Chapter 5

Question 1

what are the revenue recognition steps

Answer 1

1. Identify the contract(s) with a customer.
   The parties to the contract should be identifiable
   and the terms of the sale should be specified (including the items sold, the delivery terms, and
   the payments required).
2. Identify the performance obligation(s) in the contract.
   A performance obligation is the
   company’s contractual promise to transfer a good or service to the customer. If the contract
   involves the transfer of more than one good or service to the customer, the company needs to
   account for each promised good or service as a separate performance obligation and recog-
   nize revenue separately for each.
3. Determine the transaction price.
   If the selling price is variable, say dependent upon contin-
   gencies, the company should estimate revenue using the
   expected
   selling price.
4. Allocate the transaction price to the performance obligation(s).
   For contracts with more
   than one performance obligation, the company must allocate the transaction price to
   each
   performance obligation at its relative
   fair value
   , that is, the stand-alone selling price of the
   distinct goods or services relative to the total expected selling price. If published, stand-alone
   prices are not available, the company must use a reasonable estimate of the selling price.
5. Recognize revenue when the performance obligation is satisfied.
   Companies should recognize revenue when they satisfy the performance obligation—that is, when the customer
   obtains control of the goods or services. This will generally be when the company transfers
   the goods or services to the customer. Performance obligations that are satisfied over a period
   of time are recognized as revenue over time.

Question 2

what are some complications of revenue recognition

Answer 2

1. right of return - customers can return if not satisfied w/product - companies estimates the dollar amount of goods that are likely to be returned + deduct that amount from gross sales to arrive at the net sales reported in I/S.
2. Gift cards - considered deferred revenue until the gift card is used by customer to purchase G+S
3. nonrefundable up-front fees. companies charge fee at or near inception of the contract. fees could be for setup/access/activation/membership. this nonrefundable up-front fee compels that company to undertake an activity at or near contract inception, where that activity doesn’t result in the transfer of the goods or services as that fee is seen as an advance payment for future G+S and will be recognized as revenue when those future G+S are provided.
4. Bill-and-hold arrangements - arise when customer is billed for goods that are ready for delivery but the company “holds” the good for shipment later. revenue is recognized at a later date
   Consignment sales.
   If the seller acts as an
   agent
   for another company, such as to sell another
   company’s product on its website, it does not recognize the gross amount of the sale as rev-
   enue. Instead, it only recognizes its
   commission
   from the sale. An indicator that the seller is
   an agent includes when the seller does not bear any risk associated with the inventory or the
   related receivables.
   ■
   Licenses.
   Software sales can take the form of licensing arrangements of intellectual property
   (IP). Revenue recognition depends on whether the arrangement confers a right to
   use
   the IP
   (arguing for recognition of revenue when the customer can first use the IP) or whether the
   contract promises to provide
   access
   to the company’s IP (arguing for revenue recognition
   over a period of time).
   ■
   Franchises.
   Franchisors often sell both goods and consulting and other administrative servic-
   es. The franchisor must separate the sale into separate components for goods and services and
   recognize the appropriate revenue for each component. The goods component is recognized
   when the goods are transferred to the buyer. The services component might involve use of a
   trade name or a license or other services that are provided over time. In such cases, revenue
   should be recognized as the services are delivered.
   ■
   Variable consideration.
   Portions of the selling price may depend upon future events, such as
   incentive payments, royalties, and volume discounts. If the good or service has been transferred
   to the customer and the payment is likely and can be reasonably estimated, the seller should
   estimate the expected amount to be received and recognize that amount in current revenue.
   ■
   Multiple-element-contracts.
   Many companies bundle multiple products and services
   together for one price. The added complication is that the seller might deliver some products
   and services at the point of sale and others in the future. In such cases, the seller must first
   separate the sale into distinct goods or services (components) that can each be valued on a
   stand-alone basis. Then, revenue is recognized separately on each distinct component (see
   the Analysis Insight box above, for a discussion of how Oracle deals with its multi-element
   contracts). Components are generally viewed as distinct if the:
   ●
   Customer can use the good or service on its own.
   ●
   Good or service is not highly interrelated with other goods or services sold per the contract.

