Discussion and Assignment

Discussion (100-150 words):

Why do you think ” Gross versus Net” became such a big issue in accounting? 

Assignment (1-2 pages double space):

Revenues are at the core of a firm’s ability to grow and prosper; thus, they are central to the analysis of a firm’s profitability. Although the time-of-sale is the most common technique employed to recognize revenues, in some instances, a strong argument can be made for recognizing revenue using other methods. 

In a comprehensive presentation of the various revenue recognition methods, please discuss different circumstances where methods might be used and the rationale behind your answer.

Providing real world (cited) outside examples, including references to article links will greatly strengthen your work. 

Chapter 9

Operating Activities

1

Criteria for Revenue Recognition
Under US GAAP for accrual basis of accounting:
If firm has provided all or substantial portion of product or service; and
If firm has received an asset or satisfied a liability with a value measurable with reasonable precision.

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Criteria for Revenue Recognition (Contd.)
Outlined by SEC for accurate reporting:
If there is pervasive evidence that an arrangement exists.
If delivery has occurred or services have been performed.
If the seller’s price to the buyer is fixed or determinable.
If collectability is reasonably assured.
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Criteria for Revenue Recognition (Contd.)
Provided by IFRS with respect to sale of goods:
If seller has transferred to buyer significant risks and rewards of ownership of goods.
If seller has not retained either effective control or the kind of involvement associated with ownership.
If amount of revenue can be measured reliably.
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Criteria for Revenue Recognition (Contd.)
If probable that seller will obtain economic benefits associated with transaction.
If costs incurred or to be incurred can be measured reliably.
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Revenue Recognition at time of Sale
For most firms, occurs at time of product or service delivery.
Too early for a firm when below conditions exist:
Large and volatile uncollectible receivables.
Unusually large return of goods.
Excessive warranty expenditures.
Substantial increase in collection periods.
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Revenue Recognition at time of Sale (Contd.)
Suffers from a more fundamental problem when firms:
Recognize revenue on firm order for goods held in inventory.
Recognize revenue earlier to physical delivery and transfer of legal title to customer.
Recognize revenue based on a mere indication of interest by customer.
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Revenue Recognition delayed
When firms do not meet some or all obligations to the buyer. Examples:
Sale of redeemable vouchers
Insurance premiums paid in advance
Advance collected from customers
Firms record a liability (often called deferred revenue, unearned revenue, or advances from customers) for the amount of delayed revenue.
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Income Recognition under Long-Term (LT) Contracts
Operating cycle under LT contracts differ:
Period of production may span many accounting periods.
Customers are identified, scope and price of contract agreed upon in advance.
Customers make periodic payments as work progresses.
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Percentage-of-Completion method
Recognizes revenue on completion of milestones and customers invoiced for partial completion based on:
Total contract price
Degree of completion
Ratio of costs incurred till date to total expected costs
Recognizes proportion of expenses vis-à-vis recognition of revenue.
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Completed-Contract method
Recognizes revenue on completion of contract.
Contract price, costs, degree of completion not easily estimable
Method not permitted under IFRS if percentage-of-completion method cannot be used for reasons stated above.
Recognizes loss on contract as soon as evident; even if contract is incomplete.
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Reporting choices under LT Contracts
Contractors:
Should not use percentage-of-completion method when substantial uncertainty exists about costs.
Can use either of two methods for contracts of shorter duration.
Must use the percentage-of-completion method for income tax purposes
Prefer to use the completed-contract method to delay revenue and taxes for tax purposes.
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Revenue Recognition When Cash
Collectability is Uncertain
When firm has completed delivery of the product and customer is allowed to pay over a long period of time.
