Some Issues in Accounting and Implications for FSA

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Some Issues in Accounting and Implications for FSA

• Lecture 6

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Topics

• Revenue and expense recognition
• Inventory cost-flow assumption
• Accounting for fixed assets
• Accounting for intangible assets

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Revenue recognition

• Considered one of the most important issues in
  financial reporting by policy makers
• Despite many rulings, firms appear to have some
  discretion on when and how they recognize
  revenues
• Important to an analyst because an analyst has to
  determine the quality and the sustainability of
  revenues over time

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Regulatory concern
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Revenue recognition

• Under the accrual basis of accounting, the
  principles are clear Recognize revenue when
• Services are provided (all or substantial
  portion), and
• Benefits are realized or realizable
• Issues arise with respect to the determination of
• What constitutes a service
• When services (or a substantial portion of
  services) have been provided
• What is considered realizable
• Analyst must assess whether these determinations
  are appropriate
• Time of sale recognition most common

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Issues with time of sale recognition

• May be too early if
• High uncollectible receivables
• Increase in receivable days outstanding
• High returned goods
• Excessive warranty expenses
• The practice is to book sales upon receipt of a
  customer order, and not the delivery of the
  product

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Expense recognition

• The matching principle
• Expense costs directly associated with revenues
  in the period in which revenues are recognized
• Otherwise, treat them as period expenses
• Again, firms have some latitude with respect to
  many items such as
• Depreciation
• Bad debt expense
• Warranty expense

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Book examples

• Xerox
• Bundles
• Revenues from leasing copiers
• Revenues from maintenance services
• Photocopying paper (up to minimum usage)
• Financing
• What should Xerox be doing?
• Analyst must have a good understanding of a
  companys revenue recognition methods
• Metropolitan Life Insurance company
• Receive cash from premiums and investments
• Invest in readily marketable securities
• Issues
• When to recognize revenue and what to do with
  unrealized gains/losses from marketable
  securities?
• Expenses are selling and administrative costs and
  the face value of the policy. How should these
  expenses be recognized?

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Examples

• Microstrategy (Software company)
• Providers of customized software
• Two revenue components
• Use of software over the contract period
• Service in the form of training
• What are the revenue recognition issues?
• Walgreen
• Recognition of rebates from suppliers
• Recognize rebates when realized or based on
  estimates?

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Revenue recognition when cash collectibility is
uncertain

• Typically delay revenue recognition when the cash
  is received, or when the uncertainty goes down
  substantially. Examples
• Installment method
• Cost recovery method

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Income recognition other than at the time of sale

• Income recognition for long-term contractors
• Percentage-of-completion method
• Income recognition spread over the period that
  the contract spans
• Contract in process account reflects this income
  recognition
• Completed contract method
• Income recognition at the end of the contract
  period
• Contract in process account valued at cost
• When to use each method?

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More on managing revenues

• Analysts often issue both earnings and revenue
  forecasts. Market appears to focus on both of
  them
• Earnings announcements that provide a discussion
  of both earnings and revenue performance are easy
  to find. The following are two such examples
• ..At 21 billion, IBMs first quarter revenue
  rose 8.8 percent from the 19.3 billion it
  reported during the same period a year earlier
  and was slightly above the 20.8 billion analysts
  had generally expected, according to the First
  Call survey. (IBM meets the Street, CNNFN,
  April 18, 2001, 439PM ET).
• ..HP posted sales of 12.0 billion in the
  year-ago quarter, and 11.9 billion in its first
  fiscal quarter. First Calls forecast had called
  for the companys revenues to rise to 12.2
  billion in the current quarter. (HP warns about
  2Q results, CNNFN, April 18, 2001, 1115AM ET).
• Evidence indicates that
• Typically, market reacts positively if firms meet
  earnings forecasts, but not always!
• Electronic Data Systems announced a significant
  increase in 4th quarter earnings relative to the
  previous year. The earnings exceeded the
  analysts consensus earnings forecast by two
  cents per share. However, on the day of the
  announcement when the DJIA increased 119 points
  (1.2), the companys stock price decreased 4.7
  percent. The reason stated by analysts was that
  revenues increased by only 13 percent, which was
  below expectations of 17 percent.

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More on managing revenues

• Rees and Sivaramakrishnan (2005)
• There is a significant increase in market
  response to meeting earnings forecasts when
  revenue forecasts are met.
• There is a significant reduction is market
  response to meeting earnings forecasts when
  revenue forecasts are not met.
• There is a significant attenuation in market
  penalty to missing earnings forecasts when
  revenue forecasts are met.
• There is a significant increase is market penalty
  to missing earnings forecasts when revenue
  forecasts are not met.
• No wonder managers are worried about meeting
  revenue benchmarks

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Regulatory response

• Staff Accounting Bulletin (SAB) 101 issued by SEC
• To curb premature recognition of revenues as a
  mechanism for managing earnings to meet Wall
  Street Expectations
• Improper revenue recognition is the largest
  single issue in restatements of financial
  statements
• Requires restatements by focusing on revenue
  recognition practices

