Module 4

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Module 4

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1. Module 4 Reporting and Analyzing Operating Income

3. Composition of Cisco’s Restructuring Costs Workforce reduction. Elimination of about 6,000 jobs. This cost includes estimated severance payments and fringe benefits. Consolidation of facilities. Closure of corporate and sales offices and operational centers. This cost includes lease termination (e.g., buyout) costs, estimated losses on disposals of properties and equipment, and vendor payments to terminate supply agreements. Impairment of goodwill and other purchased intangible assets. This cost reflects the amount by which the carrying value of the asset on the balance sheet exceeds its estimated market value (e.g., the present value of the estimated cash flows to be realized from the assets). Write-down of inventory. This cost relates to the amount by which the carrying value of inventory on the balance sheet exceeds its current market value as well as the cost of honoring existing purchase commitments.

4. Cisco’s Restructuring Cost Footnote

5. Operating/Nonoperating and Core/Transitory Dimensions of Income

6. Operating Activities Operating activities refer to the main transactions and events of a company. Results of operating activities are reported in the operating section of the income statement. Information on operating activities is reflected in the current assets and current liabilities sections of the balance sheet (absent investments and short-term borrowings) and in the operating section of the statement of cash flows.

7. Ratios Across Industries

8. Revenue Recognition Revenue recognition refers to the recording of revenue by a company GAAP has two revenue recognition criteria that must be met for revenue to be recognized (and recorded on the income statement)—revenue must be: Realized or realizable Earned

9. Cisco’s Revenue Recognition Policy

10. SEC Guidelines for Revenue Recognition SEC outlines its guidance for revenue recognition in Staff Accounting Bulletin (SAB) 101, where it states that revenue is realized, or realizable, and earned when each of the following criteria are met: There is persuasive evidence that a sales agreement exists, Delivery has occurred or services have been rendered, Seller’s price to the buyer is fixed or determinable, and Collectibility is reasonably assured.

11. Revenue Recognition Challenges Some serious revenue recognition challenges are: Revenue recognition upon delivery pending execution of sales agreements. Gross vs. Net. Sales on consignment. Barter transactions. Failure to take delivery. Nonrefundable fees. Channel stuffing. Mischaracterizing extraordinary or unusual transactions as revenue. Mischaracterizing transactions as “arm’s-length.” Selling undervalued assets.

12. Percentage-of-Completion For certain industries requiring long-term contacts, revenue is recognized using the percentage-of-completion method, which recognizes revenue by determining the costs incurred to date compared with the project’s total expected costs. Percentage-of-completion method of revenue recognition requires an estimate of total anticipated costs. This estimate is made at the beginning of the contract and is used to initially bid the contract.

13. Percentage-of-Completion Example

14. Raytheon Revenue Recognition Policy

15. Employee Stock Options Employee stock options are a form of compensation. Given to a select group of upper-level employees in lieu of cash payments or salary. Terms of these plans give employees the right to purchase a fixed number of shares of stock in the company at a fixed price for a pre-determined period of time.

16. Employee Stock Option Expense Currently, GAAP allows companies to footnote the expense related to employee stock options rather than to report the expense in the income statement. The FASB and IASB are both proposing new standards to require expensing in the income statement.

17. Cisco’s Stock Option “Expense” as currently footnoted

18. Foreign Currency Translation Many companies conduct operations, not only in countries outside of the US, but also in currencies other than $US. Many purchase assets in foreign currencies, borrow in foreign currencies, and transact business with their customers in foreign currencies. US corporations can have subsidiaries whose entire balance sheets and income statements are stated in foreign currencies.

19. Rules for Foreign Currency Translation US GAAP and the SEC require that all financial statements prepared for US investors be in $US. Financial statements of foreign subsidiaries must first be translated into $US before they can be consolidated with the US parent company and presented to US investors. This translation process can dramatically affect both the income and the balance sheet.

20. Cumulative Translation Adjustment

21. Foreign Currency Translation Adjustment at Ford Motor Company

22. Income Statement Effects of Currency Swings

23. R&D Expenses R&D activities are a significant expenditure for most firms, especially for those in technological industries where R&D costs can range up to 10% of sales or higher. These costs include employment costs for R&D personnel, R&D related contract services and PP&E costs. Accounting standards relating to R&D activities allow only one accounting procedure: expense as incurred.

24. Cisco’s R&D Footnote

25. R&D Across Companies

26. Income Tax Expense Companies maintain two sets of books One for reporting to their shareholders One for reporting to the IRS. This is perfectly legal as the tax Code is different from GAAP. This can result in dramatically different levels of pre-tax (financial reports to shareholders) and taxable (reported to the IRS) income. These differences result in deferred tax liabilities (book income > taxable income) and deferred tax assets (book income < taxable income)

27. Deferred Tax Liability Example

28. Components of Cisco’s Tax Expense

29. Cisco’s Deferred Tax Footnote

30. Transitory Income Items & Core Earnings Estimation of stock prices entails forecasts of future earnings and cash flows. Forecasts are better when we can identify transitory items in reported earnings and cash flows and can eliminate those from our forecasts. Our goal is to identify core earnings and cash flows of the company. Core earnings and cash flows have the greatest persistence or predictive power and are, therefore, most useful for stock price estimation.

