Financial

Managerial
&
Accounting
for MBAs Sixth Edition

Peter D. Easton
Robert F. Halsey
Mary Lea McAnally
Module 5
Revenues, Receivables,
and Operating Expenses

© Cambridge Business Publishers, 2021

Learning
Objective 1
Apply revenue recognition
principles and assess results.

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Pfizer’s Income Statement

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Revenue Recognition Rule
General

 Financial Accounting Standards Board (FASB)

Revenue Recognition rules effective for fiscal year
ends beginning after December 15, 2017 (or earlier
if companies choose)
 The general revenue recognition principle:
 Recognize revenue when the company transfers the good or
service to the customer
 When the customer obtains control of the good or service
 It is not necessary to receive cash to recognize revenue.

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Sales on Credit

 Many sales are on credit, meaning the customer

has agreed to pay the company in the future.
 The company recognizes revenue when the good or
service is transferred to the customer, and records
an account receivable to be collected later.
 Revenue recognition is unaffected by the delayed
receipt of cash if the company has fulfilled its
performance obligation.

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Revenue Recognition Rule
5 Steps
1. Identify the contract(s) with the customer
 Parties to the contract should be identifiable.
 Terms of the sale should be specified.

2. Identify the performance obligation(s) in the

contract
 Performance obligation is a contractual promise to transfer a good
or service to the customer.
 For contracts with more than one good or service, company must
identify separate performance obligations for each contractual
promise.
3. Determine the transaction price
 If the purchase price is variable, estimate revenue using the
expected purchase price.
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Revenue Recognition Rule
5 Steps
4. Allocate the transaction price to the
performance obligation(s)
 For contracts with more than one performance obligation,
allocate the transaction price to each performance obligation at
its fair value (standalone selling price).
 If standalone prices are not available, use a reasonable
estimate of the selling price.

5. Recognize revenue as/when each performance

obligation is satisfied
 Performance obligation is satisfied when the customer obtains
control of the goods or services.
 Performance obligations satisfied over a period of time should
be recognized as revenue over time.
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Revenue Recognition
Pfizer

Chargebacks, rebates, sales allowances and sales

returns are deducted from GROSS REVENUE.

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Complications
of Revenue Recognition
 Nonrefundable up-front fees―recognize as revenue
when the goods or services are provided
 Bill-and-hold arrangements―recognize when control
of the goods transfers to the customer
 Consignment sales―recognize commission when goods
are sold
 Licenses―revenue recognition depends on the contract
 Right to use―recognize revenue when the customer can first use
the licensed IP
 Promise of access―recognize over a period of time

 Franchises―recognize revenue as goods or services are

delivered
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Complications
of Revenue Recognition
 Variable consideration―recognize the expected
amount to be received when goods or services are
provided
 Multiple element contracts―multiple performance
obligations
 Distinct goods and services sold for one price

 Performance obligations fulfilled at various points in time

 Recognize revenue as / when each performance obligation is
satisfied
 Right of return―estimate the expected return and
recognize NET revenue when control of the goods
transfers to the customer
 Gift cards―recognize when gift card is used or expires
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Performance Obligations
Satisfied Over Time

Cost-to-Cost Method
 Recognize revenue as a proportion of total costs incurred to
fulfill the contract.
 For example, if 15% of the total expected cost to create the
product are incurred in the current period, 15% of contract is
recognized as revenue.
 Consider Raytheon’s 2018 disclosure:

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Cost-to-Cost Method
Example
Assume the following facts:
 Raytheon signs a $10 million contract
 Construction will take 2 years and cost $7.5 million
 Costs incurred
 Year 1: $4.5 million
 Year 2: $3 million

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Cost-to-Cost Method
Example
Revenue and expenses recognized as follows:

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Cost-to-Cost Method
Example
Raytheon’s reported revenues and expenses for Years 1 and 2:

 Note that cash collected from the customer may or may not
coincide with the revenue recognized.
 Raytheon discloses these timing differences in footnotes:

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Cost-to-Cost Method
Example
Raytheon’s balance sheet includes:
 Receivables (revenues earned and billed to the customer)
 Contract assets (costs incurred but not yet billed)

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New Revenue Recognition Standard
 PwC 2018 survey of 700 finance executives
 “What impact did new Revenue Recognition
Standard have?”

