Monthly Archives: April 2013

Unearned Revenue & Prepayment Situations

Unearned revenue (deferred revenue) refers to funds received by a seller for goods or services not yet delivered to the buyer.

The following situations are good examples of deferred revenue:

1. When an individual makes an initial deposit as downpayment towards purchasing a land, the seller has recognized unearned revenue upon this deposit, its only when the land title is transferred to the buyer and sale transaction is complete, the seller shall recognize it as Earned Revenue.

2. In case of an airline and railroad, the passenger purchases the ticket in advance of the travel, here the service provider will recognize it as earned revenue once the transportation is delivered. In the AMR Corp. case, this was found on the liabilities side of the balance sheet, under AIR TRAFFIC LIABILITIES (Unearned Revenue).

In accrual accounting, revenues are recognized as earned when two conditions are satisfied:

  1. The revenues are earned. This means the goods and services for the revenues have been delivered, and
  2. Revenue are realized (or realizable). There is a reasonable expectation that that cash will be received.

The journal entry transaction are as follows:

If the revenue will be earned in the near term, say, within a month and within the current accounting period, the revenues may be treated as ordinary earned revenue, in which case the journal transactions are the same as for ordinary revenue:

Dr. Cash     (+A)                   500

Cr. Sales revenue   (IS, +RE)           500

However, when it is clear that the revenue will not be fully earned for several months, or until the next accounting period, the journal transactions is as below:

Dr.   Cash       (+A)             500

Cr.  Unearned Revenue   (+L)       500

The process is complete, when the goods and services have finally been delivered:

Dr.   Unearned Revenues    (-L)    500

Cr.    Sales Revenue             (IS, +RE)              500

Prepayment and deferred payment situations

Prepayment and deferred payment situations present a special challenge to the company’s bookkeepers and accountants, because it is possible for actual payment and actual delivery to fall in different accounting periods. In order to avoid violating the matching concept, bookkeepers make an initial two entries to register the first transaction event, and then, later, makes adjusting entries to register the second transaction event.

Prepayments (payment precedes delivery of goods or services)

  • From the seller’s viewpoint : The seller will recognize unearned revenue as revenues received for goods and services that have not yet been delivered. Unearned revenues are recorded as liabilities until the product or service has been delivered.
  • From the buyer’s viewpoint: The buyer recognizes it as prepaid expenses, when paying for services or goods before delivery. Examples would be prepaid insurance or prepaid rent.

Deferred Payments (delivery of goods or services precedes payment)

  • From the seller’s viewpoint: Unrealized revenues are revenues earned by the seller and are posted on the asset account, as accounts receivable, until the payments are actually received.
  • From the buyer’s viewpoint: Accrued Expenses are posted in the balance sheet as a liability, for goods and services purchased and received but not yet paid for.

For cash basis accounting system, the bookkeeping practice is much simpler. In cash basis accounting:

  • Expenses are recognized when cash is paid
  • Revenues are recognized when cash is received.

Unearned revenues with other prepayment and deferred payment situations described above, are used in accrual accounting but not cash basis accounting.

http://www.business-case-analysis.com/unearned-revenue.html

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Recognition of Revenue in the Global Airline Industry

Because of the industry low margins, revenue recognition is one of the most critical accounting policies for airlines. This publication from KPMG discusses some key accounting considerations for revenue recognition policies in the airline industry. Even though the publication focus on IFRS/IAS standards, I think that the issues discussed offer insights equally applicable to GAAP standards.

Specifically, the KPMG paper examines more closely five issues: recognition of unredeemed tickets, treatment of trade discounts and commissions, taxes and airport charges, fuel surcharges, financial statement disclosures.

Unredeemed tickets

Part of the tickets sold by airlines can have lives of one year or more, or may be specific to flight and if not used cannot be refunded. For these tickets, airlines companies decide about the timing as to when recognise the revenue based on statistical data. Assumptions are therefore very critical and can have significant impacts on financial results. Another critical area is related to non refundable tickets, especially for low cost companies. In this cases, revenue are often recognised when the airlines close the flight, meaning that the flight is completely booked.

