MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski Hassell
MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell Electronic presentation adaptation by Dr. 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.
F. O. B. Points • 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.
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) GAAP • Types of changes – Changes in estimate – Changes in accounting principle/method – Changes in reporting entity 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 - Pf. D W where, NI = Net Income Pf. D = Preferred Dividends W = Weighted average number of common shares outstanding
Complex Capital Structure Basic EPS = NI - Pf. D W where, NI = Net Income Pf. D = Preferred Dividends W = Weighted average number of common shares outstanding
Complex Capital Structure Diluted EPS = NI - Pf. D + 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
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