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Regulatory response
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Regulatory response
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Regulatory response

• Question Is there a detectable difference in a
  firms ability to manage earnings before and
  after the implementation of SAB 101?
• A study by Altumoro, Beatty and Weber (2002)

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Altumoro, Beatty and Weber (2002)

• Study a sample of firms that recorded cumulative
  effects adjustments because of SAB 101
• Compare with sample of firms matched on industry
  and assets that did not have to restate (control
  firms)
• Find that
• Restating firms had greater analyst following
• Restating firms had a stronger incentive to
  engage in earnings management
• Restating firms were less likely to miss
  important earnings benchmarks prior to SAB 101
• Approximately one third of the firms might have
  missed the earnings benchmark.
• Suggests that these firms were prematurely
  recognizing revenues
• Interestingly, the predictive ability of earnings
  with respect to future cash flows decreased after
  the implementation of SAB 101!

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Firms response to SAB 101

• Evidence indicates that
• Managers delay recognition of revenue using both
  accounts receivable and deferred revenue when
  pre-managed earnings exceed earnings benchmarks
  by a large margin
• Managers accelerate recognition of revenue when
  pre-managed earnings miss earnings benchmarks by
  a lit
• It appears there is still a lot of grey area
  subsequent to SAB 101!

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Inventory cost-flow assumptions

• Why do we need to make an assumption about
  inventory cost flows?
• FIFO, LIFO, Weighted average
• FIFO
• Ending inventory closest to current replacement
  costs
• COGS is understated
• LIFO
• COGS stated using more recent prices
• Ending inventory at older prices
• SEC requires footnote disclosure of the extent to
  which LIFO inventory valuation is less than
  inventory valuation using FIFO or current cost.
• In periods of rising prices income will be higher
  under FIFO than under LIFO, but ending inventory
  will be valued higher under LIFO than under FIFO,
  but for one exception (?)
• Firms prefer LIFO for tax purposes, but if they
  choose LIFO for tax purposes, they must also
  choose LIFO for financial reporting purposes.
• Yet, many firms adopt FIFO.

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What do LIFO adopters look like?

• Firms which face rapidly increasing prices of
  inputs
• Firms facing cyclical demand patterns and have to
  manage inventory accordingly. LIFO, by matching
  current inventory price to sales, helps more in
  smoothing fluctuations
• Motivated by tax savings
• Industry practice
• Larger firms tend to adopt LIFO
• Why would firms adopt FIFO? Why would LIFO firms
  switch to FIFO?

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How does the market react when firms change
cost-flow assumptions?

• Recall that if a firm chooses LIFO for tax
  purposes, it must also choose LIFO for financial
  reporting purposes
• A switch to LIFO results in potential tax
  savings. This should evoke a positive market
  reaction
• A switch to LIFO results in a lower income. If
  the market is fixated on income to evaluate
  companies, this may be viewed negatively
• Mixed evidence on this issue. The best answer
  perhaps is, it depends?

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Points for analysis

• How should we calculate inventory turnover
  ratios? Using FIFO or Using LIFO?
• Be careful when comparing inventory turnover
  ratios across firms if they use different
  assumptions
• Inventory cost-flow assumption also affects the
  current ratio

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Earnings quality and cost flow assumption

• Cost of goods sold is computed using more recent
  prices under LIFO
• Thus, LIFO COGS is more closely related to
  replacement costs
• It is a better measure of the opportunity cost
  which is especially relevant for a going concern
  COGS represents the cost of replacing resources
• Market return seems to more closely follow LIFO
  based income that FIFO based income
• This indicates that the market views LIFO based
  earnings as being of higher quality
• On the other hand, FIFO inventory values in the
  balance sheet are of higher quality. Why?
• Difference is not much when
• Inventory is fast moving
• Prices are stable over time
• Analysts should be aware enough
• To eliminate holding gains arising from dipping
  into LIFO LAYERS

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Accounting for intangibles

• Intangible assets include trade name, brand name,
  patents, customer base, goodwill
• Expense immediately costs incurred to develop
  intangibles
• Capitalize expenditures made to acquire
  intangible assets
• Amortize assets known to have finite useful lives
  (such as when specified in contractual
  arrangements)
• Goodwill recognized only through acquisitions. No
  amortization of goodwill. Subject to impairment
  tests.
• Typically, balance sheet understates the value of
  intangible assets.

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Accounting for RD Software development

• Research and development
• As we know, RD needs to be expensed.
• There is never an asset on the balance sheet
  indicating potential future benefits
• Why?
• For some companies RD expenses can be extremely
  high
• In steady state it may not matter
• For growing firms, this may be troublesome.
• Software development
• The rules are quite fuzzy for software
  development costs
• Expense until technological feasibility is
  established
• Amortize any additional development costs
  subsequently
• Allows room for discretion
• IBM, Microsoft, Adobe examples in the book.