Commission and discounts

The second issue discussed is related to commission and discounts for travel agencies, which still account for a large proportion of airline industry ticket sales. Discounts, which are offered as an incentive to encourage the purchase of tickets, should be recognised as a reduction of the gross revenue. Commissions to agencies however should be recognised as an expense at the same time as the revenue to which commissions are related are recognised.

Taxes and airport charges

When tickets are sold, airlines companies act as collectors of taxes on behalf of governments. Amounts received from customers have to be distinguished between amounts for airline services and amounts for third parties (governments or airports). Additionally, taxes and airport charges should be accounted as a payable in the liabilities of the balance sheet and therefore should be excluded from the amounts collected from passenger revenue.

Fuel surcharges

Due to the recent continuous increases and fluctuations on the oil prices, many airlines companies have decided to add fuel surcharges to the tickets price, in order to minimise the impacts of the oil price. Fuel surcharges are a component of the ticket fare and they are recognised as revenue at the time when the passenger flies.

Disclosures

Finally, disclosures on financial statements are very important in order to analyse financial statements, Usually, the types of disclosures that appear on financial statements are:

  • Definition of Revenue;
  • Timing of Revenue Recognition;
  • Where in the Income Statements commissions are recognised;
  • Revenue Recognition basis for unredeemed tickets;
  • Amount of Revenue net of discounts;
  • Amount of deferred income or unearned revenue.

As shown in the summary of KPMG publication, recognition policies of revenue/expenses are critical to analyse financial statements of airlines companies. In fact, adoption of different policies can have deep impacts on accounting, financial and managerial performances. Therefore, it is better to fully understand policies adopted by companies in order to compare and analyse companies’ results.

Here you guys the link:

http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/recognition-of-revenue.pdf

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American Airlines Resumes Flights After a Computer Problem

This article discusses a problem that American Airlines had with its computer systems last Tuesday, April 16th.  Due to the nationwide problem, AA was forced to ground all of its flights from midday until approximately 4:30PM.  More than 400 flights were cancelled and many more were delayed.  AA said that the problem was due to an inability to gain access to its electronic reservation system, called Sabre, commonly referred to as the “brains of an airline.”  A spokesperson for Sabre stated that the problem did not come from its computer system.  Sabre is responsible for the bookings and reservations made by customers, as well as other tasks such as printing boarding passes, ticketing, online check-ins, and tracking bags.

Such problems have happened in the past, especially when airlines merge.  While AA and United Airways are about to merge once AA comes out of chapter 11 bankruptcy, their systems are not close to being integrated together.  In response to the problems, officials from AA announced that they would waive fees for passengers wishing to change their reservations and would provide refunds to those people who wished to cancel their flights on Tuesday.  AA is a service provider that uses the accrual basis of accounting.  The decision by the AA officials, in light of the April 16th events, to refund tickets and allow schedule changes free of charge affects their accounts.

When AA receives money from a ticket sale for a flight on a later date, GAAP dictates that it records this as a liability account for the unearned revenue labeled “Air Traffic Liabilities.”  By offering this refund, the “Air Traffic Liabilities” account would be debited, but not because the service was provided.  Instead, cash would be credited because the money is being refunded to the customers.  A slightly more complicated situation would arise if these tickets were non-refundable and if accounting policies mandated that these sales, since they are non-refundable, be recognized on the date of sale.  In such a theoretical situation, the refund would cause the account for the recognized revenue to be debited.

Offering the free of charge schedule changes also affects their revenues but in a different way.  It does not affect a specific account that was already adjusted due to a prior transaction.  Instead, offering these free schedule changes decreases their potential net profit, as they are not getting paid for something they normally would be getting paid for.  The expenses for each flight change transaction remains the same, since the same process is taking place, but there are no revenues to cover these expenses.  As a result, AA’s potential net profit decreases.

Source: New York Times – http://www.nytimes.com/2013/04/17/business/american-airlines-cancels-flights-after-outage.html?_r=0

 

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Microsoft’s Profits Fall as Sales of Personal Computers Shrink

The article discusses Microsoft’s unexpectedly low earnings for the fiscal first quarter in September 2012 and attributed the slump to the declining personal computer market.  They had a 22% decline in net income from the year-earlier period, which was lower than analysts expected.  Microsoft still gets most of its sales from PCs and directly devices related to PCs, although they are slowly transitioning to other technologies such as smart phones and tablets.

