AFM 212 Week 4 Revenue Recognition And Operating Income PDF

AFM 212 Week 4 revenue Recognition and operating income professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Agenda § Analysis of Revenue § Analysis of Deferred Revenue § Analysis of AR § Analysis of foreign Curr...

AFM 212 Week 4 revenue Recognition and operating income professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Agenda § Analysis of Revenue § Analysis of Deferred Revenue § Analysis of AR § Analysis of foreign Currency Effects professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE 4.1 Analysis of Revenue Growth, Quality and Recognition Policy professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analysis of Revenue Revenue Growth Quality Recognition Policy and Changes Internal Recurring vs Consistency in External Non-Recurring revenue Customer recognition concentration New Accounting Seasonality vs Standards ( IFRS Volatility 15 or ASC 606) Gross vs Net Revenue professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Growth analysis: Internal Growth § Definition: Growth achieved through the company’s existing operations § Key Drivers § Increased Sales Volume § Price increases § New product development § New market with existing products § Features § Low risk, sustainable, builds on existing strengths § Relatively slow § Example: § Tesla introduced Model 3 in 2016 and CyberTruck in 2019 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Growth analysis: External Growth § Definition: Growth achieved through mergers, acquisitions, partnership or other external means § Key Drivers § M&A § Same industry: § Vertical M&A: supplier, distributor § Horizontal M&A: competitors § Cross-industry- Diversification § Considerations § Quick, immediate revenue increase § High risk due to integration challenges, significant capital investment may increase leverage or dilute equity § Example: § Facebook acquires Instagram in 2012 and WhatsApp in 2014 § Microsoft acquired Activision Blizzard in 2023 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Acquisition Example § n 2023, Microsoft completed its acquisition of Activision Blizzard for $68.7 billion, making it one of the largest deals in the gaming industry. Activision Blizzard is known for popular game franchises like Call of Duty, World of Warcraft, and Candy Crush. The acquisition allows Microsoft to expand its gaming portfolio, strengthen its Xbox Game Pass service, and increase its presence in the mobile gaming market. The deal is a strategic move to enhance Microsoft’s position in the competitive gaming industry and further its ambitions in cloud gaming. Is this deal a Vertical M&A, Horizontal M&A or Diversified M&A? professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE question § Given revenue growth, which of the following ratios is most relevant for distinguishing between internal revenue growth and external revenue growth? A. Return on Equity B. Profit Margin C. Asset Turnover D. Financial Leverage professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analysis of Revenue Revenue Growth Quality Recognition Policy and Changes Internal Recurring vs Consistency in External Non-Recurring revenue Customer recognition concentration New Accounting Seasonality vs Standards ( IFRS Volatility 15 or ASC 606) Gross vs Net Revenue professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE recurring vs Non-recurring recurring Non-recurring One time or irregular Example: Predictable, long One time sales term Asset Sales Discontinued Link to Core Need to analyze Business them one by one to determine their impact on earnings professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE 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 § From Pfizer’s income statement § Companies are also required to segregate the discontinued operation’s assets and liabilities on the current and prior years’ balance sheets professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Discontinued Operations § The discontinued operations line item has two components ü Net income (or loss) from the segment’s business activities prior to the divestiture ü Any gain (or loss) on the sale of the business Pfizer’s Financial Statement Note for 2020 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE 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, 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 § To be classified as a discontinued operation, the disposal of the business unit must: ü Represent a strategic shift for the company ü Have a major effect on the company’s financial results professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analyst Adjustments 5.3 § To analyze return for 2022 (ROE and ROA) and to compare to the two prior years, the appropriate earnings number is “Income from continuing operations” professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Customer concentration § Definition: the extent to which a company’s revenue is dependent on a small number of customers § Why its’ matters § High customer concentration can lead to revenue volatility if key customers reduce orders or leave. § crucial for assessing business risk. It highlights the potential vulnerability a company might face if it loses one or more major customers. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Seasonality vs. Volatility Seasonality Volatility Predictable Unpredictable fluctuations with a revenue variation year, repeat over time consistently each High volatility year indicates Interpret quarterly underlying risks report carefully Could be one time Retail, Tourism, event ski resorts Oil and Gas professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Gross Revenue vs Net-Revenue: Allowance § 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 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE  Sales Allowances: Example § Assume the following for Levi Strauss ü Sells jeans to a customer for $130 on account, jeans cost $80 ü Expects returns of 3% of sales § Levi’s income statement reports the following: professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Question: § In the previous example, the company adjusted both revenue and COGS. Can you think of a scenario where the company would adjust only revenue, but not COGS, when accounting for a sales allowance? professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Reporting Sales Allowances § Companies provide a reconciliation of their sales allowances ü Sales returns ü Sales discounts and incentives § Levi’s disclosure is typical professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analysis of Sales Allowances Three metrics to analyze sales allowances 1. Additions charged to Gross Sales ü Measures the income statement amount ü Reveals effects of the pricing pressure on net sales ü 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 ü Measures the balance sheet amount 3. Adequacy of the allowance amount ü Compares the dollar amount of the estimates for future sales returns to the amount actually realized professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Three Analysis Metrics at Levi Strauss 1 2 3 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analyst Adjustments 5.1 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analyst Adjustments 5.1 § Because sales allowances require estimates, managers can (and do) pad or shave their estimates to help the company meet net sales or earnings targets § Analyst seek to adjust numbers to “undo” any deliberate variation across years § To adjust our numbers: ü We estimate an “average” rate of additions charged (income statement number) to the Gross sales ü Apply that average rate to determine adjusted amounts for the related balance sheet and income statement accounts professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analyst Adjustments 5.1: Levi Strauss (1) § Estimate an “average” rate § Apply that average rate to determine adjusted amounts for the related balance sheet and income statement accounts professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analyst Adjustments 5.1: Levi Strauss (2) § Use the adjusted numbers to restate income statement numbers § Use the adjusted numbers to restate balance sheet numbers Balance sheet is cumulative and each year’s balance sheet adjustment is equal to that year’s adjustment plus the sum of all prior year’s adjustments. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analysis of Revenue Revenue Growth Quality Recognition Policy and Changes Internal Operating vs Consistency in External Non-Operating revenue Recurring vs recognition Non-Recurring New Accounting Gross vs Net Standards ( IFRS Revenue 15 or ASC 606) Customer concentration Seasonality vs Volatility professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Pfizer’s Income Statement professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Revenue Recognition at Pfizer Chargebacks, rebates, sales allowances and sales returns are deducted from GROSS REVENUE professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Revenue Recognition Rule: 5 Steps 1. Identify the contract(s) with the customer ü Parties to the contract should be identifiable ü Terms of the sale should be specified 2. Identify the performance obligation(s) in the contract ü Performance obligation is a contractual promise to transfer a good or service to the customer ü For contracts with more than one good or service, company must identify separate performance obligations for each contractual promise 3. Determine the transaction price ü If the selling price is variable, estimate revenue using the expected selling price professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Revenue Recognition Rule: 5 Steps 4. Allocate the transaction price to the performance obligation(s) ü For contracts with more than one performance obligation, allocate the transaction price to each performance obligation at its fair value (standalone selling price) ü If standalone prices are not available, use a reasonable estimate of the selling price 5. Recognize revenue as / when each performance obligation is satisfied ü Performance obligation satisfied when the customer obtains control of the goods or services ü Performance obligations satisfied over a period of time should be recognized as revenue over time professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Question § On Sept. 23, I made an on-line order of a USB C charger for $70 using credit card from Amazon.ca § On Sept. 24, Amazon noticed me that the order is shipped. § On Sept. 25, the order is delivered to the front door of my house. I have the right to return the product for free within 30 days after the delivery. § On Oct. 24, the return period expired. § Question: When should Amazon recognize the $70 dollar revenue from selling the charger? A. Sept. 23 B. Sept 24 C. Sept 25 D. Oct. 24 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Pool Question § On Sept. 1, I purchased an amazon gift card of $70 from Metro store. § On Sept. 23, I made an on-line order of a USB C charger for $70 using gift card from Amazon.ca § On Sept. 24, Amazon noticed me that the order is shipped. § On Sept. 25, the order is delivered to the front door of my house. I have the right to return the product for free within 30 days after the delivery. § On Oct. 24, the return period expired. § Question: When should Amazon recognize the $70 dollar revenue from selling the gift card? A. Sept. 23 B. Sept 24 C. Sept 25 D. Oct. 24 E. Sept 1st professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE 4.2 Analysis of Deferred Revenue professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE  Unearned (Deferred) Revenue § In some industries, it is common to receive cash before recording revenue § Deposits or advance payments are not recorded as revenue until the company performs the services owed or delivers the goods § Companies must record a liability (Unearned revenue) because the company is obligated to deliver those products and services § When the good is provided or the service rendered, the unearned revenue liability is reduced and revenue is recognized § Unearned revenue is particularly common among companies that: ü Receive advance payments from customers ü Sell gift cards ü Sell memberships or subscriptions © Cambridge Business Publishers professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE  Unearned (Deferred) Revenue § Walmart reports unearned (deferred) revenue details © Cambridge Business Publishers professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE  Analysis of Unearned Revenue § If deferred revenue liabilities decrease, we infer the company’s current reported revenue was collected from customers in a prior period § Thus, 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 § Growth in deferred revenue could predict future increases in revenue and profit § In either case, we must pay attention to the rate of increase or decrease as well as to the dollar amount of the change during the period professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE  Analysis of Unearned Revenue § Netflix