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Module 5
Reporting and Analyzing Operating Income
| Learning Objectives – coverage by question | |||||
| True/False | Multiple Choice | Exercises | Problems | Essays | |
| LO1 – Explain revenue recognition criteria and identify transactions of special concern. | 1-4 | 1-6 | 1-6 | 1, 2 | 1-3 |
| LO2 – Describe accounting for operating expenses, including research and development, and restructuring. | 5-9 | 7-14 | 7-12 | 3-5 | 4-6 |
| LO3 – Explain and analyze accounting for income taxes. | 10-12 | 15-20 | 13-19 | 6, 7 | 7 |
| LO4 – Explain how foreign currency fluctuations affect the income statement. | 13 | 21 | 20, 21 | 8 | 8 |
| LO5 – Compute earnings per share and explain the effect of dilutive securities. | 14, 15 | 22-25 | 22-25 | 9, 10 | 9, 10 |
| LO6 – Explain accounting quality and identify areas for analysis. | 16 | 26 | |||
Module 5: Reporting and Analyzing Operating Income
True/False
Topic: Revenue Recognition
LO: 1
1. According to GAAP revenue recognition criteria, in order for revenue to be recognized on the income statement, it must be earned and realized (realizable).
Answer: True
Rationale: According to GAAP revenue recognition criteria, revenue must be both realized (realizable) and earned, to be recognized on the income statement. The issue of when the revenue is earned is subject to professional judgment.
Topic: Percentage of Completion
LO: 1
2. Companies that engage in long-term sales contracts such as construction projects often use the percentage of completion method to recognize revenue. This means that revenue is recognized in proportion to the project’s completion.
Answer: True
Rationale: Percentage of completion method recognizes revenue by determining the costs incurred under the contract relative to its total expected costs and not evenly over time.
Topic: Sales on Consignment
LO: 1
3. Revenue from a consignment sale is recognized when the item is placed on consignment with the middleman, if sales are probable, based on past experience.
Answer: False
Rationale: When the item is delivered to the middleman (the consignee) no title has passed therefore no revenue has been earned. Revenue is only earned when the third party buys the item.
Topic: Revenue Recognition
LO: 1
4. Bed Bath and Beyond has a return policy which states that the customer “may return a purchase for a refund, merchandise credit, or exchange to any of our stores nationwide or to our returns processing center”. The company can report revenue on the full amount as soon as the merchandise is sold.
Answer: False
Rationale: Revenue will be recognized as soon as the merchandise is sold but only for the portion that the company estimates will not be returned. The estimated returns are netted against sales and set up as a liability (reserve).
Topic: R&D Costs
LO: 2
5. R&D expense is treated as an operating expense, not a capital expenditure, unless the R&D assets acquired have an alternative future use.
Answer: True
Rationale: Although the R&D assets are similar to regular plant assets, under GAAP, R&D costs are expensed unless the R&D assets have alternative future uses.
Topic: R&D Costs
LO: 2
6. Next year, Chemical Corporation plans to build a laboratory dedicated to a special project. The company will not use the laboratory after the project is finished. Under GAAP, this laboratory should be expensed.
Answer: True
Rationale: R&D costs must be expensed under GAAP unless they have alternative future uses. If these assets do, indeed, have alternative future uses, they will be capitalized and depreciated.
Topic: Discontinued Operations
LO: 2
7. Revenues from discontinued operations of a company are reported separately from revenues from continuing operations in the income statement.
Answer: True
Rationale: Discontinued operations refer to any identifiable business unit that the company intends to sell. The income (loss) of the discounted operation (net of tax), and the after-tax gain (loss) on sale of the unit, are reported in a separate section of the income statement below income from continuing operations.
Topic: Restructuring Costs
LO: 2
8. Employee severance costs, as part of board-approved restructuring plans, are reported in the income statement even if the actual payment for these costs occurs in subsequent periods.
Answer: True
Rationale: Employee severance costs are reported in the income statement as accrued costs. Total estimated costs of terminating or relocating a targeted employee group are recorded as an expense in the period in which these costs are estimated.
Topic: Extraordinary Items
LO: 2
9. For an item to be classified as extraordinary, it needs to be both unusual and infrequent. However, there is an exception for material items – for one-time items that are extremely large, firms have the option of classify these items as extraordinary to provide better information to investors.
Answer: False
Rationale: Both of the above conditions need to be fulfilled for an item to be categorized extraordinary. There is no materiality exception.
Topic: Income Taxes
LO: 3
10. Income tax expense is not recorded at the amount owing to the tax authorities even if this is the most objectively measured amount.
Answer: True
Rationale: Income tax expense is based on GAAP numbers. The amount paid is based on tax rules. The difference between the two is recorded as deferred tax expense (benefit).
Topic: Deferred Taxes
LO: 3
11. When a company reports a deferred tax asset it means that the company will receive a tax benefit in the future.
Answer: False
Rationale: The deferred tax asset may be recorded if the future benefit is more likely than not. The company does not have to be absolutely certain only relatively certain that future taxes will be lower (a benefit).
Topic: Depreciation and Taxes
LO: 3
12. For tax reporting purposes, companies typically transfer more of the asset’s cost from the balance sheet to the income statement in the earlier years of the asset’s life. This is called accelerated depreciation and it is a benefit to the company. Thus, companies record deferred tax assets (benefits) for this accelerated depreciation.
Answer: False
Rationale: Accelerated depreciation reduces taxable income and, consequently, the current tax liability and, thereby, increases cash flows early in the asset’s life. Over the life of the asset, the company must make up these taxes, thus accelerated depreciation creates a deferred tax liability and not an asset.
Topic: Foreign Currency Translation
LO: 4
13. Revenue from a foreign subsidiary will be smaller in U.S. dollars when the dollar strengthens relative to the foreign currency.
Answer: True
Rationale: Foreign currency is weaker when the dollar strengthens. Thus, revenue in the foreign currency is worth fewer U.S. dollars.
Topic: Earnings per Share
LO: 5
14. A company with outstanding in-the money employee stock options will report a diluted EPS that is lower than basic EPS.
Answer: True
Rationale: Diluted EPS will only be lower than basic EPS if the outstanding employee stock options are dilutive, which means the stock options are at or in the money.
Topic: Diluted EPS
LO: 5
15. Because diluted EPS include dilutive securities such as convertible securities and employee stock options, it must always be less than or equal to basic EPS.
Answer: True
Rationale: Diluted EPS includes dilutive securities in the denominator of the ratio. Therefore the diluted EPS ratio must always be less than or equal to basic EPS.
Topic: Accounting Quality
LO: 6
16. The two factors that enhance the quality of accounting information are reliability and relevance.
Answer: True
Rationale: Two main uses of financial reports are evaluation and valuation of a company and its performance. As a result, high-quality accounting information that is reliable and relevant is required.
Multiple Choice
Topic: Revenue Recognition
LO: 1
1. Which of the following items create risk related to revenue recognition?
A) Bonuses tied to sales goals
B) Long-term construction contracts
C) Multiple element sales contracts
D) Consignment goods
E) All of the above
Answer: E
Rationale: Each of these types of revenue or business conditions creates risk associated with revenue recognition. Each requires good internal controls to prevent and detect inappropriate revenue recognition, as well as extra management vigilance and auditor care.
Topic: Revenue Recognition at a Service Firm
LO: 1
2. Boston Consulting Group (BCG) is a management consulting, technology services and outsourcing organization. Which of the following actions should managers take when there is evidence that a fixed-rate contract is over budget and will generate a loss for the firm?
A) Use the percentage of completion method to recognize the loss over the remaining term of the engagement.
B) Recognize the loss in the current period rather than over the remaining term of the engagement.
C) Restate the financial statements and recognize the loss in the earliest period of the engagement.
D) Use the percentage of completion method and pro rate the loss over the entire term of the engagement.
E) None of the above is an appropriate action.
Answer: B
Rationale: When contracts are over-budget, managers should estimate the new, revised, total engagement cost. If this results in a loss on the engagement, that loss should be recognized immediately rather than over the remaining term of the engagement.
Topic: Percentage-of-Completion Method (Numerical calculations required)
LO: 1
3. On December 31, 2014, State Construction Inc. signs a contract with the state of West Virginia Department of Transportation to manufacture a bridge over the New River. State Construction anticipates the construction will take three years. The company’s accountants provide the following contract details relating to the project:
| Contract price | $520 million |
| Estimated construction costs | $400 million |
| Estimated total profit | $220 million |
During the three-year construction period, State Construction incurred costs as follows:
| 2015 | $ 40 million |
| 2016 | $240 million |
| 2017 | $120 million |
State Construction uses the percentage of completion method to recognize revenue.
Which of the following represent the revenue recognized in 2015, 2016, and 2017?
A) $150 million, $200 million, $170 million
B) $40 million, $240 million, $120 million
C) $22 million, $132 million, $66 million
D) $52 million, $312 million, $156 million
E) None of the above
Answer: D
Rationale:
| ($ in millions) | Year 1 | Year 2 | Year 3 |
| Construction costs incurred | $40 | $240 | $120 |
| Percentage to total costs | $40 / $400 = 10% | $240 / $400 = 60% | $120 / $400 = 30% |
| Revenue recognized | 10% × $520 = $52 | 60% × $520 = $312 | 30% × $520= $156 |
Topic: Percentage-of-Completion Method (Numerical calculations required)
LO: 1
4. In spring 2014, Parmac Engineering Company signed a $160 million contract with the city of Parkersburg, to construct a new city hall. Parmac expects to construct the building within two years and incur expenses of $120 million. The city of Parkersburg paid $40 million when the contract was signed, $80 million within the next six months, and the final $40 million exactly one year from the signing of the contract. Parmac incurred $48 million in costs during 2014 and rest in 2015 to complete the contract on time.
Using the percentage-of-completion method how much revenue should Parmac recognize in 2014?
A) $ 40 million
B) $120 million
C) $ 64 million
D) $ 80 million
E) None of the above
Answer: C
Rationale: According to the percentage-of-completion method Parmac Engineering Company should recognize the revenues as shown in the table below:
| Year | Total contract | Percentage completed | Revenue Recognized |
| 2014 | $160 million | $48 million/$120 million = 40% | 40% × $160 million = $64 million |
Topic: Risk Exposures to Revenue Recognition
LO: 1
5. Sam’s Club (part of the WalMart consolidated operations) collects annual non-refundable membership fees from customers. When should Sam’s Club recognize revenue for these membership fees?
A) Immediately when cash is received because the fees are nonrefundable
B) Evenly over the membership year
C) Evenly over the current fiscal year
D) At the end of the membership year when Sam’s has discharged its obligation to the customer
E) Pro rata over the customer’s actual purchasing pattern
Answer: B
Rationale: Sam’s should record membership fees evenly over the year even if the fee is nonrefundable because Sam’s has an obligation to stay open for business for a year to honor the customer’s membership.
Topic: Revenue Recognition
LO: 1
6. Tickets Today contracts with the producer of Riverdance to sell tickets online. Tickets Today charges each customer a fee of $6 per ticket and receives $15 per ticket from the producer. Tickets Today does not take control of the ticket inventory. Average ticket price for the event is $150.
How much revenue should Tickets Today recognize for each Riverdance ticket sold?
A) $6 because the $15 from the producer is similar to a negative cost of goods sold
B) $150 because the $135 is cost of goods sold paid to the Riverdance producer
C) $21 because both the fee from the customer and the producer are earned
D) $156 because the $135 is cost of goods sold paid to the Riverdance producer
E) None of the above
Answer: C
Rationale: Tickets Today should record $21 revenue each time it sells a ticket. Of that, $6 will be received in cash and $15 will be recorded as receivable from the Riverdance producers.
Topic: Research and Development Expenses
LO: 2
7. On its 2013 income statement, Yahoo! reported product development expense of $919,368,000. Which of the following statements must be true?
A) Yahoo spent $919,368,000 in cash to develop new products and improve old products.
B) Product development expense reduced Yahoo’s 2013 net income by $919,368,000.
C) Yahoo capitalized at least $919,368,000 of product development costs in 2013.
D) The $919,368,000 included amortized product development costs from prior years that were not previously expensed, because Yahoo incurs such expenses each year.
E) None of the above
Answer: E
Rationale: Yahoo included in product development expense certain non-cash expenses such as depreciation on related assets, thus (A) is not correct. Yahoo recorded deferred tax expense on the product development expense, thus net income was affected on an after-tax basis and (B) is therefore not correct. Under US GAAP, firms may not capitalize R&D costs, thus (C) is not correct. All R&D expenses must be included in the income statement in the period, thus (D) is wrong.
Topic: Research and Development Expenses
LO: 2
8. Life Technologies Corporation reported research and development expense of $341,892 thousand on its 2012 income statement. This expense included many types of costs.
