CFA Level 1 (2009) - 3

Study Session 8

Lro,,-Kdcn.:nce to CFA Institule Assigned Reading #32 - Understanding [he Income Statemenl

If a firm ren:ives cash before revenuc rculgnition is com pine, lhe firm rcports il as Uncarned rdenuc is reponed on the ld;tncc sheCI as a liability. Thc

liability is reduccd in the futurc as lhc l"Cvcnue is earncd. hll exampIL', a mag;lJ.inc publisher tYI)ically tcccives subscription paymelHs in advance of delivery. When payments arc reccivcd, both assets (cash) ~lnd liabilitics (uncarned revcnue) increase. As thc magazincs arc delivered, lhc pul1lisher recognizes ITvenuc 01\ the income statement and the liability is rcdmed.

Specific Revenue Recognition Applications

Rcvcnuc is usually tecognized ;It delivcry using the revenue rccognition critcria previously discussed. Howevcr, in somc ClSCS, rcvcnue nLt)' bc rccognii'.ed before delivcry occurs or even :tf-rer delivery takes place.

I.Ol/g-IeJ'1II COl/lrllcls

The perccntage-of-completion ml'tllOd ;ll1d thc compktcd"col\lraet mcthod arc used for contracts thaI' otend beyond one accounting period, often contrans related to consrruction projCCts.

In certain uses in\"()lving servicc conrLIClS or liccnsing dgrc:'emenrs, rhe hrm may simply rccogni/-c revcnuc equally ovc!" the rerm of the cOlHract or agrcement.

The percentage-of-completion method is appro[Hiatc when the pruject's cost and revenue can be reliably estim:ned. Accol'dingl)" rCVenlle, expense, and therd-ore pronr, "re rccognized 'IS the work is pcrformcd. The I'C!'CcnLIge of completion is measured by the totJI COSt incurred to datc divided hy the total expectcd cost of the project.

The completed-contract method is llsed when the outcomc of a project cannot be reliably measured or the project is shon-rerrn Accordinglv, revenue, expense, and profit arc recognized onl), when the contract is complele. Under eirher mClhud, if a loss is cxpecred, the loss Illust he recognized il11l11edi'lIe!r.

Under IlHcrnarional Financial Reporting St~ll1(hrds (lFRS), if rhe Ilrm cannot reliably measure the outcome of the projecr, revenue is recogni7.ed LO the extcnt of contract costs, costs are expensed when incurred, ,\11\.1 profit is recognized oniy at completion.

The effect of using these different revenue recognition methods for long-term contracrs on the income statement is illustrated in rhe following example.

Sludy Session H

Cross-Reference to eFA Institute Assigncd Reading 1132 - Undcrstanding the Incomc Statemcnt

As compared to the compkted contract method, the percentagc-of-completion method

I is more aggressive since revenue is reported sooner. Also, the percentage-of-completion Illethod is more subjective heClusc it involves cost estimates. However, the percentage- of-completion method provides smoother earnings and results in better m:uching of reven ues and ex penscs over time. Cash How is rhe same under both met hods.

Installment Sales

An installment sale occurs when a firm finances a sale and payments are expected to be received over an extendeJ period. if coiltctibility is certain, revenue is recognized at

the time of sale using the normal revenue recognition criteria. If collectibility cannor be reasonahly estimated, the installment method is useJ. II'col\cctibility is highly uncertain, the cost recovery method is used.

Under the installment method, profit is tecognized as cash is colleCled. Profil is equal to the cash collecled during the pl"IioJ multiplied hy the lOLl I expelled proJil as a percentage of sales. The installment method is used ill limiled circulllstances, usually involving the sale of real estate or other firm assets.

Under the cost recovery method, proht is recognized only when cash collected exceeds costs incurred.

The effects of using the installment and rhe cost recovery Illerhods are illustrated in the following example.

Example: Revenue recognition for installment sales

Assume that BBB Property Corp, sells a piece of land for $1,000. The original cost of the land was $800. Collections received by BBB for the sale are as follows:

BBB lnstallment Collections

Determine BBB's profit under the installmenr and cost recovery merhods.

Answer:

Total expected profit as a percentage of sales is 20% [($1,000 - $800) / $1,000]. Under the installment method, BBB will repon profit in 20X5 and 20X6 of $80 [$400 x 20%] each year. In 20X7, BBB will report profit of$40 [$200 x 20%].

Under the cost recovery method, the collections received during 20X5 and 20X6 are applied to the recovery of costs. In 20X7, BBB will report $200 of profit .

Study Sl:ssiun 8

Cross-Refercncc to eFA Institute Assigned Reading #32 - Understanding thl.' Income Statl.'ll1l.'lll

IFRS ;\(.ldrcsses when installmcnt sale treatment is appropriate JiH n:nain rca] estatc transactions. Specifically, [he date whl'n tide (() the propnty is transferred and the dare whcn the buyn acquircs a vcsted interest may diller. Also, installmcnt sale treatment may be relJuired when the risks and rewards of ownership arc not transferred because the seller remains involved in the l)J"openy. Finally, significant llllccnainry rhar the buyer em complete Ihe trallsaction lJIay require installlllell( sale treatment.

Bartel' ]i-flllS{/ctioIlS

In a barter transaction, rwo parries exchange goods or services withour c;lsh !)aymell(. A round-trip transaction involves the sale of goods to one party wirh rhe simultaneous

purchase of almost identictl goods from the same parry. The underlying issue with these Iransacrions is wherhl'l' revenue should be recognized. In rite late 1990s, several in ternet companies increased their revcnuc signilicanrly by "buying" equal values of advenising space on cach others' websites.

According to U.S. (; AA 1>, reVl'lllle from a barrel' transaction can he recognized ~lt fair value only if the firm has historically received cash payments for such goods and services and can usc this historical experience to determine fair value. 4

Under IFRS, revenue from barter transactions must be based on the fair value of revellue from similar nonbarter transactions with unrelated parries."

Gross find Net Reporting of Revellue

Under gross revenue reporting, the selling firm reports sales revenue and cost of goods sold separately. Under net revenue reporting, only the ditTerence in s,11es and cosr is reponed, While profit is the same, sales are higher using gross revenue reponing.

For example, consider a travel agent who arranges a ilrst-c1ass ticket for a customer flying to Singapore. The ticket price is $10,000, and the travel agent receives a $1,000 comm ission. Using gross repo ning, the travel agen t would repon $10,000 of reven ue, $9,000 of expense, and $1,000 of profit. Using net reponing, the travel agent would simply repon $1,000 of reven ue and no expense.

The following criteria must be met in order to usc gross revenue reponing under U.S.

GAAP. The firm must:

Be the primary obligor under the contract,

• Bear the inventory risk and credit risk.

• Be able to choose its supplier.

• Have reasonable latirude to establish the price.

Implications for Financial Analysis

As noted previously, firms can recognize revenue before delivery, at the time of delivery, or afrer delivery takes place, as appropriate. Different revenue recognition methods can

4.Emerging Issues Task Force EITF 99-17, "Accoullting for Advertising B;ll'\er Tr;lI1Sactiol1s."

5.IASB, SIC In terpretation 31, Reven LIe - Barrel' Transactions Involving Advertising Services, paragraph 5.

Study Session 8

Cross-Refercm:e to CFA InstitUle Assigned Reading #32 - Undcrstanding the Incomc Statement

be llsed within thc firm, Firms disclose their revenllC rccognition I)olicies in the financial slatc:ment f;)()!IlOtc'S,

Usc'!'s of financial information must consider twO points when ;lnalyzing a firm's reVCllUC:

(1) Illlw conservativc arc the firm's rc'velllle rccognition policics (rccoglliJ,ing revenlle sooner rather than later is more ;lggressive), and (2) thc' extent to whiLh the firm's policies rely on jndgrllcn[ and c'srin1;ucs,

LOS :')2.c: Discllss the general principles of expense recognition, such as

the matching principle, specific e~pensc rCLognition ;ll'plications (including deprcc'iatioll of IOllg-term ;lsselS and invclltory ll1l'lhodsi, ;llld the implicttiol':; of expense recognition principles for financial alulvsis.

l':xp,:nses arc sllhtraClc,d !"I'om rc'VCllllc' to cdcllJate nCl incollle, ALcording to the IASB,

C'XjWIlSCS ;lrc dClT'cascs ill l'collomic hCllciits dming rhl' accollnting period in [he I;HI1l of olltflows or dcplctions or ;ISSc'lS or inClllTCnLe or liahilities that resliit in deuclscs ill equity orhcr than those relating to disrrihurions to equity panicipants('

If rhe financial SCHemelHS wne prepared 011 a cash b:-tsis, I1cithl'l' ITVTIIUC recogllition nor expense 1'l:,cognition would be an issuc. The finn would simply recogniJ,e cash receivcd as revenue and cash payments as expcl1se.

Under the accrU;l1 method of accounting, expense recognition is based on the matching principle vv'hereby expenses 10 generate revenue arc recogniJ.ed in the same I)criod as the revenue, Inventory provides a good example. Assume inventory is pllrchasnl during the fourth quaner of one year and sold during the first quartL[ of the following year.

Using the matching principle, both the revenue and [he expense (cost of goods sold) arc recognized in the firsr quarter, when the inventory is sold, nor the period in which the inventory was purchased.

Not all expenses can be directly tied to revenue generation, These costs ate known

as period costs. Period costs, such as administrative costs, are expensed in the period incurred.

The cost of long-Jived assets must also be matched with revenues. Long-lived assets are expected to provide economic bendits beyond one accouming period. The allocation of cost over an asset's useful life is known as depreciation, depletion, or amottization expense.

If a firm sells goods or services on credit or provides a warranty to the customer, the matching principle requires the firm to estimate bad debt expense and/or warranty expense. By doing so, the fitm is recognizing the expense ill the period of the sale, rather than a later period.

6. lASH Framework JOr the Preparation and Presentation ofFinancial Statements, paragraph 70.

Swdy Session 8

Cross-Refercnce to CFA Institute Assigned Reading #.12 - Understanding thc Income Statement

Implications for Financial Analysis

Like revenue recognition, expense recognition requires a nlllnher of estimates. Since estimates arc involved, it is possible for firms to delay or accelerate the recognition of expenses. Delayed expense recognition increases current net income and is therdare more aggressive.

Analysts must consider the underlying reasons (~)[ a change in an expense estimate. If a firm's bad debt expense has recently decreased, did the firm lower its expense estimate because its colleerion experience improved, or was the expense decreased (0 manipulate net income?

Analysts should also compare a firm's estimates to those of other firms within the firm's industry. If a firm's warranty expense is signif1cantly less than rhat of a peer f1rm, is

rhe lower warrant)' expense a result of higher quality prot!uLts, or is the firm's expense recognilion more ;\ggressive than that of the peer firm?

Firms disclose their accoullting policies and signif1cant estimates in d1e financial statement footnotes and in the management discussion and analysis (MD&A) section of the annual repon.

LOS .)l.d: DCl,,·tIlliJll: which mcthod oj' c!cprcci;lliop, accol!l1(ing for ;']\,Cl'iCli'\' or amortizing jn,;'ngihL'~ is ai)i)l'Jpri~lle, L;iscd (HI L,L'l.S (h:\( migh, ;'lfi"CllCC the decision.

Depreciation

Most f1rms use the straight-line depreciation method for financial reporting purposes. The straight-line method recognizes an equal amount of depreciation expense each period. However, most assets generate more benefits in the early years of their economic life and fewer benefirs in the larer years. In this case, an accelerated depreciatio71 method is more appropriate for matching the expenses to revenues.

In the early years of an asset's life, the straight-line method will result in lower depreciation expense as compared to an accelerated method. Lower expense results in higher net income. In the later years of the asset's life, the effect is reversed, and straightline depreciation results in higher expense and lower net income compared to accelerated methods.

Inventory

If a firm can identify exactly which items were sold and which irems remain in inventory, it can usc the specijic identification method. For example, an aura dealer records each vehicle sold or in inventory by its identification number.

Under rhejirst-in, jirst-out (l~IFO) method, the first item purchased is assumed to be the first item sold. FIFO is appropriate for inventory that has a limited shelf life.

Study Session 8

Cross-Reference to CFA Institute Assigned Reading #32 - Understanding the Inl'oll1e Statement

For example, a food products company will sell its oldest inventory first to keep the inventory on hand fresh.

Under the It/st-ill, first-out (UFO) method, the last item purchascd is assulllcd to be the first item sold. LIFO is appropriate for invell[ory that docs not deteriorate with age. hll' example, a coal mining company will sell coal off the top of the pile.

In the United States, LIFO is popular because of its income tax benefits. In an inflationary environment, LII~O results in higher cost of goods sold. Higher cost of goods sold results in lower taxable income and, therefore, lower income taxes.

The lUeighted al/erage cost method is not affected by the physical How of thc invclI[ory. It is popular because of its case of usc.

FIFO and average cost can be used under U.S. CAAIJ or JFRS. UH) is allownl llllLln

U.S. CAAP but is prohibited under IfRS.

Figure 2 summarizes the effects of the inventory methods.

Figure 2: Inventory Method Comparison

Amortization expense for intangible assets with limited lives is similar to depreciation. The expense should match the proportion of the asset's economic benefits used during the period. Most firms use the straight-line method for financial reporting. Goodwill and other intangible assets with indefinite lives arc not amortized.

Sludy Session H

Cross-Reference to crA Institutc Assigned Reading #32 - Understanding lhe Incomc Statement

-----~-------_.__ .. ---

I.OS 32.c: Dcmonstrate lhe depreciation of long-term assCls using cach approved mcthod, accouJlting for inventory using each :lpproved method, aud amortization of illl<lngihics.

Depreciation expense can he compll[ed lllllkr a numher of dilTercnl Illl'lhuds.

Straight-line depreciation (SL) allocates all equal aIllOUJ1l of depreciation each year over the asset's uscful lile as follows:

Cost - Resid ual value

SL Depreciation expense --- ----------------

Usefu I lj fe

Example: Calculating straight-line depreciation expense

Littlefield Company reccntly purchased a machine at a cost of $12,000. The machine is cxpcClcd to have a residual valuc of $2,000 at the end of its useful life in

5 years. Calculate depreciation expense using the straight-line method. Answer:

Accelerated depreciation specds lip the recognilion of depreciation expense in a systcmatic way to recognize more depreciation cxpense in the early years of the asset's useI'll I life and less depreciation expense in Ihe bter years of its life. Tot,d depreciatioll expense over the life of the asset will be the same as it would be if srraight-line depreciation were used.

The declining balance method (DB) ap[llies a conSLlIH rale of depreciatio/l (O a declining hook valuc.

The most common form of the declining balance method is double-declining balance (DDB), which uses 200% of the straight-line rate as the percentage rate applied to the declining balance. If an asset's life is ten ycars, the straight-line rate is 1110 or 10%. The DDB rate for this asset is 2/1 0 or 20%.

DDB depreciation = [ 2. J(cos t - accumulated depreciation) useful lIfe

DB does not explicitly use the asset's residual value in the calculations, hut depreciation ends once the estimated residual value has been reached. If the asset is expected to have no residual value, the DB method will never fully depreciate it, so the method has to change (typicaJJy to straight-line) at some point in the asset's life.

Study Session 8

Cross-Reference to CFA Institute Assigned Reading #32 - Understanding the Income Statcmcnt

Example: Calculating double-declining balancc deiJreciatioll expense

Littlefield Company recently purchased a machine at a cost of $12,000. The machine is expected to have a residual value of $2,000 at the end of its useful life in five years. Calculate depreciation expense for all five years using the doubledeclining balance method.

Answer:

The depreciation expense using the double declining balance method is:

•Year 1: (2/5)($12,000) = $4,800

•Year 2: (2/5)($12,000 - $4,800)= $2,880

•Year 3: (2/5)($12,000 - $7,680)= $1,728

In years 1 through 3, the company has recognized cumulative depreciation expense of $9,408. Since the total depreciation expense is limited to $10,000 ($12,000 - $2,000 salvage value), the depreciation in year 4 is limited to $592, rather than the

(2/5)($12,000 - $9,408) = $1,036.80 using the DDB formula.

Year 5: Depreciation expense is $0, since the asset is fully depreciated.

Note that the rate of depreciation is doubled (2/5) from straight-line, and the only thing that changes from year to year is the base amOU11l (book value) used to calculate annual depreciation.

o;'"el. Professor's Note: we've been discussing the "double" declining balance method, which uses a factor oftwo times the straight-line rate. You can compute declining balance depreciation btlsed on any factor (e.g., 1.5, double, triple).

Inventory Accounting Methods

Three methods of inventory accounting are:

1. First In, First Out (FIFO)

•The cost of inventory first acquired (beginning inventory and early purchases) is

assigned to the cost of goods sold for the period.

• The cost of the most recent purchases is assigned to ending inventory.

2.Last In, First Out (LIFO)

•The cost of inventory most recently purchased is assigned to the cost of goods sold for the period.

•The costs of beginning inventory and earlier purchases arc assigned to ending ll1ventory.

3.Average cost

•The cost per unit is calculated by dividing cost of goods available by total units available.

This average cost is used to determine both cost of goods sold and ending lI1ven tory.

•Average cost results in cost of goods sold and ending inventory values between

LIFO and FIFO.

Study Session 8

Cmss-Rcfcrcncc to CFA Institute Assigned Reading 1132 - Understanding thc Income Statcmcnt

Example: Inventory costing

Use the inventory data in the table below to calculate the cost of goods sold and ending inventory under each of rile three methods.

FIFO COGS Calculation

LIFO COGS Calculation