 “How difficult will it be to implement the new

standard in the following areas?” Response:
Somewhat―Very difficult

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Learning
Objective 2
Examine and evaluate
sales allowances.

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Sales Allowances
 Many companies offer customers a variety of sales
allowances
 Rights of return
 Sales discounts for volume purchases
 Retailer promotions (point-of-sale price markdowns and other
promotions)
 These reduce the amount of cash the company
receives.
 Under GAAP companies must report amount of cash
expected to be received (NET sales).
 Companies must deduct from GROSS sales the
expected sales returns and other allowances.
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Sales Allowances
Example
Assume the following for Levi Strauss:
 Sells jeans to a customer for $130 on account; jeans cost $80
 Expects returns of 3% of sales

 Levi’s income statement reports the following:

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Reporting Sales Allowances
 Companies provide a reconciliation of their sales
allowances
 Sales returns
 Sales discounts & incentives

 Levi’s disclosure is typical

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Analysis of Sales Allowances
Three metrics to analyze sales allowances:
1 Additions charged to Gross Sales
 Measures the income statement amount
 Reveals effects of the pricing pressure on net sales
 Expect the percentage of sales allowances to gross sales
to increase (thus reducing net sales) as pricing pressure
increases
2 Allowance as Percentage of Gross Sales
 Measures the balance sheet amount

3 Adequacy of the allowance amount

 Compares the dollar amount of the estimates for future
sales returns to the amount actually realized

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Three Analysis Metrics
Levi Strauss

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Learning
Objective 3
Analyze deferred revenue.

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Unearned (Deferred) Revenue

 In some industries, it is common to receive cash

before recording revenue.
 This creates a liability (Unearned Revenue) for the
company’s obligation to deliver a good or perform a
service at a future date.
 When the good is provided or the service rendered,
the unearned revenue liability is reduced and
revenue is recognized.

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Unearned (Deferred) Revenue

 Lowe’s Companies reports unearned (deferred)

revenue details:

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Analysis of Unearned Revenue
 If deferred revenue liabilities decrease, we infer the
company’s current reported revenue was collected from
customers in a prior accounting period and there have
been fewer new prepayments for which revenue will be
recognized in the future.
 Such a trend could predict future declines in revenue and
profit.
 This is not the case for Lowe’s. The company reports a
reconciliation of the unearned (deferred) revenue
account.

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Learning
Objective 4
Evaluate how foreign currency
exchange rates affect revenue.

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Accounting for
Foreign Currency Effects
 Companies’ foreign subsidiaries maintain their
accounting records in foreign currencies (other than
the $US).
 Before the subsidiaries’ financial statements are
consolidated, they must be translated into $US.
 As the $US weakens vis-à-vis other world currencies each
unit of foreign currency buys more $US.
 When the income statement of a foreign subsidiary is
translated into $US, the income statement grows.
 Reported revenues and expenses are larger than before the
$US weakened.
 The balance sheet also grows, resulting in a higher $US value
for assets, liabilities, and equity.
© Cambridge Business Publishers, 2021 29
Foreign Currency Effects
Pfizer

 Revenues “increased” in 2018 due to foreign currency

changes.
 We can infer that the $US dollar weakened during the year.

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Foreign Currency and Cash Flows

Consider three examples of how foreign currency gains and

losses may affect cash flow:

1. $US company transacts business in foreign

currencies
 For example, a U.S. company might write a sales contract in
Euros.
 If the $US weakens between the date of the sale and the
collection of a Euro-denominated account receivable, the U.S.
company realizes a foreign currency transaction gain.
 Conversely, If a U.S. company purchases goods, and the $US
weakens, the foreign currency denominated account payable
would grow and more $US would be required to settle the
obligation, the U.S. company realizes a foreign currency
transaction loss.

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Foreign Currency and Cash Flows

Consider three examples of how foreign currency gains and

losses may affect cash flow:

2. $US company borrows in a foreign currency

 If a U.S. parent company borrows in foreign currencies and the
$US weakens, the parent company will realize a loss as it repays
more $US to settle the foreign currency-denominated loan.

3. Foreign subsidiary’s cash is repatriated

 If the U.S. parent repatriates cash from foreign subsidiaries by
means of a cash dividend, the parent company will realize a
foreign currency transaction gain if the $US weakens before the
dividend is converted into $US.