Which of the following types of costs would not be included in the $341,892 thousand?
A) Salaries and wages for R&D personnel
B) Costs of applying for FDA approval
C) Depreciation on equipment used in experiments
D) Supplies and inventory related to R&D activities and new-product sales
E) None of the above
Answer: D
Rationale: R&D expenses exclude any costs related to sales.
Topic: Research and Development Expenses (Numerical calculations required)
LO: 2
9. Life Technologies Corporation and Affymetrix Inc. are competitors in the life sciences and clinical healthcare industry. Following is a table of Total revenue and R&D expenses for both companies.
| (in thousands) | Life Technologies Corporation | Affymetrix Inc | |||||
| 2012 | 2011 | 2010 | 2012 | 2011 | 2010 | ||
| Total revenue | $3,798,510 | $3,775,672 | $3,588,094 | $295,623 | $267,474 | $310,746 | |
| R&D expenses | $341,892 | $377,924 | $375,465 | $57,881 | $63,591 | $67,934 | |
Which of the following is true?
A) Life Technologies Corporation is the more R&D intensive company of the two.
B) Life Technologies Corporation has become more R&D intensive over the three years.
C) Affymetrix is more R&D intensive in 2012 than in 2011.
D) Affymetrix is less R&D intensive in 2012 than in 2011.
E) None of the above
Answer: D
Rationale: To make comparisons, we need to common size the R&D expenditures of both firms by scaling by total revenues.
| Life Technologies Corporation | Affymetrix Inc | ||||||
| 2012 | 2011 | 2010 | 2012 | 2011 | 2010 | ||
| Common sized R&D | 9.0% | 10.0% | 10.5% | 19.6% | 23.8% | 21.9% | |
Affymetrix spends proportionately more on R&D than Life Technologies. Affymetrix is more R&D intensive thus, (A) is not true. Life Technologies has spent less on R&D in 2012 than in 2011 and 2010, thus, (B) is not true. Affymetrix decreased R&D from 23.8%% in 2011 to 19.6%% in 2012, thus (D) is true, but not (C).
Topic: Research and Development Expenses – Building with no Alternate Use
LO: 2
10. Dow Chemical Corporation plans to build a laboratory dedicated to a special project. The company will not use the laboratory after the project is finished. Under GAAP, this laboratory should be:
A) Capitalized and depreciated.
B) Expensed in the current year.
C) Depreciated and expensed.
D) Capitalized only.
E) None of the above
Answer: B
Rationale: Project-directed or highly-specific research buildings and equipment with no alternate uses must be expensed as incurred.
Topic: Research and Development Expenses (Numerical calculations required)
LO: 2
11. Yahoo! reported the following in its 2013 financial statements (in millions):
| (in millions) | December 31, 2013 | December 31, 2012 |
| Total assets | $17,103.3 | $16,805.0 |
| Revenues | $4,984.2 | $4,986.6 |
| Product development expense | $919.4 | $885.8 |
| Net income | $1,048.8 | $3,945.5 |
What is Yahoo’s common-sized product development expense for 2013?
A) 5.4%
B) 20.2%
C) 18.4%
D) 87.7%
E) None of the above
Answer: C
Rationale: To common-size income statement items, we divide by current period sales. Common-sized product development expense for 2013 is therefore $919.4 / $4,984.2 = 18.4%.
Topic: Restructuring Charges (Numerical calculations required)
LO: 2
12. Nickolas Imports recorded a restructuring charge of $21.6 million during fiscal 2014 related entirely to the closing of its California based operations in San Diego and in Tijuana, Mexico. The company’s financial statement footnotes indicated that expected employee separation payments amounted to $16.8 million and that fixed asset write-downs accounted for the remainder. Nickolas had never before incurred restructuring charges. At the end of the year, the company’s balance sheet included a restructuring accrual of $3,600,000.
The cash flow effect of Nickolas’s restructuring during fiscal 2014 is:
A) $0 (there was no cash flow effect in 2014)
B) $13,200,000
C) $16,800,000
D) $ 3,600,000
E) $21,600,000
Answer: B
Rationale: The total restructuring charge accrued was $16.8 million because asset write-downs are not accrued. That is, there is no credit to a liability account for write-downs, the assets are credited (reduced). Thus, the company must have paid $16,800,000 – $3,600,000 = $13,200,000 in cash during fiscal 2014.
Topic: Restructuring Charges (Numerical calculations required)
LO: 2
13. Cranberry Chemical recorded pretax restructuring charges of $1,378 million in 2014. The charges consisted of asset write-downs of $908 million, costs associated with exit or disposal activities of $132 million, and employee severance costs of $338 million. The company paid $144 million cash to settle these restructuring charges during the year (2014).
At year end, the restructuring accrual associated with these charges was:
A) $ 1,378 million
B) $ 326 million
C) $ 1,234 million
D) $ 194 million
E) There is not enough information to determine the amount.
Answer: B
Rationale: Of the $1,378 million total restructuring charge, only the exit costs and severance costs must eventually be settled in cash. The asset write downs are not accrued – they reduce the assets on the balance sheet. The company accrued $132 million + $338 million = $470 million as a liability. Thus, if the company paid $144 million cash, the remaining accrual is $326 million at year end.
Topic: Restructuring Charges (Numerical calculations required)
LO: 2
14. Brown Bear, Inc. recorded restructuring charges of $314,056 thousand during fiscal 2014 related entirely to anticipated employee separation payments. Brown Bear, Inc. had never before incurred restructuring charges. At the end of the year, the company’s balance sheet included a restructuring accrual of $39,524 thousand.
The cash flow effect of Brown Bear’s restructuring during fiscal 2014 was:
A) $274,532 thousand
B) $314,056 thousand
C) $353,580 thousand
D) $ 39,524 thousand
E) None of the above
Answer: A
Rationale: The total restructuring charge accrued was $314,056 thousand of which $39,524 thousand was still unpaid (a liability) at the end of the year. The difference of $274,532 thousand must have been paid in cash during the year. The cash flow effect is $274,532 thousand.
Topic: Tax Expense (Numerical calculations required)
LO: 3
15. In fiscal 2013, Microsoft Corp. reported a statutory tax rate of 35.00% and an effective tax rate of approximately 19.18 %. The tax rate on operating profit was 19.39%. The 2013 income statement reported income tax expense of $5,189 million.
What did Microsoft report as income before income tax expense that year?
A) $14,826 million
B) $28,071 million
C) $27,054 million
D) $ 7,571 million
E) None of the above
Answer: C
Rationale: Income tax expense / Effective tax rate = $5,189 million / 0.1918 = $27,054 million. (Note actual income before tax expense was $27,052 million. The difference is due to rounding.)
Topic: Tax Expense (Numerical calculations required)
LO: 3
16. In fiscal 2013, Snap-On Inc. reported a statutory tax rate of 35.00%, an effective tax rate of 31.68% and a tax rate on net earnings attributable to Snap-On Inc. of 32.30%. Income before income tax for 2013 was $526.2 million.
What did Snap-On report as tax expense (on its income statement) in 2013?
A) $166.7 million
B) $170.0 million
C) $136.5 million
D) $184.7 million
E) None of the above
Answer: A
Rationale: Snap-On reported taxes on the income statement of $166.7 million. This is calculated as Income before tax × Effective tax rate = $526.2 × 0.3168 = $166.7
Topic: Deferred Tax Valuation Allowance (Numerical calculations required)
LO: 4
17. The 2013 annual report of Dow Chemical Company disclosed a valuation allowance of $1,112 million related to various deferred tax assets. The 2012 valuation allowance had a balance of $1,399 million.
What effect did this decrease in the allowance have on Dow Chemical’s net income in 2013?
A) Decrease net income by $287 million
B) Increase net income by $287 million
C) Increase net income by $1,112 million
D) Decrease net income by $1,112 million
E) None of the above
Answer: B
Rationale: Changes in valuation allowance affect net income in the opposite direction, dollar for dollar. Dow Chemical decreased the allowance by $287 million ($1,399 million – $1,112 million). The effect was to increase Dow’s net income by $287 million in 2013.
Topic: Changes in Deferred Income Tax Accounts (Numerical calculations required)
LO: 3
18. The 2013 annual report of Dow Chemical disclosed the following: Deferred tax assets decreased by $1,503 million and deferred tax liabilities increased by $38 million.
How do these balance-sheet changes affect tax expense on the income statement for the year?
A) Increase tax expense by $1,331 million
B) Decrease tax expense by $1,331 million
C) Increase tax expense by $1,541 million
D) Decrease tax expense by $1,541 million
E) None of the above
Answer: C
Rationale: Changes in the deferred tax asset account inversely affects tax expense. Changes in the deferred tax liability account directly affect tax expense. Therefore Dow’s decrease in deferred tax assets increases tax expense by $1,503 million and Dow’s increase in deferred tax liabilities increases income tax expense by $38, for a net increase in income tax expense of $1,541 million.
Topic: Deferred Portion of Income Tax Expense (Numerical calculations required)
LO: 3
19. As a result of using accelerated depreciation for tax purposes, The Amin Corporation reported $372 million income tax expense in its income statement, while the actual amount of taxes paid by the company was $412 million.
How did these tax transactions affect the company’s balance sheet?
A) Increase deferred tax liability by $40 million
B) Decrease deferred tax assets by $372 million
C) Decrease retained earnings by $372 million
D) Decrease cash by $372 million
E) Both C and D
Answer: C
Rationale: The tax expense of $372 million will reduce net income by that amount and thus, retained earnings on the balance sheet will be $372 million lower. The company pays $412 million tax in cash, which reduces assets (cash). The difference of $40 million is recorded as an increase in deferred tax asset or a decrease in a deferred tax liability.
Topic: Income Tax Expense (Numerical calculations required)
LO: 3
20. The income tax footnote to the financial statements of Life Technologies Company for the year ended December 31, 2012, includes the following information (in thousands). How much of the income tax expense is payable in 2012?
| Current tax provision | |
| Federal | $237,481 |
| State | 13,156 |
| Foreign | 50,548 |
| 301,185 | |
| Deferred tax provision | |
| Federal | (174,953) |
| State | (9,925) |
| Foreign | (1,182) |
| (186,060) | |
| Changes in tax rate | (13,662) |
| Changes in valuation allowance | (87) |
| Provision for income taxes | $101,376 |
A) $301,185 thousand
B) $186,060 thousand
C) $101,376 thousand
D) $114,951 thousand
E) None of the above
Answer: A
Rationale: The current tax provision of $301,185 is payable in 2012.
Topic: Foreign Currency Translation
LO: 4
21. The 2013 annual report of Computer Corporation included the following disclosure:
During fiscal 2013, the U.S. dollar strengthened relative to the other principal currencies in which we transact business with the exception of the Japanese Yen.
What effect did these currency fluctuations have on Computer Corporation’s 2013 consolidated income statement?
A) Net profit of the Japanese subsidiary will be higher
B) Net profit of the Japanese subsidiary will be lower
C) Net assets of the subsidiaries that report in the other principal currencies will be higher
D) Net assets of the subsidiaries that report in the other principal currencies will be lower
E) Both A and D
Answer: A
Because the US dollar weakened during the year, each Yen will translate to more dollars. Thus, revenues, expenses, and net profit of the Japanese subsidiary will be higher than they would have been absent the foreign currency fluctuations. With respect to the other principal currencies, given that the US dollar strengthened during the year, the profits in these countries will translate to fewer dollars. Thus, revenues, expenses, and net profits of these subsidiaries will be lower than they would have been absent the foreign currency fluctuations. However, D is not a correct answer because the question asked about the income statement, not the balance sheet. This render answer E incorrect too.
Topic: Computing Basic and Diluted EPS (Numerical calculations required)
LO: 5
22. Oracle Corporation reported the following earnings per share information in its 2013 annual report. The company has only one class of stock outstanding. ($ in millions)
| Net income | $10,925 |
| Dividends to common shareholders | $1,433 |
| Weighted average common shares outstanding | 4,769 |
| Weighted average dilutive shares from employee stock plans | 75 |
Basic and diluted earnings per share were, respectively:
A) $0.30 and $0.30
B) $0.77 and $0.74
C) $1.08 and $1.06
D) $2.29 and $2.26
E) None of the above
Answer: D
Rationale: Basic EPS = $10,925 / 4,769 = $2.2908367 = $2.29
Diluted EPS = $10,925 / 4,844 = $2.2553675 = $2.26
Topic: Diluted Earnings per Share (Numerical calculations required)
LO: 5
23. Oil Services Corp. reports the following EPS data in its 2014 annual report (in million except per share data).
| Net income | $2,436 |
| Earnings per share: | |
| Basic | $2.08 |
| Diluted | $2.06 |
| Weighted average shares outstanding: | |
| Basic | 1,172 |
How many weighted average shares were dilutive in 2014?
