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Income Taxes, Unusual Income Tax Items, And Investments in Stocks

Income Taxes, Unusual Income Tax Items, And Investments in Stocks

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Chapter 14

Income Taxes, Unusual Income Tax Items, and Investments in Stocks
Accounting, 21st Edition
Warren Reeve Fess
PowerPoint Presentation by Douglas Cloud
Professor Emeritus of Accounting Pepperdine University © Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.

Some of the action has been automated, Some of the action has been automated, so click the mouse when you see this so click the mouse when you see this lightning bolt in the lower right-hand lightning bolt in the lower right-hand corner of the screen. You can point and corner of the screen. You can point and click anywhere on the screen. click anywhere on the screen.

Objectives Objectives
1. Journalize the entries for corporate income taxes, including deferred income taxes. After studying this After studying this 2. Prepare an income statement reporting the chapter, you should chapter, you should following unusual items: fixed asset be able to: impairments, restructuringto: be able charges, discontinued operations, extraordinary items, and changes in accounting principles. 3. Prepare an income statement reporting earnings per share data.

Objectives Objectives
4. Describe the concept and the reporting of comprehensive income. 5. Describe the accounting for investments in stocks. 6. Describe alternative methods of combining businesses and how consolidated financial statements are prepared. 7. Compute and interpret the priceearnings ratio.

Corporate Income Taxes Corporate Income Taxes

Corporate Income Taxes Corporate Income Taxes
AAssume that amakes four Assume that a corporation A corporation makes four corporation corporation income tax installment payments estimates its taxes for the income tax installment payments estimates its taxes for the throughout the year. year to be $84,000. throughout the year. year to be $84,000.

Corporate Income Taxes Corporate Income Taxes
On April 15, the first of four estimated On April 15, the first of four estimated annual tax payments of $21,000 is made. annual tax payments of $21,000 is made.
Apr. 15 Income Tax Expense Cash
To record quarterly payment of estimated income tax.

21 000 00 21 000 00

Corporate Income Taxes Corporate Income Taxes
Ratio of Reported Income Tax Expense to Earnings Before Taxes for Selected Industries Automobiles 33% Banking 35 Computers 35 Food 35 Integrated oil 39 Pharmaceutical 30 Retail 39 Telecommunication 17 Transportation 38

Allocating Income Taxes Allocating Income Taxes
1. Revenues or gains are taxed after they are reported in the income statement. 2. Expenses or losses are deducted in determining taxable income after they are reported in the income statement. 3. Revenues or gains are taxed before they are reported on the income statement. 4. Expenses or losses are deducted in determining taxable income before they are reported in the income statement.

Temporary Differences
 Differences in tax law and GAAP create some temporary differences that reverse in later years.  Temporary differences do not change or reduce the total amount of tax paid, they affect only the timing of when the taxes are paid.

Temporary Differences Temporary Differences
MACRS (tax depreciation) Straight-line (financial statement depreciation)

Total
r ea Y 1 r ea Y 2 r ea Y r ea Y 4 r ea Y
rs ea Y

3

5

-5 1

Temporary Differences Temporary Differences
Temporary Differences in Reporting Revenues
Revenue Reporting EXAMPLE: Income reporting methods. Financial Reporting
Report Now

Tax Reporting
Taxable Later

Point-of-Sale Method
Report Later

Installment Method
Taxable Now

EXAMPLE: Cash collected in advance.

When Earned

When Collected

Temporary Differences Temporary Differences
Temporary Differences in Reporting Expenses
Expense Deductions EXAMPLE: Product warranty expense. Financial Reporting
Deduct Now

Tax Reporting
Deduct Later

When Estimated
Deduct Slower

When Paid
Deduct Faster

EXAMPLE: Methods of depreciation.

Straight-Line Method

MACRS Method

Temporary Differences Temporary Differences
At the end of the first year of operations, a corporation reports $300,000 income before income taxes. With a 40% tax rate, the firm faces a tax of $120,000. Using tax planning, the net income is reduced to $100,000 and the actual income tax due is $40,000. The difference is deferred to future years.

Temporary Differences Temporary Differences
The entry to record income taxes on April 15 The entry to record income taxes on April 15 reflects the deferred amount of $80,000. reflects the deferred amount of $80,000.
Apr. 15 Income Tax Expense Income Tax Payable Deferred Income Tax Payable
To record income tax for the year.