The article also discusses Microsoft’s new operating system Windows 8 and its release date of October 26th and the article states that Microsoft has deferred revenues of $1.36 billion dollars due to the software upgrades and the pre-order sales of this new system.  Accounting for this unearned revenue, Microsoft still would have been flat on its expected revenues, but by less than 1% from the prior year.

Specifically owed to the Windows 8 release, deferred revenues make up 8.5% of it’s would-be total revenue.  Micrsoft therefore has 1.36 billion in cash and accounts receivables as assets on its balance sheet and 1.36 billion as unearned revenues as a liability.  Generally Accepted Accounting Principles tell us that we cannot recognize revenue until 1) the earnings process is complete, 2) one can quantify/measure the revenue, 3) the risk and rewards of the product/service have been transferred to the buyer, and 4) payment is assured.  Microsoft understands that although cash has been received, the product has not yet been delivered and therefore, cannot attribute the cash to revenue.

This article shows how the clear discrepancy between cash and accrual accounting methods can affect companies.  Once Windows 8 is (was) released, they can credit the $1.36 billion in revenue on their income statement (RE), and debit the unearned revenue on their balance sheet.  Microsoft’s 2012 Annual Report actually shows that Windows & Windows Live Division’s unearned revenue had increased to $2.44 billion at the fiscal yearend.

Source: http://www.nytimes.com/2012/10/19/technology/microsoft-profit-falls-as-pc-sales-shrink.html?_r=1&

Source:  New York Times  Date:  October 18, 2012

 

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Delta’s Multiple approaches to increase their margins

In order to extend an equipment or aircraft’s useful life, there were only a few possibilities for Delta: route changes, maintenance, and/or betterment through more efficient technology.  Delta, has taken many routes in order to increase their profits very efficiently.  Since acquiring the transatlantic from bankrupt Pan Am and later acquiring Northwest Airlines after they rose back from bankruptcy, Delta has acquired many aircrafts and equipment from other airlines.

Delta’s new approach in cutting down the size of their flights to be more cost and fuel-efficient has been one of their many ways of approaching their increasing debt and increasing fuel costs.  An article published in 2011 shows that Delta has put in orders for Boeing aircraft MD-90 that were previously owned to come in during 2013-2017 through a financing program.  These flights are more narrow and have less number of seats which and are more fuel efficient.  In doing this, Delta believes they will be cutting down their maintenance costs and fuel costs.  Fuel consumption took a huge toll on Delta’s revenue in 2011; their annual report shows an increase of nearly $2.9 billion from 2010.  Also, from the annual report, it is clear that Delta still performs more on domestic flights than international, therefore depreciating their aircraft sooner than if they had more international routes.  Their long-term debt seems to be forecasted to be increasing due to this financing with Boeing, co., however it is not evident that Delta would be making enough revenue to cover their obligations and costs, and attain marginal profits from the change in their strategy.

Another article published in 2012 explains Delta’s interest in lowering these fuel costs by buying a refinery.  Through this Delta expects to have fuel savings of nearly $100; fuel costs were a major factor in Delta’s annual report of expenses and cost increase from previous years.  Delta expects this new partnership with Trainer refinery to increase their margins and recover within the first year of operations once this falls into full act.  We will have to take a look at Delta’s 2013 annual report to determine the benefits of this partnership in 2012.

Both the partnership and purchasing older flights (MD-90) to save per unit costs so that Delta can pay back their debt may not be a realistic approach to their current situation.  By purchasing older planes, Delta may be trapped in increased maintenance costs.  The useful lives of these planes are less, therefore reaching their salvage value sooner than other planes.  Maintaining these planes may actually cost more in order to increase their useful lives than purchases newer plans with initial high life expectancy.  Especially due to Delta’s often domestic routes, the flights are more likely to have maintenance problems, increasing their operational costs more.  Boeing expects to come out with more efficient engine aircraft by 2017, which Delta was not interested in at all to save their expenses.  Delta’s “penny-pinching” investments in their aircraft may end up working against them if the older aircraft die out sooner than their given expected life.  The refinery partnership however may work in their favor to lower fuel costs, however I do not believe that they can make higher margins.