A) 1,182 million
B) 10 million
C) 20 million
D) 1,038 million
E) None of the above
Answer: B
The company included about 10 million shares for the diluted EPS calculation. This is computed as: $2,436 million / $2.06 = 1,182 million. Thus, the company included 10 million dilutive shares computed as: 1,182 million – 1,172 million.
Topic: Basic Earnings per Share (Numerical calculations required)
LO: 5
24. Cisco Systems Inc. reported the following in its income statement for the year ended July 27, 2013: Basic earnings per share of $1.87 and diluted earnings per share of $1.86. 5,329 million weighted average shares were outstanding during the year.
What approximate net income, did the company report for 2013?
A) $7,624 million
B) $7,796 million
C) $9,965 million
D) $4,310 million
E) None of the above
Answer: C
Rationale: Net income = basic EPS × Average number of shares outstanding during the year. Thus, net income is $1.87 × 5,329 million = $9,965 million (Note: Actual net income is $9,983 million. Difference is due to rounding.)
Topic: Earnings per Share Definition and Computations
LO: 5
25. All of the following are potentially dilutive in computing diluted EPS except:
A) Employee stock options
B) Convertible preferred stock
C) Convertible bonds
D) Warrants
E) All of the above are dilutive securities
Answer: E
Topic: Accounting Quality
LO: 6
26. All of the following ways can diminish accounting quality, except:
A) Unintentional errors
B) Deliberate management intervention
C) Reliable numbers that are predictive
D) Pro forma disclosures
E) All of the above can diminish accounting quality
Answer: C
Rationale: All of the following ways can diminish accounting quality except for C. Reliable numbers that are not predictive can diminish accounting quality.
Exercises
Topic: Revenue Recognition
LO: 1
1. Identify when each of the following companies should recognize revenue.
a. Valero Energy – integrated petroleum company that sells crude oil, natural gas and petroleum and chemical products under short-term agreements at prevailing market prices
b. Boeing – airplane manufacturer whose revenue is derived largely from long-term fixed-price contracts with airlines
c. Wells Fargo – large commercial bank that earns interest on loans
d. Harley Davidson – manufactures and retails motorcycles, provides financing for dealers and customers
Answer:
a. Valero: revenues are recognized when the products are delivered, which occurs when the gas station owner (for independent stations) or the retail customer (for company owned locations) has taken delivery of the gasoline.
b. Boeing: Record revenue using percentage-of-completion method.
c. Wells Fargo: Interest is earned by the passage of time. If cash is not received, Wells Fargo accrues income on its loans and establishes an account receivable on its balance sheet.
d. Harley-Davidson: Retail revenue recorded when customer takes delivery of the motorcycle. Sales that are financed will yield interest revenue over the life of the note. This is similar to how banks earn revenue.
Topic: Revenue Recognition at a Service Firm
LO: 1
2. Boston Consulting Group (BCG) is a management consulting, technology services and outsourcing organization.
a. Identify the revenue recognition method that BCG should use for its consulting services.
b. How should BCG account for client deposits?
c. Sometimes a fixed-rate contract goes over budget such that BCG will incur a loss on the engagement. How should BCG account for such an event?
Answer:
a. BCG should recognize revenues from long-term contracts on a percentage-of-completion basis as services are provided.
b. Client deposits and prepayments (even if nonrefundable) should not be recorded as revenue. Instead, BCG should record deferred revenue (a liability) recognize the revenue over future periods as services are delivered or performed.
c. When contracts are over-budget, managers should estimate the new, revised, total engagement cost. If this results in a loss on the engagement, that loss should be recognized immediately rather than over the remaining term of the engagement.
Topic: Revenue Recognition Percentage-of-Completion Method (Numerical calculations required)
LO: 1
3. On December 31, 2014, State Construction Inc. signs a contract with the state of West Virginia Department of Transportation to manufacture a bridge over the New River. State anticipates the construction will take three years. The company’s accountants provide the following contract details relating to the project:
| Contract price | $520 million |
| Estimated construction costs | $400 million |
| Estimated total profit | $120 million |
During the three-year construction period, Tri-State incurred costs as follows:
| 2015 | $ 40 million |
| 2016 | $240 million |
| 2017 | $120 million |
Compute the revenue recognized, construction costs expensed, and income earned for each year using the percentage of completion method.
Answer:
| ($ in millions) | 2015 | 2016 | 2017 |
| Construction costs incurred | $40 | $240 | $120 |
| Percentage to total costs | $40 / $400 = 10% | $240 / $400 = 60% | $120 / $400 = 30% |
| Revenue recognized | 10% × $520 = $52 | 60% × 520 = $312 | 30% × 520= $156 |
| Income earned | $52 – $40 = $12 | $312 – $240 = $72 | $156 – $120 = $36 |
Topic: Revenue Recognition Multiple Elements Contract (Numerical calculations required)
LO: 1
4. On December 31, 2014, Bandit Independents, a network solutions consultancy, signs a multi-year contract with USS Inc. Under the terms of the contract, Bandit will install hardware and software for USS and provide a one-year warranty on the hardware. In addition, Bandit will provide software updates and tech support for two years. The total contract price for the solution is $9,000,000. In addition, Bandit will train USS employees via on-site classes and provide one-on-one training for supervisors and higher level managers. USS will pay $100 per hour per employee for classes and $500 per hour for one-on-one training. USS must pay Bandit an upfront fee of $500,000 for the educational package, which will be used to offset educational hours in the future.
How should Bandit recognize revenue on the $9,000,000 contract? How should Bandit record the $500,000?
Answer:
Bandit has a multiple element contract with USS. Each of the four elements must be accounted for separately: hardware (recognize revenue when installed and running), software (recognize when client signs off on installation and beta tests), warranty (recognize over the one-year coverage period), and software updates / tech support (recognize over the two-year coverage period). To determine the amount of each part, Bandit must determine the fair value of each element separately and then allocate the contract price of $9,000,000 to each element. The retainer received is unearned revenue (a liability) until the educational services are rendered. Each month, as Bandit provides training, it will bill USS and reduce the unearned revenue liability. When total educational services exceed $500,000, Bandit will set up a receivable from USS.
Topic: Revenue Recognition Percentage-of-Completion Method (Numerical calculations required)
LO: 1
5. In spring 2014, Eva Engineering Company signed a contract with the city of Springfield, to construct a new city hall. Eva expects to construct the building within two years and incur expenses of $120 million, which means the company earns a $40 million profit on the contract. The city of Springfield paid $40 million when the contract was signed, $80 million within the next six months, and the final $40 million exactly one year from the signing of the contract. Eva incurred $48 million in costs during 2014 and rest in 2015 to complete the contract on time.
Using the percentage-of-completion method how much revenue should Eva recognize in 2014? What profit from the Springfield contract, will the company report each year?
Answer: According to the percentage-of-completion method Eva Engineering Company should recognize the revenues as shown in the table below:
| Year | Contracted Sales | Percentage completed | Revenue Recognized |
| 2014 | $160 million | $48 million/$120 million = 40% | (40% of $160 million)
or $64 million |
| 2015 | $72 million/$120 million = 60% | (60% of $160 million)
or $96 million |
Eva will earn profits according to the revenue recognized, which means that 40% of the profits ($16 million) should be recorded in 2014 and the rest ($24 million) in 2015 when the building construction is completed.
Topic: Risk Exposures to Revenue Recognition
LO: 1
6. When should each of the following companies recognize revenue for the following operations? Identify potential revenue recognition issues or risk exposures facing the company:
a. Sam’s Club (part of the WalMart consolidated operations) collects annual membership fees from customers.
b. Wall Street Journal receives advertising revenues in advance from Banco do Brasil, for an ad campaign that will run a full-page spread once a week for six months.
c. J. Jill is an internet clothing retailer. It receives credit card payments when customers place their orders and ships products from warehouses within 5-7 business days.
d. Tickets Now contracts with the producer of Riverdance to sell tickets online. Tickets Now charges each customer a fee of $4 per ticket and receives $10 per ticket from the producer. Tickets Now does not take control of the ticket inventory. Average ticket price for the event is $150.
Answer:
a. Sam’s should record membership fees evenly over the year. A risk is that they might record all the fees as revenue when the customer makes the initial payment. This won’t really be a significant issue if Sam’s receives about the same membership fees over the year.
b. The Wall Street Journal should record the revenue as each ad appears (weekly). There is a potential risk that the company could record all of the advance payment as revenue when Banco do Brasil pays it. This could be a significant issue if advance advertising revenues are not uniform during the year.
c. Even though cash is received (credit cards are essentially cash), revenue should not be recognized until the product is shipped. Until that time, the cash received is recognized as an asset on the balance sheet and a liability (deferred revenue) is recorded to reflect an obligation to deliver product. Thus, one revenue risk is that J. Jill could record the cash receipts as revenue, before the product is delivered, to boost current sales and profit. This risk is small however in that most shipments follow cash receipt by only a few days.
d. Tickets Now should record $14 revenue each time it sells a ticket. Of that $4 will be received in cash and $10 will be recorded as receivable from the Riverdance producers. The risk exposure is that Tickets Now could record $154 for each ticket sold and offset that with a cost of goods sold of $140 (along with a $140 accounts payable) to the Riverdance producer. This would seriously overinflate the company’s top line but would not have any effect on the bottom line.
Topic: Research and Development Expense (Numerical calculations required)
LO: 2
7. Google reported the following in its 2013, Form 10K (in millions). Use the information to determine in which year, Google reported a more significant R&D expenditure.
| 2013 | 2012 | |
| Total assets | $110,920 | $93,798 |
| Revenues | $59,825 | $50,175 |
| Research and development expense | $7,952 | $6,793 |
Answer:
Google spent more dollars on R&D in 2013, nearly $8.0 billion versus $6.8 billion in 2012. But to determine the more significant expenditure, we need to common-size the R&D expense. To common-size income statement items, we divide by current period sales. Common-sized R&D for 2013 is $7,952 / $59,825 = 13.29% and for 2012 is $6,793 / $50,175 = 13.54%. Thus, on a percentage basis, Google spent slightly less in 2013.
Topic: Research and Development Expenses (Numerical calculations required)
LO: 2
8. Yahoo! reported the following in its 2013 financial statements (in thousands):
| December 31, 2013 | December 31, 2012 | December 31, 2011 | |
| Revenues | $4,680,380 | $4,986,566 | $4,984,199 |
| Product development expense | $1,008,487 | $885,824 | $919,368 |
a. List three types of costs that Yahoo likely includes in the product development line item on the income statement.
b. What trend do you notice in Yahoo’s spending for product development?
Answer:
a. Types of costs included in product development could include:
- salaries and wages for R&D personnel
- computer and other types of equipment used by programmers who are performing the product development
- costs of applying for patents and copyright protection
- legal fees for new patents
- overhead for R&D activities (heat, lighting, etc in research labs and offices)
- depreciation of capitalized R&D fixed assets
- lease payments for leased equipment or space used for development purposes
b. To detect a trend, we need to calculate common-sized R&D expense, which means to divide each year’s expense by that year’s revenues. Yahoo’s R&D spending decreased in 2012, but then increased in 2013. This is consistent with the changes in actual dollars of expense incurred each year.
| December 31, 2013 | December 31, 2012 | December 31, 2011 | |
| Product development / Revenues | 21.55% | 17. 76% | 18.45% |
Topic: Research and Development Expenses
LO: 2
9. Life Technologies Corporation reported research and development expense of $ 341,892 thousand on its 2012 income statement. This expense included many types of costs. Briefly explain how Life Technologies Corporation would account for each of the following types of R&D costs:
a. Salaries and wages for R&D personnel
b. Supplies and inventory
c. Equipment used in experiments
d. Costs of applying for FDA approval
e. Overhead for R&D activities
Answer:
Life Technologies Corporation would report for each of the R&D items as follows:
a. Salaries and wages for R&D personnel – as paid and would include amounts incurred at year end but not yet paid
b. Supplies and inventory – would set up inventory as asset and expense items as they are used up in R&D activities
c. Equipment used in experiments – if equipment has no alternate use, Life Technologies would expense in period acquired. But if equipment has alternate use, Life Technologies would capitalize as PPE and depreciate over assets’ lives.
d. Costs of applying for FDA approval – as incurred
e. Overhead for R&D activities – allocate R&D related overhead as incurred
Topic: Research and Development Expenses
LO: 2
10. Life Technologies Corporation and Affymetrix Inc. are competitors in the life sciences and clinical healthcare industry. Following is a table of R&D expenses and sales revenues for both companies (in thousands).
| Life Technologies Corporation | Affymetrix Inc | ||||||
| 2012 | 2011 | 2010 | 2012 | 2011 | 2010 | ||
| Total revenue | $3,798,510 | $3,775,672 | $3,588,094 | $295,623 | $267,474 | $310,746 | |
| R&D expenses | $341,892 | $377,924 | $375,465 | $57,881 | $63,591 | $67,934 | |
a. Compare R&D expenses of the two companies. Which company is more R&D intensive?
b. What trend do you notice in the R&D expense of each company over time?