120 000 00 40 000 00 80 000 00

Temporary Differences Temporary Differences
If $48,000 of the deferred tax reverses and becomes due If $48,000 of the deferred tax reverses and becomes due in the second year, the entry will reflect this fact. in the second year, the entry will reflect this fact.
Apr. 15 Deferred Income Tax Payable Income Tax Payable
To record current liability for deferred tax.

48 000 00 48 000 00

Permanent Differences Permanent Differences
Differences between taxable income Differences between taxable income and income before taxes reported on and income before taxes reported on the income statement may be the result the income statement may be the result of differences that never reverse. of differences that never reverse.

Permanent Differences Permanent Differences
These differences are referred to as These differences are referred to as permanent differences. Interest on permanent differences. Interest on municipal bonds is an example of municipal bonds is an example of this type of timing difference. this type of timing difference.

Unusual Items Affecting the Unusual Items Affecting the Income Statement Income Statement
Unusual Items Affecting Unusual Items Affecting Income from Continuing Income from Continuing Operations Operations

Unusual Items Affecting the Unusual Items Affecting the Income Statement Income Statement
    Fixed Asset Impairments Fixed Asset Impairments Decrease in market price of fixed assets Significant changes in the business or regulations related to fixed assets Adverse conditions affecting the use of fixed assets Expected cash flow losses using fixed assets

Unusual Items Affecting the Unusual Items Affecting the Income Statement Income Statement
Fixed Asset Impairments Fixed Asset Impairments On March 1, Jones Company consolidates On March 1, Jones Company consolidates operations by closing a factory. As a operations by closing a factory. As a result of the closing, plant and equipment result of the closing, plant and equipment is impaired by $750,000. is impaired by $750,000.

Unusual Items Affecting the Unusual Items Affecting the Income Statement Income Statement
Fixed Asset Impairments Fixed Asset Impairments
Mar. 1 Loss on Fixed Asset Impairment Fixed Assets—Plant Fixed Assets—Equipment
To record impairment of fixed assets due to plant closing.

750 000 00 400 000 00 350 000 00

Jones Corporation Partial Income Statement For the Year Ended December 31, 2006 Net sales $12,350,000 Cost of merchandise sold 5,800,000 Gross profit $ 6,550,000 Operating expenses $3,490,000 Restructuring charge 1,000,000 Loss from asset impairment 750,000 5,240,000 Income from continuing operations before income tax $ 1,310,000 Income tax expense 620,000 Income from continuing operations $ 690,000

Unusual Items Affecting the Unusual Items Affecting the Income Statement Income Statement
Restructuring charges are costs associated Restructuring charges are costs associated with involuntarily terminating employees, with involuntarily terminating employees, terminating contracts, consolidating terminating contracts, consolidating facilities, or relocating employees. facilities, or relocating employees.

Unusual Items Affecting the Unusual Items Affecting the Income Statement Income Statement
Fixed Asset Impairments Fixed Asset Impairments The management of Jones Company The management of Jones Company communicate a plan to terminate 200 communicate a plan to terminate 200 employees from the closed manufacturing employees from the closed manufacturing plant on March 1. The plan calls for a plant on March 1. The plan calls for a termination benefit of $5,000 per employee. termination benefit of $5,000 per employee.

Unusual Items Affecting the Unusual Items Affecting the Income Statement Income Statement
Restructuring Charges Restructuring Charges
Mar. 1 Restructuring Charge Employee Termination Obligation
To record restructuring charge due to plant closing.

1000 000 00 1000 000 00

Unusual Items Affecting the Unusual Items Affecting the Income Statement Income Statement
Restructuring Charges Restructuring Charges
Mar. 1 Restructuring Charge Employee Termination Obligation Mar. 25 Employee Termination Obligation Cash 125 000 00 125 000 00 1000 000 00 1000 000 00

Unusual Items Not Affecting Income Unusual Items Not Affecting Income From Continuing Operations From Continuing Operations

Closed

Discontinued Operations Discontinued Operations
A gain or loss from disposing of a A gain or loss from disposing of a business segment is reported as a gain business segment is reported as a gain or loss from discontinued operations. or loss from discontinued operations.

Jones Corporation Income Statement For the Year Ended December 31, 2006 Net sales $12,350,000

Income from continuing operations before income tax $ 1,310,000 Income tax 620,000 Income from continuing operations $ 690,000 Loss on discontinued operations (Note B) 100,000 Income before extraordinary items and cumulative effect of a change in accounting principle $ 590,000 Extraordinary item: Gain on condemnation of land, net of applicable income tax of $65,000 150,000 Cumulative effect on prior years of changing to different depreciation method (Note C) 92,000 Net income $ 832,000

Extraordinary Items Extraordinary Items
Extraordinary items result from events and Extraordinary items result from events and transactions that (1) are significantly transactions that (1) are significantly different from the typical or the normal different from the typical or the normal operating activities of the business AND operating activities of the business AND (2) occur infrequently. (2) occur infrequently.

