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6-28
Revenue Analysis




EXHIBIT 2
Oracle Systems Corporation “ Review of Quarterly Results in Fiscal
1989 and 1990 (in $000 except per share data)

Fiscal 1990 Quarter Ended
..................................................................................




Oracle Systems Corporation
Aug. 31 Nov. 30 Feb. 28 May 31
1989 1989 1990 1990
..........................................................................................................................

Revenues $175,490 $209,023 $236,165 $350,166
Net income 11,679 28,491 24,282 52,958
Earnings per sharea $ .09 $ .21 $ .18 $ .39


Fiscal 1989 Quarter Ended
..................................................................................
Aug. 31 Nov. 30 Feb. 28 May 31
1988 1988 1989 1989
..........................................................................................................................

Revenues $90,639 $123,745 $153,354 $215,935
Net income 7,067 17,189 23,964 33,546
Earnings per sharea $ .05 $ .13 $ .18 $ .25
..........................................................................................................................

a. Adjusted to reflect the two-for-one stock splits in the third quarter of fiscal 1988 and the first quarter of fiscal 1990.




EXHIBIT 3
Days Receivable for Selected Companies in the Software
Industry for 1989“90

Company 1989 1990
.................................................................................................

Borland International Corp. 49 45
Lotus Development Corp. 64 64
Microsoft Corp. 51 56
Novell Corp. 85 81
Average 62 62
.................................................................................................

Oracle Systems Corporation “ Review of Quarterly Results in Fiscal 1989 and 1990
7
7 E xp e n s e An al ys is
chapter




E xpenses are the economic resources that have been consumed or
have declined in value. Firms incur expenses to acquire or produce products or services
that are sold. In addition, expenses are incurred for marketing (including advertising
Business Analysis and 2
Valuation Tools
costs, sales force salaries and commissions, and salaries of marketing management), for
managing the ¬rm (salaries of the head of¬ce staff and depreciation on headquarters),
for the cost of any debt ¬nancing, for taxes, and for realized and unrealized declines in
asset values.
Analysis of expenses focuses on assessing when expenses should be recognized in
the ¬nancial statements. Should they be recognized when the resources are used? Should
they be recognized when the ¬rm is billed for resources? Should they be recognized
when payment for resources is made? Or should they be reported when the revenues
generated from using the resources are recognized?
The key principles in accounting that dictate how expenses are recorded are matching
and conservatism. Under these principles, resources directly associated with revenues
are recorded in the same period as revenues are recognized. Resources that are more
closely associated with a speci¬c period are recorded in that period. Finally, all other
costs are recognized as an expense when they are incurred or can be reasonably esti-
mated.
Challenges in recognizing expenses arise when resources provide bene¬ts over mul-
tiple periods, when resources have been consumed but there is uncertainty about the tim-
ing and amount of payment, when the value of resources consumed is dif¬cult to de¬ne,
and when resources have declined in value. These challenges give rise to opportunities
for ¬nancial analysis of expenses.


MATCHING AND CONSERVATISM
Cash outlays are a poor indicator of resource use when a ¬rm acquires (and pays for)
resources but has yet to use them, or when a ¬rm uses resources but has yet to pay for
them. Indeed, recognizing resource use at the outlay of cash can be misleading and can
provide perverse incentives for managers to improve reported performance by deferring
payments for resources. This incentive to delay making cash outlays is likely to be mag-
ni¬ed for big-ticket items, such as purchases of assets that provide bene¬ts for multiple
periods.


7-1




249
250 Expense Analysis




7-2
Expense Analysis




Figure 7-1 Criteria for Recognizing Expenses and Implementation
Challenges

First Criterion Second Criterion Third Criterion
Resources consumed Resources have no cause- There is a decline in the
have a cause-and-effect and-effect relation with future bene¬ts expected
relation with revenues revenues but are consumed from resources.
recognized during the during the period.
period.




Recognize expense.



Challenging Transactions
1. Resources provide bene¬ts over multiple periods.
2. Resources are consumed, but the timing and amount of future payments is uncertain.
3. The value of resources consumed is dif¬cult to de¬ne.
4. Unused resources have declined in value.



Accrual accounting relies on the matching and conservatism principles to determine
the cost of resources used. As shown in Figure 7-1, these principles classify expenses
into three types. First, the matching principle views expenses as the cost of consumed
resources that have a cause-and-effect relation with revenues. These include the cost of
materials consumed in manufacturing a product or the cost of acquiring merchandise by
retailers. Matching therefore makes it easier for ¬nancial statement readers to assess
whether a ¬rm™s products or services are pro¬table. The cost of resources that have no
clear cause-and-effect relation to revenues are recorded as expenses during the period
they are consumed. Examples include general administration and marketing costs. Fi-
nally, under the conservatism principle, accountants require ¬rms to record expenses
when there is a decline in the future bene¬ts expected to be generated by resources, or
when it becomes dif¬cult to estimate bene¬ts with reasonable certainty. Write-downs of
impaired assets are one such form of expense.


EXPENSE REPORTING CHALLENGES
Four types of resource uses are particularly challenging from a ¬nancial reporting view-
point. These arise when resources have bene¬ts across multiple accounting periods,
when resources are consumed but the timing and amount of payment is uncertain, when
the value of resources consumed is dif¬cult to de¬ne, and when unused resources have
declined in value. Considerable management judgment is involved in recording these
types of expenses. Managers are likely to have better information on the cost of resources
251
Expense Analysis




7-3 Part 2 Business Analysis and Valuation Tools




consumed by the ¬rm during the period, but they are also self-interested. Further,
accounting rules sometimes require certain outlays to be recorded as an expense, regard-
less of the future economic bene¬ts they provide. Both these reporting limitations create
incentives for analysis of expenses by ¬nancial statement users.
Below we analyze the key challenges in implementing the criteria for expense recog-
nition and use speci¬c industries and types of transactions to illustrate the key points.
However, the challenges discussed are quite general.


