1. Chapter 10 Other Items That Affect Net Income and Owners’ Equity

2. Components of Owners’ Equity
Common stock.
Preferred stock.
Direct debits.
Direct credits.

3. Topics in chapter Nonowner transactions affecting OE.
Disclosure requirements.
Extraordinary items.
Discontinued operations.
Accounting changes.
Accounting errors.
Foreign currency translation adjustments.
Derivatives.

4. Reporting Requirement
Total nonowners changes in owners’ equity (OE), which is sum of:
Net income.
Other nonowner changes in OE.
Accumulated balances of unrealized gains and losses on available-for-sale securities (Chapter 5).
Net investment translation adjustments.
Gains and losses on certain derivatives.
Other items (not addressed).
Considerable leeway in reporting format.

5. Extraordinary Items Criteria: Reported on Income Statement:
Unusual: highly abnormal and unrelated to ordinary activities of entity.
Infrequent: not reasonably expected to recur in foreseeable future.
Reported on Income Statement:
After income from continuing operations and
Net of income tax effect .

6. Not Extraordinary items
Write-downs or write-offs of AR, inventory, or intangible assets.
Gains or losses from exchange rate changes.
Gains or losses on disposal of segment of a business.
Gains or losses from disposal of fixed assets.
Effects of a strike.

7. Discontinued Operations
Discontinuance of a division or other identifiable segment of a business.
Must involve a whole business unit, not one asset or a product line.
May be abandoning segment and selling off assets (usually at a loss) or
Selling off the segment (for a gain or a loss).

8. Accounting for Discontinuance
If loss is expected:
Record in period in which decision is made.
Estimation of loss requires estimating:
Revenues less expenses until disposition.
Proceeds of sale.
Book value of assets disposed of.
If gain is expected: do not recognize until realized.

9. Discontinued Operations Income Statement Presentation
Reported net of tax in 2 amounts:
Net income or loss attributable to operations of segment until it is sold.
Estimation of gain or loss on disposal arising from all aspects of sale.

10. Change in Accounting Principles
Consistency concept requires using same accounting principle year after year.
Can change only if there is a sound reason.
Retained earnings adjusted to reflect cumulative effect.
Shown on income statement as nonrecurring item.

11. Adjustments to Retained Earnings
Prior period adjustments to Retained Earnings:
Limited by FASB to only corrections of accounting errors defined as:
Mathematical mistakes, mistakes in the application of accounting principles, or oversight or misuse of facts that existed at the time the financial statements were prepared.
A change from a principle that is not generally accepted to one that is … is a correction of an error.

12. Personnel Costs
Wages and salaries earned by employees and other costs related to their services.
Deducted from gross earnings before payment (and not a cost of the employer):
FICA contributions for Social Security and Medicare.
Withholding for federal and state income taxes.
Deductions for union dues, ….

13. Fringe Benefits
Provided and paid for by employer to employees. Possibilities include:
Pensions, life insurance, health care, sick pay, vacations.

14. Pensions Payments received by employees after they retire.
Typically 5%-10% of payroll.
Regulated under ERISA.
In most cases pensions must be partially funded.

15. Types of Pension Plans Defined contribution plan:
Employer contributes an agreed amount.
No promise as to how much benefits will be.
Defined benefit plan:
Employer agrees to contribute an amount so that employees will receive a specified amount.

16. Pension Cost
Complicated determination for a defined benefit plan. Must estimate:
How many years employees will work.
Employee turnover.
Average employee earnings.
How many years employees live after retirement.
Inflation.
Earnings on invested pension funds.
Other factors.
Determination is extremely complicated and uses present value (PV) concept.

17. Components of Pension Cost
Service cost: PV of future benefits employees earned during year.
Interest cost: amount by which plan’s beginning of year obligations has increased.
Return on plan assets: Offsetting element, assumed gain on plan assets over the long run.
Prior service cost: considers employees service prior to initiation (or change) of plan.

18. Pension Plan Entries Cost is $500,000: Net pension cost 500,000
Accrued pension cost (liability) 500,000
Employer contributions are $450,000:
Accrued pension cost ,000
Cash ,000

19. Pension Disclosures Period’s net pension cost.
Unfunded plan position for each defined benefit plan.
Four components of net pension cost.
Assumptions of calculations of a plan’s funding position.

20. Other Post Retirement Benefits
E.g., healthcare, life insurance.
Present value of a portion of these costs are expensed.

