Chapter 14 Income Taxes, Unusual Income Tax Items, and Investments in Stocks Accounting, 21 st 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.

Corporate Income Taxes How are Income Taxes accounted for?

Where is Income Tax shown on the Income Statement? If the tax rate is 30%, what is the amount of tax expense? Why might “tax owed” be different from tax shown?

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

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

Corporate Income Taxes Ratio of Reported Income Tax Expense to Earnings Before Taxes for Selected Industries Automobiles33% Banking35 Computers23 Food35 Integrated oil39 Pharmaceutical30 Retail39 Telecommunication17 Transportation38

Corporation Income Income may be shown in two different formats: –Financial Statement Net Income (accrual) –Income tax reporting Net Income (cash) Can these be different? –Yes—temporary differences exist because of timing –Income of one year may not be reported until later years

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. Allocating Income Taxes

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

Year 1 Year 2 Year 3 Year 4 MACRS (tax depreciation) Straight-line (financial statement depreciation) Year 5 Years 1-5 Total

Temporary Differences in Reporting Revenues Report NowTaxable Later Report LaterTaxable Now EXAMPLE: Income reporting methods. Point-of-Sale Method Installment Method Financial Reporting Tax Reporting EXAMPLE: Cash collected in advance. When Earned When Collected Revenue Reporting Temporary Differences

Temporary Differences in Reporting Expenses Deduct NowDeduct Later Deduct SlowerDeduct Faster EXAMPLE: Product warranty expense. When Estimated When Paid Financial Reporting Tax Reporting EXAMPLE: Methods of depreciation. Straight-Line Method MACRS Method Expense Deductions 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 The entry to record income taxes on April 15 reflects the deferred amount of $80,000. Apr. 15Income Tax Expense To record income tax for the year. Income Tax Payable Deferred Income Tax Payable

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

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

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

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

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

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

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$3,490,000 Restructuring charge1,000,000 Loss from asset impairment 750,000 5,240,000 Income from continuing operations before income tax$ 1,310,000 Income tax expense 620,000 Income from continuing operations$ 690,000

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

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

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

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

Unusual Items Not Affecting Income From Continuing Operations Closed

Discontinued Operations A gain or loss from disposing of a business segment is reported as a gain 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 $65,000150,000 Cumulative effect on prior years of changing to different depreciation method (Note C) 92,000 Net income$ 832,000

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. Extraordinary Items

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 $65,000150,000 Cumulative effect on prior years of changing to different depreciation method (Note C) 92,000 Net income$ 832,000

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

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

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 $65,000150,000 Cumulative effect on prior years of changing to different depreciation method (Note C) 92,000 Net income$ 832,000

 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 share (EPS) is the net income per share of common stock outstanding. When unusual items exist, EPS should be reported for: Earnings per Common Share

Earnings per common share = Net Income Number of common shares outstanding If there is no preferred stock: If there is preferred stock: Earnings per common share = Net Income – Preferred stock dividends 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 Companies may report comprehensive income on the income statement, in a separate statement, or in the statement of stockholders’ equity.

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

Stockholders’ equity: Common stock $ 20,000$ 20,000 Paid-in capital in excess of par36,00036,000 Retained earnings165,500157,000 Accumulated other comprehensive income 1,290 1,200 Total stockholders’ equity$222,790$214,200 Stockholders’ Equity Section

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 Temporary investments are recorded in the current asset account, Marketable Securities, at their cost.

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

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

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

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

Short-Term Investments in Stocks Crabtree Co. Balance Sheet December 31, 2006 Crabtree Co. Balance Sheet December 31, 2006 Current assets: Cash$119,500 Temporary investments in marketable securities at cost$690,000 Plus unrealized gain (net of applicable income tax of $18,000) 42,000732,000 Current assets: Cash$119,500 Temporary investments in marketable securities at cost$690,000 Plus unrealized gain (net of applicable income tax of $18,000) 42,000732,000 Stockholders’ Equity Accumulated other comprehensive income42,000 Stockholders’ Equity Accumulated other comprehensive income42,000

Short-Term Investments in Stocks Crabtree Co. Statement of Comprehensive Income For the Year Ended December 31, 2006 Crabtree Co. Statement of Comprehensive Income For the Year Ended December 31, 2006 Net income$720,000 Other comprehensive income: Unrealized gain on temporary investments in marketable securities (net of applicable tax of $18,000) 42,000 Comprehensive income$762,000 Net income$720,000 Other comprehensive income: Unrealized gain on temporary investments in marketable securities (net of applicable tax of $18,000) 42,000 Comprehensive income$762,000

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

Equity Method Cost Method Not significant influence Significant influence Ownership % Controlling Interest 100% 100% Cost Method Not significant influence 0% 0% 20% 20% 50% 50% With less than 20% ownership the buyer does not usually have significant influence. The buyer uses the cost method to account for the investment. Long-Term Investments in Stocks

Equity Method Cost Method No significant influence Significant influence Ownership % Controlling Interest 0% 0% Equity Method 50% 50% Ownership over 20% usually indicates significant influence. The buyer uses the equity method to account for the investment. 100% 100% 20% 20% Long-Term Investments in Stocks

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

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

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

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

Equity Method Cost Method No significant influence Significant influence Ownership % 0% 0% 20% 20% Controlling Interest 100% 100% 50% 50% Business Combinations The corporation owning all or a majority of the voting stock is called the parent company. The controlled corporation is the subsidiary company. Consolidated financial statements are prepared which combines the operating results of the two entities.

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.

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

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

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

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. The price-earnings ratio indicates that a share of common stock was selling for 10 times earnings for 2005 and 12.5 times for An example: Market price per share$20.50$13.50 Earnings per share$1.64 $1.35 Price-earnings ratio

The End Chapter 14

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

4.Describe the concept and the reporting of comprehensive income. ObjectivesObjectives 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 price- earnings ratio.