31. Transitory Income Items Discontinued Operations Extraordinary Items Changes in Accounting Principle

32. Discontinued Operations Discontinued operations refer to any separately identifiable business operation that the company intends to sell. Profits (loss) of the discontinued operations (net of tax), together with the gain (loss) on sale, of the segment are reported in a separate section of the income statement below income from continuing operations.

33. Example of Reporting for Discontinued Operations

34. Criteria for Discontinued Operations Business operations are treated as a discontinued operation provided that the following conditions are met: Business unit has its own identifiable operations and cash flows Operations and cash flows of the business unit have been or will be removed from the ongoing company operations as a result of the disposal transaction The company will have no significant continuing involvement in the operations of the business unit after the disposal transaction

35. Best Buy’s Reporting of Discontinued Operations

36. Best Buy’s Reporting of Discontinued Operations

37. Extraordinary Items Extraordinary items represent transitory events that are both unusual and infrequent. Extraordinary items are segregated from the rest of the income statement items and presented separately following income from continuing operations. The company makes the determination of whether an event is unusual and infrequent.

38. GAAP Guidelines for Extraordinary Items GAAP provides the following guidance for the determination of extraordinary item status: Unusual nature - Event or transaction is abnormal and unrelated to the ordinary activities of the company Infrequent – Event is not reasonably expected to recur

39. Examples of Extraordinary Items

40. Change in Accounting Principle A change in accounting principle results from adoption of a generally accepted accounting principle different from the one previously used for reporting purposes.

41. Steps to Account for a Change in Accounting Principle

42. Change in Accounting Estimate Applied prospectively (current and future periods) from the date of adoption. No cumulative effect adjustments or restatements of prior periods’ income statements are made.

43. Recognition of Gains on Assets Sales When assets are purchased they are recorded at their purchase price. Subsequently, they are carried at their historical cost, even if they appreciate in value, and are written down only if they suffer a permanent decline in value. When they are sold, the company recognizes a gain (loss) equal to the difference between their selling price and the amount at which they are carried on the balance sheet: Selling price of asset – Asset carrying amount from balance sheet = Gain (loss) on sale

44. Gains (Losses) on Asset Sales Gain (loss) = sale proceeds – asset book value Assume that a company sells a machine for $10,000 that it carries on its balance sheet for $8,000 (historical cost of $12,000 less accumulation depreciation of $4,000). The company reports a gain of $2,000 ($10,000-$8,000). This gain is reported in income from continuing operations.

45. Restructuring Charges: Employee Severance Employee severance costs represent the accrual of estimated costs relating to the termination of employees as a result of a restructuring program. “Accrual” means the following: The company has estimated the total costs of terminating or relocating a targeted group of employees. This cost might include severance pay, outplacement costs, relocation or retraining costs for those employees who remain with the company, and so forth. Once costs are estimated, the company must record this total estimated cost as an expense in the period that costs are estimated and the restructuring program announced to employees.

46. Restructuring Charges: Employee Severance In the same period, the company must also record a liability on its balance sheet for the total amount of cost recognized in the income statement as expense. When paid, the payments reduce the liability previously recognized and, as a result, do not result in any additional expense in the income statement.

47. Restructuring Charges: Asset Write-downs Asset write-downs: restructuring activities that usually encompass closure or relocation of manufacturing or administrative facilities. This can entail the write-offs of long-term assets (such as plant assets), write-downs of inventories that are no longer salable at current carrying costs or greater, and the write-offs of goodwill.

48. Restructuring Charges: Asset Write-downs Recall that the cost of an asset is first recorded on the balance sheet and is, subsequently, removed from the balance sheet and transferred to the income statement as expense when the asset is used up. Write-down (write-off) of an asset accelerates this process for a portion of (all of) the asset’s cost. It is an entry made into the company’s books and does not involve any cash flow effects, other than any potential tax benefits.

49. Cisco’s Footnote

50. Goodwill Write-Down Goodwill is the excess of the purchase price paid for a company over the fair market value of its net assets (assets less liabilities assumed in the acquisition). Under current accounting standards, goodwill is carried on the books as an asset at its original (historical) cost and its carrying amount on the balance sheet is not reduced unless it is deemed to be impaired, at which time it is written down or written off in its entirety. Goodwill charge-offs refer to the immediate transfer of some or all of the goodwill cost from the balance sheet to the income statement as expense.

51. Cisco’s Goodwill Impairment

52. Pro Forma Earnings

53. Summary: Operating/Nonoperating vs. Core/Transitory

54. Earnings per Share (EPS)

55. Earnings per Share (EPS) Basic EPS is computed as (Net income – Dividends on preferred stock) / Weighted average number of common shares outstanding during the year. Since net income already includes interest expense, but not dividends (dividends are not treated as an expense under GAAP), subtraction of dividends on preferred stock yields the amount of profit per common share available for payment of dividends to common shareholders. Diluted EPS reflect the additional shares that would have been issued had all stock options and convertible securities been exercised at the beginning of the year.

56. Cisco’s Earnings Per Share

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