These transactions describe realized gains/losses,

whereas translation effects are unrealized gains/losses.
© Cambridge Business Publishers, 2021 32
Analysis of Foreign Currency

 U.S. companies hold about $1 trillion of overseas

earnings, mostly invested in U.S. marketable securities.
 The Tax Cuts and Jobs Act (TCJA) removed a major
tax barrier to repatriating these overseas profits.
 From 2017 onward, companies must pay a one-time tax
of 15.5% (down from 35%) on repatriated earnings.
 Since the new tax law was passed, companies have
started to bring foreign profits back to the U.S.
 Companies repatriated more earnings in the first half of
2018 than in 2015, 2016, and 2017 combined.

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Foreign Profits and Repatriation
 Using the income statement as reported implicitly
includes the foreign currency effects.
 10-K disclosures report foreign currency effects, which
allows analysts to isolate the effects. For example, Pfizer
reports:

 Good analysis computes ratios WITH and WITHOUT the

effect of foreign currency.
 Because foreign currency effects are unpredictable and
out of the company’s direct control, good analysis
exclude foreign currency effects to better forecast
operating cash flow.
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Learning
Objective 5
Analyze accounts receivable and
uncollectible amounts.

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Accounts Receivable
 Accounts receivable are reported on the balance
sheet net of the allowance for doubtful
(uncollectible) accounts:

 Firms use aging analysis to estimate uncollectible

accounts.

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Accounting for Accounts Receivable
 Assume a company
 Sells goods on account for $100,000
 Establishes an allowance for uncollectible accounts of $2,900

 The financial statement effects are as follows:

 The company reports the following on its balance sheet:

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Write-Off of Uncollectible Account
 Assume a customer who owes $500 files for bankruptcy.
 If the company determines the receivable is now
uncollectible, the company records a “write off” and
adjusts the allowance.

 The company reports the following balances at period

end:

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Analysis of (A/R)—Magnitude

 The magnitude of accounts receivable is measured

with the following two ratios:
1. Accounts receivable turnover = Sales .

Average A/R

2. Days sales outstanding (DSO) = 365 .

A/R Turnover
 For Pfizer:

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Interpretation of A/R Ratios

 When accounts receivable have grown more quickly

than sales, we observe:
 Lower accounts receivable turnover ratio
 Higher percentage of accounts receivable to sales
 Lengthening of the DSO

 Generally, such a trend is not favorable for two

possible reasons
 The company is becoming more lenient in granting credit to
its customers
 Credit quality is deteriorating

© Cambridge Business Publishers, 2021 40

A/R Turnover and DSO
Pfizer

 Pfizer’s A/R turnover ratio increased over the past five

years—a good sign
 DSO declined by 10 days from 2014 to 2018
 Collecting A/R more quickly increases operating cash flow

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Analysis of A/R—Quality
 10-K Schedule II reports a “roll forward” of the allowance
that shows movements in the account.

 Over the 3-year period, the company wrote off $7,112

($3,973 + $1,893 + $1,246) but only increased the
allowance by $6,124 ($2,284 + $1,645 + $2,195).
 Allowance / Gross Receivables has declined:

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Analysis of A/R—Quality

There are two possible interpretations for the Levi

Strauss trend:
1. Credit quality has improved
 If Levi Strauss feels that the collectability of its remaining
receivables has improved, it can feel confident in allowing the
allowance for uncollectible accounts to decline.

2. Levi Strauss is underestimating the

allowance account
 This is the more troubling of the two possibilities.

 Levi Strauss might be attempting to increase its profitability by

not adding to the allowance account, and thus, avoiding more
bad debt expense.

© Cambridge Business Publishers, 2021 43

Learning
Objective 6
Evaluate operating expenses
and discontinued
operations.

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Deductions From Income
Pfizer