Jones Corporation Income Statement For the Year Ended December 31, 2006 Net sales $12,350,000

Income from continuing operations before income tax $ 1,310,000 Income tax 620,000 Income from continuing operations $ 690,000 Loss on discontinued operations (Note B) 100,000 Income before extraordinary items and cumulative effect of a change in accounting principle $ 590,000 Extraordinary item: Gain on condemnation of land, net of applicable income tax of $65,000 150,000 Cumulative effect on prior years of changing to different depreciation method (Note C) 92,000 Net income $ 832,000

Accounting Changes Accounting Changes
Accounting changes occur when a Accounting changes occur when a business voluntarily change from one business voluntarily change from one generally accepted accounting generally accepted accounting principle to another. principle to another.

Accounting Changes Accounting Changes
Another type of accounting change occurs Another type of accounting change occurs when businesses are required to change the when businesses are required to change the way they treat an accounting situation when way they treat an accounting situation when the FASB issues a new accounting standard. the FASB issues a new accounting standard.

Jones Corporation Income Statement For the Year Ended December 31, 2006 Net sales $12,350,000

Income from continuing operations before income tax $ 1,310,000 Income tax 620,000 Income from continuing operations $ 690,000 Loss on discontinued operations (Note BA) 100,000 Income before extraordinary items and cumulative effect of a change in accounting principle $ 590,000 Extraordinary item: Gain on condemnation of land, net of applicable income tax of $65,000 150,000 Cumulative effect on prior years of changing to different depreciation method (Note C) 92,000 Net income $ 832,000

Earnings per Common Share Earnings per Common Share
Earnings per share (EPS) is the net income per share of common stock outstanding. When unusual items exist, EPS should be reported for:
 Income from continuing operations  Income before extraordinary items and the cumulative

effect of a change in accounting principle  Extraordinary items and the cumulative effect of a change in accounting principle  Net income

Earnings per Common Share Earnings per Common Share
If there is no preferred stock:
Net Income Earnings per = common share Number of common shares outstanding

If there is preferred stock:
Net Income – Preferred stock dividends Earnings per = common share Number of common shares outstanding

Jones Corporation Income Statement For the Year Ended December 31, 2006
Income from continuing operations $690,000

Net income $832,000 Earnings per common share: Income from continuing operations $ 3.45 Loss on discontinued operations (Note B) .50 Income before extraordinary item and cumulative effect of a change in accounting principle $2.95 Extraordinary item .75 Cumulative effect on prior years of changing to a different depreciation method .46 Net income $ 4.16

Jones Corporation Income Statement For the Year Ended December 31, 2006
Income from continuing operations $690,000

Net income $832,000 Earnings per common share: Income from continuing operations $ 3.45 Loss on discontinued operations (Note B) .50 Income before extraordinary item and cumulative effect of a change in accounting principle $2.95 Extraordinary item .75 Cumulative effect on prior years of changing to a different depreciation method .46 Net income $ 4.16

Jones Corporation Income Statement For the Year Ended December 31, 2006
Income from continuing operations $690,000

Net income $832,000 Earnings per common share: Income from continuing operations $ 3.45 Loss on discontinued operations (Note B) . 50 Income before extraordinary item and cumulative effect of a change in accounting principle $2.95 Extraordinary item .75 Cumulative effect on prior years of changing to a different depreciation method .46 Net income $ 4.16

Jones Corporation Income Statement For the Year Ended December 31, 2006
Income from continuing operations $690,000

Net income $832,000 Earnings per common share: Income from continuing operations $ 3.45 Loss on discontinued operations (Note B) .50 Income before extraordinary item and cumulative effect of a change in accounting principle $2.95 Extraordinary item .75 Cumulative effect on prior years of changing to a different depreciation method .46 Net income $ 4.16

Jones Corporation Income Statement For the Year Ended December 31, 2006
Income from continuing operations $690,000

Net income $832,000 Earnings per common share: Income from continuing operations $ 3.45 Loss on discontinued operations (Note B) .50 Income before extraordinary item and cumulative effect of a change in accounting principle $2.95 Extraordinary item .75 Cumulative effect on prior years of changing to a different depreciation method .46 Net income $ 4.16

Comprehensive Income Comprehensive Income
Companies may report comprehensive Companies may report comprehensive income on the income statement, in a income on the income statement, in a separate statement, or in the statement separate statement, or in the statement of stockholders’ equity. of stockholders’ equity.

