Financial Reporting and Analysis

-Session 4-

Professor Raluca Ratiu, PhD

 Problem 2 Solution

Dollar $ Component
 
Amount Percentages %
Sales revenue 200,000  100% 
Cost of goods sold 80,000  40%
Gross profit 120,000 60% 
Operating expenses 101,000  50.5% 
Interest expense 4,000  2%
Income before income tax 15,000   7.5%
Income tax expense (rate 20%) 3,000   1.5%
Net income 12,000  6%
Reporting and Analyzing Revenues, Receivables, and
Operating Income

-Chapter 6-
 Reporting Operating Income

Income statement information is used to:

 Predict future performance for investment
purposes
 Assess the creditworthiness of a company
 Evaluate the quality of management

The income statement attempts to answer the following:

How profitable is the company?

How did it achieve that profitability?
Will the current profitability level persist?
Income Statement Classifications

Income Statement Classifications

Reporting Operating Income

Operating
activities
• The primary
transactions and
events of a
company
• Separated from
nonoperating
activities on the
statement
 Revenue Recognition Issues
 Revenue is an important measure of customers’ response to a
company’s offerings of products and/or services

 Revenue recognition can be subject to manipulation by

management when attempting to meet performance targets

 SEC is often concerned about premature revenue recognition

 Footnote disclosures are an important tool for investors

 Revenue Recognition
 Concern about premature revenue recognition
 The FASB- Accounting Standard Codification 606
and the IASB- International Financial Reporting
Standard 15 have issued NEW, converged revenue
standards, effective Jan 31, 2018 for publicly
traded companies
 Revenue Recognition Standard
There are five steps to be followed in implementing
that core standard:
 Step 1: Identify the contract with the customer
 Step 2: Identify the performance obligations in the
contract
 Step 3: Determine the transaction price
 Step 4: Allocate the transaction price to the performance
obligations
 Step 5: Recognize revenue when or as the entity satisfies
a performance obligation
 Step 1: Identify the Contract with a Customer

 Existence of a “contract” may involve – but does not

require – a legal document

 Based on normal business practices, e.g., might be an

oral agreement or a legal document

 But, the contract should create enforceable rights

and obligations
 Step 2: Identify the Performance Obligations in
the Contract

 Identify distinct performance obligations

 These are the “deliverables” that the company agrees

to provide to the customer

 Each performance obligation should be distinct,

i.e., capable of providing benefits on its own or in
combination with readily available resources

 Becomes the “unit of account”

 Step 3: Determine the Transaction Price

 The amount to which the seller expects to be entitled

when the contract performance obligations are
fulfilled

 Includes variable consideration

 Price concessions, volume discounts, credits, performance
bonuses, royalties, etc
 Requires estimates by management prior to completion of
the contract
 Step 4: Allocate the Transaction Price to
Performance Obligations

 Required if there are multiple performance

obligations

 Based on Stand-alone Selling Prices (SSPs) of the

performance obligations
 If SSPs are not available, then they must be estimated

 Allocate total transaction price based on the

individual SSPs
 Step 5: Recognize Revenue when (or as) the
Seller Satisfies a Performance Obligation

 Performance obligation is satisfied when the

customer obtains control of the product or service

 i.e, when the customer obtains the ability to direct the use
and obtain substantially all of the remaining benefits

 This condition may be satisfied over time or at a point in time

 Revenue Recognition Subsequent to
Customer Purchase

 Customers often purchase products or services prior

to delivery

 Amounts paid in advance by customers are

recognized as a liability
• Unearned (deferred) revenue

 Examples
• Magazine or newspaper subscriptions
• Season tickets to football or basketball games
• Rental income
 Bundled Sales

 Two or more products or services are sold under

the same sales agreement for one lump-sum price
• AKA, multiple element arrangements

 Commonplace in software industry where

software, training, maintenance, and customer
support are bundled together

Reporting standards require the sales price be allocated among

the various elements of the sale in proportion to their fair value.
Bundled Sales
Allocation of the Sales Price in Bundled Sales
 Revenue recognition long term projects
Percentage-of-Completion (The input
method)
 Special revenue recognition required for projects that
cover a long time period to complete
 Revenue is recognized using percentage-of-completion
method
• Recognizes revenue based on the costs incurred under the
contract relative to its total expected costs
• Matching principle requires that related costs be recognized
in the same period as the associated revenue

Examples
Highway construction
Buildings
Ships
Defense contracts
 Percentage-of-Completion Example
Haskell Construction signed a $8,000,000 contract to
build a new library. Cost information:
Year 1 Year 2
Costs Incurred During the Year $1,800,000 $4,200,000