Answer:
- Comparing R&D measured in dollars indicates that Life Technologies spends more. However, common sizing the expense is more appropriate to make comparisons:
| Life Technologies Corporation | Affymetrix Inc | |||||
| 2012 | 2011 | 2010 | 2012 | 2011 | 2010 | |
| 9.0% | 10.0% | 10.5% | 19.6% | 23.8% | 21.9% | |
Affymetrix spends proportionately more on R&D than Life Technologies –double the percentage, which is a significant difference. Affymetrix is more R&D intensive.
b. Life Technologies maintained R&D spending at about 10% during 2010 and 2011, but then decreased in 2012. Affymetrix fluctuated R&D spending by increasing in 2011, but then decreasing in 2012.
Topic: Restructuring Charges (Numerical calculations required)
LO: 2
11. Nickolas Imports recorded a restructuring charge of $21.6 million during fiscal 2014 related entirely to the closing of its California based operations in San Diego and in Tijuana, Mexico. The company’s financial statement footnotes indicated that expected employee separation payments amounted to $16.8 million and that fixed asset write-downs accounting for the remainder. Nickolas had never before incurred restructuring charges. At the end of the year, the company’s balance sheet included a restructuring accrual of $3,600,000.
Calculate the cash flow effect of Nickolas’s restructuring during fiscal 2014.
Answer:
The total restructuring charge accrued was $16.8 million because asset write-downs are not accrued. That is there is no credit to a liability account for write-downs, the assets are credited (reduced). Thus, the company must have paid $16,800,000 – $3,600,000 = $13,200,000 in cash during fiscal 2014.
Topic: Restructuring Charges (Numerical calculations required)
LO: 2
12. Dow Chemical included the following information in footnotes to its 2013 Form 10-K:
The Company announced two restructuring programs in 2012 in response to macroeconomic uncertainties and changing and volatile economic conditions, particularly in Western Europe.
On March 27, 2012, the Company’s Board of Directors approved a restructuring plan (“1Q12 Restructuring”) to optimize its portfolio, respond to changing and volatile economic conditions, particularly in Western Europe, and to advance the Company’s Efficiency for Growth program, which was initiated by the Company in the second quarter of 2011. The 1Q12 Restructuring plan includes the elimination of approximately 900 positions. In addition, the Company shut down a number of manufacturing facilities. These actions were substantially completed at December 31, 2013. As a result of the 1Q12 Restructuring activities, the Company recorded pretax restructuring charges of $357 million in the first quarter of 2012 consisting of costs associated with exit or disposal activities of $150 million, severance costs of $113 million and asset write-downs and write-offs of $94 million.
On October 23, 2012, the Company’s Board of Directors approved a restructuring plan (“4Q12 Restructuring”) to advance the next stage of the Company’s transformation and to address macroeconomic uncertainties. The restructuring plan accelerates the Company’s structural cost reduction program and will affect approximately 2,850 positions and result in the shutdown of approximately 20 manufacturing facilities. These actions are expected to be completed by March 31, 2015. As a result of the 4Q12 Restructuring activities, the Company recorded pretax restructuring charges of $990 million in the fourth quarter of 2012 consisting of costs associated with exit or disposal activities of $39 million, severance costs of $375 million and asset write-downs and write-offs of $576 million.
a. Reconcile the various parts of Dow Chemical’s “Restructuring charges” of $357 and $990 million.
b. How should Dow Chemical report the restructuring charges in its income statement? On its balance sheet?
c. The SEC has expressed concern about abuses surrounding restructuring charges. What is the nature of the SEC’s concerns?
Answer:
a.
| (in millions) | 1Q12 | 4Q12 | Total |
| Asset write-downs and write-offs | $94 | $576 | $670 |
| Exit or disposal activities | 150 | 39 | 189 |
| Severance costs | 113 | 375 | 488 |
| Total | $357 | $990 | $1,347 |
b. Under GAAP, the restructuring charges would be reported as a separate line item in the income statement, if it’s material, which $$357 and $990 million certainly are. In addition, any accrued liabilities resulting from the restructuring would be reflected on the balance sheet. The footnotes detail the change in the accrual (liability) account each period.
c. The timing and magnitude of restructuring costs is subject to management’s discretion. Thus, some companies might overestimate such costs, especially if earnings are already low, a practice which is referred to as a “big bath.” Overestimating the restructuring costs creates a cushion for adjusting future earnings. On the other hand, because materiality is also discretionary, management could deem these costs to be immaterial in order to avoid recording them as separate items. Either tactic would impair the quality of the companies’ financial reports.
Topic: Tax Expense (Numerical calculations required)
LO: 3
13. In fiscal 2013, Microsoft Corp. reported a statutory tax rate of 35.00% and an effective tax rate of 19.18%. The tax rate on operating profit was 19.39 %. The 2013 income statement reported income tax expense of $5,189 million. What did Microsoft report as income before income tax expense that year?
Answer:
Microsoft reported income before income tax expense of $27,054 million. This is calculated as Income tax expense / Effective tax rate = $5,189 million / 0.1918 = $29,054 million. (Note actual income before tax expense was $27,052 million. The difference is due to rounding.)
Topic: Tax Expense (Numerical calculations required)
LO: 3
14. In fiscal 2013, Snap-On Inc. reported a statutory tax rate of 35.00%, an effective tax rate of 31.68% and a tax rate on net earnings attributable to Snap-On of 32.30%. Income before income tax for 2013 was $526.2 million. What did Snap-On report as tax expense (on its income statement) in 2013?
Answer:
Snap-On reported taxes on the income statement of $166.7 million. This is calculated as Income before tax × Effective tax rate = $526.2 million × 0.3168 = $166.7 million.
Topic: Deferred Tax Valuation Allowance (Numerical calculations required)
LO: 3
15. The 2013 annual report of Dow Chemical disclosed a valuation allowance of $1,112 million related to various deferred tax assets. During 2013, the company decreased this allowance from $1,399 million reported in 2012. Quantify the effect that this decrease in the allowance had on Dow Chemical’s net income in 2013.
Answer:
Changes in valuation allowance affect net income in the opposite direction, dollar for dollar. Dow Chemical decreased the allowance by $287 million ($1,399 million – $1,112 million). The effect was to increase Dow’s net income by $287 million in 2013.
Topic: Changes in Deferred Income Tax Accounts (Numerical calculations required)
LO: 3
16. The 2013 annual report of Dow Chemical disclosed the following: Deferred tax assets decreased by $1,503 million and deferred tax liabilities decreased by $81 million. How do these balance sheet changes affect tax expense for the year?
Answer:
Changes in deferred tax asset account, inversely affects tax expense. Changes in the deferred tax liability account, directly affects tax expense. Therefore Dow’s decrease in deferred tax assets increases tax expense by $1,503 million and Dow’s decrease in deferred tax liabilities decreases tax expense by $81 million, for a net increase in income tax expense of $1,422 million ($1,503 million – $81 million = $1,422 million increase in tax expense).
Topic: Income Tax Expense: Deferred Portion (Numerical calculations required)
LO: 3
17. As a result of using accelerated depreciation for tax purposes, The Starburst Company reported $372 million income tax expense in its income statement, while the actual amount of taxes paid by the company was $412 million. How did this tax transaction affect the company’s balance sheet?
Answer:
The tax expense of $372 million will reduce net income by that amount and thus, retained earnings on the balance sheet will be $372 million lower. The company pays $412 million tax in cash, which reduces assets. The difference of $40 million is recorded as an increase in deferred tax asset or a decrease in deferred tax liability.
Topic: Deferred Tax Assets Arising from Restructuring Charge (Numerical calculations required)
LO: 3
18Cranberry Chemical recorded a pretax restructuring charge of $1,378 million in 2014. By year-end (December 31, 2014), the company had paid only $144 million of cash related to the restructuring charges. How did the restructuring charge of $1,378 million affect income before taxes? How did this charge affect deferred taxes on the balance sheet? Assume a tax rate of 35%.
Answer:
The restructuring charge of $1,378 million reduces income before taxes by that amount. However, restructuring charges are not deductible until they are paid. Thus, during 2014, the tax-basis expense for restructuring was $144 million. The difference of $1,234 million gives rise to a deferred tax asset of $432 million ($1,234 million × 0.35) reported on the 2014 balance sheet.
Topic: Income Tax Expense (Numerical calculations required)
LO: 3
19. The income tax footnote to the financial statements of Life Technologies Company for the year ended December 31, 2012, includes the following information (in thousands):
| Current tax provision | |
| Federal | $237,481 |
| State | 13,156 |
| Foreign | 50,548 |
| 301,185 | |
| Deferred tax provision | |
| Federal | (174,953) |
| State | (9,925) |
| Foreign | (1,182) |
| (186,060) | |
| Changes in tax rate | (13,662) |
| Changes in valuation allowance | (87) |
| Provision for income taxes | $101,376 |
a. What income tax expense did Life Technologies Company report in its 2012 income statement?
b. How much of the income tax expense is payable in 2012?
Answer:
a. The income statement will show $101,376 for income tax expense.
b. The current tax provision of $301,185 is payable in 2012.
Topic: Foreign Currency Translation
LO: 4
20. The Bean Import Export Corp. has a profitable Portuguese subsidiary that maintains its financial records in Euros. During the current year, the U.S. dollar strengthened vis-à-vis the Euro. What affect did this have on The Bean’s consolidated income statement for the current year?
Answer:
Because the US $ strengthened during the year, each Euro will translate to fewer dollars. Thus, revenues, expenses, and net profit of the Portuguese subsidiary will be lower than they would have been absent the foreign currency fluctuations.
Topic: Foreign Currency Translation
LO: 4
21. The 2013 annual report of Computer Corporation included the following disclosure:
During fiscal 2013, the U.S. dollar strengthened relative to the other principal currencies in which we transact business with the exception of the Japanese Yen.
Explain the effect on Computer Corporation’s 2013 income statement of the U.S. dollar:
a. weakening vis-à-vis the Japanese Yen, and
b. strengthening versus all other currencies.
Assume that Computer Corporation reported a net profit in each of the countries involved.
Answer:
a. Because the US dollar weakened during the year, each Yen will translate to more dollars. Thus, revenues, expenses, and net profit of the Japanese subsidiary will be higher than they would have been absent the foreign currency fluctuations.
b. With respect to the other principal currencies, given that the US dollar strengthened during the year, the profits in these countries will translate to fewer dollars. Thus, revenues, expenses, and net profits of these subsidiaries will be lower than they would have been absent the foreign currency fluctuations.
Topic: Computing EPS and Explaining Anti-Dilutive Stock Options (Numerical calculations required)
LO: 5
22. Oracle reported the following earnings per share information in its 2013 annual report filed on Form 10-K (in millions except per share data). The company has only one class of stock outstanding. Compute basic and diluted earnings per share.
| Net income | $10,925 |
| Dividends to common shareholders | $1,433 |
| Weighted average common shares outstanding | 4,769 |
| Dilutive effect of employee stock plans | 75 |
| Diluted weighted average common shares outstanding | 4,844 |
Answer:
Basic EPS = $10,925 / 4,769 = $2.2908367 = $2.29
Diluted EPS = $10,925 / 4,844 = $2.2553675 = $2.26
Topic: Diluted Earnings per Share (Numerical calculations required)
LO: 5
23. Oil Services Corp. reports the following EPS data in its 2014 annual report (in millions except per share data).
| Net income | $2,436 |
| Earnings per share: | |
| Basic | $2.08 |
| Diluted | $2.06 |
| Weighted average shares outstanding: | |
| Basic | 1,172 |
a. Recompute basic earnings per share.
b. How many weighted average shares were dilutive in 2014?
Answer:
a. $2,436 / 1,172 = $2.0785
b. The company included about 10 million shares for the diluted EPS calculation. This is computed as: $2,436 million / $2.06 = 1,182 million. Thus, the company included 10 million dilutive shares computed as: 1,182 million – 1,172 million.
Topic: Basic Earnings per Share (Numerical calculations required)
LO: 5
24. Cisco Systems Inc. reported the following in its income statement for the year ended July 27, 2013: Net income $9,983 million, basic earnings per share of $1.87 and diluted earnings per share of $1.86. How many additional dilutive shares did Cisco include in the diluted EPS for the year?
Answer:
Average number of shares outstanding during the year = Net income / basic EPS = $9,983 million / $1.87 = 5,338.5 million shares.