Challenge One: Resources Provide Benefits over Multiple Periods
Many resources acquired by a ¬rm provide bene¬ts over multiple years. These include
outlays for plant and equipment, research and development, advertising, and drilling oil
and gas wells. A challenge in accounting for these types of transactions is how to allocate
the cost of these types of resources over multiple periods. Should it be allocated equally
over their useful life? Or should it be recorded conservatively as an expense when it is
incurred? The matching principle argues for spreading out the cost of a resource over its
expected life if it has a clear and reasonably certain cause-and-effect relation with future
revenues. Alternatively, if the cause-and-effect relation is unclear or highly uncertain,
the resource cost is recognized as an expense in the period incurred.
To illustrate the issues in reporting for outlays for resources with multi-period bene-
¬ts, we discuss the ¬nancial reporting treatment of ¬xed asset depreciation, goodwill
amortization, research and development outlays, and advertising outlays.

EXAMPLE: FIXED ASSET DEPRECIATION. Fixed assets include plant, buildings,
manufacturing equipment, computer equipment, automobiles, and furnishings, all
of which have multi-year lives. There is typically little question that these resources are
expected to directly or indirectly help generate future revenues for the ¬rm. Thus, the
cause-and-effect relation between outlays for such resources and future revenues is typ-
ically reasonably certain.
It is more challenging, however, to assess how the cost of these types of resources
should be matched with future revenues. Generally accepted accounting rules require
managers to make estimates of the expected useful lives of these assets and their ex-
pected salvage values at the end of their lives. These estimates are then used to allocate
the cost of the ¬xed assets over their useful lives in a systematic manner.
Assets™ useful lives are determined by the risk of technological obsolescence and
physical use. Managers™ estimates of these effects are therefore likely to depend on their
¬rms™ business strategies and their prior experience in operating, managing, and resell-
ing similar assets. For example, in 1998 Delta Air Lines depreciated new aircraft over
25 years and estimated salvage values at 5 percent of cost. In contrast, Singapore Air-
lines estimated the life of aircraft at 10 years and salvage values at 20 percent of cost.
These estimates partially re¬‚ect differences in the two airlines™ business strategies. Sin-
gapore Airlines targets business travelers who are typically less price conscious and
252 Expense Analysis




7-4
Expense Analysis




demand reliable service. In contrast, Delta focuses more on economy travelers who are
highly price-sensitive and for whom on-time arrival is less critical. As a result, the two
airlines follow very different operating strategies for their aircraft. Singapore Airlines re-
places older aircraft regularly to maintain a relatively new ¬‚eet. This reduces the risk of
¬‚ight delays for maintenance problems, enabling the company to have high on-time ar-
rival rates. In contrast, Delta holds its aircraft longer, lowering its equipment outlays, but
at the cost of increased maintenance and lower on-time arrival rates. These differences
in operations are re¬‚ected in the depreciation estimates made by the two companies. Of
course, there may be other factors that in¬‚uence management™s estimates for the two
companies. For example, Delta is likely to face more pressure to report pro¬ts for own-
ers since it is 100 percent publicly owned. In contrast, Singapore Airlines is majority
owned by the Singapore government.
A variety of depreciation methods are permitted under generally accepted accounting
rules. The standard method used for ¬nancial reporting in the U.S. is straight-line depre-
ciation, which allocates the depreciable cost (de¬ned as purchase price less estimated
salvage value) equally over the asset™s estimated useful life. More than 90 percent of all
publicly owned ¬rms in the U.S. use this method. Outside the U.S., many companies em-
ploy accelerated depreciation, in conformance with their tax reporting method.1
Accelerated depreciation generates higher depreciation expenses than the straight-line
method in the early years of an asset™s life, and lower expenses toward the end of its life.
A third depreciation method, the units of production method, is used for assets whose
lives can be measured in physical units. The depreciation expense for a given year is then
the cost of the asset multiplied by the percentage of lifelong physical capacity used dur-
ing that period. This method is commonly used by natural resource companies to record
depreciation on production assets whose useful lives are tied to the resource capacity at
a particular mine or well site.
Management uses its judgment in estimating asset lives and salvage values and in se-
lecting depreciation methods. Thus, there is a risk that depreciation expenses re¬‚ect
management™s reporting incentives as well as the economics of the business.

EXAMPLE: GOODWILL AMORTIZATION. As discussed in Chapter 4, when a ¬rm
acquires another ¬rm and accounts for the acquisition using purchase accounting, good-
will is recorded. Goodwill represents the premium paid for the target™s intangible assets.
These assets include brand names, research and development, customer base, superior
management, well trained employees, patents, and other sources of superior performance.
For several reasons, the cause-and-effect relation between purchased goodwill re-
sources and future revenues is less obvious than for ¬xed assets. First, the particular
source of the future bene¬ts to be derived from goodwill is less clear than for ¬xed as-
sets. Second, goodwill can represent any overpayment by the acquirer for the target™s
business as well as payment for intangibles. As a result of these uncertainties, goodwill
amortization policies permitted by standard setters have differed across countries. For

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