1. Income Taxes, Unusual Income Tax Items, and Investments in Stocks
Chapter 14
Income Taxes, Unusual Income Tax Items, and Investments in Stocks
Accounting, 21st Edition
Warren Reeve Fess
© Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved.
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PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

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3. After studying this chapter, you should be able to:
Objectives
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.
After studying this chapter, you should be able to:

4. 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 price-earnings ratio.

5. Corporate Income Taxes

6. Corporate Income Taxes
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.

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

8. 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

9. 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.

10. 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.

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

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

13. Temporary Differences in Reporting Expenses
Financial
Reporting
Tax
Reporting
Expense
Deductions
Deduct Now Deduct Later
Deduct Slower Deduct Faster
EXAMPLE: Product warranty expense.
When
Estimated
When
Paid
EXAMPLE: Methods
of depreciation.
Straight-Line
Method
MACRS
Method

14. 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.

15. Temporary Differences
The entry to record income taxes on April 15 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.

16. Temporary Differences
If $48,000 of the deferred tax reverses and becomes due 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.

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

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

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

20. 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

21. 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.

22. Unusual Items Affecting the Income Statement
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.

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

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

25. 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.

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

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

28. Unusual Items Not Affecting Income From Continuing Operations
Closed

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

30. 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 ,000
Income from continuing operations $ ,000
Loss on discontinued operations (Note B) ,000
Income before extraordinary items and cumulative
effect of a change in accounting principle $ ,000
Extraordinary item:
Gain on condemnation of land, net of
applicable income tax of $65, ,000
Cumulative effect on prior years of changing to
different depreciation method (Note C) ,000
Net income $ ,000

31. Extraordinary Items
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.

32. 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 ,000
Income from continuing operations $ ,000
Loss on discontinued operations (Note B) ,000
Income before extraordinary items and cumulative
effect of a change in accounting principle $ ,000
Extraordinary item:
Gain on condemnation of land, net of
applicable income tax of $65, ,000
Cumulative effect on prior years of changing to
different depreciation method (Note C) ,000
Net income $ ,000

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

34. 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.

35. 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 ,000
Income from continuing operations $ ,000
Loss on discontinued operations (Note BA) ,000
Income before extraordinary items and cumulative
effect of a change in accounting principle $ ,000
Extraordinary item:
Gain on condemnation of land, net of
applicable income tax of $65, ,000
Cumulative effect on prior years of changing to
different depreciation method (Note C) ,000
Net income $ ,000

36. Earnings Per
Common Share

37. 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

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

39. 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)
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
Net income $ 4.16

40. 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)
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
Net income $ 4.16

41. 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)
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
Net income $ 4.16

42. 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)
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
Net income $ 4.16

43. 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)
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
Net income $ 4.16

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

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

46. Stockholders’ Equity Section
Common stock $ 20,000 $ 20,000
Paid-in capital in excess of par 36,000 36,000
Retained earnings 165, ,000
Accumulated other
comprehensive income , ,200
Total stockholders’ equity $222,790 $214,200

47. 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.

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

49. 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.
$89.75 x 2,000 shares + $500
June 1 Marketable Securities
Cash
Purchased 2,000 shares of Inis Corporation common stock.

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

51. 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.

52. 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.

53. Short-Term Investments in Stocks
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) , ,000
Stockholders’ Equity
Accumulated other comprehensive income 42,000

54. Statement of Comprehensive Income For the Year Ended December 31, 2006
Short-Term Investments in Stocks
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) ,000
Comprehensive income $762,000

55. 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.

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

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

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

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

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

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

62. Business Combinations
Equity
Method
Cost
No significant
influence
Significant
Ownership % 0%
20%
Controlling Interest
100%
50%
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.

63. 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.

64. Business Combinations
Mergers
Consolidations C A B A 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.

65. 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.

66. Price-Earnings Ratio 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 =

67. 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.
An example:
Market price per share $20.50 $13.50
Earnings per share $ $1.35
Price-earnings ratio
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.

68. Chapter 14
The End