Electronic Presentation by Douglas Cloud Pepperdine University Chapter 12 Special Income and Investment Reporting Issues Electronic Presentation by Douglas Cloud Pepperdine University

After studying this chapter, you should be able to: Learning Goals 1. Describe the accounting for and interpretation of deferred income taxes. 2. Prepare an income statement reporting the following unusual items: discontinued operations, extraordinary items, and changes in accounting principles. 3. Describe the accounting for and interpretation of fixed asset impairments and restructuring charges. After studying this chapter, you should be able to: Continued

Learning Goals 4. Prepare an income statement reporting earnings per share data. 5. Describe the concept and the reporting of comprehensive income. 6. Describe the accounting for investments in stocks. 7. Describe alternative methods of combining businesses and how consolidated financial statements are prepared. Continued

Learning Goals 8. Describe financial statement presentations of stockholders’ equity.

Learning Goal 1 Describe the accounting for and interpretation of deferred income taxes.

Payment of Income Taxes At year-end, the actual taxable income and the related taxes are determined. If additional taxes are owed, the additional liability is recorded. Most corporations are required to pay estimated federal income taxes in four installments throughout the year.

Payment of Income Taxes Year Ended June 30, 2001 (Amounts in millions) Net Sales $39,244 Cost of products sold 22,102 Marketing, research, and administrative expenses 12,406 Operating income $ 4,736 Interest expense 794 Other income, net 674 Earnings Before Income Taxes $ 4,616 Income taxes 1,694 Net earnings $ 2,922

Temporary Differences Revenues or gains are taxed after they are reported in the income statement. Expenses or losses are deducted in determining taxable income after they are reported in the income statement. Revenues and gains are taxed before they are reported in the income statement. Expenses or losses are deducted in determining taxable income before they are reported in the income statement.

Allocation of Income Taxes A corporation has $300,000 of income before income taxes, a 40% tax rate, and $100,000 of taxable income. Income Tax Expense 120,000 Income Taxes Payable 40,000 Deferred Income Taxes Payable 80,000 $300,000 x .40 $100,000 x .40

Allocation of Income Taxes In the second year, $48,000 of the deferred tax reverses and becomes due. Deferred Income Taxes Payable 48,000 Income Taxes Payable 48,000

A corporation’s taxable income and its income before taxes may also differ because certain revenues are exempt from taxes…

Interest on municipal bonds Fines for overloading delivery trucks …and certain expenses are not deducted in determining taxable income. Such differences are called permanent differences. Examples Interest on municipal bonds Fines for overloading delivery trucks

Learning Goal 2 Prepare an income statement reporting the following unusual items: discontinued operations, extraordinary items, and changes in accounting principles.

Discontinued Operations A gain or loss from disposing of a business segment or component of an entity is reported on the income statement as a gain or loss from discontinued operations. A business segment refers to a major line of business for a company. A component of an entity is the lowest level at which the operations and cash flows can be clearly distinguished from the rest of the entity.

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

Changes in Accounting Principles Changes in GAAP disclosures should include the following: The nature of the change. The justification for the change. The effect on the current year’s net income. The cumulative effect of the change on the net income of prior periods.

Learning Goal 3 Describe the accounting for and interpretation of fixed asset impairments and restructuring charges.

Fixed Asset Impairment Such impairments should be recognized on the income statement as a loss at the time of the impairment.  Fixed asset impairment occurs when the fair value of a fixed asset that is held or used falls below its book value and is not expected to recover.

Restructuring Charges Restructuring charges are the accrued employee termination benefits associated with a management-approved employee termination plan. Restructuring Charge xxxxx Employee Termination Benefit Obligation xxxxx An expense A current or long-term liability

Restructuring Charges Later, the actual benefits are paid to the terminated employees. Employee Termination Benefit Obligation xxxxx Cash xxxxx

Learning Goal 4 Prepare an income statement reporting earnings per share data.

Earnings per Common Share No preferred stock outstanding EPCS = Net income Number of common shares outstanding Preferred stock outstanding EPCS = Net income – Preferred stock dividend Number of common shares outstanding

For the Year Ended December 31, 2005 Jones Corporation Income Statement For the Year Ended December 31, 2005 Earnings per common share: Income from continuing operations $3.45 Loss on discontinued operations (Note A) 0.50 Income before extraordinary items and cumulative effect of a change in accounting principle $2.95 Extraordinary item: Gain on condemnation of land, net of applicable income tax of $65,000 0.75 Cumulative effect on prior years of changing to a different depreciation method (Note B) 0.46 Net income $4.16

Learning Goal 5 Describe the concept and the reporting of comprehensive income.

