Chapter 11 Expenditure Cycle: Other Operating Items

2 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Balance Sheet Income Statement Statement of Cash Flows Long-Term Assets: Net Pension Asset Deferred income tax asset Long-Term Liabilities: Net pension liability Deferred income tax liability Contingent liabilities Employee Compensation Expense Research and Development Expense Advertising Expense Losses/Gains on contingent Items Income Tax Expense Operating Cash paid for: Employee Compensation Research and Development Advertising Income Taxes Financial Statement Items Covered in this Chapter

Employee Compensation

4 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The employee compensation time line illustrates that issues relating to employee compensation can extend long after the employee stops working for the company Employee Compensation Timeline PayrollStock OptionsPensions and and Bonuses Postretirement Compensated Postemployment Benefits Other Absences Benefits Than Pensions

5 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Payroll and Payroll Taxes Payroll : –salaries and wages earned by employees for work done in the current period Employee payroll taxes : –Federal income tax –State income tax –FICA taxes Employer payroll taxes: –FICA taxes –Federal unemployment taxes –State unemployment taxes

6 Financial Accounting, 7e Stice/Stice, 2006 © Thomson A company pays employees for a certain number of days when the employees do not work –vacation leave days –sick leave days The expense should be recognized in the period in which the days are earned, not in the period in which the actual cash payment occurs Compensated Absences

7 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Bonuses Allow employees to receive additional compensation if certain earnings objectives are met These plans are usually restricted to top management Potential that managers will attempt to manipulate reported earnings

8 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Employee Stock Options Managers are given the option of purchasing shares of the company’s stock in the future at a price that is specified today ( option price )

9 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Intrinsic value method based on the assumption that the value of an option, if any, is measured on the day it is granted (market price minus the option price) Fair value method based on the assumption that the value of the option lies in the chance that the stock price will increase above the exercise price Employee Stock Options Accounting for Employee Stock Options

10 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Employee Stock Options: Intrinsic Value Method Most companies set the option price above the market price at the date of grant so that no compensation expense is measured and recorded MarketMarket $$ Option price > market value results in no expense to issuing company Option price < market value results in expense to issuing company

11 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Employee Stock Options: Fair Value Method The fair value is estimated by a formula that considers several factors including the expected volatility of the stock price and the length of the exercise period The fair value of the options is reported as compensation expense on the income statement

12 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Employee Stock Options: FASB’s Treatment Companies are encouraged, but not required, to adopt the fair value method The intrinsic value method is allowed, but if used, companies must disclose what net income would have been under the fair value method Stay tuned for further FASB action HW #11-4

13 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Postemployment Benefits Benefits that occur after an employee has ceased to work for an employer but before an employee retires –Example: a severance pay package The cost must be estimated and reported when the decision is made –Example: to downsize the labor force

14 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Pensions Cash compensation received by an employee after the employee has retired Two types of pension plans: –Defined contribution plan –Defined benefit plan

15 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Pensions: Defined Contribution Plan Requires the company to contribute a fixed amount of money to a pension fund each year on behalf of the employee The amount of cash contributed to the pension fund during the year is reported as pension expense

16 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Pensions: Defined Benefit Plan Requires the company to pay employees a fixed monthly cash amount after they retire based on a pension formula that considers years of service and highest salary

17 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Estimation of the pension liability –The amount that would have to be deposited in a bank today to accumulate enough interest to pay employees their pension benefits at retirement (actuarial present value) –Called the projected benefit obligation (PBO) –The PBO is offset against the plan assets fair value when reported on the balance sheet Pensions: Defined Benefit Plan

18 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Three components of pension expense: +Interest cost +Service cost –Expected return on pension fund assets =Net pension expense HW # E11-9 Pensions: Defined Benefit Plan

19 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Interest cost –The increase in the PBO due to the passage of time (PBO × discount rate) –The discount rate used is the settlement rate The implicit rate of interest necessary to purchase annuity contracts settling the pension obligation Pensions: Defined Benefit Plan

20 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Service cost –The increase in the PBO from service provided by employees during the current period Expected return on pension fund assets –The return that the company earns on the assets in the pension fund –A negative (off-set) component of pension expense Pensions: Defined Benefit Plan

21 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Postretirement Benefits Other Than Pensions Other employee benefits provided after retirement include –Health care plans –Life insurance plans U.S. GAAP requires that these benefits be recognized as an expense and a liability as they are incurred

Income Taxes

23 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Income Taxes Income tax expense and the amount paid for income tax during a period are different for two reasons: –Income taxes are not paid in the same year in which they are incurred –A firm may choose one accounting method for tax purposes and another for financial reporting purposes