Comprehensive Income Comprehensive Income
However, comprehensive income However, comprehensive income Comprehensive income is defined Comprehensive income is defined does not include changes caused by does not include changes caused by asissuing dividends or from all changes in stockholders’ asissuing dividends or from all changes in stockholders’ equity during a period. equity during a period. stockholders’ investments. stockholders’ investments.

Stockholders’ Equity Section Stockholders’ Equity Section
Stockholders’ equity: 2006 2005 Common stock $ 20,000 $ 20,000 Paid-in capital in excess of par 36,000 36,000 Retained earnings 165,500 157,000 Accumulated other comprehensive income 1,290 1,200 Total stockholders’ equity $222,790 $214,200

Accounting for Investments in Stocks
Trading securities are securities that management intends to actively trade for profit. Available-for-sale securities are securities that management expects to sell in the future, but which are not actively traded for profit.

Short-Term Investments in Stocks Short-Term Investments in Stocks
Temporary investments are Temporary investments are recorded in the current recorded in the current asset account, Marketable asset account, Marketable Securities, at their cost. Securities, at their cost.

Short-Term Investments in Stocks Short-Term Investments in Stocks
On June 1, Crabtree Company purchased 2,000 On June 1, Crabtree Company purchased 2,000 shares of Inis Corporation common stock at shares of Inis Corporation common stock at $89.75 per share plus a brokerage fee of $500. $89.75 per share plus a brokerage fee of $500.
June 1 Marketable Securities+ $500 $89.75 x 2,000 shares Cash
Purchased 2,000 shares of Inis Corporation common stock.

180 000 00 180 000 00

Short-Term Investments in Stocks Short-Term Investments in Stocks
On October 1, Inis declared a $0.90 per On October 1, Inis declared a $0.90 per share dividend payable on November 30. share dividend payable on November 30.
Nov.30 Cash 2,000 shares x $0.90 Dividend Revenue
Received dividend on Inis Corporation common stock.

1 800 00 1 800 00

Short-Term Investments in Stocks Short-Term Investments in Stocks
On the balance sheet, temporary On the balance sheet, temporary investments are reported at their fair market investments are reported at their fair market value. Any difference between the fair value. Any difference between the fair market value and the cost is an unrealized market value and the cost is an unrealized holding gain or loss. holding gain or loss.

Short-Term Investments in Stocks Short-Term Investments in Stocks
At year-end, the total cost of Crabtree At year-end, the total cost of Crabtree Co.’s four temporary investments is Co.’s four temporary investments is $690,000. The current market for these $690,000. The current market for these four items totaled $750,000 at year-end. four items totaled $750,000 at year-end. Thus, Crabtree Co. had a before tax Thus, Crabtree Co. had a before tax unrealized gain of $60,000. unrealized gain of $60,000.

Short-Term Investments in Stocks Short-Term Investments in Stocks
Current assets: Current assets: Cash $119,500 Cash $119,500 Temporary investments in Temporary investments in marketable securities at cost $690,000 marketable securities at cost $690,000 Plus unrealized gain (net of Plus unrealized gain (net of applicable income tax of applicable income tax of $18,000) 42,000 732,000 $18,000) 42,000 732,000 Stockholders’ Equity Stockholders’ Equity Accumulated other comprehensive income 42,000 Accumulated other comprehensive income 42,000 Crabtree Co. Crabtree Co. Balance Sheet Balance Sheet December 31, 2006 December 31, 2006

Short-Term Investments in Stocks Short-Term Investments in Stocks
Crabtree Co. Crabtree Co. Statement of Comprehensive Income Statement of Comprehensive Income For the Year Ended December 31, 2006 For the Year Ended December 31, 2006 Net income Net income Other comprehensive income: Other comprehensive income: Unrealized gain on temporary investments Unrealized gain on temporary investments in marketable securities (net of in marketable securities (net of applicable tax of $18,000) applicable tax of $18,000) Comprehensive income Comprehensive income $720,000 $720,000

42,000 42,000 $762,000 $762,000

Long-Term Investments in Stocks Long-Term Investments in Stocks
Long-term investments are Long-term investments are those investments made by a those investments made by a firm that are not intended as a firm that are not intended as a source of cash in the normal source of cash in the normal operations of the business. operations of the business.