 Cost of sales―The cost Pfizer incurred to make or buy

the products it sold during the year
 Selling, informational and administrative
expense―Usually, this expense category is labelled
Selling, general and administrative (SG&A) expense, and
includes a number of general overhead expense
categories, such as Salaries, Marketing, IT, Legal, etc.
 Research and development expense―This is the
amount Pfizer incurs to conduct research for new
products
 Amortization of intangible assets―Amortization
expense is a noncash expense, similar to depreciation
expense
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Deductions From Income
Pfizer
 Restructuring charges―The cost Pfizer incurred (and
expects to incur) to restructure its operations
 Provision for taxes on income―Taxes to federal and
state tax authorities as well as income taxes levied by
foreign governments
 Discontinued operations―The operating profit (or
loss) on businesses that Pfizer has decided to divest plus
the gain (or loss) on the sale of those businesses
 Income attributable to noncontrolling interest―The
portion of the subsidiaries’ income that is owned by the
noncontrolling shareholders, that is, the portion NOT
attributable to Pfizer’s shareholders (who own the
controlling interest)
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Research and Development
Expense
 R&D costs broadly consist of the following:
 Salaries and benefits for researchers and developers
 Supplies needed to conduct the research
 Licensing fees for intellectual property or software used in
the R&D process
 Third-party payments to collaborators at other firms and
universities
 Laboratory and other equipment
 Property and buildings to be used as research facilities

 R&D costs are expensed as incurred except for

general purpose PPE assets which are capitalized
and depreciated as usual.
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Median S&P 500 Firm R&D/Revenue
2018

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Analysis of R&D
 To analyze R&D:
 Compare R&D expense ($ and as a % of revenue) over time
 Compare the company’s R&D spending to peers

 Financial analysts aim to develop forward-looking

predictions of a company’s income and cash flow.
 Monitor new products in the pipeline
 Develop estimates of their ultimate commercial feasibility

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Provision (Benefit)
for Taxes on Income
 Tax expense―the income taxes the company has paid and
expects to pay to federal, state, municipal, and foreign tax
authorities
 The Tax Cuts and Jobs Act (TCJA) made sweeping changes
that impacted taxes and income statements
 Reduced the corporate tax rate from 35% to 21%
 Imposed tax on all future foreign earnings even if the cash profits
remain abroad
 Reduced the repatriation tax on prior foreign earnings to 15.5% (from
35%)
 TCJA effective in 2017 but companies took action in 2016 in
anticipation of the new rules and continued to respond in 2018
 U.S. company income statements gyrated wildly 2016 – 2019

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Provision (Benefit)
for Taxes on Income

5.9% -73.5%
13.4%

Average (effective) tax rate = Tax expense/Income

before tax
 Average rates during the 2016 to 2019 period are not
predictive of future tax rates.
 Pfizer projects a 16% tax rate for 2019 and beyond.
 Critical to carefully read tax footnotes

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Discontinued 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.
 The discontinued operations line item has two
components:
 Net income (or loss) from the segment’s business activities prior to
the divestiture
 Any gain (or loss) on the sale of the business

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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, they are largely
irrelevant to predicting future performance.
 Investors tend to focus on income from continuing
operations because that is the level of profitability that is
likely to persist (continue) into the future.
 In order to be classified as a discontinued operation, the
disposal of the business unit must:
 Represent a strategic shift for the company
 Have a major effect on the company’s financial results

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Learning
Objective 7
Interpret pro forma
and non-GAAP disclosures.

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Pro Forma Income Reporting

 Pro forma income statements are non-GAAP numbers

that company management believes provide a better
measure of their financial performance.
 The Securities and Exchange Commission (SEC) requires
that companies reconcile non-GAAP information to GAAP
numbers (Regulation G).
 Remember that a company’s purpose for making a non-
GAAP disclosure is to portray its financial performance
the way that management would like us to analyze it.
 Unscrupulous companies might attempt to present
financial results in the best possible light (opportunism).

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Pro Forma Disclosure
Pfizer

 Adjusted diluted EPS is not a GAAP metric.

 Analysts may or may not agree with Pfizer’s adjustments
that excludes costs relating to acquisitions, discontinued
operations, and other one-time nonrecurring items.
 Must examine disclosure carefully and consider the
company’s incentives for reporting “adjusted” numbers.
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SEC Warning

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Disclosures and Market
Assessments
For a thorough reading of the GAAP financials:
 Read the external audit report and note any deviation from
boilerplate language.
 Peruse accounting policy footnote and compare to peers.
 Examine changes in accounting policies.

 Compare key ratios over time.

 Review competitors’ ratios and consider how macroeconomic
conditions have shifted ratios over time.
 Identify nonrecurring items and separately assess their impact
on company performance and position.
 Recast financial statements as necessary to reflect accounting
policies more in line with competitors or that better reflect
economically relevant numbers.

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Financial
Manageri
&
al
Accountin
for MBAs Sixth Edition

g
Cambridge Business Publishers
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