Question 3

define cost to cost method

Answer 3

recognize revenue
over the life of a long-term contract in amounts that track the percentage of completion of the con-
tract. Companies typically use the percentage of projected contract costs that have been incurred
to estimate the contract’s percentage of completion.

requires an estimate of total costs. This estimate
is made at the beginning of the contract and is typically the one used to bid the contract. However,
estimates are inherently inaccurate. If the estimate changes during the construction period, the per-
centage of completion is computed as the total costs incurred to date divided by the
current
estimate
of total anticipated costs (costs incurred to date plus total estimated costs to complete). Then revenue
recognized for the current period is the difference between total revenue to be recognized to date,
based on the new percentage of completion, and previously recognized revenue.
If total construction costs are underestimated, the percentage of completion is overestimated (the denominator is too low), revenue and gross profit to date are overstated, and the
remaining revenue and gross profit to be recognized in the future is understated. The estimation process inherent in this method has the potential for inaccurate or even improper revenue
recognition. In addition, estimates of remaining costs to complete projects are difficult for the
auditors to verify. This uncertainty adds additional risk to financial statement analysis.

Question 4

define contract liabilities

Answer 4

another term for deferred or unearned revenue - obligation to deliver the product for which it has been paid

Question 5

where are sales allowances especially prevalent in

Answer 5

industries with undifferentiated commoditized products

Question 6

how to record down sales allowances

Answer 6

reduce sales by the amount you expect return to sales to be

Question 7

what are the steps to an analysis of sales allowance

Answer 7

1. “Additions charged to net sales” as compared with gross sales for both sales returns
   and sales discounts.
   This ratio reveals any effects of the pricing pressure on net sales and
   we would expect the percentage of sales allowances to gross sales to increase (thus reducing
   net sales) as pricing pressure increases.
2. Allowances as a percentage of gross sales.
   The allowance balance has declined steadily over
3. Adequacy of the allowance account.
   This analysis compares the dollar amount Levi Strauss
   estimates for future sales returns with the amount actually realized during the year. If the
   company’s estimates are 100% accurate, the two amounts will be roughly the same (with
   some variance due to sales and returns that cross a fiscal year-end). If the amount charged to
   sales is greater than the cost incurred, the company has reduced sales more than is needed and
   has reduced its profit accordingly. If the amount charged to sales is less than the cost incurred,
   the company has under-reserved the allowance account, thus increasing profit.

Question 8

where is unearned revenue common among companies that

Answer 8

Receive advance payments from customers for products or services not yet delivered.
■
Sell gift cards.
■
Sell memberships or subscriptions.

Question 9

why do companies frequently hedge their foreign currency exposures using derivatives + derivative securities

Answer 9

These hedging activities act like an insurance policy to offset the income
statement effects of
realized
foreign exchange gains and losses. The derivatives and derivative
securities transfer some of the foreign-currency risk to other parties that are willing to accept that
risk for a fee. An effective hedging strategy reduces the effects of realized gains and losses and
greatly mitigates the impact on net income.

Question 10

what’s the effect of foreign currency on revenue, expenses and cash flow

Answer 10

foreign currency effects are largely translation effects and not transaction effects as sales contract are written in local currency, not always the currency that the company reports in.

strengthen currency compared to a foreign currency may lead to lower revenues + expenses

there may a change in pretax income but not a change in operation cash flows as business are conducted in local currency

including organic growth rate

Question 11

define organic growth rate

Answer 11

discuss growth of company in MD&A, organic growth excludes these foreign currency effect/effects of M&A, or opening of new stores for a retailer to isolate the core growth of the company

Question 12

why do companies use an aging analysis of receivables

Answer 12

to estimate the uncollectible amounts as the aging analysis groups A/R by number of days past due

Question 13

how to account for A/R

Answer 13

using the allowance of uncollectible accounts (allowance for doubtful accounts) to reduce gross amount of receivables that reported on B/S

Question 14

what’s an important analysis tool for A/R

Answer 14

to determine the magnitude + quality of the receivables. The relative magnitude of accounts receivable is usually measured with respect
to sales volume using either of the following ratios - A/R turnover and DSO

Question 15

what can a DSO reveal

Answer 15

DSO reveals the number of days, on average, that accounts receivable are outstanding before they
are paid. The DSO can be:
■
Compared with the company’s established credit terms to investigate if the company’s cus-
tomers are conforming to those credit terms.
■
Computed over several years for the same company to investigate trends. DSO reveals the number of days, on average, that accounts receivable are outstanding before they
are paid. The DSO can be:
■
Compared with the company’s established credit terms to investigate if the company’s cus-
tomers are conforming to those credit terms.
■
Computed over several years for the same company to investigate trends.