Long-Term Investments in Stocks Long-Term Investments in Stocks
Ownership % 100%

Controlling Interestthe buyer With less than 20% ownership With less Equity than 20% ownership the buyer 50% does not usually have significant does Method not usually have significant influence. The buyer uses the cost method Significant influence. The buyer uses the cost method to account for the investment. influence to account for the investment. Cost Method
20%

0%

Not significant influence

Long-Term Investments in Stocks Long-Term Investments in Stocks
Ownership % 100%

Equity Method

Ownership over 20% Ownership Controlling over 20% usually indicates significant usually indicates significant Interest influence. The buyer uses 50% influence. The buyer uses the equity method to the equity method to Significant account for the investment. account for the investment. influence
20%

Cost Method

0%

No significant influence

Long-Term Investments in Stocks Long-Term Investments in Stocks
On January 2, Hally Inc. pays cash of $350,000 On January 2, Hally Inc. pays cash of $350,000 for 40% of Brock Corporation’s common stock. for 40% of Brock Corporation’s common stock.
Jan. 2 Investment in Brock Corp. Stock Cash
Purchased 40% of Brock Corp. common stock.

350 000 00 350 000 00

Long-Term Investments in Stocks Long-Term Investments in Stocks
For the year ending December 31, Brock For the year ending December 31, Brock Corporation reports net income of $105,000. Corporation reports net income of $105,000.
Dec. 31 Investment in Brock Corp. Stock Income of Brock Corp.
Recorded share (40%) of Brock Corp. net income of $105,000.

42 000 00 42 000 00

Long-Term Investments in Stocks Long-Term Investments in Stocks
On December 31, Brock Corporation declared a On December 31, Brock Corporation declared a $45,000 dividend, payable on December 31. $45,000 dividend, payable on December 31.
Dec. 31 Cash Investment in Brock Crop. Stock
Recorded share (40%) of dividends of $45,000 paid by Brock Corp.

18 000 00 18 000 00

Long-Term Investments in Stocks Long-Term Investments in Stocks
On March 1, an investment in Drey Inc. On March 1, an investment in Drey Inc. stock that had a carrying amount of stock that had a carrying amount of $15,700 is sold for $17,500. $15,700 is sold for $17,500.
Mar. 1 Cash Investment in Drey Inc. Stock Gain on Sale of Investments
Sold investment in Drey Inc. stock.

17 500 00 15 700 00 1 800 00

Business Combinations Business Combinations
Ownership % 100%

Significant The corporation owning all or a majority of the voting The corporation owning all or a influenceof the voting majority stock is called the parent company. The controlled stock is called the parent company. The controlled 20% corporation is the subsidiary company. Consolidated corporation is the subsidiary company. Consolidated Cost No significant financial statements are prepared which combines the financial Method are prepared which combines the statements influence operating results of the two entities. operating results of the two entities. 0%

Equity Method

Controlling Interest
50%

Business Combinations Business Combinations
 A merger combines two corporations by one acquiring the properties of another that is then dissolved.  Many businesses combine in order to produce more efficiently or to diversify product lines.  A consolidation is the creation of a new corporation, to which the combined assets and liabilities of the old corporations are transferred to the new corporation.

Business Combinations Business Combinations
Mergers Consolidations

A

A

C

B B Mergers: Company A acquires company B. The assets and liabilities of B are transferred to A and B is then dissolved.
Consolidations: Company A acquires company B. The assets and liabilities of both A and B are transferred to a new company C and A and B are then dissolved.

FINANCIAL ANALYSIS AND INTERPRETATION
A firm’s growth potential and future A firm’s growth potential and future earnings prospects are indicated by how earnings prospects are indicated by how much the market is willing to pay per much the market is willing to pay per dollar of a company’s earnings. dollar of a company’s earnings.

Accounting: Earnings Per Share Earnings per Net Income = Share of Common Common Shares Stock Investing: Price - Earnings Ratio Market Price Per Share Priceof Common Stock = Earnings Earnings Per Share of Ratio Common Stock

The price-earnings ratio represents how much the market is willing to pay per dollar of a company’s earnings. This indicates the market’s assessment of a firm’s growth potential and future earnings prospects. An example: Market price per share Earnings per share Price-earnings ratio
2006

$20.50 $1.64 12.5

2005 $13.50 $1.35 10.0

The price-earnings ratio indicates that a share of common stock was selling for 10 times earnings for 2005 and 12.5 times for 2006.

Chapter 14 The End The End

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