24 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Financial Income vs Taxable Income Differences in financial income and taxable income are – Permanent – Temporary

25 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Permanent Differences Used to determine financial income, but never taxable income Reflect statutory differences between GAAP and the Internal Revenue Code –Example: interest on state and local bonds is included in financial income, but not in taxable income

26 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Temporary Differences Some transactions affect taxable income in a different period from financial accounting income –Depreciation methods –Rent received in advance Reported on the balance sheet as –Deferred tax assets –Deferred tax liabilities HW # E-10

27 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Tax Liabilities Income taxes payable –Based on taxable income on the tax return –An existing (current) legal liability Deferred tax liability –Requires a payment in the future –Is the expected income tax on income earned but not yet taxed –Not an existing legal liability HW # E-11-14

28 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Deferred Tax Liability A typical entry for recording income taxes with a Deferred Tax Liability would be Income Tax Expense is reported on the income statement Income Taxes Payable and Deferred Tax Liability are reported on the balance sheet

29 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The expected benefit of a future tax deduction for an expense item that has already been incurred but is not yet deductible for tax purposes Can only be recognized if it is“ more likely than not ” that future income will be realized against which the deduction can be offset Deferred Tax Asset

30 Financial Accounting, 7e Stice/Stice, 2006 © Thomson A typical entry for recording income taxes with a Deferred Tax Asset would be Income Tax Expense is reported on the income statement Income Taxes Payable and Deferred Tax Asset are reported on the balance sheet Deferred Tax Asset

31 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Income Tax Disclosure Provide details about –Current and deferred federal taxes –Current and deferred state taxes –Taxes owed to foreign governments –Taxes attributable to foreign operations

Capitalize vs Expense

33 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Expense/Asset Continuum An expenditure that is expected to benefit future periods is capitalized as an asset All other expenditures are treated as expenses Supplies UsedRepairs Research and Develop- ment Software Develop- ment Oil and Gas Explora- tion Land and Buildings Expense Asset

34 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Research and Development Research Those activities undertaken to discover new knowledge that will be useful in developing new products, services, or processes or that will result in significant improvement of existing products or processes Development Applies the research findings to develop a plan or design for new or improved products and processes

35 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Research and development costs are expensed in the period incurred due to the uncertainty surrounding the future economic benefits of R&D activities Research and Development

36 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Point of technological feasibility Research & Development: Software Expense Treat as R&D (future benefit uncertain) Capitalize Uncertainty of future benefit is decreased

37 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Oil and Gas Exploration Costs Two methods of accounting for the cost of “dry holes” – Full cost method All exploratory costs are capitalized and allocated to the cost of successful wells – Successful efforts method Exploratory costs for dry holes are expensed, and only exploratory costs for successful wells are capitalized

38 Financial Accounting, 7e Stice/Stice, 2006 © Thomson General treatment: –expensed due to the uncertainty of their future economic benefits Exception: –Capitalize if –Future benefits are more certain Target customers who have purchased before Able to estimate degree of favorable response HW # E11-16 Advertising Costs

39 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Contingencies An uncertain circumstance involving a potential gain or loss that will not be resolved until some future event occurs HW # E11-17

40 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Three important definitions: – Probable Likely to occur – Remote Not likely to occur – Reasonably possible More than remote but less than likely Contingencies

41 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting for Contingencies LossesGains Probable Recognize a probable liability if the amount can be reasonably estimated. May be disclosed in the financial statements by note, but should not be reflected in income, because doing so may result in recognizing revenue prior to its realization. Care should be exercised in disclosing gain contingencies to avoid misleading implications Possible Disclose a possible liability in a note. Remote No recognition or disclosure unless contingency represents a guarantee. Then, note disclosure is required No recognition or disclosure

42 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting for Contingencies: Lawsuits If the facts of the case indicate that a loss is probable and the amount of the loss can be estimated, a loss should be reported on the income statement and a liability should be reported on the balance sheet

43 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting for Contingencies: Environmental Liabilities Most companies do not reflect these loss contingencies as liabilities on the balance sheet – The future cost of the cleanup is very difficult to estimate –Accounting standards do not provide disclosure guidance

44 Financial Accounting, 7e Stice/Stice, 2006 © Thomson In Summary... In addition to payroll, compensation takes the form of bonuses, stock options, pensions, and other benefits Taxable income and financial income are normally different amounts; deferred taxes are recorded as non-current assets and/or liabilities Capitalized expenses have future benefit and are recorded as assets Contingencies are described as probable, possible, and remote; accounting treatment depends on likelihood and ability to estimate an amount