SOURCES:

http://online.wsj.com/article/SB10001424052702304050304577376354288927594.html?KEYWORDS=Delta+refinery

http://online.wsj.com/article/SB10001424052970203406404578072960852910072.html?mod=WSJ_article_comments#articleTabs%3Darticle

http://www.annualreports.com/Company/511

http://online.wsj.com/article/SB10001424053111904875404576530340951416116.html?KEYWORDS=Delta+aircraft

 

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LBBB First Quarter Earnings Announcement

LBBB (Liberty Bell Bank) is a full-service, state-chartered commercial bank and provides diversified financial products through three locations in Burlington County, New Jersey and one location in Camden County, New Jersey. On April 16, 2013, it announced its earnings for the first quarter of 2013. The reported net income was $202,000, a $167,000 increase from net income for the same period of last year ($35,000). The report explains that one primary reason for this substantial climb in net income is the gains on the sale of available-for-sale (AFS) securities ($156,000).

As we have learnt, this sale would have following impact on the financial statement of LBBB:
1. It decreased the “investment securities” under current assets on balance sheet.
2. It brought down the unrealized gain under Shareholder’s equity on balance sheet.
3. It increased the realized gain on income statement.

In addition, the report also disclosed that interest income for AFS securities increased $54,000 in the first quarter. This interest income, same as dividend from AFS securities, was recognized on income statement immediately. Unlike revaluation of AFS securities, unrealized gain/loss is recorded under shareholders’ equity on balance sheet and the realized gain/loss is ONLY recognized on income statement when the securities are sold.

For more information, please see the article: http://eon.businesswire.com/news/eon/20130416006787/en.

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Good maintenance + older aircrafts = higher profits

Most Airlines prefer new planes with low fuel consumption and the latest high-tech gadgets. Delta on the other hand in an effort to cut costs, has focused on an asset most airlines avoid – older planes, It now has one of the oldest fleets in the U.S. and is making a habit of using or buying older planes.

Besides the MD-90s it purchased in 2012, Delta has picked up the leases on 88 Boeing 717s, with an average age of 11 years, from Southwest Airlines. Surprisingly, even with the planes’ higher fuel consumption and maintenance costs, Delta figures it is saving at least $1 billion on the MD-90 purchases, compared with buying new planes. Regarding the 717’s Delta fleet executive said he is “thrilled about the deal we got.”

 

Although safety experts used to fear old planes in the past, most say now that “with careful maintenance, older jets can fly safely”. Boeing has showed that only 12 of 36 commercial jetliner accidents in 2011 that destroyed planes or caused substantial damage involved aircraft 20 years or older.

At the heart of Delta’s older fleet strategy is its 2.7 million-square-foot complex of maintenance hangars and shops at Hartsfield-Jackson Atlanta International Airport. With its mechanics having 19 years of experience on average, Delta believes it has the built-in expertise to care for its aircrafts.

Thus, by having great maintenance, Delta is able to increase the useful life of its aircrafts. John Enders, an aeronautical engineer and aviation safety consultant, allowed that airplanes “have no practical end date.” But older planes require an “extremely careful inspection and maintenance system,” he said.

 

Source:

http://online.wsj.com/article/SB10001424052970203406404578072960852910072.html

 

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JPMorgan Finds a Good Mate for Its Trading Loss

This article takes a look at how JPMorgan Chase & Co. managed to offset their second quarter losses using marketable securities. JPMorgan realized a $2 billion loss, mainly from it’s derivative trading securities, so far in the second of 2012. To help offset these losses, JPMorgan looked to sell some of their available-for-sale securities that have produced cumulative unrealized gains they were purchased. Thus far in the second quarter of 2012, a $1 billion gain was realized from JPMorgans sale of available-for-sale securities and many investors believe that this is not a coincidence.