Average diluted number of shares outstanding during the year = Net income / diluted EPS
= $9,983 million / $1.86 = 5,367 million shares.
Total number of dilutive additional shares = 5,367 million shares – 5,338.5 million shares
= 28.5 million shares
Topic: Earnings per Share Definition and Computations (Numerical calculations required)
LO: 5
25. OMNICARE, INC. reports the following in its 2013 10-K report (in thousands). Use the information to calculate basic and diluted earnings per share (EPS) numbers from continuing operations.
| Net income from continuing operations | $84,892 |
| Weighted-average common shares: Basic | 102,080 |
| Weighted-average common shares: Diluted | 109,449 |
Answer:
Basic EPS – continuing operations: $84,892 / 102,080 = $0.83
Diluted EPS – continuing operations:$84,892 / 109,449 = $0.78
Problems
Topic: Interpreting Revenue Recognition Policy and Recording Revenue
LO: 1
1. The annual report of Costco Wholesale Corporation for fiscal year ended September 1, 2013, includes the following footnote (excerpted):
Revenue Recognition
The Company generally recognizes sales, which include shipping fees where applicable, net of estimated returns, at the time the member takes possession of merchandise or receives services. When the Company collects payments from customers prior to the transfer of ownership of merchandise or the performance of services, the amounts received are generally recorded as deferred sales, included in other current liabilities on the consolidated balance sheets, until the sale or service is completed. The Company reserves for estimated sales returns based on historical trends in merchandise returns, net of the estimated net realizable value of merchandise inventories to be returned and any estimated disposition costs. Amounts collected from members, which under common trade practices are referred to as sales taxes, are recorded on a net basis.
The Company evaluates whether it is appropriate to record the gross amount of merchandise sales and related costs or the net amount earned as commissions. Generally, when Costco is the primary obligor, is subject to inventory risk, has latitude in establishing prices and selecting suppliers, can influence product or service specifications, or has several but not all of these indicators, revenue and related shipping fees are recorded on a gross basis. If the Company is not the primary obligor and does not possess other indicators of gross reporting as noted above, it records the net amounts as commissions earned, which is reflected in net sales.
The Company accounts for membership fee revenue, net of estimated refunds, on a deferred basis, whereby revenue is recognized ratably over the one-year membership period. The Company’s Executive Members qualify for a 2% reward (up to a maximum of $750 per year on qualified purchases), which can be redeemed at Costco warehouses. The Company accounts for this reward as a reduction in sales. The sales reduction and corresponding liability (classified as accrued member rewards on the consolidated balance sheets) are computed after giving effect to the estimated impact of non-redemptions based on historical data. The net reduction in sales was $970, $900, and $790 in 2013, 2012, and 2011, respectively.
Required:
a. Explain in plain English how Costco recognizes the cash received from customers who purchase goods or services.
b. What are “sales returns” and how does Costco record them in their financial statements?
c. Explain in plain English how Costco recognizes revenue from annual memberships.
d. Assume that on September 1, 2013, Costco collected $7,200 in membership fees from customers. Use the financial statements effects template that follows to show how Costco would record this transaction and what accounting adjustment Costco would record on November 30, 2013.
e. Costco is contemplating adding a fitness facility to its warehouses – customers would pay a monthly fee to use fitness equipment and take classes. How would Costco record monthly fees from customers if Costco runs the facility itself, that is, Costco purchases all the equipment and the fitness facility is staffed entirely by Costco employees? How would Costco record revenue if the company sub-contracts the fitness facility to a third-party operator and receives a percentage of monthly customer fees from the sub-contractor?
| Balance Sheet | Income Statement | |||||||||||||
| Transaction | Cash Asset | + | Noncash Assets | = | Liabil-
ities |
+ | Contrib. Capital | + | Earned
Capital |
Rev-enues | – | Expen-ses | = | Net
Income |
| Sept. 1, 2013 | = | – | = | |||||||||||
| Nov. 30, 2013 | = | – | = | |||||||||||
Answer:
a. Costco recognizes cash from customers as the goods or services are delivered. For goods, revenue is recognized when the customer leaves the store with the products. For services, revenue is recognized with completion of the service. Deposits for either goods or services are not recorded as revenue.
b. Sales returns happen when customers bring goods back. This represents revenue that was not really earned, in the end. In anticipation of this, Costco estimates the value of goods that will be returned, based on historical experience. Costco reduces sales revenue for this and sets up a “sales return” liability for the same amount.
c. Members join for a year at a time. Costco recognizes the membership fee over the year, likely recognizing 1/12 per month.
d.
| Balance Sheet | Income Statement | |||||||||||||
| Transaction | Cash Asset | + | Noncash Assets | = | Liabil-
ities |
+ | Contrib. Capital | + | Earned
Capital |
Rev-
enues |
– | Expen-ses | = | Net
Income |
| Collect $7,200 membership fees | +7,200 | = | +7,200
(Unearned Revenue) |
– | = | |||||||||
| Record membership fees earned | = | -1,800
(Unearned Revenue) |
+1,800
(Retained Earnings) |
+1,800
(Revenue) |
– | = | +1,800 | |||||||
e. If Costco runs the fitness facility itself, it would seem like the company “is subject to inventory risk, has latitude in establishing prices and selecting suppliers, can influence product or service specifications” and so Costco should record revenue from customers on a gross basis – record the fitness facility monthly fees at the end of each month. If however, Costco subcontracts the fitness facility to a third-party operator, the company is not the primary obligor and should only record the “commission earned” which would be the contractual percentage of the fitness fees received from the third party.
Topic: Interpreting Revenue Recognition Policy
LO: 1
2. The 2013 annual report of Oracle Corporation includes the following footnote (excerpted):
Revenue Recognition
Our sources of revenues include: (1) software, which includes new software licenses revenues earned from granting licenses to use our software products and fees from cloud software subscriptions offerings, and software license updates and product support revenues; (2) hardware systems, which includes the sale of hardware systems products including computer servers, storage products, networking and data center fabric products, and fees from infrastructure-as-a-service (IaaS) offerings, and hardware systems support revenues; and (3) services, which includes software and hardware related services including consulting, managed cloud services and education revenues. Revenues generally are recognized net of any taxes collected from customers and subsequently remitted to governmental authorities.
For software license arrangements that do not require significant modification or customization of the underlying software, we recognize new software licenses revenues when: (1) we enter into a legally binding arrangement with a customer for the license of software; (2) we deliver the products; (3) the sale price is fixed or determinable and free of contingencies or significant uncertainties; and (4) collection is probable. Revenues that are not recognized at the time of sale because the foregoing conditions are not met, are recognized when those conditions are subsequently met.
The vast majority of our software license arrangements include software license updates and product support contracts, which are entered into at the customer’s option and are recognized ratably over the term of the arrangement, typically one year.
Revenues from the sales of our nonsoftware elements are recognized when: (1) persuasive evidence of an arrangement exists; (2) we deliver the products and passage of the title to the buyer occurs; (3) the sale price is fixed or determinable; and (4) collection is reasonably assured. Revenues that are not recognized at the time of sale because the foregoing conditions are not met are recognized when those conditions are subsequently met. When applicable, we reduce revenues for estimated returns or certain other incentive programs where we have the ability to sufficiently estimate the effects of these items. Where an arrangement is subject to acceptance criteria and the acceptance provisions are not perfunctory (for example, acceptance provisions that are long-term in nature or are not included as standard terms of an arrangement), revenues are recognized upon the earlier of receipt of written customer acceptance or expiration of the acceptance period.
Our hardware systems support offerings generally provide customers with software updates for the software components that are essential to the functionality of our server and storage products and can also include product repairs, maintenance services and technical support services. Hardware systems support contracts are generally priced as a percentage of the net hardware systems products fees. Hardware systems support contracts are entered into at the customer’s option and are recognized ratably over the contractual term of the arrangements, which are typically one year.
Many of our software arrangements include consulting implementation services sold separately under consulting engagement contracts and are included as a part of our services business…. Revenues for consulting services are generally recognized as the services are performed.
Our cloud software subscriptions offerings generally provide customers access to certain of our software within a cloud-based IT environment that we manage and offer to customers on a subscription basis. Revenues for our cloud software subscriptions offerings are recognized ratably over the contract term commencing with the date our service is made available to customers and all other revenue recognition criteria have been satisfied.
Education revenues are also a part of our services business and include instructor-led, media-based and internet-based training in the use of our software and hardware products. Education revenues are recognized as the classes or other education offerings are delivered.
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We also enter into multiple-element arrangements that may include a combination of our various software related and nonsoftware related products and services offerings including hardware systems products, hardware systems support, new software licenses, software license updates and product support, cloud software subscriptions and IaaS offerings, consulting, managed cloud services and education. In such arrangements, we first allocate the total arrangement consideration based on the relative selling prices of the software group of elements as a whole and to the nonsoftware elements. We then further allocate consideration within the software group to the respective elements within that group following the guidance in ASC 985-605 and our policies as described above. After the arrangement consideration has been allocated to the elements, we account for each respective element in the arrangement as described above.
Required:
a. What are the seven sources of revenue for Oracle Corporation?
b. Explain in plain English how Oracle recognizes revenue for each of the seven types of revenue.
c. What are “arrangements with multiple elements”? How does Oracle account for such arrangements?
d. Assume that Oracle has a sale that involves new software, software license updates and product support for two years, and an educational package for the customer’s employees, which will be fulfilled in six months. If sold separately, Oracle would charge the following for each of these elements: $4 million, $600,000, and $1,600,000. Because the customer buys the entire package, the sales price is $5,270,000. What revenue would Oracle record for each element?
Answer:
a. Oracle’s seven types of revenue are: 1) new software licenses, 2) software license updates and product support 3) hardware system products (nonsoftware elements), 4) hardware systems support, 5) consulting services, 6) managed cloud services, and 7) education revenues.
b. Revenue on new software licenses is recorded when the customer takes delivery of the software provided that the sales price is established and the customer has the ability to pay. Revenue on updates and product support is pro rated over the contractual period that Oracle promises the updates or support, which is typically one year. Revenue from the sale of hardware systems is recorded when the customer takes delivery of the products provided that the sales price is established and the customer has the ability to pay. Consulting revenues are recognized as the services are performed. Managed cloud services revenues are recognized ratably over the life of the subscription. Education revenues are recognized at the end of the training sessions.
c. Arrangements with multiple elements are sales that include two or more of the seven types of revenue items that Oracle has. To account for these, Oracle first determines the fair value of each element separately and then pro rates the total sales amount to each element. Then the company recognizes revenue as earned on each element according to when it is earned.
d. If sold separately the bill would come to $6,200,000 for this sale ($4,000,000 + $600,000 + $1,600,000). Oracle allocates the sales price of $5,270,000 in proportion to the market value of each piece. The allocation would be: new software: $3,400,000 recognized when the software is delivered; updates and support: $510,000 recognized over two years; and educational package: $1,360,000 recognized over six months.
Topic: Research and Development Expenses
LO: 2
3. Following are income statements for Life Technologies Corporation and Affymetrix Inc., competitors in the life sciences and clinical healthcare industry. Use these financial statements to answer the required.
| Life Technologies Corporation
Consolidated Statements of Operations |
|||
| (In thousands) | |||
| For the Years Ended December 31, | 2012 | 2011 | 2010 |
| Revenues | $3,798,510 | $3,775,672 | $3,588,094 |
| Cost of revenues | 1,372,277 | 1,356,967 | 1,188,199 |
| Purchased intangibles amortization | 291,756 | 308,728 | 293,754 |
| Gross profit | 2,134,477 | 2,109,977 | 2,106,141 |
| Selling, general and administrative | 1,054,616 | 1,008,973 | 1,023,179 |
| Research and development | 341,892 | 377,924 | 375,465 |
| Purchased in-process research and development | — | — | 1,650 |
| Business consolidation costs | 72,732 | 75,324 | 93,450 |
| Total operating expenses | 1,469,240 | 1,462,221 | 1,493,744 |
| Operating income | 665,237 | 647,756 | 612,397 |
| Other income (expense): | |||
| Interest income | 2,401 | 3,932 | 4,266 |
| Interest expense | (123,915) | (162,073) | (152,322) |
| Loss on early extinguishment of debt | — | — | (54,185) |
| Gain on divestiture of equity investments | — | — | 37,260 |
| Other income (expense), net | (11,898) | (10,913) | (5,864) |
| Total other expense, net | (133,412) | (169,054) | (170,845) |
| Income before provision for income taxes | 531,825 | 478,702 | 441,552 |
| Income tax provision | (101,376) | (100,868) | (63,694) |
| Net income | 430,449 | 377,834 | 377,858 |
| Net loss attributable to noncontrolling interests | 406 | 658 | 437 |
| Net income attributable to Life Technologies | $430,855 | $ 378,492 | $ 378,295 |
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| Affymetrix Inc.