Question 16

why is it not favourable to have A/R grow more quicker than sales

Answer 16

Company is becoming more lenient in granting credit to its customers.
Perhaps this is
in response to greater competition, or perhaps the company is finding it difficult to maintain
sales volume and is reaching for additional volume by selling to new customers with weaker
credit scores.
■
Credit quality is deteriorating.
If existing customers are not paying on time, the level of
accounts receivable relative to the level of sales will increase. This will be highlighted in the
DSO statistic, which will increase as the percentage of receivables to sales grows.
■
Mix of products sold changes with products or customer contracts having longer pay-
ment terms.
In this case, the quality of the receivables is not in question.

Question 17

how to analyze the quality of a/r

Answer 17

focus on allowance for uncollectible accounts

Question 18

what are the interpretations to allowance for doubtful accounts decreasing for a company

Answer 18

1. Credit quality has improved.
   If AT&T believes the collectability of its receivables has
   improved, it can feel confident in allowing the allowance for uncollectible accounts to
   decline. An improvement in credit quality might be plausible given that most companies’
   liquidity improved since the pandemic.
2. Allowance account is underestimated.
   This is the more troubling of the two possibilities.
   Remember, AT&T reports bad debt expense in its income statement when it
   increases
   its allow-
   ance account. Write-offs have no effect on profit; only the estimation of the loss affects income.
   So, AT&T might be attempting to increase its profitability by not
   adding
   to the allowance
   account, and, thus, avoiding more bad debt expense.

Question 19

what are the typical deduction from I/S?

Answer 19

Cost of sales.
This is the cost Pfizer incurred to make or buy the products it sold during the
year. As goods are manufactured or purchased, the cost is recognized as inventory on the
balance sheet. The inventory remains there until the product is sold, at which time the cost is
transferred from the balance sheet into the income statement as cost of goods sold. Given that
the product is sold, revenue from the sale of the product is also added to the income statement.
The difference between revenue and cost of sales is the gross profit on the sale. We discuss
this cost together with inventories in Module 6 and the analysis of the gross profit margin
(Gross profit/Sales) in Module 3.
■
Selling, informational and administrative expense.
Usually, this expense category is
labeled Selling, general and administrative (SG&A) expense, and it includes a number of
general overhead expense categories, such as:
●
Salaries and benefits for administrative personnel and executives.
●
Rent and utilities for office facilities.
●
Marketing and selling expenses.
●
IT, legal, and accounting expenses.
●
Depreciation for Pfizer’s depreciable assets that are used for administrative purposes (we
discuss this expense together with property, plant, and equipment in Module 6).
■
Research and development expense.
This is the amount Pfizer incurs to conduct research
for new products. We discuss this cost in a separate section below.
■
Acquired in-process research and development expenses.
This represents R&D projects
that were in-process at a company that Pfizer acquired. On the acquisition date, Pfizer added
the fair value of the projects to its balance sheet like all other assets acquired. Later, when
Pfizer scaled back or abandoned the projects, the remaining balance sheet value was recog-
nized as an expense on that year’s income statement.
■
Amortization of intangible assets.
When Pfizer acquires an intangible asset, such as a pat-
ent, it amortizes that cost over the useful life of the patent (the period of time Pfizer expects
the patent to produce cash flow). Amortization expense is a noncash expense, similar to
depreciation expense. Often, it is included with the SG&A expense.
■
Restructuring charges.
This represents the cost Pfizer has incurred and expects to incur to
restructure its operations, say, by the elimination of lines of business, consolidation of opera-
tions, reduction of the number of employees, and the like. We discuss restructuring charges
in Module 6.
■
Provision for taxes on income.
The tax provision shown on the income statement relates to
Pfizer’s profit. These are taxes that will be paid to federal and state taxing authorities as well as
income taxes levied by foreign governments and municipalities. We discuss income tax expense
in a separate section below and, in greater depth, in Module 10. Other types of taxes, such as
sales tax or employment taxes, are included in SG&A and not with the income tax expense
■
Discontinued operations.
This represents the operating profit (or loss) plus the gain (or loss)
on the sale of businesses Pfizer has decided to divest.
We discuss discontinued operations in
a separate section below.
■
Income attributable to noncontrolling interest.
Noncontrolling interest arises because
Pfizer has one or more subsidiaries where Pfizer does not own 100% of the voting stock. So,
while Pfizer owns the controlling interest, other shareholders own the balance of the stock
(the noncontrolling interest). The income attributable to the noncontrolling interest is their
portion of the subsidiary’s income (and is added to the noncontrolling interest equity account
on Pfizer’s balance sheet). The remainder of the subsidiary’s net income is credited to Pfizer’s
shareholders and is added to retained earnings on Pfizer’s balance sheet. We discuss noncon-
trolling interest in greater depth in Module 9.