Expense
Year Percentage Completed Revenue Recognized Recognized Gross Profit

$1,800,000/$6,000,000 = $8,000,000 × 30% =

1 30% $2,400,000 $1,800,000 $600,000

$4,200,000/$6,000,000 = $8,000,000 × 70% =

2 70% $5,600,000 4,200,000 1,400,000

$6,000,000 $2,000,000

Haskell would recognize $600,000 (30%) of gross

profit in year 1 and $1,400,000 in year 2 (70%).
 Percentage-of-Completion

 Requirements to use percentage-of-completion

• Company must have a signed contract with the
customer
• Contract must specify a fixed or determinable price
• Project costs must be reasonably estimable

If all 3 requirements are not met:

1) Defer all revenue until completion,
and
2) Use the completed contract method
 Completed Contract Method
Example

Haskell Construction signed a $8,000,000 contract to

build a new library. Cost information:
Year 1 Year 2
Costs Incurred During the Year $1,800,000 $4,200,000

Expense
Year Revenue Recognized Recognized Gross Profit
1 $0 $ 0 $ 0
2 $8,000,000 6,000,000 2,000,000
$6,000,000 $2,000,000

Haskell would recognize no gross profit in year 1

and $2,000,000 in year 2 (100%).
 Comparing Long-Term Contract Methods
Total gross profit and total revenue are the same
over the two-year period under both methods:
 Percentage-of-completion
 Completed contract

Percentage-of-Completion Method Completed Contract Method

  Year 1 Year 2 Year 1 Year 2
Revenues $2,400,000 $5,600,000 $0 $8,000,000
Expenses 1,800,000 4,200,000 0 6,000,000

Gross profit $ 600,000 $1,400,000 $0 $2,000,000

Only difference in the two methods is when the

revenue and gross profit are recognized
 Earnings Management
 Occurs when management uses discretion to mask
the underlying economic performance of a company
 Two motives for earnings management

The desire to mislead The desire to

some financial influence legal
statement users about contracts that use
the financial reported accounting
performance of the numbers to specify
company to gain contractual obligations
economic advantage and outcomes
 Earnings Management Tactics

 Overly optimistic or pessimistic estimates

• Extensive use of estimates in accrual accounting
• Examples
 Revenue recognition timing
 Depreciation expense useful lives and salvage values
 Bad debts expense
 Channel Stuffing

 Arises when a company uses its market power over

customers to induce them to purchase more goods
than necessary to meet immediate needs
 Usually occurs immediately before the end of a seller’s
accounting period
 Causes seller’s revenue to increase

Revenue can be recognized as long as special

arrangements for returns have not been made.
 Earnings Management Tactics

 Strategic timing of nonrecurring gains and losses

 Arise under management’s discretion in reporting
certain amounts
 Income smoothing
• Occurs when management times gains or losses in
order to maintain a steady improvement in income
each year
 Big bath
• Occurs when management reports the recognition of
a nonrecurring loss in a period of already depressed
income
 Recognizing Earnings Management- exercise

Twelve years ago, Cleaver Construction began operating out of a

new building that cost $21 million to construct. At that time,
Cleaver’s management estimated the building had a useful life of 30
years. Today (or twelve years later), management revised its estimate
of the useful life of the building to 36 years, which will reduce
annual depreciation expense to $525,000.
 
A. How would the change in the estimated useful life of the
building impact Cleaver’s income statement?
B. What possible incentives might management have to
overestimate or underestimate the useful life of a long-term asset?
 Recognizing Earnings Management- solution

Answer:
A. For the first 12 years, annual depreciation expense was
$21 million divided by 30 years, or $700,000 per year.
The income statement would show only $525,000
instead of $700,000 expense which would result in a
larger net income amount.
B. By manipulating the useful life of an asset, management
can effectively manage earnings to meet earnings targets
and achieve desired earnings growth. If the useful life is
overestimated, a loss will be recorded when the under-
depreciated asset is sold. If the useful life is
underestimated, lower earnings will be reported and a
potential gain will be recorded when the over-depreciated
asset is sold.
 Accounts Receivable and the
Collectability of Receivables Risk

 Accounts receivable are an asset consisting of

claims held against customers for money, goods
or services
 Risk of selling on credit is possible nonpayment
 Companies establish credit policies to determine
which customers receive credit
• Expected losses are weighed against expected
profits generated by offering credit

Accounting standards require companies to estimate the

dollar amount of uncollectible accounts for financial
reporting purposes.
 Types of Receivables

 Trade receivables:
• Accounts Receivable: Amounts customers
owe on account that result from the sale of
goods and services
• Notes Receivable: Written promise (formal
instrument) for amount to be received.
Normally requires the collection of interest

 Other Receivables: Nontrade receivables such

as interest, loans to officers, advances to
employees, and income taxes refundable
 Reporting Accounts Receivable

Amazon.com’s current asset section of its balance

sheet reports a net realizable value of receivables
equal to $16,677 million.
 Reporting Accounts Receivable

Alternative Reporting Format

(Allowance information obtained from the financial statement notes.)