reports unearned (deferred) revenue details § Deferred revenue grew – more cash from subscribers than reported revenue § Deferred revenue growth slowed each year and decreased sharply in 2021-22 § A slowdown in deferred revenue is a likely predictor of slower revenue growth § Analysts forecast a slowdown in deferred revenue for 2023 and beyond professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE 4.3 Analysis of Account Receivable professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Accounts Receivable § Selling goods on account carries the risk that some customers are unable to pay the amount due § GAAP requires companies to estimate the amount of receivables that are likely to be uncollectible and to report only the net collectible amount § Pfizer’s customers owe the company $11,401 million ($10,952 + $449) § Pfizer estimates that 3.9% ($449 /$11,401) is likely uncollectible professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Aging Analysis of Receivables § Firms frequently employ aging analysis to estimate uncollectible accounts § Aging analysis groups accounts receivable by number of days past due § The company estimates that $2,900 (2.9%) of its gross A/R is likely uncollectible § The net amount $97,100, represents the company’s best estimate of what it expects to ultimately collect from its customers professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Accounting for Accounts Receivable § Assume a company ü Sells goods on account for $100,000 ü Establishes an allowance for uncollectible accounts of $2,900 § The financial statement effects are as follow: § The company reports the following on its balance sheet professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE  Write-off of Uncollectible Account § Assume a customer who owes the company $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 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analysis of A/R – Magnitude § The magnitude of accounts receivable is measured with two ratios: Accounts receivable turnover Days sales outstanding (DSO) § DSO reveals the number of days, on average, that accounts receivable are outstanding before they are paid. The DSO can be: ü Compared with the company’s established credit terms to investigate if the company’s customers are conforming to those credit terms. ü Computed over several years for the same company to investigate trends ü Compared with peer companies professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Interpretation of A/R Ratios § Evidence that A/R have grown more quickly than sales, we observe: ü Lower accounts receivable turnover ratio ü Higher percentage of accounts receivable to sales ü Lengthening of the DSO § Generally, such a trend is not favorable for two possible reasons ü The company is becoming more lenient in granting credit to its customers ü Credit quality is deteriorating ü Mix of products sold changes with products or customer contracts having longer payment terms professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Pfizer’s A/R Turnover and DSO § S&P Capital IQ reports the following data for Pfizer: § Pfizer’s A/R turnover ratio increased over the past 5 years § DSO ranged from a high of 72.6 days in 2018 to a low of 40.8 in 2022 § DSO declined by about 16 days from 2017 to 2022 § Collecting A/R more quickly increases operating cash flow professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE  Pfizer’s A/R Turnover and DSO § As Pfizer collect its cash more quickly, its cash balance will increase § We can quantify the cash increase as follows for 2022: § Pfizer generated a one-time cash inflow of $742.17 million in 2022 © Cambridge Business Publishers professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analysis of A/R – AT&T § 10-K Schedule II reports a “roll forward” of the allowance § AT&T’s allowance has decreased each year from 2020 to 2022 © Cambridge Business Publishers 48 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analysis of A/R – AT&T There are two possible interpretations for the decrease in allowance 1. Credit quality has improved üIf AT&T believes the collectability of its receivables has improved, it can feel confident in allowing the allowance for uncollectible accounts to decline 2. The company is underestimating the allowance account üThis is more troubling üAT&T might be attempting to increase its profitability by not adding to the allowance account, and, thus, avoiding more bad debt expense professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE  Analyst Adjustments © Cambridge Business Publishers professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analyst Adjustments § Allowance for doubtful accounts is an estimate, managers can (and do) use the allowance account to help the company meet net sales or earnings targets (via bad debt expense) § Analyst seek to adjust numbers to “undo” any deliberate variation across years § To adjust our numbers, we estimate an “average” rate of the allowance to Accounts receivable, gross § Apply that average rate to determine adjusted amounts for the related balance sheet and income statement accounts professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analyst Adjustments § Pfizer’s average Allowance to A/R gross over past three years is 4.558% § We use that rate to recalculate and adjust all three year’s allowance § We adjust both the income statement (bad debt expense) and the allowance account professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Survey Question Which factor do you believe is most important when analyzing a company’s Accounts Receivable (AR) and Sales Allowances Options: A) Days Sales Outstanding (DSO): Important for measuring the efficiency of a company’s credit and collection policies. High DSO might indicate problems in collecting receivables, which can impact cash flow. B) AR Aging Analysis: Crucial for assessing the risk of bad debts. It provides insight into how long receivables have been outstanding and whether the company might face difficulties in collecting them.. C) Sales Allowances Trends: Important for understanding the company’s customer satisfaction and pricing strategy. Increasing sales allowances could signal problems like poor product quality or aggressive discounting strategies. D) Allowance for Doubtful Accounts: Essential for assessing whether the company is adequately prepared for potential bad debts. Underestimating this allowance could inflate reported profits and mislead stakeholders. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE