6-1

Analyzing Operating Activities

6
CHAPTER
 6-2

Operating Activities

Revenue Deferred
Income Recognition Charge
Measurement
Guideline Employee
Concepts Uncertainty Benefit
Measurement Analysis
Alternative/Term
Analysis
Non
Recurring item

Extraordinary
Acc. Charge
Special Item
 6-3

Financial Statements Reflect Business Activities

 6-4

Operating Activities

Income
Measurement

Concepts
Measurement
Alternative/Term
Analysis
 6-5

Income Measurement
Concepts
 Based on accrual accounting
 Suffers from measurement error, arising because of accounting
distortions

Accounting Income consists of:

 Permanent Component--the recurring component expected to
persist indefinitely
 Transitory Component--the transitory (or non-recurring)
component not expected to persist
 6-6

Income Measurement
Measurement
Two main components of accounting income:
Revenues (gains)
Expenses (losses)
 6-7

Income Measurement
Measurement
Revenues and Gains

• Revenues are earned inflows or prospective

inflows of cash from operations*
• Gains are recognized inflows or prospective
inflows of cash from non-operations**

 
* Revenues are expected to
recur
**Gains are non-recurring
 6-8

Income Measurement
Measurement
Expenses and Losses

• Expenses are incurred outflows, prospective

cash outflows from operations
• Losses are decreases in a company’s
net assets arising from non-operations 

Expenses and losses are resources consumed, spent,

or lost in pursuing revenues and gains
 6-9

Income Measurement
Alternatives/Term
Two major income dimensions:

1. operating versus non-operating

2. recurring versus non-recurring*

 *Motivated by need to separate permanent and

transitory components
 1-10
6-10

2017 2016 2015

 6-11

Income Measurement
Alternatives/Term
Alternative Income Statement Measures

• Net income—widely regarded as “bottom line” measure of

income
• Comprehensive income--includes most changes to equity that
result from non-owner sources
• Core income--excludes all non-recurring items from net income
 6-12

Income Measurement
 

Analysis
Determination of Comprehensive Income—sample company

Net income
Other comprehensive income:
+/- Unrealized holding gain or loss on marketable securities
+/- Foreign currency translation adjustment
+/- Postretirement benefits adjustment
+/- Unrealized holding gain or loss on derivative instruments
Comprehensive income
 6-13

Income Measurement
Analysis
Operating versus Non-Operating Income
 
Operating income--measure of company income as generated from
operating activities
 
Three important aspects of operating income
 Pertains only to income generated from operations
 Focuses on income for the company, not simply for equity holders
(means financing revenues and expenses are excluded)
 Pertains only to ongoing business activities (i.e., results from
discontinued operations is excluded)
 
Non-operating income--includes all components of net income
excluded from operating income
 
Useful to separate non-operating components pertaining to financing and
investing
 6-14

Operating Activities

Income
Measurement

Concepts
Measurement
Alternative/Term
Analysis
Non
Recurring item

Extraordinary
Acc. Charge
Special Item
 6-15

Non-Recurring Items
 

 Extraordinary items

 Accounting changes

 Restructuring charges

 Special items
 6-16

Non-Recurring Items
 

Extraordinary Items
Criteria
Unusual in nature
Infrequent in occurrence

Examples
Uninsured losses from a major casualty (earthquake,hurricane,
tornado)

Disclosure & Accounting

Classified separately in income statement
 6-17

Non-Recurring Items
Accounting Changes
First Type of Accounting Change is
Accounting Principle Change—involves
Change
switch from one principle to another

 Disclosure includes:
• Nature of and justification for change
• Effect of change on current income and
earnings per share
 6-18

Non-Recurring Items
Accounting Changes
Second Type of Accounting Change is
Accounting Estimate Change—
Change
involves change in estimate
underlying accounting
 
• Prospective application—a change
is accounted for in current and
future periods
• Disclose effects on current income
and EPS
 6-19

Non-Recurring Items
 

Accounting Changes
Analyzing Accounting Changes
• Are cosmetic and yield no cash flows
• Can better reflect economic reality
• Can reflect earnings management (or even
manipulation)
• Impact comparative analysis (apples-to-apples)
 6-20

Non-Recurring Items
 

Special Items
Special Items--transactions and events that are unusual or
infrequent
 
Challenges for analysis

 Often little GAAP guidance

 Discretionary nature serves earnings management aims
 
Two major types

 Asset impairments (write-offs)

 Restructuring charges
 6-21

Non-Recurring Items
 

Special Items
Asset Impairment—when asset fair value is below carrying (book) value
 
Some reasons for impairments
 Decline in demand for asset output
 Technological obsolescence
 Changes in company strategy
 
Accounting for impairments
 Conservative presentation of assets
 Report at the lower of market or cost
 No disclosure about determination of amount
 No disclosure about probable impairments
 Flexibility in determining when and how much to write-off
 6-22

Non-Recurring Items
 

Special Items
Restructuring Charges—costs usually related to major changes in company
business
 
Examples of these major changes include
 Extensive reorganization
 Divesting business units
 Terminating contracts and joint ventures
 Discontinuing product lines

Accounting for estimated costs of restructuring program

 Establish a provision (liability) for estimated costs
 Charge estimated costs to current income
 Actual costs involve adjustments against the provision when incurred
 6-23

Non-Recurring Items
 

Analyzing Special Items

Earnings Management with Special Charges

(1)  Special charges often garner less investor

attention under an assumption they are non-recurring
and do not persist

(2)  Managers motivated to re-classify operating

charges as special one-time charges

(3) When analysts ignore such re-classified charges

it leads to low operating expense estimates and
overestimates of company value
 6-24