Accounts receivable, gross $17,172

Less allowance for doubtful accounts 495
Net realizable value $16,677
 Allowance for Uncollectible Accounts

 Represents the amount a company expects that

its customers will not pay
 Can be estimated based on
• An aging analysis
 Focuses on receivables owed by customers that
might be uncollectible
• Percentage of sales
 Focuses on potentially uncollectible accounts
among current period sales

Generally, the longer past due an account receivable is,

the more likely it is to be uncollectible.
 Aging of Accounts Receivable Example

A seller classified its receivable balances based

on age and provided estimates of uncollectible
amounts:
Estimated % Estimated
Age of Accounts Receivable Receivable Balance Uncollectible Uncollectibles
Current $41,000 1.0% $ 410
1-60 days past due 32,000 3.0% 960
61-90 days past due 16,500 4.5% 743
Over 90 days past due 8,700 11.0% 957
Total $98,200 $3,070

Each balance is In this example, the company

multiplied by its
estimates that $3,070 out of the
estimated
uncollectible
$98,200 in Accounts Receivable will
percentage. prove uncollectible.
 Percentage of Sales Example
A seller estimates that 2.3% of its sales revenue will be
uncollectible for the current year. Sales totaled
$156,000. The uncollectible amount is:

$156,000 × 2.3% = $3,588

In this example, the company estimates that $3,588

will prove uncollectible.

While easier than the aging analysis method, it is

less accurate as it assigns the same percentage to all
sales amounts.
 Reporting the Allowance for Uncollectible Accounts
1. Recording Sales on Account
Sales for the year totaled $560,000
  Balance Sheet   Income Statement
Noncash Contrib. Earned Net
Transaction Cash Asset+ Asset = Liabilities + Capital + Capital   Revenues – Expenses = Income
Sell $560,000 +560,000 +560,000   +560,000 +560,00
of sales on Accounts = Retained Sales ‒ =0
account Receivable Earnings Revenue

Accounts receivable (+A) 560,000  

Sales (+R, +SE)   560,000

Accounts Receivable (A) Sales Revenue ( R)  

560,000 560,000
 2. Recording Estimated Bad Debt Expense
A seller classified its $98,200 receivable balance based
on age and calculated the amount to be uncollectible as
$3,070.
    Income Statement
Cash Noncash Contra Liabilitie Contrib Earned Net
Transaction Asset + Asset ‒ Asset = s + . + Capital   Revenues – Expenses = Income
Capital
Estimate +3,070 –3,070   +3,070 –3,070
bad debt ‒Allowance = Retained ‒ Bad Debts =
expense for for Earnings Expense
the year Uncollecti (provision
ble for
Accounts uncollectible
accounts)

Bad debt expense (+E, –SE) 3,070  

Allowance for uncollectible accounts (+XA, –A)   3,070

Allowance for Uncollectible
Bad Debts Expense (E) Accounts (XA)
3,070 3,070
 3. Recording Write-offs of Uncollectible Accounts
During the next accounting period, the seller determined
that customers owing $2,100 were not going to pay. The
accounts were written off.
    Income Statement
Cash Noncash Contra Liabilitie Contrib Earned Net
Transaction + ‒ = + . +   Revenues – Expenses =
Asset Asset Asset s Capital Capital Income
Write off –2,100 –2,100  
$2,100 in Accounts ‒ Allowance = ‒ =
accounts Receivabl for
receivable e Uncollecti
ble
Accounts

Allowance for uncollectible accounts (–XA, +A) 2,100  

Accounts receivable (–A)   2,100

Allowance for Uncollectible Accounts

(XA) Accounts Receivable (A)

2,100 2,100
 Effects of a Receivable Write-Off

The write-off causes assets to increase and decrease by

the same amount:
Before Write- Effects on After Account
Off Write-Off Write-Off
Accounts receivable $98,200 $(2,100) $96,100
Less Allowance for uncollectible accounts 3,070 2,100. 970
Accounts receivable, net of allowance $95,130 $(0) $95,130

