Week 4 - Revenue Recognition Flashcards
Analysis of Revenue Includes
Growth
- internal and external
quality:
- recurring vs non-recurring
- customer concentration
- seasonality vs volatility
- gross vs net revenue
revenue recognition policy changes
- consistency in revenue recognition
- new accounting standards (IFRS 15 or ASC 606)
What are the drivers and features of internal growth
Definition: Growth achieved through the company’s existing operations
Drivers:
- increased sales volume
- price increases
- new product development
- new market with existing products
Features
- low risk, sustainable, and builds on existing strengths
- relatively slow
what are the drivers and considerations about external growth
Definition: Growth achieved through mergers, acquisitions, partnership or other external means
Drivers:
Mergers and Acquisitions
- same industry: (vertical M&A - supplier, distributer) (horizontal M&A - competitors)
- cross-industry: diversification
considerations
- quick, immediate revenue increase
- high risk due to integration challenges
what happens when a company discontinues 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
Companies are also required to segregate the discontinued
operation’s assets and liabilities on the current and prior years’
balance sheets
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, are largely irrelevant
to predicting future performance
what is customer concentration
Definition: the extent to which a company’s revenue
is dependent on a small number of customers
- high concentration = revenue volatility
- would be difficult if they lose major customers
seasonality vs volatility
seasonality
- predictable fluctuations
- interpret quarterly report carefully
Volatility
- unpredictable revenue over time
- high volatility could indicate underlying risks
- could be one time event
What are Sales Allowances
- rights of return
- sales discounts
- retailer promotions
Adj alloance:
DR. sales returns and allowance (RE)
CR. Allowance for returns (A)
Adj COGS
DR. COGS adj returns (RE)
CR. Inventory (A)
How to analyze sales allowances
- additions charged to Gross Sales
- allowance as a percentage of gross sales
- adequacy of the allowance amount
What are the steps in the revenue recognition rule
- identify contracts
- identify performance obligations
- determine the transaction price
- allocate transaction price to each obligation
- recognize revenue when each performance obligation is satisfied
what is Unearned (differed) revenue
- when receive cash before revenue is recorded
- recorded as unearned revenue (Liability)
- when the service or product is provided revenue is recognized and the liability is reduced
Analysis of Unearned revenue: what does it mean when it decreases or increases
decreases - the company’s current reported revenue was collected from prior periods
growth - could predict future increases in revenue and profit
what does it mean to sell goods on account
Selling goods on account carries the risk that some customers are unable to pay the amount due
Accounts receivable turnover
= sales / Avg Ar
Days Sales Outstanding DSO
= 365 / Accounts receivable turnover
DSO reveals the number of days, on average, that accounts receivable are
outstanding before they are paid.
what is evidence that AR has grown more quickly than sales
- lower AR turnover
- higher AR/sales
- lengthening of DSO
- more favorable to have a shorter DSO
- could result from deteriorating credit quality, or mix of products changes to have longer payment terms
what does a decrease in AR mean
- improving credit quality
- company is understating their allowance for doubtful accounts
What is the importance of analyzing DSO
Important for measuring the efficiency of a
company’s credit and collection policies. High DSO might indicate problems in
collecting receivables, which can impact cash flow
what is the importance of analyzing AR aging
Crucial for assessing the risk of bad debts. It provides insight
into how long receivables have been outstanding and whether the company might face
difficulties in collecting them
what is the importance of analyzing Sales Allowance Trends
Important for understanding the company’s customer
satisfaction and pricing strategy. Increasing sales allowances could signal problems
like poor product quality or aggressive discounting strategies
What is the importance of analyzing the Allowance for Doubtful Accounts
Essential for assessing whether the company is
adequately prepared for potential bad debts. Underestimating this allowance could
inflate reported profits and mislead stakeholders
what are the 3 methods of depreciation
Straight Line
Double Declining Balance
Units of Production
when to use each of the 3 methods of depreciation
SL - best for assets that generate revenue evenly
UP - best for assets that wear out because of use
DDB- best for assets that generate revenue early in useful life
how to calculate depreciation expense for SL method
= (cost - Residual value) / useful life
how to calculate depreciation for UP method
depreciation per unit = (cost - Residual value) / useful life in units
depreciation expense = depreciation per unit * units in a year
how to calculate depreciation expense for DDB method
= carrying amount * 2/useful life
how to calculate the gain or loss on the sale of an asset
= proceeds from sale - NBV of asset
NBV = acquisition cost - accumulated depreciation
analysis on gain or loss on sale of asset
*a gain suggests that too much depreciation was recorded
*a loss suggests that not enough depreciation was recorded
you can say that we misstated the depreciation (in hindsight)
what can you do to adjust for gains/loss on sale of asset
- do nothing
- adjust prior period by allocating gain/loss over the misstated periods
what accounts on the income statement would you adjust for a gain/loss on sale of asset
depreciation expense = gain or loss / years
tax expense = gain or loss * tax rate /year
Net Income = depreciation expense per year - tax expense per year
what Balance Sheet accounts would you adjust for a gain/loss on sale of assets
Accumulated Depreciation = gain or loss / years
Differed tax liabilities = gain or loss * tax rate / years
Retained earnings = accumulated depreciation per year - differed tax liabilities per year
Note: this balance accumulates over the years; so by the time you get to the current year the adjustment is 0
what does it mean when an asset is impaired
the sum of expected cash flows is less than NBV of asset
IF the asset value is deemed to be permanently impaired
then, the company must write off the impaired cost and recognize
losses
why would a company restructure?