Operating Activities

Revenue
Income Recognition
Measurement
Guideline
Concepts Uncertainty
Measurement Analysis
Alternative/Term
Analysis
Non
Recurring item

Extraordinary
Acc. Charge
Special Item
 6-25

Revenue Recognition
Guidelines
Revenue Recognition Criteria
 Earning activities are substantially complete and no significant
added effort is necessary
 Risk of ownership is effectively passed to the buyer
 Revenue, and related expense, are measured or estimated with
accuracy
 Revenue recognized normally
yields an increase in cash,
receivables or securities
 Revenue transactions are at arm’s
length with independent parties
 Transaction is not subject to revocation (Example : Ship
builder, Highway builder, deposit vs delivery? )
 6-26

Revenue Recognition

Guidelines
Some special revenue recognition situations are

 Revenue When Right of Return Exists

 Franchise Revenues
 Revenue under Contracts
 Percentage-of-completion method
 Completed-contract method
 6-27

Revenue Recognition
 
Analysis
Revenue is important for
 Company valuation
 Management pressure to achieve income expectations
 Management compensation linked to income
 Valuation of stock options
 
Analysis must assess whether revenue reflects business reality
 Assess risk of transactions
 Assess risk of collectibility
 
Circumstances fueling questions about revenue recognition include
 Sale of assets or operations not producing cash flows to fund interest
or dividends
 Lack of equity capital
 6-28

Operating Activities

Revenue Deferred
Income Recognition
Measurement Charge

Guideline
Concepts Uncertainty
Measurement Analysis
Alternative/Term
Analysis
Non
Recurring item

Extraordinary
Acc. Charge
Special Item
 6-29

Deferred Charges

Costs incurred but deferred because they are

expected to benefit future periods

Consider four categories of deferred costs

•Research and development

•Computer software costs
•Costs in extractive industries
•Miscellaneous (Other)
 6-30

Deferred Charges
Research and Development
Accounting for R&D is problematic due to:*

• High uncertainty of any potential benefits

• Time period between R&D activities and determination of success
• Intangible nature of most R&D activities
• Difficulty in estimating future benefit periods
 
Hence:
• U.S. accounting requires expensing R&D when incurred
• Only costs of materials, equipment, and facilities with alternative
future uses are capitalized as tangible assets
• Intangibles purchased from others for R&D activities with alternative
future uses are capitalized
 
*These accounting problems are similar to those encountered with
employee training programs, product promotions, and advertising
 6-31

Deferred Charges
Computer Software Costs
[Note: Accounting for costs of computer software to be
sold, leased, or otherwise marketed identifies a point
referred to as technological feasibility]
 
Prior to technological
feasibility, costs
are expensed when
incurred
 
After technological feasibility, costs are capitalized as an
intangible asset (how many success ? In Silicon Valley?)
 6-32

Deferred Charges
Costs in Extractive Industries
Search and development costs for natural resources is important to
extractive industries including oil, gas, metals, coal, and nonmetallic
minerals
 
Two basic accounting viewpoints:
• “Full‑cost” view—all costs,
productive and nonproductive,
incurred in the search for resources
are capitalized and amortized to
income as resources are produced
and sold

• “Successful efforts” view—all costs that do not result directly in

discovery of resources have no future benefit and should be
expensed as incurred. Prescribed for oil and gas producing
companies (Recent Oil price plunge ?)
 6-33

Operating Activities

Revenue Deferred
Income Recognition Charge
Measurement
Guideline Employee
Concepts Uncertainty Benefit
Measurement Analysis
Alternative/Term
Analysis
Non
Recurring item

Extraordinary
Acc. Charge
Special Item
 6-34

Employee Benefits

Overview

 Increase in employee benefits supplementary to salaries and

wages
 Some supplementary benefits are not accorded full or timely
recognition:

• Employee Stock Options (ESOs)

 6-35

Employee Benefits
Employee Stock Options
ESOs are a popular form of
incentive compensation
—reasons include:

 Enhanced employee performance

 Align employee and company incentives
 Viewed as means to riches
 Tool to attract talented and enterprising workers
 Do not have direct cash flow effects
 Do not require the recording of costs
 Apple Inc, Alibaba, Inc ?
 6-36

Employee Benefits
Employee Stock Options
Option Facts
• Option to purchase shares at a specific price on or after a future
date
• Exercise price is the price a holder has the right to purchase
shares at
• Exercise price often set equal to
stock price on grant date
• Vesting date is the earliest date
the employee can exercise
option
• In-the-Money: When stock
price is higher than exercise
price
• Out-of-the-Money: When stock price
is less than exercise price
 6-37

Employee Benefits
Employee Stock Options

Two main accounting issues

• Determining Dilution of earnings per share (EPS)
 ESOs in-the-money are dilutive securities and affect diluted
EPS
 ESOs out-of-the-money are antidilutive securities and do not
affect diluted EPS
• Determining Compensation expense
 Determine cost of ESOs granted
 Amortize cost over vesting period
 6-38

Question
• Page 380-381/ 390-395
• 6-1
• 6-2
• 6-8
• 6-9
• 6-15
• 6-17
• 6-24
• Exercise 6-4 (20 minutes)
 6-39

Question
10th 11st

Page 380-381 Page 392

6-1 6-1
6-2 6-2
6-8 6-8
6-9 6-9
6-15 6-15
6-17 6-17
6-24 6-24

Pg 383 Pg 395
Exercise 6-4 (20 minutes) Exercise 6-4 (20 minutes)

Discuss the brand value of Discuss the brand value of

Technology companies like Technology companies like
Apple Inc, Google Inc and etc.
Apple Inc, Google Inc and etc.