Chapter 5 Income Recognition and Asset Valuation

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Chapter 5 Income Recognition and Asset Valuation
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Opportunities for Earnings Management
Operating Cycle for a Manufacturing Firm
Acquisition of Raw Materials, Plant, and
Equipment
Collection of Cash
Sale of Product
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Revenue Recognition

• Criteria for recognition
• earned
• measurable
• Problems in recognition
• uncertainty of total amount of revenue
• uncertainty in timing of the amount
• uncertainty in the amount of related expenses

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Timing of recognition

• Recognition is normally at the point of sale, but
  other possibilities exist
• Percentage of completion
• Completed contract
• Installment sales method
• Cost-recovery method
• Firms using different methods are not directly
  comparable

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Expense Recognition

• Product costs - recognize when goods are sold
• Period expenses - recognize in period incurred
• Discretionary period expenses are often
  susceptible to management
• r d
• advertising
• maintenance and repairs
• Changes in levels - whether in absolute dollars
  or as a percentage of sales - bear investigation

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Detecting Earnings Management

• Early sales recognition
• large and/or volatile uncollectibles
• increase in receivable days outstanding
• increase in sales returns
• decrease in warranty expenditures
• To be effective, ratios must be interpreted as a
  unit

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Inventory Cost Flows

• FIFO, LIFO and Average costing flow different
  costs through the income statement and leave
  different costs on the balance sheet
• Differences can be significant if
• prices are not stable
• inventory turnover is slow or moderate (less than
  four turns per year)

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Affect on the Financial Statements

• Current amounts are higher quality measures
• Income Balance
• Statement Sheet
• FIFO Not Current Current
• LIFO Current Not Current
• In periods of rising prices, LIFO produces lower
  income (and lower taxes!) and lower inventory
  numbers

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Adjusting for inventory affects

• LIFO liquidations
• can create significant distortions in income
• Inventory turnover ratio, number of days of
  inventory, current ratio
• better when calculated using FIFO
• Most non-U.S. firms use FIFO

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Asset valuation

• Compromise from many directions
• historical cost
• estimates of useful life
• estimates of salvage value
• depreciation method
• Intangible assets
• variation in treatment when developed internally
  vs. when purchased

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To be continued...