Consolidated Statements of Operations |
|||
| (In thousands) | |||
| Year Ended December 31, | 2012 | 2011 | 2010 |
| Product sales | $266,063 | $241,273 | $277,743 |
| Services | 29,560 | 26,201 | 33,003 |
| Total revenue | 295,623 | 267,474 | 310,746 |
| Cost of product sales | 116,261 | 97,815 | 117,384 |
| Cost of services and other | 15,874 | 13,137 | 15,822 |
| Research and development | 57,881 | 63,591 | 67,934 |
| Selling, general and administrative | 142,853 | 109,572 | 114,773 |
| Restructuring charges | 1,845 | — | — |
| Total costs and expenses | 334,714 | 284,115 | 315,913 |
| Loss from operations | (39,091) | (16,641) | (5,167) |
| Interest income/(expense) and other, net | (265) | (6,302) | (1,487) |
| Interest expense | 7,193 | 3,813 | 7,706 |
| Gain from repurchase of convertible notes | — | — | 6,297 |
| Loss before income taxes | (46,549) | (26,756) | (8,063) |
| Income tax provision (benefit) | (35,853) | 1,405 | 2,170 |
| Net loss | $(10,696) | $ (28,161) | $ (10,233) |
Required:
a. How do Life Technologies and Affymetrix account for R&D expenditures?
b. Life Technologies and Affymetrix R&D expense includes many different types of costs. List three specific costs included in R&D expense on the income statement.
c. Compare R&D expenses of the two companies. (Hint: prepare common-size R&D expenses. Consider both direct R&D expenses as well as acquired R&D.)
d. What trend do you notice in the R&D expenses of each company over time?
Answer:
a. R&D expenditures are expensed in the income statement, except for the portion relating to depreciable assets that have alternate uses. Expensing R&D costs (rather than capitalizing and depreciating them) reduces assets on both Life Technologies’ and Affymetrix’ balance sheets. As well, expensing R&D expenses as incurred increases expenses, which reduces profit reported on the income statement and stockholders’ equity on the balance sheet (via the reduction in retained earnings).
- R&D costs could include the following types of costs:
- salaries and wages for R&D personnel
- supplies and inventory for R&D
- equipment used in experiments
- costs of applying for FDA approval
- legal fees for lawyers applying for patents
- overhead for R&D activities
- depreciation on PPE equipment capitalized and used for R&D
c. R&D expenses as a proportion of revenues (i.e. common-sized R&D expense).
| Life Technologies Corporation | Affymetrix Inc | ||||||
| 2012 | 2011 | 2010 | 2012 | 2011 | 2010 | ||
| Total revenue | $3,798,510 | $3,775,672 | $3,588,094 | $295,623 | $267,474 | $310,746 | |
| R&D expenses | $341,892 | $377,924 | $377,115 | $57,881 | $63,591 | $67,934 | |
| Common-size R&D | 9.00% | 10.01% | 10.51% | 19.58% | 23.77% | 21.86% | |
Affymetrix spends proportionately more on R&D than Life Technologies –double the percentage for all 3 years, which is a significant difference. Affymetrix is more R&D intensive.
d. Life Technologies maintained R&D spending at about 10% during 2010 and 2011, but then decreased in 2012. Affymetrix fluctuated R&D spending by increasing in 2011, but then decreasing in 2012. It appears that Affymetrix is a more research-intensive firm.
Topic: Analyzing and Assessing R&D Expense (Numerical calculations required)
LO: 2
4. Below are income statements for Google and Yahoo! for fiscal 2013. Use these financial statements to answer the requirements.
| Google Inc. | |||
| Consolidated Statements of Income | |||
| (In millions) | |||
| Year Ended December 31, | 2013 | 2012 | 2011 |
| Revenues | $59,825 | $50,175 | $37,905 |
| Cost of revenues | 25,858 | 20,634 | 13,188 |
| Research and development | 7,952 | 6,793 | 5,162 |
| Sales and marketing | 7,253 | 6,143 | 4,589 |
| General and administrative | 4,796 | 3,845 | 2,724 |
| Charge related to resolution of Dept. of Justice investigation | 500 | ||
| Total costs and expenses | 45,859 | 37,415 | 26,163 |
| Income from operations | 13,966 | 12,760 | 11,742 |
| Interest income and other, net | 530 | 626 | 584 |
| Income before income taxes | 14,496 | 13,386 | 12,326 |
| Provision for income taxes | 2,282 | 2,598 | 2,589 |
| Net income from continuing operations | 12,214 | 10,788 | 9,737 |
| Net income (loss) from discontinued operations | 706 | (51) | 0 |
| Net income | $12,920 | $10,737 | $ 9,737 |
| Yahoo! Inc. | |||
| Consolidated Statements of Income | |||
| (In thousands) | |||
| Year Ended December 31, | 2013 | 2012 | 2011 |
| Revenues | $4,680,380 | $4,986,566 | $4,984,199 |
| Cost of revenues | 1,349,380 | 1,620,566 | 1,586,997 |
| Sales and marketing | 1,130,820 | 1,101,572 | 1,122,193 |
| Product development | 1,008,487 | 885,824 | 919,368 |
| General and administrative | 569,555 | 540,247 | 497,288 |
| Amortization of intangibles | 44,841 | 35,819 | 33,592 |
| Restructuring charges, net | 3,766 | 236,170 | 24,420 |
| Gains on sales of patents | (79,950) | —— | —— |
| Goodwill impairment charge | 63,555 | —— | —— |
| Total operating expenses | 4,090,454 | 4,420,198 | 4,183,858 |
| Income from operations | 589,926 | 566,368 | 800,341 |
| Other income, net | 43,357 | 4,647,839 | 27,175 |
| Income before provision for income taxes, earnings in equity interests | 633,283 | 5,214,207 | 827,516 |
| Provision for income taxes | (153,392) | (1,940,043) | (241,767) |
| Earnings in equity interests | 896,675 | 676,438 | 476,920 |
| Net income | 1,376,566 | 3,950,602 | 1,062,669 |
| Less: Net income attributable to noncontrolling interests | (10,285) | (5,123) | (13,842) |
| Net income attributable to Yahoo! Inc. | $1,366,281 | $3,945,479 | $1,048,827 |
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Required:
a. How are the balance sheets and income statements of Google and Yahoo! affected by the accounting for R&D costs?
b. Compute common-sized R&D expense for both firms for the three-year period. Assess the differences and any trends that you notice.
c. How can one evaluate the effectiveness of R&D spending? Does the difference in R&D as a percentage of sales necessarily imply that one company is more heavily invested in R&D? Why might this not be the case?
d. In your opinion, would Google and Yahoo favor capitalizing R&D expenses, if that were an available alternative?
Answer:
a. All R&D costs are expensed in the income statement, except for the portion relating to depreciable assets that have alternate uses. Expensing of R&D expenses (rather than capitalizing and depreciating them) reduces assets on both Google and Yahoo!’s balance sheets. As well, expensing R&D expenses as incurred increases expenses, which reduces profit reported on the income statement and stockholders’ equity on the balance sheet (via the reduction in retained earnings).
b.
| Google (in millions) | 2013 | 2012 | 2011 |
| Revenues | $59,825 | $50,175 | $37,905 |
| Research and development expense | $7,952 | $6,793 | $ 5,162 |
| Common-sized R&D expense | 13.3% | 13.5% | 13.6% |
| Yahoo! (in millions) | 2013 | 2012 | 2011 |
| Revenues | $4,680 | $4,987 | $4,984 |
| Research and development expense | $1,008 | $886 | $919 |
| Common-sized R&D expense | 21.5% | 17.8% | 18.4% |
Google spent more dollars on R&D than Yahoo!, in 2013: $7.95 billion versus $1.01 billion. But to determine the more significant expenditure, we need to common-size the R&D expense. To common-size income statement items, we divide by current-period sales. The table above shows the common-sized amount. From this we see that, on a percentage basis, Yahoo! spent more for product development each year.
As far as trends, Google has increased its R&D expense in dollar amounts, but decreased the percentage over the three years. However, Yahoo! has decreased its R&D expense in dollar amounts percentage in 2012 and then increased in 2013. .
c. It is very difficult to evaluate the effectiveness of R&D because R&D spending affects revenues but with some time lag (current-period R&D expenditures yield future sales). Over time, however, the number and quality of new product introductions, number of patents, market share, etc., can be compared across companies and against relative levels of R&D spending. Both Google and Yahoo! spend considerable amounts on their R&D because innovating and developing new Web technologies is the lifeblood for these companies.
d. Google and Yahoo!! are very profitable, and as a consequence, very visible to the public and to governmental agencies. Thus, they probably welcome additional expenses and would not favor capitalizing their R&D expenses.
Topic: Restructuring Costs (Numerical calculations required)
LO: 2
5. The Dow Chemical Corporation announced two restructuring programs in 2012 in response to macroeconomic uncertainties and changing and volatile economic conditions, particularly in Western Europe. The following footnote (excerpted) of the Company comes from the December 31, 2013 financial statements:
On March 27, 2012, the Company’s Board of Directors approved a restructuring plan (“1Q12 Restructuring”) to optimize its portfolio, respond to changing and volatile economic conditions, particularly in Western Europe, and to advance the Company’s Efficiency for Growth program, which was initiated by the Company in the second quarter of 2011. The 1Q12 Restructuring plan includes the elimination of approximately 900 positions. In addition, the Company shut down a number of manufacturing facilities. These actions were substantially completed at December 31, 2013. As a result of the 1Q12 Restructuring activities, the Company recorded pretax restructuring charges of $357 million in the first quarter of 2012 consisting of costs associated with exit or disposal activities of $150 million, severance costs of $113 million and asset write-downs and write-offs of $94 million.
On October 23, 2012, the Company’s Board of Directors approved a restructuring plan (“4Q12 Restructuring”) to advance the next stage of the Company’s transformation and to address macroeconomic uncertainties. The restructuring plan accelerates the Company’s structural cost reduction program and will affect approximately 2,850 positions and result in the shutdown of approximately 20 manufacturing facilities. These actions are expected to be completed by March 31, 2015. As a result of the 4Q12 Restructuring activities, the Company recorded pretax restructuring charges of $990 million in the fourth quarter of 2012 consisting of costs associated with exit or disposal activities of $39 million, severance costs of $375 million and asset write-downs and write-offs of $576 million.
The following table summarizes the activities related to the Company’s restructuring reserve (liability):
| 1Q12 Restructuring Activities | Costs Associated with Exit or Disposal Activities | |||||||||||||||
| In millions | Severance Costs | Impairment of Long-Lived Assets and Other Assets | Total | |||||||||||||
| Restructuring charges recognized in the first quarter of 2012 | $ | 150 | $ | 113 | $ | 94 | $ | 357 | ||||||||
| Adjustments to the reserve | — | — | (4 | ) | (4 | ) | ||||||||||
| Charges against the reserve | — | — | (90 | ) | (90 | ) | ||||||||||
| Cash payments | (45 | ) | (82 | ) | — | (127 | ) | |||||||||
| Noncash settlements | (47 | ) | — | — | (47 | ) | ||||||||||
| Foreign currency impact | (2 | ) | — | — | (2 | ) | ||||||||||
| Reserve balance at December 31, 2012 | $ | 56 | $ | 31 | $ | — | $ | 87 | ||||||||
| Adjustments to the reserve | (16 | ) | — | — | (16 | ) | ||||||||||
| Cash payments | (15 | ) | (28 | ) | — | (43 | ) | |||||||||
| Noncash settlements | (8 | ) | — | — | (8 | ) | ||||||||||
| Foreign currency impact | (1 | ) | — | — | (1 | ) | ||||||||||
| Reserve balance at December 31, 2013 | $ | 16 | $ | 3 | $ | — | $ | 19 | ||||||||
| 4Q12 Restructuring Activities | Costs Associated with Exit or Disposal Activities | Impairment of Long-Lived Assets, Other Assets and Equity Method Investments | ||||||||||||||
| In millions | Severance Costs | Total | ||||||||||||||
| Restructuring charges recognized in the fourth quarter of 2012 | $ | 39 | $ | 375 | $ | 576 | $ | 990 | ||||||||
| Charges against the reserve | (9 | ) | — | (576 | ) | (585 | ) | |||||||||
| Cash payments | — | (8 | ) | — | (8 | ) | ||||||||||
| Reserve balance at December 31, 2012 | $ | 30 | $ | 367 | $ | — | $ | 397 | ||||||||
| Adjustments to the reserve | (6 | ) | — | — | (6 | ) | ||||||||||
| Cash payments | (5 | ) | (228 | ) | — | (233 | ) | |||||||||
| Reserve balance at December 31, 2013 | $ | 19 | $ | 139 | $ | — | $ | 158 | ||||||||
Required:
a. Explain why Dow Chemical planned this restructuring. When did the company record the restructuring expense? When will the restructuring take place? Explain the difference.
b. What are the three types of restructuring costs for Dow Chemical for 2013?
c. Explain why no cash is involved in settling the impairment of long-lived assets portion of the restructuring reserve.
d. Dow Chemical managers estimated all of the charges above. What would be the income-statement consequences next year (in 2014) if only $100 million of additional cash payments were necessary to completely settle the employee severance costs? Assume that Dow Chemical did not intentionally overestimate these severance costs.