Recognizes revenue only when cash is collected using either:
Installment method
Cost-Recovery method
These methods are used only when amount of cash firms will receive in future cannot be assessed.
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Installment method
Recognizes revenue as and when portion of selling price is collected in cash.
Recognizes proportion of cost of goods sold as an expense vis-à-vis recognition of revenue.
Often used by manufacturing firms selling on extended payment plans.
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Cost-Recovery method
Recognizes revenue not until cash is received.
Recognizes matching amount of expenses each period until full cost recovery occurs.
Shows profit only when cumulative cash receipts exceed total costs.
On full cost recovery, recognizes further cash receipts as revenues with no matching costs.
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Criteria for Expense recognition
Under US GAAP and IFRS:
Costs directly associated with revenues be recognized as expenses in the period when firm recognizes revenues (product costs).
Costs not directly associated with revenues be recognized as expenses in the period when firm consumes the services or benefits of costs in operations (period costs).
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Cost of Sales
Single largest expense for most retail and manufacturing firms.
An expense is recognized when inventory is consumed.
Expense recognition becomes difficult when unit costs are small and inventory items similar:
In such cases, cost of goods sold is measured by making assumptions about the flow of costs , i.e Lifo, Fifo, Weighted Average.
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Cost-flow assumptions
Weighted average
Determines the weighted average cost of all inventory items available for sale.
Assigns the cost to each unit sold and in the ending inventory.
Most recent purchase prices receive greater weightage in cost.
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Cost-flow assumptions (Contd.)
First-in, first-out (FIFO)
Values ending inventory in balance sheet at prices closest to current replacement cost of inventory.
Results in the highest net income and highest balance sheet value for inventory of all three methods in a period of rising prices.
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Cost-flow assumptions (Contd.)
Last-in, first-out (LIFO)
Assigns amounts to cost of goods sold closest to current replacement cost of inventory.
Results in the highest cost of goods sold and lowest net-income of all three methods in a period of rising prices.
Is preferred by firms for income tax purposes.
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Cost-flow assumptions (Contd.)
LIFO layer liquidation
Is an exception to the generalization that LIFO produces the lowest net income during periods of rising prices.
Occurs when a firm sells more units during a period than it purchases.
LIFO assigns the cost of all current period’s purchases plus costs assigned to the liquidated LIFO layers to COGS.
During periods of rising prices, the liquidated layers of LIFO may be lower than current costs, causing COGS to be relatively low and net income relatively high.
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Why restate LIFO to FIFO?
If LIFO inventory valuation results in low out-of-date inventory values, reflecting poor accounting information quality.
Inventory turnover ratio based on LIFO gives poor indication of the actual inventory turnover.
LIFO measure of the inventory turnover ratio does not accurately portray the number of days inventories are held if LIFO costs are very old.
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Reporting changes in Fair market value of inventory
Under U.S. GAAP and IFRS, inventory reported at each balance sheet date is to be lower of cost or market.
Increases in market value is not reflected in the financial statements until inventory is sold.
Under U.S. GAAP and IFRS, losses due to decline in market values of inventory below cost, are reflected as decrease in inventory and increase in cost of goods sold.
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Accounting Quality: Cost of Sales and Inventory
Following are considered for assessing quality of information:
Inventory cost-flow assumption.
Price variation and inventory turnover ratio.
Liquidation of LIFO inventory layers.
Physical deterioration or obsolescence of inventory.
Financing of inventory acquisitions.
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Cost-Flow Assumptions by firms
Should be ascertained by any analyst without regard to:
Rapid Inventory Turnover and Price Stability.
Liquidation of LIFO Inventory Layers.
Obsolete or Damaged Inventory.
Inventory Financing Arrangements.