Comprehensive income is defined as all changes in stockholders’ equity during a period except those resulting from dividends and stockholders’ investments. Foreign currency items Pension liability adjustments Unrealized gains and losses on investments

Note that the “other comprehensive income” items do not affect net income or retained earnings.

Learning Goal 6 Describe the 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 are not actively traded for profit.

Available-for-Sale Equity Investments On June 1 Crabtree Co. purchased 2,000 shares of Inis Corporation common stock at $89.75 per share plus a brokerage fee of $500. June 1 Marketable Securities 180,000 Cash 180,000 ($89.75 x 2,000) + $500

Available-for-Sale Equity Investments On October 1, Inis declared a $0.90 per share cash dividend payable on November 30. Nov. 30 Cash 1,800 Dividend Revenue 1,800 2,000 x $0.90

Available-for-Sale Equity Investments Unrealized Common Stock Cost Market Gain (Loss) Appears on both the balance sheet and the statement of income and comprehensive income Edward, Inc. $150,000 $190,000 $40,000 SWS Corp. 200,000 200,000 — Inis Corporation 180,000 210,000 30,000 Bass Co. 160,000 150,000 (10,000) Total $690,000 $750,000 $60,000 Appears on the balance sheet $60,000 – (.30 x $60,000) = $42,000

Equity Method The equity method is used for long-term investments in stocks where the investor has a significant influence over the activities of the investee. Generally, if the investor owns 20% or more of the voting stock of the investee, the investor is assumed to have significant influence over the investee. Equity

Equity Method On January 2 Hally Inc. pays cash of $350,000 for 40% of the common stock and net assets of Brock Corporation. Jan. 2 Investment in Brock Corp. Stock 350,000 Cash 180,000 Unless there is evidence to the contrary, this should give Hally Inc. significant influence over the operating or financial activities of Brock Corp.

Equity Method For the year ending December 31, Brock Corporation reports net income of $105,000 and pays $45,000 in dividends. Dec. 31 Investment in Brock Corp. Stock 42,000 Income of Brock Corp. 42,000 $45,000 x 40% $105,000 x 40% 31 Cash 18,000 Investment in Brock Corp. Stock 18,000

Investment in Brock Corporation Stock Equity Method Investment in Brock Corporation Stock Jan. 2 350,000 Dec. 31 42,000 Dec. 31 18,000 $374,000

Sale of Investments in Stocks An investment in Drey Inc. stock has a carrying amount of $15,700 when it is sold on March 1 for $17,500. Mar. 1 Cash 17,500 Investment in Drey. Inc. Stock 15,700 Gain on Sale of Investment 1,800

Learning Goal 7 Describe alternative methods of combining businesses and how consolidated financial statements are prepared.

Mergers and Consolidations When one corporation acquires all the assets and liabilities of another corporation, which is then dissolved, a merger has taken place.

Mergers and Consolidations When one corporation acquires all the assets and liabilities of another corporation, which is then dissolved, a merger has taken place.

Parent and Subsidiary Corporations The corporation owning all or a majority of the voting stock of the other corporation is called the parent company.

Parent and Subsidiary Corporations The corporation that is controlled is called the subsidiary company. Two or more corporations closely related through stock ownership are sometimes called the affiliated company.

Parent and Subsidiary Corporations At the end of the year, the financial statements of the parent and subsidiary are combined and are referred to as consolidated financial statements. If the parent owns less than 100% of the subsidiary stock, the other parties’ ownership is referred to as minority interest.

Learning Goal 8 Compute and interpret the price-earnings ratio and price-book ratios.

Price-Earnings Ratio The price-earnings ratio indicates a firm’s growth potential and future earnings prospects.

Price-Earnings Ratio It indicates how much the market is willing to pay per dollar of a company’s earnings.

Price-Earnings Ratio Dell Computer 30 Market price per share of common stock Earnings per share of common stock $26.10 P/E ratio = 30 $0.87 Market price per share = $26.10 Basic earnings per share = $0.87 Dell Computer 2001

Price-Book Ratio The price-book ratio is the ratio of the market value of a share of common stock to the book value of a share of common stock.

Price-Book Ratio The first step is to determine the book value per share of common stock. Total stockholders’ equity Common shares outstanding $10,519,000,000 $12.32 BVS = 854,000,000 Alcoa, Inc.

The market price per share of Alcoa, Inc. was $34 on May 7, 2002. Price-Book Ratio The market price per share of Alcoa, Inc. was $34 on May 7, 2002. Market price per share Book value per share $34 P-B ratio = 2.76 $12.32 Alcoa, Inc.’s market price is 2.76 times greater than the book value of the firm. Alcoa, Inc.

Chapter 12 The End