Answer:
a. The Dow Chemical Corporation announced two restructuring programs in 2012 in response to macroeconomic uncertainties and changing and volatile economic conditions, particularly in Western Europe. In order to be successful and profitable, Dow felt it necessary to restructure current operations. The company decided to cut employees, shut down manufacturing facilities, and try to streamline operations. Because the board of directors passed a motion to restructure in 2012, GAAP allows Dow to accrue the costs in 2012. The restructuring was started in 2012 and some of the cash was paid out during 2012. However, the restructuring continues into 2015, but the expenses were recorded in 2012.
b. Asset impairment charges relate to the write-down of assets to fair values. This likely represents plants that will be shuttered, equipment that will be scrapped, and office locations that will be closed. Costs associated with exit or disposal relate to the costs that will arise as the company tries to sell off long-term assets, charges of early termination of leases, legal fees, closure and relocation of manufacturing and administrative facilities etc. Employee severance costs represent accrued costs for the termination of employees whose jobs are to be eliminated under the restructuring. This includes layoff packages, pension payouts, and any other costs paid to or on behalf of, the laid-off employees.
c. Asset write-offs are noncash charges. The income statement shows the $670 ($94 + $576) million as part of the total restructuring expense, and assets (property, land, equipment, etc.) are reduced on the balance sheet.
d. If only $100 million additional severance costs will be paid, Dow Chemical has an excess liability on its balance sheet for $42 [($139 +$3) – $100] and this will never be paid. The consequence is that the charge will be reversed. This reversal will reduce expenses, which will increase net income 2014.
Topic: Analyzing and interpreting income tax footnote (Numerical calculations required)
LO: 3
6. The following are excerpts from the 2013 annual report of Valero Energy. Use the information to answer the requirements.
Components of income tax expense related to continuing operations were as follows (in millions):
| Year Ended December 31, | |||||||||||
| 2013 | 2012 | 2011 | |||||||||
| Current: | |||||||||||
| U.S. federal | $ | 635 | $ | 515 | $ | 562 | |||||
| U.S. state | 36 | 22 | 13 | ||||||||
| International | 82 | 126 | 186 | ||||||||
| Total current | 753 | 663 | 761 | ||||||||
| Deferred: | |||||||||||
| U.S. federal | 459 | 854 | 527 | ||||||||
| U.S. state | 59 | 77 | 32 | ||||||||
| International | (17 | ) | 32 | (94 | ) | ||||||
| Total deferred | 501 | 963 | 465 | ||||||||
| Income tax expense | $ | 1,254 | $ | 1,626 | $ | 1,226 | |||||
The tax effects of significant temporary differences representing deferred income tax assets and liabilities were as follows (in millions):
| December 31, | |||||||
| 2013 | 2012 | ||||||
| Deferred income tax assets: | |||||||
| Tax credit carryforwards | $ | 48 | $ | 61 | |||
| Net operating losses (NOLs) | 338 | 247 | |||||
| Inventories | 264 | 258 | |||||
| Property, plant, and equipment | 8 | 78 | |||||
| Compensation and employee benefit liabilities | 178 | 383 | |||||
| Environmental liabilities | 92 | 83 | |||||
| Other | 187 | 157 | |||||
| Total deferred income tax assets | 1,115 | 1,267 | |||||
| Less: Valuation allowance | (347 | ) | (304 | ) | |||
| Net deferred income tax assets | 768 | 963 | |||||
| Deferred income tax liabilities: | |||||||
| Property, plant, and equipment | 6,536 | 6,143 | |||||
| Deferred turnaround costs | 331 | 300 | |||||
| Inventories | 310 | 381 | |||||
| Investments, primarily in VLP and DGD | 94 | — | |||||
| Other | 81 | 103 | |||||
| Total deferred income tax liabilities | 7,352 | 6,927 | |||||
| Net deferred income tax liabilities | $ | 6,584 | $ | 5,964 | |||
Required:
a. What income tax expense does Valero Energy report in its 2013 income statement? How much of this expense is currently payable?
b. Valero Energy reports deferred tax liabilities related to “Property, plant and equipment.” Describe how these liabilities arise. How likely is it that these liabilities will be paid? Specifically, describe a scenario that will (i) defer these taxes indefinitely, and (ii) will result in these liabilities requiring payment within the near future.
c. Valero Energy reports a deferred tax asset relating to “Compensation and employee benefit liabilities.” When a company has a pension plan it records an expense and related liability each year while the employee works for the company. Pension payments are not made to employees until they retire. Explain why pension plans create a deferred tax asset.
d. Valero Energy reports deferred tax assets from net loss carry forwards. Explain how these arise and how they will result in a future benefit.
e. Valero Energy reports a valuation allowance of $347 million in 2013 and of $304 million in 2012, which is deducted from the deferred tax assets. Why? How did the change in the allowance from 2012 to 2013 affect net income in 2013? How can a company use this allowance to meet its income targets in a particular year?
Answer:
a. Valero Energy reports $1,254 million of tax expense in its 2013 income statement. Of this amount, $753 million is currently payable.
b. Deferred tax liabilities relating to property plant and equipment relate to accelerated depreciation. These liabilities arise because the company is depreciating buildings and equipment more quickly in its tax return than in its GAAP income statement. Thus, the assets’ tax-reporting book value is less than the financial-reporting book value, which yields a deferred tax liability. For any particular asset, future depreciation expense in the tax return will be lower and the difference between the two net book values will shrink and the liability will reverse. However, if Valero adds significant depreciable assets each year, the first-year’s accelerated depreciation on the new assets will more than offset the lower depreciation on the older assets, resulting in a permanent deferred tax liability. Once the growth rate for assets subsides, the depreciation expense deduction in the tax return will as well, and the deferred tax liability will shrink.
c. Valero reports an accrued liability for compensation and employee benefit liabilities on its balance sheet. This does not create a tax-basis liability however because the tax authorities do not permit a deduction for this sort of expense until employees (retirees) are paid. Consequently, GAAP liabilities are greater than tax-basis liabilities, which creates a deferred tax asset that recognizes the future deductions of pension payments.
d. Net operating losses (NOL) arise when a company reports a tax loss. Such losses can be carried back for up to two years to offset against taxable income and the company receives a tax refund. Unused tax losses can be carried forward for up to 20 years as future tax deductions to reduce future taxable income and tax liability. This creates a deferred tax asset because at some point in the future, the company will pay fewer taxes than it would absent the NOL carryforward.
e. The valuation allowance arises when the company believes that some of the related deferred tax assets will not generate future benefits. These allowances typically arise because the carry forward deduction will likely not be used before it expires. Increases and decreases in deferred tax valuation allowances affect net income dollar-for-dollar in the opposite direction. For 2013, the increase in the allowance decreased net income by $43 million. Since establishing and subsequently adjusting the valuation allowance is highly subjective (dependent upon the company’s estimation of whether the deductions will or will not be realized), companies might increase or decrease this account to manage net income to reach income targets. Financial statement users need to be aware of how changes in the valuation allowance affects net income in their analysis of the profitability of the company.
Topic: Analyzing and Interpreting Income Tax Footnote (Numerical calculations required)
LO: 3
7. The 2013 annual report of Netflix, Inc. includes the following footnote.
The components of provision for income taxes for all periods presented were as follows:
| Year Ended December 31, | |||||||||||
| 2013 | 2012 | 2011 | |||||||||
| (in thousands) | |||||||||||
| Current tax provision: | |||||||||||
| Federal | $ | 58,558 | $ | 34,387 | $ | 123,406 | |||||
| State | 15,154 | 7,850 | 28,657 | ||||||||
| Foreign | 7,003 | 1,162 | (70 | ) | |||||||
| Total current | 80,715 | 43,399 | 151,993 | ||||||||
| Deferred tax provision: | |||||||||||
| Federal | (18,930 | ) | (26,903 | ) | (14,008 | ) | |||||
| State | (2,751 | ) | (3,168 | ) | (4,589 | ) | |||||
| Foreign | (363 | ) | — | — | |||||||
| Total deferred | (22,044 | ) | (30,071 | ) | (18,597 | ) | |||||
| Provision for income taxes | $ | 58,671 | $ | 13,328 | $ | 133,396 | |||||
Deferred tax assets (liabilities) were as follows (in thousands):
| As of December 31, | |||||||
| 2013 | 2012 | ||||||
| (in thousands) | |||||||
| Deferred tax assets (liabilities): | |||||||
| Stock-based compensation | $ | 69,201 | $ | 66,827 | |||
| Accruals and reserves | 13,022 | 11,155 | |||||
| Depreciation and amortization | (11,159 | ) | (18,356 | ) | |||
| R&D credits | 19,196 | 8,480 | |||||
| Other | 824 | (244 | ) | ||||
| Total deferred tax assets | 91,084 | 67,862 | |||||
| Valuation allowance | (481 | ) | — | ||||
| Net deferred tax assets | $ | 90,603 | $ | 67,862 | |||
Required:
a. Use the financial statement effects template below to record income tax expense for Netflix for 2013.
| Balance Sheet | Income Statement | |||||||||||||
| Transaction | Cash Asset | + | Noncash Assets | = | Liabil-
ities |
+ | Contrib. Capital | + | Earned
Capital |
Rev-enues | – | Expen-ses | = | Net
Income |
| 12/31/2013 | = | – | = | |||||||||||
b. Netflix reports a deferred tax liability relating to depreciation. Describe how this liability arises. How likely is it that this liability will be paid?
c. Assume that Netflix records deferred tax liabilities at a rate of 35%. The balance sheet reports net property, plant and equipment, of $133,605 thousand. Compute the tax basis for these assets. Hint: recall that the difference between the assets’ net book value and the tax basis is the timing difference and that deferred taxes are recorded as timing difference × tax rate.
d. Netflix reports a significant deferred tax asset relating to stock-based compensation. The company has compensated executives and other managers with stock options. Explain why this gives rise to a deferred tax asset.
Answer:
a.
| Balance Sheet | Income Statement | |||||||||||||
| Transaction | Cash Asset | + | Noncash Assets | = | Liabil-
ities |
+ | Contrib. Capital | + | Earned
Capital |
Rev-enues | – | Expen-
ses |
= | Net
Income |
| 12/31/2013 | -80,715* | +22,044 (Deferred Tax Assets) | = | -58,671 (Retained Earnings) | – | +58,671 (Tax Expense) | = | -58,671 | ||||||
*The $80,715 thousand credit can be to cash (if paid in cash), or to a liability (if paid in the next year.)
b. Deferred tax liabilities relating to property plant and equipment relate to accelerated depreciation. These liabilities arise because the company is depreciating buildings and equipment more quickly in its tax return than in its GAAP income statement. Thus, the assets’ tax-reporting book value is less than the financial-reporting book value, which yields a deferred tax liability. For any particular asset, future depreciation expense in the tax return will be lower and the difference between the two net book values will shrink and the liability will reverse. However, if Netflix adds significant depreciable assets each year, the first-year’s accelerated depreciation on the new assets will more than offset the lower depreciation on the older assets, resulting in a permanent deferred tax liability. Once the growth rate for assets subsides, the depreciation expense deduction in the tax return will as well, and the deferred tax liability will shrink.
c. Timing difference = Deferred tax liability / Tax rate = $11,159 thousand / 0.35 = $31,883 thousand. Tax basis = GAAP net book value – timing differences.
Tax basis = $133,605 thousand – $31,883 thousand = $101,722 thousand.
d. Netflix Co. reports GAAP expense for stock options as the options are granted. However for tax purposes, the company may only expense the options if and when they are exercised. This creates a timing difference and, a deferred tax asset.