No change occurs to the net realizable value of

receivables.
 Receivables Footnote Disclosure

Following is an excerpt from Amazon.com’s 2018 footnote

disclosure concerning its receivables:
Accounts Receivable, Net and Other
Included in “Accounts receivable, net and other” on our consolidated balance
sheets are amounts primarily related to customers, vendors, and sellers. As of
December 31, 2017 and 2018, customer receivables, net, were $6.4 billion and
$9.4 billion, vendor receivables, net, were $2.6 billion and $3.2 billion, and seller
receivables, net, were $692 million and $710 million. Seller receivables are
amounts due from sellers related to our seller lending program, which provides
funding to sellers primarily to procure inventory.
We estimate losses on receivables based on known troubled accounts and
historical experience of losses incurred. Receivables are considered impaired
and written-off when it is probable that all contractual payments due will not be
collected in accordance with the terms of the agreement. The allowance for
doubtful accounts was $237 million, $348 million, and $495 million as of
December 31, 2016, 2017, and 2018. Additions to the allowance were $451
million, $626 million, and $878 million, and deductions to the allowance were
$403 million, $515 million, and $731 million in 2016, 2017, and 2018.
 Useful Accounting Transactions

 Recording Sales on Account:

• Accounts receivable (+A) = Sales (+R, +SE)

 Recording Estimated Bad Debt Expense into the Allowance

for Uncollectible Accounts
• Bad debt expense (+E, –SE) = Allowance for uncollectible
accounts (+XA, –A)

 Recording Write-offs of Uncollectible Accounts

• Allowance for uncollectible accounts (–XA, +A) = Accounts
receivable (–A)
 Recording Receivables Payment
• Cash (+A) = Accounts receivable (-A)
 Pledging and Factoring Receivables

 Pledging
• Using receivables as collateral for a loan
• A short-term loan is also presented in the liabilities
section of the balance sheet

 Factoring
• Selling receivables to a bank or other financial institution
• Receivables are removed from the balance sheet if sold

Disclosed in financial statement notes

 Shifting Income

 Allowance account sometimes used by managers to

shift income from one year into another
 Cookie jar reserve is created

2019 2020

Bad debt expense Less bad debt

overestimated in expense required
2019 creating a during 2020 to show
bigger expense higher profits
 Insight into Changes in the Allowance Account

Found in the Notes to the Financial statements

and/or MD&A section of a company’s 10-K report
• Explains changes in company policies, customers,
economic conditions, etc.
• Helps explain changes in the allowance account for
financial statement users

Ultimately the amount in the allowance account is

controlled by management
Calculate accounts receivable turnover
and average collection period.
 Accounts Receivable Turnover (ART)
Reflects the efficiency with which a firm collects on the
credit it issues to its customers. Shows the number of
times each year that accounts receivable is converted
into cash.
Accounts
Sales Revenue
Receivable =
Average Accounts Receivable
Turnover
Amazon’s ART for 2017 and 2018
$177,866
ART(2017) = = 11.92 times
[$13,164 + 16,677]/2
$232,887
ART(2018) = = 21.66 times
[$8,339+ $13,164]/2
Amazon collected its receivable balance almost 12 times
during 2017 and almost 22 times in 2018.
 Comparison of Accounts
Receivable Turnover

Competitors and their receivable turnovers:

Higher receivable turnover implies amounts are

being collected more quickly.
 Average Collection Period

Reflects how long (how many days), on average, a

company takes to collects its outstanding receivables
Also called Days Sales Outstanding (DSO)
Average Average Accounts Receivable 365 days
Collection = Average Daily Sales = ART
Period
Amazon’s DSO for 2018

365 days 16.85

21.66 = days

Amazon collects its receivable balance

every 17 days, on average.
 Insights on Receivables
Receivables turnover and the average collection period
provide insight into
• Receivables quality
 What is occurring if turnover slows?
o Deterioration in collectibility may be occurring
o Seller may have extended its credit terms
o Seller may be taking on longer paying customers
o Seller may need to increase the allowance account balance
• Asset utilization
 Asset turnover indicates efficiency and productivity
 AR Problems 1
1. Mouser, Inc. provided the following aging of its receivables at December 31.

During the year, $12,512 of receivables were written off. The balance at the
beginning of the year in the allowance account was $ 11,880.
 
A. How much will Mouser report as bad debt expense for the year?
B. How much is the net realizable value of Mouser’s receivables at year end?
AR Problems 1
 AR Problems 2
2. Alliance Auto estimated uncollectible accounts receivable at December 31,
2015 at $6,744, based on estimates on various ages of receivables and before
learning of the bankruptcy of one of its customers. The customer owed $2,680,
and the legal department has estimated costs to collect the balance owed by this
customer at $4,000. The gross receivables balance on December 31, 2015 after
write-offs is $168,600, and the allowance of uncollectible accounts balance is
$7,240 at December 31, 2014. At December 12, 2015, the company wrote off
$3,400 other accounts deemed uncollectible.
 
A.How would the legal department advise Alliance Auto to handle the collection
of the $2,680?
B. Draw a t-account for Allowance for Uncollectible Accounts and post all 2015
amounts to it, assuming that both the $3,400 and $2,680 have been written off.
C. What is the effect of the $3,400 write off on gross and net accounts receivable?
AR Problems 2