week 4 | revenue recognition Flashcards
3 sections to analyze revenue
growth
- internal & external
quality
- Recurring vs Non-Recurring
- Customer concentration
- Seasonality vs volatility
- Gross vs Net Revenue
rev. rec. policy & changes
- consistency in rev rec
- new accounting standards (IFRS 15/ASC 606)
definition of internal & external growth
internal: growth achieved through the company’s existing operations
external: growth achieved through mergers, acquisitions, partnership or other external means
key drivers of internal & external growth
internal:
- Increased sales volume
- Price increases
- New product development
- New market w/ existing products
- Strong opportunities & huge potential CF
external: M&A
- Same industry:
- Vertical M&A: supplier, distributor
- Horizon. M&A: competitors
- When monopoly → stopped
- 70-80% of M&A result in failure → spent too much/cannot achieve synergy
- Cross-industry-diversification
- Managers want stable cash flow & reasonable benchmark for personal compensation
features/considerations of internal & external growth
internal:
- Low risk, sustainable, builds on existing strengths
- Relatively slow
external:
- Quick, immediate revenue increases
- High risk due to integration challenges, significant capital investment may increase leverage or dilute equity
difference between recurring & non-recurring revenue
recurring:
- Predictable, long term
- Link to Core Business
non-recurring:
- One time or irregular
- One time sales
- Asset sales
- Discontinued
- Need to analyze one by one to determine their impact on earnings
what happens with discontinued operations on IS?
Companies often divest of business segments
- Company reports the event at the bottom of the IS by segregating income from continuing vs discontinued operations
Companies are required to segregate the discontinued operation’s A&L on current & prior years’ BS
2 components on the discontinued operations line
- Net income/loss from segment’s business activities prior to the divestiture
- Any gain/loss on sale of business
Why Segregate Discontinued Operations?
Segregated in IS → represent a transitory item (not expected to continue)
- Transitory items won’t recur → largely irrelevant to predict future performance
Investors tend to focus on income from continuing operations → level of profitability likely to persist (continue) into the future
To be classified as a discontinued operation, the disposal of business unit must:
Represent a strategic shift for the company
Have a major effect on the company’s financial results
what is customer concentration & why is it crucial for assessing business risk?
The extent to which a company’s revenue is dependent on a small # of customers
- High customer concentration → revenue volatility if key customers reduce orders or leave
- Crucial for assessing business risk → highlights the potential vulnerability a company might face if it loses one or more major customers
describe Seasonality
- Predictable fluctuations w/ a yr, repeat consistently each year
- Interpret quarterly report carefully
- Retail, tourism, ski resorts
- Depends on economic condition (demand & supply)
- Ex. tension in middle east
describe Volatility
- Unpredictable revenue variation over time
- High volatility indicates underlying risks
- Could be one time event
- Oil & gas, commodities
types of sales allowance and what changes do they cause
Rights of return
Sales discounts (volume purchases)
Retailer promotions (point-of-sale price markdowns & other promotions)
These reduce the amount of cash the company receives
what should be done with sales allowance
Under GAAP company must report amount of cash expected to be received (NET sales)
Companies must deduct from GROSS sales the expected sales return & other allowances
- Use net but do adjustments
reporting sales allowance & the process
companies provide a reconciliation of sales allowance (sales returns & sales discounts & incentives)
process:
1. beginning balance
2. estimate sales return added
3. deduct to get actual sales return
4. ending balance
3 metrics to analyze sales allowance
- additions charged to gross sales
- measures IS amt
- reveals effects of the pricing pressure on net sales
- expect the % of sales allowance to gross sales to increase (reducing net sales) as pricing pressure increases
- allowance as percentage of gross sales
- measures BS amt
- adequacy of the allowance amount
- compares the dollar amt of estimates for future sales returns to amt actually realized (allowance is an expectation - judgement > may be adjusted)
sales allowance adjustments from estimates
- Sales allowances require estimates → managers can (and do) pad/shave estimates to help the company meet net sales or earnings targets
- Analyst seek to adjust numbers to “undo” any deliberate variation across years
- To adjust numbers:
- Estimate an “average” rate of additions charged (IS #) to the Gross Sales
- Apply that average rate to determine adjusted amounts for the related BS & IS accounts
- Average won’t change the sum
- Hard to adjust BS cuz cumulative → judge the prior 2 years (?)
revenue recognition (5 steps)
- Identify the contract(s) w/ the customer
- Parties to the contract should be identifiable
- Terms of the sale should be specified - Identify the performance obligation(s) in the contract
- PO is a contractual promise to transfer a good/service to the customer
- Contracts w/ more than 1 good/service, company must identify separate PO for each contractual promise - Determine the transaction price
- If the selling price is variable, estimate revenue using the expected selling price - Allocate the transaction price to the performance obligation(s)
- Contracts w/ more than 1 PO, 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 - Recognize revenue as/when each performance obligation is satisfied
- PO satisfied when the customer obtains control of the goods/services
- PO satisfied over a period of time should be recognized as revenue over time
when will gift card revenue be recognized?
Gift card revenue is recognized when something is purchased using that gift card
unearned (deferred) revenue
Deposits or advance payments are not recorded as revenue until the company performs the services owed or delivers the goods
Companies must record a liability (unearned revenue) → the company is obligated to deliver those products & services
When the good is provided/service rendered → unearned revenue liability is reduced & revenue is recognized
Unearned revenue is particularly common among companies that:
Receive advance payments from customers
Sell gift cards
- Recognized when used to purchase items
Sell memberships or subscriptions
Deferred revenue decrease
Company’s current reported revenue was collected from customers in a prior period
Fewer new prepayments of revenue will be recognized in the future
Trend could predict future declines in revenue & profit
Deferred revenue increase
Predict future increases in revenue & profit
Accounts Receivable & what does GAAP require?
Selling goods on account carries the risk that some customers are unable to the amount due
GAAP requires companies to estimate the amount of receivables likely to be uncollectible & to report only the net collectible amount
Aging Analysis of Receivables
Firms frequently employ aging analysis to estimate uncollectible accounts
Aging analysis groups accounts receivable by # of days past due
Write-off of Uncollectible Account
Assume a customer who owes the company $500 files for bankruptcy
If the company determines the receivable is now uncollectible, the company records a “write-off” & adjusts the allowance
AR down $500
AFDA down $500
The magnitude of A/R is measured w/ 2 ratios
a/r turnover & DSO
AR turnover formula
sales / average AR
dso formula
days sales outstanding = 365 days / AR turnover
what does DSO show
DSO reveals the # of days (on average) that A/R are outstanding before paid
what is DSO used for
Compared w/ the company’s established credit terms to investigate if the company’s customers are conforming to those credit terms
Computed over several years for the same company to investigate trends
Compared w/ peer companies
Evidence that A/R have grown more quickly than sales:
Lower A/R turnover
Higher percentage of A/R to sales
Lengthening of the DSO (lower DSO is better)
AR growing faster than sales is not favourable for 3 possible reasons
Company is becoming more lenient in granting credit to its customers
Credit quality is deteriorating
Mix of products sold changes w/ products/customer contracts having longer payment terms
2 possible interpretations for the decrease in allowance
Credit quality has improved
The company is underestimating the allowance account