21. Compensated Absences Future compensated absences:
Vacation and sick leave earned this year but taken next year.
Expensed in period earned. dr expense cr accrued liability.

22. Income Tax Expense Tax expense for current year consists of:
Current income tax expense (this year’s tax bill) and
Deferred income tax expense.
Income tax expense
Taxes payable
Deferred income taxes liability

23. Book-to-Tax Differences
Arises because for some items tax accounting differs from book (GAAP).
Taxable income: income reported to tax authorities to compute income tax.
Pretax accounting income = pretax book income = income before taxes: income before tax under GAAP.

24. Why Do Book and Taxable Income Differ?
Objective of tax accounting: raise taxes and encourage behavior. E.g., accelerated depreciation to encourage investment.
Objective of GAAP/Financial reporting: Provide info useful to investors.

25. Permanent Differences between Book and Tax
Do not reverse in future years.
Expenses under GAAP that are not deductible. (E.g., fines.)
Revenues excluded from taxable income. (E.g., revenue on municipal bonds)
Does not create accounting problems.

26. Temporary Difference between Book and Tax
Differences that reverse or turnaround in a later period.
Revenues or expenses that are permitted or required to be reported in a different period. E.g., depreciation.
Creates accounting complexities in order to match income tax expense to period in which revenue or expense item is recognized.

27. Deferred Tax Reporting
Deferred Income Taxes: liability account.
Shown separately from Taxes payable.
Indicates the amount that future tax expense will be reduced when differences between book and tax reverse.
Interest free loan from the government.
Increases as long as company grows.

28. Deferred Tax Assets
Temporary differences resulting in Taxable income higher than book:
Warranty expensed when revenue recognized for book, when actually paid for tax.
Subscription receipts recognized when received for tax, when earned for book.
Tax-loss carryforwards: cannot exceed amount of expected future tax benefits.

29. Tax Rate Changes and Disclosures
New deferrals recorded based on rates currently in tax law.
Disclosures:
Deferred tax asset and liability amounts shown separately.
Must be classified appropriately as current or noncurrent.

30. Foreign Currency Transactions
Fluctuating foreign currency exchange rates cause changes in values of receivable and payables. Accounting requirements:
Transactions are recorded at the exchange rate in effect at the time the transaction is recognized.
At each balance sheet date, recorded balances are adjusted to the current (i.e., spot) exchange rate.
Gains and losses are included in net income in the period in which they are incurred.

31. Foreign Currency Translation
Foreign subs records kept in local (foreign) currency.
To consolidate with other operations, must be translated into dollars (reporting currency).

32. Functional Currency
Currency of the primary economic environment in which the company operates.
Selection of functional currency effectively determines which translation method is used.
If functional currency is the local currency:
Translate using the net investment or current rat method.
If functional currency is the dollar:
Translate using the remeasurement or temporal method.

33. Current Rate Method
All assets and liabilities translated at the exchange rate at balance sheet date.
All revenue and expense items are translated at the weighted average exchange rate.
Balance sheet differences arising from translation do not go through income but are recorded directly to stockholders’ equity in an account such as “Cumulative Translation Adjustment.”

34. Remeasurement
Objective: report foreign sub’s financial statement amounts as if activities were carried out by parent and recorded on parent’s books.
Most items are translated at same rate as current rate method. Exceptions:
Long-lived assets and inventory are translated using the rate at date acquired (historical rate).
Expenses related to these assets (depreciation and cost of goods sold) also translated at historical rate.
Gains and losses arising from remeasurement are included in income.

35. Derivatives
A financial instrument or other contract that derives its value by direct references to the changes in value of one or more underlyings.
Underlyings can be: return or yield on another security, price of a share, an interest or exchange rate.
Used to hedge risk of changes in interest rates, commodities, exchange rates….

36. Accounting for Derivatives
Recognized as assets or liabilities and measured at fair value.
Underlying gains and losses included in net income except when designated as and qualifying as a type of hedge. Accounting can be complex.)

37. Pro Forma Earnings At discretion of management.
Supplements GAAP Income Statement.
Excludes certain items such as merger related charges, non-recurring items and goodwill impairment write-offs.
SEC insists they are not misleading.

38. Net Income Bottom line of Income Statement.
Never appears on any other line.
Net addition to Retained Earnings during accounting period whether arise from operations or other times.