– An Extraordinary Item reported net of tax, below income from continuing operations

Changes in Measurement (Accounting Changes)

• Types of changes

– Changes in estimate

– Changes in accounting principle/method

– Changes in reporting entity

GAAP

Reporting will be either prospective, current, or retroactive!

• Three possible treatments:– Prospective treatment

• No restatement of prior period financial statements

• No cumulative catch-up adjustment at beginning of year

• All effects appear in future financials

– Current treatment• Cumulative catch-up adjustment

at beginning of year– Amount reported, net of tax, on the

income statement after income from operations as cumulative effect of accounting change

– Pro forma disclosure is added to prior period financial statements

No restatement of prior financial statements!

– Retroactive treatment (e.g., errors in prior periods)• Restate prior period financial statements• Cumulative catch-up adjustment at

beginning of year– Amount reported net of tax, as direct

adjustment of beginning retained earnings (i.e., prior period adjustment)

– Does not affect current net income report

• Matching accounting treatment with type of change in measurement

– Change in estimate …

prospective treatment!

– General rule for change in principle … current treatment!

– Change in reporting entity ... Retroactive treatment!

• One exception in using the prospective method:– Change to LIFO inventory method

• Specific exceptions for changes in principle and the retroactive treatment:

– Change from LIFO inventory method– Change in construction accounting method

(percentage-of-completion versus completed contract method)

– Change in method for extractive industries (full costing versus successful efforts)

– Other exceptions

The Earnings Per Share (EPS) Statistic

• EPS is a standard measure of performance across time.

• Unit of standardization = a common share!

• Presentation depends upon capital structure– Simple capital structure (i.e., no dilutive,

potential common stock securities outstanding)• One EPS amount presented

Could it have been worse?

– Complex capital structure (i.e., at least one dilutive, potential common stock security outstanding)• Two EPS amounts presented

– Basic EPS– Diluted EPS

» Calculates the EPS amount as if all dilutive securities had been converted during the period

» Purpose is to show investors the worst case: how much EPS could decline if holders of all dilutive securities converted them

Simple Capital Structure

EPS = NI - PfD

W

where, NI = Net Income PfD = Preferred Dividends W = Weighted average number of

common shares outstanding

Complex Capital Structure

Basic EPS = NI - PfD

W

where, NI = Net Income PfD = Preferred Dividends W = Weighted average number of

common shares outstanding

Complex Capital Structure

Diluted EPS = NI - PfD + AAC

W + AAC

where, AAC = Adjustments for assumed conversion of dilutive securities.

Adjustments in Computing Diluted EPS

• Adjustments reflect:– the number of common shares that would have

been issued if the dilutive security had been converted during the period, AND ,,,

– the related numerator effect

• Conversion is assumed to occur at later of date of issuance or beginning of year

• Convertible preferred stock– Denominator: use the weighted average

number of common shares that would have been outstanding.

– Numerator: any related preferred dividends are not included in the amount subtracted.

• Convertible debt– Denominator: use the weighted average

number of common shares that would have been outstanding.

– Numerator: increased by the amount of interest expense, net of tax, that would not have been incurred if the convertible debt had been converted into common shares.

• Stock options, rights, and warrants– Denominator: use the weighted average

number of net common shares that would have been outstanding• Net number equals the number of shares

that would be issued, less the number of shares that would be repurchased using the treasury stock method

– Numerator: no effect (as before)

Treasury stock method uses average market price during the year.

End of Chapter 10