Question 20

what costs does R&D cost have

Answer 20

■
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. As we discuss in a later module,
research facilities are include

Question 21

how to analyze R&D

Answer 21

measure R&D expense in dollar and as a percentage of total revenue - important to compare a company’s R&D sending to its peers (benchmarks)

Question 22

what’s the challenges for analysts in developing forward looking predictions of a company’s income and cash flow

Answer 22

the challenge for analysts is two-fold; not only must we
estimate the magnitude of future revenues, but we must estimate revenue timing as well. There is
often a considerable lag between when R&D expenditures occur and when the resulting revenue
is earned. But while the income statement might suffer from such lags, the company’s market cap
reflects at least some of the future revenue related to current period R&D expenditure.

Question 23

what happens when a company acquires in-proces R&D

Answer 23

it records the acquired IPR&D as an asset
on the balance sheet. This is true whether the company purchases the IPR&D outright from
another company or acquires the company that owns the IPR&D. In the latter case, the fair value
of the IPR&D assets is recognized on the acquiring company’s balance sheet just like all other
assets of the acquired company. IPR&D assets represent indefinite-lived intangible assets that are
not amortized until the associated research and development activities are either completed (then,
the intangible assets are amortized over their remaining useful lives) or abandoned (in which case
they are written off in the year of abandonment).

Question 24

what did TCIA do and its effects

Answer 24

■
Reduced the corporate tax rate from 35% to 21%.
■
Imposed tax on all
future
income earned outside the U.S. even if the cash profits remain abroad.
■
Reduced the repatriation tax on
prior
foreign earnings to 15.5% (from 35%).

Question 25

what are 2 components of discontinued operations

Answer 25

Net income (or loss) from the segment’s business activities prior to divestiture or sale.
■
Any gain (or loss) on the sale of the business.

Question 26

why are discontinued operations segregated in the I/S?

Answer 26

discontinued operations represent transitory item (transactions/events that affect the current period but will not recur)

lthough the segregation of transitory items can help us analyze past performance to
uncover core operating profit, they are largely irrelevant to predicting future performance. This
means investors and other users tend to focus on income from continuing operations because
that is the level of profitability that is likely to
persist
(continue) into the future. Likewise, the
financial press tends to focus on income from continuing operations when it discloses corporate
earnings

Question 27

what’s a con of pro forma numbers

Answer 27

they may not be accurate representations of F/S bs they don’t follow GAAP

Question 28

what are steps to reading GAAP financials

Answer 28

Read the reports from the external auditor, and take special note of any deviation from boil-
erplate language.
■
Peruse the note on accounting policies (typically note 1), and compare the company’s policies
with its industry peers. Deviations from the norm can signal opportunism.
■
Examine changes in accounting policies. What would the company have reported absent the
change? Did the new policy help it avoid reporting a loss or violating a debt covenant?
■
Compare key ratios over time. Follow up on marked increases or decreases in ratios, read
notes and the MD&A to see how management explains such changes. Follow up on ratios that
do not change when a change is expected. For example, during the tech bubble,
Worldcom
Inc.
reported an expense-to-revenue ratio (ER ratio) of 42% quarter after quarter, despite
worsening economic conditions. Later, it was discovered that managers had deliberately
underreported expenses to maintain the ER ratio. The lesson is that sometimes no change
signals managerial intervention.
■
Review ratios of competitors, and consider macroeconomic conditions and how they have
shifted over time. Are the ratios reasonable in light of current conditions? Are changes in the
income statement aligning with changes on the balance sheet?
■
Identify nonrecurring items, and separately assess their impact on company performance and
position.
■
Recast financial statements as necessary to reflect an accounting policy(ies) that is more in
line with competitors or one that better reflects economically relevant numbers. We illustrate
recasting at several points in future modules.

Question 29

what’s the point of reporting pro forma income

Answer 29

to eliminate the transitory items to enhance year-to-year comparability

Question 30

GAAP vs IFRS in R&D costs

Answer 30

Under IFRS standard 38, companies
shall capitalize and recognize
as intangible assets, all develop-
ment costs related to products and services when the company can demonstrate the following:
■
Intangible asset’s technical feasibility;
■
Intention to complete the development of the intangible asset;
■
Ability to use or sell the intangible asset;
■
How the intangible asset will generate probable future economic benefits (for example, the
existence of a market for the output of the intangible asset or for the intangible asset itself); ■
Availability of resources to complete the development; and
■
Ability to reliably measure the related expenditures (costs pertaining to the intangible asset).
These
internally generated intangible assets
are amortized over their useful lives and periodically
assessed for impairment. As such, we observe larger intangible assets on the balance sheets of
IFRS companies.