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AFS Notes & Assignment

Date: 15 Jan 2017

Gross profit is the amount that remains after the direct costs of producing a product or service are subtracted
from revenue.
Subtracting operating expenses, such as selling, general, and administrative expenses, from gross profit results
in another subtotal known as operating profit or operating income.
Specific Revenue Recognition Applications: Revenue is usually recognized at delivery using the revenue
recognition criteria previously discussed. However, in some cases, revenue may be recognized before delivery
occurs or even after delivery takes place.
o Long-Term Contracts
percentage-of-completion method:
When the outcome of a long-term contract can be reliably estimated
The percentage of completion is measured by the total cost incurred to date
divided by the total expected cost of the project.
completed-contract method:
is used when the outcome of the project cannot be reliably estimated.
Accordingly, revenue, expense, and profit are recognized only when the contract
is complete.
Implications for Financial Analysis
Different revenue recognition methods can be used within the firm. Firms disclose their revenue
recognition policies in the financial statement footnotes.
Users of financial information must consider two points when analyzing a firm's revenue:
o how conservative are the firm's revenue recognition policies (recognizing revenue sooner rather
than later is more aggressive), and
o the extent to which the firm's policies rely on judgment and estimates
Inventory recognition
o LIFO
o FIFO
o Weighted Average
Depreciation Expense Recognition
o The cost of long-lived assets must also be matched with revenues.
o Long-lived assets are expected to provide economic benefits beyond one accounting period.
o The allocation of cost over an asset's life is known as
depreciation (tangible assets),
depletion (natural resources)
amortization (intangible assets)
o Straight Line Method
o Declining balance method (DB) or Written Down Value (2 * SLM)
common-size income statement

In the review of Financial Analysis Techniques, a number of financial ratios that can be used to assess a
company's profitability, leverage, solvency, and operational efficiency. The analyst can evaluate trends in
these ratios, as well as their levels, to evaluate how the company has performed in these areas.

Trends in financial ratios and differences between a firm's financial ratios and those of its competitors or
industry averages can indicate important aspects of a firm's business strategy.

Consider two firms in the personal computer business. One builds relatively high-end computers with
cutting-edge features, and one competes primarily on price and produces computers with various
configurations using readily available technology.
What differences in their financial statements would we expect to find?

Premium products are usually sold at higher gross margins than less differentiated commodity-like
products, so we should expect cost of goods sold to be a higher proportion of sales for the latter. We
might also expect the company with cutting edge features and high quality to spend a higher proportion
of sales on research and development, which may be quite minimal for a firm purchasing improved
components from suppliers rather than developing new features and capabilities in-house.

The ratio of gross profits to operating profits will be larger for a firm that spends highly on
research and development or on advertising.

In general, it is important for an analyst to understand a subject firm's business strategy.


If the firm claims it is going to improve earnings per share by cutting costs, examination
of operating ratios and gross margins over time will reveal whether the firm has actually
been able to implement such a strategy and whether sales have suffered as a result.

Ratio analysis of historic 3 to 5 years in a correct way is used to reveal the companys strategy and the
action taken