- poor performance
- mounting debt
- shareholder pressure
what does restructuring involve
- eliminating business segments
- selling major assets
- downsizing workforce
- refiguring debt
GOAL: better long-term financial performance
what are the 3 components of restructuring
- employee severances
- asset write-downs
- other costs
how do you adjust for employee severances or relocation costs
- estimate total cost of terminating or relocating employees
- report total cost as an expense and liability in the period the restructuring is announced
*subsequent payments to employees reduce restructuring accrual (liability)
how do you adjust for asset write downs
Fair value < book value
could include:
- PPE
- intangibles (goodwill)
- inventories
*has no cash flow effects unless it has tax consequences
what income statement and balance sheet accounts need to be adjusted for employee termination costs
INCOME STATEMENT:
Wages expense increase = total termination cost / years
pretax income decrease = total termination cost / years
tax expense decrease = total termination cost * tax rate / years
total net income = wages expense increase per year - tax expense decrease per year
BALANCE SHEET:
Wages payable increase = total termination cost / years
differed tax assets increase = total termination cost * tax rate / years
(use differed tax assets because tax expense decreased)
Retained earnings = wages payable increase per year - differed tax assets increase per year
Balance Sheet Note: this balance accumulates over the years; so by the time you get to the current year the adjustment is 0
what income statement and balance sheet items need to be adjusted for restructuring impairment changes
INCOME STATEMENT:
depreciation expense increase = total impairment cost / years
pretax income decrease = total impairment cost / years
tax expense decrease = total impairment cost * tax rate / years
total net income = depreciation expense increase per year - tax expense decrease per year
BALANCE SHEET:
Accumulated depreciation increase = total impairment cost / years
differed tax assets increase = total impairment cost * tax rate / years
(use differed tax assets because tax expense decreased)
Retained earnings = accumulated depreciation increase per year - differed tax assets increase per year
Balance Sheet Note: this balance accumulates over the years; so by the time you get to the current year the adjustment is 0
what is PPE turnover
A crucial issue in analyzing PP&E is determining productivity
(utilization)
= sales / average PPE net
Higher PP&E turnover is preferable because it implies a lower capital
investment for a given level of sales
Increases profitability because
- avoid asset carrying costs
- freed-up assets can generate operating cash flow
PP&E turnover is
lower for capital-
intensive firms
and higher for
companies in
service or IT
PPE useful life (assuming SL depreciation)
= average depreciable asset cost / depreciation expense
average depreciable cost = (PPE year 1 less land and construction in progress + PPE year 2 less land and construction in progress) /2
how to calculate percent used up
Percent used up measures the proportion of a company’s
depreciable assets that have already been “used up” that is,
transferred to the income statement
= accumulated depreciation / depreciable asset cost
Knowing the degree to which a company’s assets are used up is
of interest in forecasting future cash flows
We also expect that older assets are less efficient and will incur higher maintenance costs
how can you adjust for ROU assets
Analysts can adjust PP&E turnover by adding ROU assets to
PP&E and calculating an adjusted PP&E turnover
We must check notes to determine the size of ROU and finance lease
assets
