UNDERSTANDING FINANCIAL STATEMENTS

1. UNDERSTANDING FINANCIAL STATEMENTS Accounting Environment and Financial Statements Chapter 1

2. Timing of Revenues/Expenses • Financial statements are prepared on an “accrual” basis, not “cash” basis. • Revenues reported when “earned” not when received in cash • Matching Principle • Matching process involves judgments by management regarding recognition of revenues and/or expenses • Usually the more conservative the approach (usually lower income, higher expenses) the higher the quality of earnings

3. Revenue Recognition • Although general rules and guidelines exist, the significant variety of marketing methods for products and services make it difficult to apply the rules consistently in all situations. • Per FASB Statement of Financial Accounting Concepts No.5  Revenues generally are recognized when 2 criteria are met: 1. REALIZED OR REALIZABLE 2. EARNED

4. Revenue Recognition • SEC Staff Accounting Bulletin (SAB) 101 – December 1999 • Persuasive evidence of an arrangement exists. • Delivery has occurred or services have been rendered. • The seller’s price to the buyer is fixed or determinable. • Collectability is reasonably assured.

5. Revenue Recognition • Important issue with the SEC. • Research of accounting irregularities shows that over ½ of fraudulent financial reporting involves overstated revenue (www.revenuerecognition.com) • Largest single issue involved in restatement of financial statements • Results in larger drops in market capitalization than any other type of restatement (based on SEC research)  

6. Revenue Recognition • Revenue is recognized at the following time depending on the circumstances: A) At time of sale B) During production C) When production is complete D) When cash is received • Note that the PCAOB board is currently studying revenue recognition issues.

7. Revenue Recognition A. At time of sale: 1)  Revenue from selling products is recognized at the date of sale…essentially time the goods are transferred to customers. • Need an allowance for estimate for uncollectible accounts. • May need an allowance for estimate for returns. • May need to recognize warranty expense/payable 2) Revenue from services rendered is recognized when services are provided and are billable. 3) Gains or losses from disposing of assets recognized at the date of sale.

8. Revenue Recognition B.During Production (over time): • Proportional revenue recognition - Recognize revenue for amount of months earned in a given year • Interest, • rent, and • royalties income - Revenue from multi-year contracts should be recognized over the contract period (not when cash is received)

9. Revenue Recognition B.During Production (over time): 2) Long-term Construction Contracts • Percentage of Completion Method - Revenue andexpenses are recognized as construction progresses. (b) Completed Contract Method -Revenue and expenses are recognized when the contract is completed

10. Revenue Recognition A company must use of Percentage of Completion method for L-T contracts when the following conditions are met. Otherwise use Completed Contract method. (1) Reasonably costs estimates can be made (2) Contract specifies legally enforceable rights, the consideration, and the terms of settlement (3) Buyer is expected to pay obligations under contract (4) Contractor is expected to fulfill contractual obligations

11. Revenue Recognition Percentage of Completion Method (1) Input measures: (a) Costs-to-date divided by estimated total cost (b) Efforts expended: DLhours-to-date divided by estimated total DL hrs (2) Output measures: (a) number miles completed to total miles contracted (b) number of units completed to total units contracted

12. Revenue Recognition C. When Production is Complete (not waiting for sale): (1) Commodities - Agricultural products & Precious metals (2) Readily available market price Recognize 100% revenue at the market price and 100% cost of sales on the date that production is completed. At time of sale, recognize the difference between the sales price and the previously recognized amount as a “financing gain or loss” in Other Income.

13. Revenue Recognition D. When Cash is Received (after sales date): (1) Installment Sales -Recognizes sales revenue in the period the cash is collected rather than the period of sale. Defers/postpones revenue recognition. (2) Cost of goods sold is deferred proportionally to the deferred sales. (3) Widespread use for tax accounting. (4) Use installment method for financial stmt. purposes when: (a) Periodic payments made over a lengthy time interval. (b) There is significant uncertainty about the collectibility

14. Ways to Increase Net Income:Increase revenues A. Use accounting principles that result in higher revenue/sales/gains 1. percentage-of-completion method vs. completed contract B. Use estimates that increase revenues 1. use a higher estimate of the % completed on a long-term project. C. Engage in business decisions only to increase revenues 1. sell major assets

15. Increase revenues D. Recognize revenue/sales/gains early (not GAAP) • sales for goods that are not transferred until after yearend • revenue recognized on multi-year contracts early (in first year instead of over contract period) • not using installment sales method when required 4. Sales recognized even though it is not authorized E. Recognize fictitious revenue/sales/gains (not GAAP) 1. sham sales F. Change in a revenue accounting principle that results in a “cumulative income from the change” (GAAP)

16. Decrease expenses A. Use accounting principles that result in lower expenses and/or losses (GAAP) 1.FIFO vs. LIFO 2. straight-line depreciation vs. accelerated depreciation B. Use estimates that decrease expenses (GAAP, if reasonable) • lower estimate of bad debt expense (lower % of sales) • longer useful lives for depreciable assets • lower estimate of warranty costs • lower estimate of pension costs

17. Decrease expenses C. Defer/decrease discretionary expenses (GAAP) 1. research and development expenditures 2. marketing costs 3. repairs and maintenance

18. Decrease expenses D. Under report valid expenses (not GAAP) 1. capitalizing costs versus expensing them 2. transfer expenses/losses and related liability to another entity 3. failing to record expenses/losses and related liability (a) purchases made near yearend that are paid after yearend (b) contingency losses/liabilities E. Changing an accounting principle that results in a “cumulative income from the change” by recapturing expenses (GAAP) Changing from accelerated depreciation method to straight-line method

19. Nonrecurring/Nonoperating Items • Nonrecurring and non-operating items are not part of normal ongoing business • Earnings figure should reflect future operating potential • Therefore segregate such things as major asset sales, asset impairments, discontinued segment, accounting changes, extraordinary items

20. Missing Information • Morale/efficiency/expertise of employees • Reputation/public perceptions of firm • Effectiveness of management team • Provisions for succession • Potential exposure to regulatory changes