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Working Capital Investments
Revenues and cash inflows are not necessarily equal.
Cash inflows occurring after revenue is recognized results in:
Working capital asset or Accounts receivable.
Cash inflows occurring before revenue is recognized results in:
Working capital liability or Deferred revenues.
Inventory purchases affect Cash flow from operations due to:
Increase in Accounts Payable or
Decrease in Cash.
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SG&A (Selling, General, and Administrative) Costs
Bear a less direct relationship with sales.
Represent the consumption of assets and incurrence of liabilities to carry on corporate functions other than production.
Examples: Advertising, Marketing, Administration, Accounting, Information systems, Warranty expense and Credit functions.
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Operating Profit
Sales revenue – Cost of sales – SG&A expenses = Operating profit before tax
Financial revenues and expenses along with equity in the earnings of affiliates are disclosed.
Income tax expense is subtracted to obtain Net Income.
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Income Tax Expense Computation
Balance-sheet approach used to compute income tax expense:
Identify all differences between book and tax basis of all assets, liabilities and tax loss carry-forwards.
Eliminate permanent differences between book and tax basis.
Compute deferred tax assets and liabilities arising out of temporary differences and tax credit carry-forwards.
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Income Tax Expense Computation (Contd.)
Assess the likelihood of benefits realizable from deferred tax assets.
Income taxes currently payable on taxable income.
Plus (minus) an increase (a decrease) in deferred tax liabilities between the beginning and the end of the period.
Minus (plus) an increase (a decrease) in deferred tax assets.
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Required Income Tax Disclosures (GAAP)
Components of income tax expense
Current expense
Deferred expense
Components of income before taxes
Domestic operations
Foreign operations
Reconciliation of income taxes at statutory rate with income tax expense
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Required Income Tax Disclosures (GAAP) (Contd.)
Reconciling tax rate differences
Permanent differences
Components of deferred tax assets and liabilities
Uncollectible Accounts Receivable
Warranties
Pensions
Leases
Net operating losses
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Required Income Tax Disclosures (GAAP) (Contd.)
Net operating losses
Depreciable assets
Inventories
Installment receivables
Intangible Drilling and Development Costs
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Assessing a Firm’s Tax Position
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Tax effective ways of operating:
Shifting operations from higher tax regions to lower tax regions.
Adjusting transfer prices or cost-allocations to shift income from high-tax to low-tax jurisdictions.
Shifting from domestic to foreign borrowing to increase deductions for interest against foreign-source income.

Assessing a Firm’s Tax Position (Contd.)
Shifting from equity to debt financing to increase interest deductions.
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Pensions and other Post retirement benefits
Benefits provided by employers after employees retire.
‘Pension Benefit’ plans are sponsored by employers:
Employers place a certain percentage of employee’s earnings into an investment vehicle as specified by employee.
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Pensions and other Post retirement benefits (Contd.)
Employer’s obligation under the plan is satisfied once funds are placed into the investment account.
Fund balance at retirement depends on the investing success of the investment company.
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Pension Accounting in a Defined Benefit plan
Key amounts in Defined Benefit Plan:
Pension Obligation (Liability):
Projected Benefit Obligation (PBO): Actuarially determined present value of estimated retirement payments to employees.
Calculated according to the benefit formula (using expected future salary levels).
Discount rate used is the rate at which an outside party would effectively settle the obligation.
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Pension Accounting in a Defined Benefit plan (Contd.)
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Pension Benefit formula:
Pension Assets:
Funds set aside by employers to make pension payments.
Measured at fair market value (FMV) at the end of each year:
Employers use Year-end FMV or an average FMV over a period of time, usually five years in financial reporting.

Economic Status of Pension Plan
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Determined by comparing two economic amounts:
Projected Benefit obligation
Fair market value of Plan Assets
Economic status of plan reflected on the balance sheet:
Changes in the economic status of plan reported in comprehensive income.

What Changes the Economic Status of the Plan?
What Changes the PBO?
Service cost
Interest cost
Prior service cost
Actuarial gains and losses
Benefit payments to retirees

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What Changes the Economic Status of the Plan (Contd.)
What Changes the FMV of Pension Plan Assets?
Cash contribution to Plan assets by employers.
Actual return on plan assets.
Benefit payments to retirees.
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Reporting Income Effects of Pension Plans
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Income Statement Effects of Pension Plans
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Gain and Loss Recognition in Pension Plans
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Gains and losses occur when expectations turn out to be different than realizations.

Net deferred gain/loss is amortized only if very large:
corridor amount set as threshold for deferred gain or loss amortization by FASB.
corridor is defined as 10 percent of the greater of actual PBO or actual FMV.

Actuarial Assumptions under Pension Plans
To be disclosed in notes to financial statements:
Discount rate used to compute the pension benefit obligation.
Expected rate of return on pension investments.
Rate of compensation increase, which affects the amount of the PBO.
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Other Postretirement Benefits
Benefits provided to employees other than pension (eg; health care).
Expected obligation computed as the actuarially determined present value of future payments.
Accounting framework different from that of Pensions wrt following:
Payments are made as and when claims are made with no dedicated plan assets, and
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Other Postretirement Benefits (Contd.)
Additional disclosures for Postretirement Benefits other than Pensions:
Assumed health care cost trend rate in actuarial computations.
Effect of a one-percentage-point change in health care cost trend rate on accumulated PBO and aggregate of service and interest cost of Health care benefits.
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Signals about Earnings Persistence
Sharp swings in market values of investments can impact pension expense and earnings.
Firms use long-term expected returns on investments to compute expected return on assets each period.
Impact of changing stock prices is to be considered to forecast future earnings based on current earnings.
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Derivative Instruments
Help a firm mitigate the following risks:
Interest rate risk.
Foreign currency exchange rate risk.
Commodity price risk.
Nature and use
Derive value from some other financial instrument.
Typically used to hedge against losses from above mentioned risks.
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Derivative Instruments (Contd.)
Their change in value offset changes in value of an asset or a liability or changes in future cash flows, thereby neutralizing losses.
Reported as assets or liabilities depending on rights and obligations under a contract.
Must be revalued to fair value each period with revaluation amount affecting net income or other comprehensive income.
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Derivative Instruments (Contd.)
Classified under US GAAP and IFRS as:
Speculative investments
Fair value hedges
Cash flow hedges
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Treatment of Hedging Gains and Losses
Under Fair Value hedges:
Gains and losses recognized in net income.
Asset or liability revalued with a corresponding amount.
Under Cash Flow hedges:
Gains and losses recognized in Other Comprehensive income.
Gain or loss out of ineffective hedges included in Net income.
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Treatment of Hedging Gains and Losses (Contd.)
Accumulated amount in Other Comprehensive income is transferred to net income periodically.
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Disclosures Related to Derivative Instruments (FASB Statement 133)
Risk management strategy of the firm distinguishing the derivative instruments used.
Net gains or losses under Fair Value and Cash Flow hedges due to ineffective hedging.
Transactions resulting in re-classification of gains and losses from Other Comprehensive income to net income.
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Disclosures Related to Derivative Instruments (FASB Statement 133) (Contd.)
Net gains or losses when a:
hedged firm commitment no longer qualifies as a fair value hedge or
hedged forecasted transaction no longer qualifies as a cash flow hedge.
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Accounting Quality Issues and Derivatives
Fair market values reported for derivative instruments not reliable when active markets do not exist.
Classification of derivatives as ‘fair value’ hedges versus ‘cash flow’ hedges by firms questionable.
Different impact on earnings due to gains or losses from each kind of hedge.
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Income Tax Expense
Book Income before Income Taxes
Average Tax Rate=
Sheet1

As reported Adjustments FIFO basis
Sales (a) 23,663,324 23,663,324
Beginning inventory 1,601,600 581,500 2,183,100
Purchases 20,418,840 20,418,840
Goods available for sale 22,020,440 22,601,940
Ending inventory (2,408,157) (923,400) (3,331,557)
Cost of sales 19,612,283 (341,900) 19,270,383
Gross margin (b) 4,051,041 4,392,941