JPMorgan's Trading Loss Since the change in the fair value of a trading security is recorded in retained earnings on the income statement, the gain or loss from this security is seen immediately. However, the change in value of an available-for-sale security does not affect net income until the security is sold. The change in fair value is only seen on the balance sheet (accumulated other comprehensive income – stockholders’ equity) So, companies can classify any security, no matter how volatile, as available-for-sale and keep the accumulated gains/losses off the income statement.

Selling available-for-sale securities to offset losses is not unlawful under FASB, but it does complicate financial reporting and makes it difficult for investors to determine the current intrinsic value of the company. Additionally, a company that is having a poor quarter may sell their most promising long-term securities in order to offset their losses. The author is pushing for FASB to make companies earnings a little more transparent by not allowing companies to have a “holding tank” where they can offset losses by selling promising investments, and I agree with this proposition.

Source: http://www.bloomberg.com/news/2012-06-21/jpmorgan-s-profit-is-scarier-than-its-loss.html

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Classification Choices and their Effect

A company similar to Chemical Financial Corporation is First Federal of Northern Michigan Bancorp, Inc. (FFNM). It too is a Michigan bank holding company operating.   FFNM released its 2012 results last month.  Unfortunately, the company had a net loss of $214,000.

Within their financial statements is an Available-for-Sale Securities adjustment for a year-over-year unrealized gain of $79,000.  This is interesting because if instead of Available-for-Sale Securities they had been classified as Trading Securities this unrealized gain would have been recorded as earnings. While it would not have fixed their net loss since this was an unusual loss for them (they had net income of $742,000 in 2011), this could have put them in a better position.

In most instances choosing to classify a security as either trading or available-for-sale is subjective.  This is because classification depends on the intentions of the company, which only the company really knows.  With available-for-sale, securities’ unrealized gains and losses are recorded under Shareholders’ Equity.  Trading, however, is recorded within Retained Earnings.  By classifying securities as trading a company can increase their earnings by reporting unrealized earnings, which could put them in a better position.  Therefore, if FFNM had classified these securities as trading instead of available-for-sale they would have had a smaller loss for 2012. However, it understandably can also have the opposite effect.  For if the securities had instead had an unrealized loss then it would have hurt FFNM even more.

For more information, please visit: http://www.marketwatch.com/story/first-federal-of-northern-michigan-bancorp-inc-announces-fourth-quarter-2012-and-full-year-results-2013-03-22.

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JP Morgan Reported record net income of $6.5 billion for the first quarter of 2013

Any security acquired by a company is classified at the time it is purchased depending on the amount of the security purchased or the nature of its lifetime. If we have the intent and  time to hold the security until maturity, it is classified as held-to-maturity. Securities to be held for indefinite periods of time, but not necessarily to be held-to-maturity or on a long-term basis, are classified as available-for-sale and carried at fair value with unrealized gains or losses reported as a separate component of stockholders’ equity in accumulated other comprehensive income, net of applicable income taxes. Realized gains or losses on the sale of securities are determined using the amortized cost of the specific securities sold.

In order to incorporate the changes in market price of securities, companies have to make adjustments (unrealized gain/loss) to their financial statements at the end of each accounting period. For AFS (Available-for-sale) Securities, these changes are usually done quaterly, semi-annually or annually.   With changes in market value of available for sale securities, considerable changes can be noticed in the financial statement particularly Balance Sheet i.e. Shareholders’ equity section. The only time securities actually effect the cash flow statement, apart from the time they are sold are when interest income or dividends are recognized. To see the impact of market valuation on the financial statement of a company, we consider the current quarter returns announced by JP Morgan chase.

JP Morgan Chase recently announced its numbers for the first quarter, with record amount of net income of $6.5 billion.  Net revenue has been recorded at $113 million compared with a $233 million loss in the previous year. Net revenue included net securities gains of $503 million from sales of available-for-sale investment securities during the current quarter. Net interest income was a loss of $472 million due to low interest rates and limited reinvestment opportunities.

More details: http://www.fiercefinance.com/press-releases/jpmorgan-chase-reports-record-first-quarter-2013-net-income-65-billion-or-r

 

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