Topic: Foreign Currency Translation
LO: 4
8. Oracle reports the following in footnotes to its 2013 form 10-K.
Geographic Information
Disclosed in the table below is geographic information for each country that comprised greater than three percent of our total revenues for any of fiscal 2013, 2012 or 2011.
| As of and for the Year Ended May 31, | ||||||||||||||||||||||||
| 2013 | 2012 | 2011 | ||||||||||||||||||||||
| (in millions) | Revenues | Long Lived Assets(1) |
Revenues | Long Lived Assets(1) |
Revenues | Long Lived Assets(1) |
||||||||||||||||||
| United States | $ | 16,003 | $ | 2,921 | $ | 15,767 | $ | 2,468 | $ | 15,274 | $ | 2,359 | ||||||||||||
| United Kingdom | 2,165 | 203 | 2,302 | 171 | 2,200 | 168 | ||||||||||||||||||
| Japan | 1,770 | 428 | 1,865 | 550 | 1,731 | 551 | ||||||||||||||||||
| Germany | 1,308 | 44 | 1,484 | 47 | 1,475 | 29 | ||||||||||||||||||
| Canada | 1,232 | 34 | 1,234 | 37 | 1,174 | 16 | ||||||||||||||||||
| Australia | 1,084 | 54 | 1,163 | 38 | 1,041 | 34 | ||||||||||||||||||
| France | 1,054 | 17 | 1,162 | 16 | 1,145 | 15 | ||||||||||||||||||
| Other countries | 12,564 | 814 | 12,144 | 741 | 11,582 | 661 | ||||||||||||||||||
| Total | $ | 37,180 | $ | 4,515 | $ | 37,121 | $ | 4,068 | $ | 35,622 | $ | 3,833 | ||||||||||||
| (1) | Long-lived assets exclude goodwill, intangible assets, equity investments and deferred taxes, which are not allocated to specific geographic locations as it is impracticable to do so. |
Required:
a. What proportion of Oracle’s total revenue is potentially exposed to foreign currency risk?
b. Assume that Oracle does not undertake any measures to reduce its foreign currency exposure. If the U.S. dollar strengthens on average 10% vis-à-vis the European currencies in which the company transacts, and weakens 5% relative to the Japanese yen, what will be the impact on revenues in 2013?
c. Explain what steps Oracle can take to reduce its foreign currency risk.
Answer:
a. Domestic revenues are $16,003. This is 43% of total revenues ($16,003/ $37,180). Thus, 57% of 2013 revenues are exposed to foreign currency risk.
b. When the USD strengthens, the foreign currency decreases when translated to dollars. Conversely, when the USD weakens, the foreign currency increases in US dollar equivalents. Thus, the changes in the European and Japanese currency rates will affect revenues as follows:
| Europe | Japan | |||
| Revenues | USD strengthens 10% | USD weakens 5% | Revenues reflecting current exchange rates | |
| United States | $16,003 | $16,003 | ||
| United Kingdom | 2,165 | $1,968 | 1,968 | |
| Japan | 1,770 | $1,859 | 1,859 | |
| Germany | 1,308 | 1,189 | 1,189 | |
| Canada | 1,232 | 1,232 | ||
| Australia | 1,084 | 1,084 | ||
| France | 1,054 | 958 | 958 | |
| Other foreign countries | 12,564 | 12,564 | ||
| Total | $37,180 | $36,857 |
c. Company such as Oracle, can take several steps to mitigate foreign currency risk. The company can match its revenues and expenses in the various foreign currencies. This will mean that only the total (net income) will be exposed to risk. The company can also use hedging instruments such as options and forward contracts that pay off when the company’s foreign currency position is in a loss.
Topic: Earnings per Share (Numerical calculations required)
LO: 5
9. The 2013 annual report of NetFlix includes the following footnoted information. Use this information to answer the required.
The computation of net income per share is as follows:
| Year ended December 31, | 2013 | 2012 | 2011 | ||||||||
| (in thousands, except per share data) | |||||||||||
| Basic earnings per share: | |||||||||||
| Net income | $ | 112,403 | $ | 17,152 | $ | 226,126 | |||||
| Shares used in computation: | |||||||||||
| Weighted-average common shares outstanding | 58,198 | 55,521 | 52,847 | ||||||||
| Diluted earnings per share: | |||||||||||
| Net income | $ | 112,403 | $ | 17,152 | $ | 226,126 | |||||
| Convertible Notes interest expense, net of tax | 49 | 195 | 17 | ||||||||
| Numerator for diluted earnings per share | 112,452 | 17,347 | 226,143 | ||||||||
| Shares used in computation: | |||||||||||
| Weighted-average common shares outstanding | 58,198 | 55,521 | 52,847 | ||||||||
| Convertible Notes shares | 715 | 2,331 | 217 | ||||||||
| Employee stock options | 1,848 | 1,052 | 1,305 | ||||||||
| Weighted-average number of shares | 60,761 | 58,904 | 54,369 | ||||||||
Employee stock options with exercise prices greater than the average market price of the common stock were excluded from the diluted calculation as their inclusion would have been anti-dilutive.
The following table summarizes the potential common shares excluded from the diluted calculation (in thousands):
| Year ended December 31, | 2013 | 2012 | 2011 |
| Employee stock options | 198 | 1,207 | 225 |
Required:
a. What are the potential sources of dilution of NetFlix’s earnings per share?
b. List two additional dilutive securities (other than those NetFlix includes).
c. NetFlix did not include all outstanding employee stock options in the calculation of diluted net income per share in 2013? Why not? How many options were excluded?
d. Calculate basic EPS for each of the three years.
e. Calculate diluted EPS for each of the three years.
Answer:
a. NetFlix has convertible notes outstanding that allow holders to purchase common stock. NetFlix also has granted employee stock options, which, if exercised would increase the number of shares outstanding. Both of these are potential sources of dilution.
b. Convertible preferred stock and warrants are two additional potentially dilutive securities.
c. Some of NetFlix’s outstanding employee stock options are out of the money – the strike price on these options is greater than NetFlix’s current stock price. Employees who hold these options are not going to exercise them. Thus, these options are not included in the calculation of diluted net income per share for 2013 because they are anti-dilutive. NetFlix excluded 198 thousand of these anti-dilutive options in 2013.
d.
| 2013 | 2012 | 2011 | |
| Basic earnings per share = Net income / Weighted-average common shares outstanding | $ 1.93 | $ 0.31 | $ 4.28 |
e.
| 2013 | 2012 | 2011 | |
| Diluted earnings per share = Net income + Convertible Notes interest expense / Weighted-average common shares outstanding + Dilutive securities | $ 1.85 | $ 0.29 | $ 4.16 |
Topic: Earnings per Share (Numerical calculations required)
LO: 5
10. The 2013 annual report of Pacific Gas & Electric Corporation includes the following information in the income statement. Compute the missing amounts.
| PG&E Corporation | |||
| Consolidated Statements of Income | |||
| (Dollars and shares in millions, except per share amounts) | |||
| For the year ended December 31, | 2013 | 2012 | 2011 |
| Net income | $828 | $830 | $858 |
| Preferred stock dividends | $14 | $14 | |
| Average common shares outstanding, basic | 444 | 401 | |
| Basic earnings per common share (rounded to three decimal places for calculation purposes) | $1.925 | $2.105 | |
Answer:
| For the year ended December 31, | 2013 | 2012 | 2011 |
| Net income | $828 | $830 | $858 |
| Preferred stock dividends | $14 | $14 | $14 |
| Average common shares outstanding, basic | 444 | 424 | 401 |
| Basic earnings per common share (rounded to three decimal places for calculation purposes) | $1.833 | $1.925 | $2.105 |
Essay Questions
Topic: Revenue Recognition Timing and Determination
LO: 1
1. Discuss when each of the following types of businesses should likely recognize revenue:
a. A software company such as Microsoft when significant production, modification, or customization does not exist.
b. A clothing retailer like Neiman Marcus.
Answer:
a. Microsoft recognizes revenue when there exists persuasive evidence of an arrangement, delivery has occurred, the contract or sales price is fixed or determinable, and collectability is probable.
b. Neiman Marcus is a retailer and revenue recognition is fairly straight-forward. The company will record revenue when the customer takes possession of the merchandise and pays (primarily with either cash or credit card). Catalogue and e-commerce sales are recorded upon customer receipt of merchandise. Amounts relating to shipping and handling billed to customers are classified as revenue and the related costs are classified as cost of goods sold.
Topic: Revenue Recognition
LO: 1
2. Why would a company deliberately report sales on consignment as gross instead of at the net amount. Explain why you believe this is or is not a fair method of reporting revenue this way.
Answer:
Companies sometimes act as agents for other companies. A company might attempt to inflate revenues by reporting these transactions on a “gross” basis, when in fact these commissions or revenues should be reported on a net basis. Start-up and dot.com companies may employ this method under the assumption that the market prices of their stocks are determined by revenue growth and profitability. The SEC mandates that all such sales should be reported on a net basis.
Topic: Percentage-of-Completion
LO: 1
3. When is the percentage-of-completion method an appropriate method to recognize revenues. What are some of the potential risks associated with this practice?
Answer:
Companies that are awarded long-term contracts that span over one year typically use the percentage-of-completion method to recognize revenue. The difficulty arises when a company must forecast all project-related costs in order to accurately estimate at any given point in time how far along the percentage of completion. Errors can result whereby the company recognizes too much revenue on the front end, only to be reversed at the end of the project.
Topic: Restructuring Charges
LO: 2
4. Firms typically report three categories of restructuring costs. What are they and how do they affect the balance sheet and the income statement?
Answer:
Restructuring costs consist of three general categories: asset write-downs, liability accruals for severance and relocation costs, and accruals of other restructuring-related costs. Asset write-downs reduce assets’ net book value and are recognized in the income statement as an expense. Liability accruals for severance and other expenses create a liability, such as for anticipated severance costs and exit costs, and yield a corresponding expense that reduces income and equity.
Topic: Big Bath
LO: 2
5. Discuss what is meant when a company takes a “big bath.” In addition, provide an example of “big bath” behavior and discuss why an analyst or potential investor may be concerned with this behavior.
Answer:
“Big Bath” behavior refers to an event in which companies are perceived as overestimating the amount of asset write-downs or liability accruals to deliberately reduce current- period earnings. The effect is to remove future costs from the balance sheet or to create reserves that can be used to increase future-period earnings. An example of big bath behavior would be to time recognition of restructuring costs for a year when its income is already depressed. An analyst or potential investor may be concerned with this behavior because of the inaccurate portrayal of a company’s costs and or earnings that result.
Topic: Deferred Taxes
LO: 3
6. What are deferred taxes? When do they arise?
Answer:
There are two kinds of deferred taxes: deferred tax liabilities and deferred tax assets. The former arise when a company’s taxable income is less than its book income, typically resulting from higher depreciation expense for tax reporting. The company records this effect in its financial statements as an increase in deferred tax liability to recognize the taxes that will be paid when the item causing the difference reverses. Deferred tax assets arise for the opposite reason: taxable income is greater than financial reporting income. This can arise, for example, when a company reports a restructuring expense that is recognized for financial reporting purposes when incurred, but is not deductible for tax purposes until paid.
Topic: Foreign Currency Fluctuations
LO: 4
7. What effect, if any, does a strengthening of the dollar have on reported sales and net income for companies operating outside the United States, when those foreign operations are translated to U.S. dollars for consolidation purposes?
Answer:
When the U.S. dollar strengthens foreign currencies weaken – they are translated to fewer USD. This reduces every reported number on the financial statements compared to what the USD equivalent would have been if the U.S. dollar had not strengthened. Thus, reported sales, expenses and net income are all smaller.
Topic: Earnings per Share
LO: 5
8. How are earnings per share calculated? What is the main problem in comparing operating results for companies of different sizes, using EPS figures?
Answer:
There are two measures of reporting the earnings per share (EPS) figures: basic and diluted EPS.
Basic EPS is equal to the ratio of net income less dividends on preferred stock to the weighted average of common shares outstanding for the year. Computation of diluted EPS reflects the additional shares that would be issued assuming all stock options and convertible securities are exercised at the beginning of the year. Therefore, diluted EPS is calculated by subtracting the EPS impact of dilutive options and warrants and the EPS impact of dilutive convertibles from basic EPS.
Some financial analysts and investors compare EPS figures across companies of different sizes. The assumption is that the number of shares outstanding is proportional to the income level. However, this assumption is not correct, since the number of shares outstanding is controlled by managers, and different companies may have different share issuance and repurchase attitudes.
Topic: Earnings per Share Definitions and Computations
LO: 5
9. The SEC requires that firms report both basic and diluted earnings per share in their 10-K reports. Why do firms’ basic EPS and diluted EPS differ? Which EPS number is more informative to you as an investor?
Answer:
Basic earnings per share is defined as net income less any preferred dividends divided by the weighted average number of common shares outstanding for the period. Diluted earnings per share adjusts the numerator (earnings) for the impact of issuing dilutive securities (such as convertible securities or employee stock options); and the denominator. Consequently, diluted earnings per share is always less than or equal to basic earnings per share. As an investor, I pay more attention to diluted earnings per share because it tells me about the worst-case scenario if all dilutive security holders converted their debt or exercised their options. This informs me about the potential loss in value of my holdings.
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