Sheet2

Average Tax Rate = Income Tax Expense
Book Income before Income Taxes

Sheet3

Annual Benefits=Annual CreditxYears of ServicexSalary at Retirement Date
Sheet5

Annual Benefits = Annual Credit x Years of Service x Salary at Retirement Date

If PBO>FMV of plan assets: Plan is underfunded (net obligation)
If PBO FMV of plan assets: Plan is underfunded (net obligation)
If PBO < FMV of plan assets: Plan is overfunded (net asset) Sheet3 Type of Change in Pension PlanTreatment in Reporting Income Changes in PBO: Service costIncrease pension expense (decrease net income) Interest cost on PBOIncrease pension expense (decrease net income) Prior service costDecrease other comprehensive income Liability gains/losses on PBOIncrease/decrease other comprehensive income Changes in FMV of plan assets: Actual return on plan assets: Expected return on plan assetsDecrease pension expense (increase net income) Asset gains/lossesIncrease/decrease other comprehensive income Sheet1 As reported Adjustments FIFO basis Sales (a) 23,663,324 23,663,324 Beginning inventory 1,601,600 581,500 2,183,100 Purchases 20,418,840 20,418,840 Goods available for sale 22,020,440 22,601,940 Ending inventory (2,408,157) (923,400) (3,331,557) Cost of sales 19,612,283 (341,900) 19,270,383 Gross margin (b) 4,051,041 4,392,941 Sheet2 Average Tax Rate = Income Tax Expense Book Income before Income Taxes PBO > FMV of plan assets: Plan is underfunded (net obligation)
PBO < FMV of plan assets: Plan is overfunded (net asset) Sheet3 Type of Change in Pension Plan Treatment in Reporting Income Changes in PBO: Service cost Increase pension expense (decrease net income) Interest cost on PBO Increase pension expense (decrease net income) Prior service cost Decrease other comprehensive income Liability gains/losses on PBO Increase/decrease other comprehensive income Changes in FMV of plan assets: Actual return on plan assets: Expected return on plan assets Decrease pension expense (increase net income) Asset gains/losses Increase/decrease other comprehensive income Service cost AddInterest on PBO LessExpected return on assets AddAmortization of Prior Service cost AddAmortization of gain/loss Net pension expense Computation of Net Pension Expense Sheet4 Computation of Net Pension Expense Service cost Add Interest on PBO Less Expected return on assets Add Amortization of Prior Service cost Add Amortization of gain/loss Net pension expense Expected PBO≠Actual PBO, results in liability gains or losses Expected FMV≠Actual FMV, results in asset gains or losses Sheet1 As reported Adjustments FIFO basis Sales (a) 23,663,324 23,663,324 Beginning inventory 1,601,600 581,500 2,183,100 Purchases 20,418,840 20,418,840 Goods available for sale 22,020,440 22,601,940 Ending inventory (2,408,157) (923,400) (3,331,557) Cost of sales 19,612,283 (341,900) 19,270,383 Gross margin (b) 4,051,041 4,392,941 Sheet2 Average Tax Rate = Income Tax Expense Book Income before Income Taxes PBO > FMV of plan assets: Plan is underfunded (net obligation)
PBO < FMV of plan assets: Plan is overfunded (net asset) Sheet3 Type of Change in Pension Plan Treatment in Reporting Income Changes in PBO: Service cost Increase pension expense (decrease net income) Interest cost on PBO Increase pension expense (decrease net income) Prior service cost Decrease other comprehensive income Liability gains/losses on PBO Increase/decrease other comprehensive income Changes in FMV of plan assets: Actual return on plan assets: Expected return on plan assets Decrease pension expense (increase net income) Asset gains/losses Increase/decrease other comprehensive income Sheet4 Computation of Net Pension Expense Service cost Add: Interest on PBO Less: Expected return on assets Add: Amortization of Prior Service cost Add: Amortization of gain/loss Net pension expense Sheet5 Expected PBO ≠ Actual PBO, results in liability gains or losses Expected FMV ≠ Actual FMV, results in asset gains or losses