Income Taxes, Unusual Items, Investments in Stocks By Rachelle Agatha, CPA, MBA Slides by Rachelle Agatha, CPA, with excerpts from Warren, Reeve, Duchac

Objectives: Journalize the entries for corporate income taxes, including deferred income taxes. Describe and illustrate the reporting of unusual items on the income statement.

Objectives: Prepare an income statement reporting earnings per share data. Describe the concept and the reporting of comprehensive income. Describe the accounting for investments in stocks.

Objective 1 Journalize the entries for corporate income taxes, including deferred income taxes.

Corporate Income Taxes Most corporations are required to pay estimated federal income taxes in four installments throughout the year. A corporation estimates its income tax expense for the year to be $84,000. The first of four estimated payments is journalized as follows: Apr. 15 Income Tax Expense 21 000 00 Cash 21 000 00

Automobiles 33% Banking 35 Computers 23 Food 35 Integrated oil 39 Ratio of Reported Income Tax Expense to Earnings Before Taxes for Selected Industries Automobiles 33% Banking 35 Computers 23 Food 35 Integrated oil 39 Pharmaceuticals 30 Retail 39 Telecommunication 37 Transportation 38

Allocating Income Taxes Some differences between taxable income and income before income taxes are created because items are recognized in one period for tax purposes and in another period for income statement purposes. Such differences are call temporary differences because they reverse or turn around in later years.

Examples of Items That Create 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 or gains are taxed before they are reported on the income statement. Expenses or losses are deducted in determining taxable income before they are reported in the income statement.

Total depreciation is the same for tax and financial purposes. Exhibit 1 Temporary Differences MACRS (tax depreciation) Straight-line (financial statement depreciation) Years 1-5 Total Year 1 Year 2 Year 3 Year 4 Year 5 Total depreciation is the same for tax and financial purposes.

At the end of the first year of operations, a corporation reports $300,000 of income before income taxes. With a 40% tax rate, the firm faces a tax of $120,000 ($300,000 x 40%). Using tax planning, the net income is reduced to $100,000 and the actual income tax due is $40,000 ($100,000 x 40%). The difference is deferred to future years.

The entry to record income taxes reflects the deferred amount of $80,000. Income Tax Expense 120 000 00 Income Tax Payable 40 000 00 Deferred Income Tax Payable 80 000 00

If $48,000 of the deferred tax reverses and becomes due in the second year, the entry will reflect this fact. Deferred Income Tax Payable 48 000 00 Income Tax Payable 48 000 00

A corporation has $200,000 of income before income taxes, a 40% tax rate, and $130,000 of taxable income. Provide the journal entry for the current year’s taxes.

Income Tax Expense 80,000 Income Tax Payable 52,000 Deferred Income Tax Payable 28,000 Income tax expense based on $200,000 reported income at 40% $80,000 Income tax payable based on $130,000 taxable income at 40% 52,000 Income tax deferred to future years $28,000

Permanent Differences Differences between taxable income and income before taxes reported on the income statement may be the result of differences that are not “timing” differences. These are permanent differences that never reverse. Interest income that is exempt on municipal bonds is an example of this type of a permanent difference.

Objective 2 Describe and illustrate the reporting of unusual items on the income statement.

Fixed asset impairments Restructuring charges Reporting Unusual Items on the Income Statement Reporting Unusual Items on the Income Statement Unusual items subtracted from gross profit in determining income from continuing operations are: Fixed asset impairments Restructuring charges

Fixed Asset Impairment A fixed asset impairment occurs when the fair value of a fixed asset falls below its book value and is not expected to recover.

Decrease in market price of fixed assets. Examples of Events That Might Cause an Asset Impairment 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.

On March 1, Jones Corporation consolidates operations by closing a factory. As a result of the closing, plant and equipment is impaired by $750,000. Mar. 1 Loss on Fixed Asset Impairment 750 000 00 Equipment 750 000 00 To record impairment of fixed assets due to plant closing.

Fixed asset impairments Reporting of Unusual Items on the Income Statement Fixed asset impairments

Unusual Items in the Income Statement 23

Fixed asset impairments Restructuring charges Reporting Unusual Items on the Income Statement Unusual items subtracted from gross profit in determining income from continuing operations are: Fixed asset impairments Restructuring charges

Restructuring Charges Restructuring charges are costs incurred with actions such as canceling contracts, laying off or relocating employees, and combining operations.

The management of Jones Company communicates a plan to terminate 200 employees from the closed manufacturing plant effective March 1. The restructuring plan calls for a termination benefit of $5,000 per employee. The employees have the right to work 60 days beyond March 1, but may elect to leave the firm earlier.

The fair value of this plan would be $1,000,000 (200 x $5,000), which is the aggregate expected cost of terminating the employees. The restructuring charge would be recorded as follows: Mar. 1 Restructuring Charge 1,000 000 00 Employee Termination Obligation 1,000 000 00 To record impairment of fixed assets due to plant closing.

14-2 Twenty five employees find employment elsewhere and leave the company on March 25. Payment is made to these employees on that date.

On March 25, the entry to record a severance payment of $125,000 to 25 of the terminated employees would be as follows: Mar. 25 Employee Termination Obligation 125 000 00 Cash 125 000 00 To record payment to 25 employees as severance compensation.

Restructuring charges Reporting of Unusual Items on the Income Statement Restructuring charges

Unusual Items in the Income Statement

On December 20 of the current year. Torro Corporation determined that equipment had been impaired so that the book value of the equipment was reduced by $180,000. In addition, the senior management of the company communicated an employee severance plan whereby 80 employees could receive a termination benefit of $7,000 per employee. Provide the journal entries for the asset impairment and the restructuring charge. 32

Dec. 20 Loss on Fixed Asset Impairment 180,000 Equipment 180,000 20 Restructuring Charge 560,000* Employee Termination Obligation 560,000 *80 employees x $7,000

Discontinued operations Extraordinary items Reporting Unusual Items on the Income Statement Unusual items that may add or subtract income from continuing operations in determining net income are: Discontinued operations Extraordinary items

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.

Discontinued operations Reporting of Unusual Items on the Income Statement Discontinued operations

Unusual Items in the Income Statement 14-2 37

Discontinued operations Extraordinary items Reporting Unusual Items on the Income Statement 14-2 Unusual items that adjust income from continuing operations in determining net income are: Discontinued operations Extraordinary items

Extraordinary items result from events and transactions that— Extraordinary Items 14-2 Extraordinary items result from events and transactions that— are significantly different (unusual) from the typical or the normal operating activities of the business, and occur infrequently.

Insert Exhibit 2 here also, p. 13 Reporting of Unusual Items on the Income Statement 14-2 14-2 Insert Exhibit 2 here also, p. 13 Extraordinary items 40

Unusual Items in the Income Statement

Retroactive Restatement In addition to unusual items impacting the income statement, there are two major items that require a retroactive restatement of prior period earnings. These two items are: errors in the recognition, measurement, presentation, or disclosure of financial statements, and changes from one generally accepted accounting principle to another generally accepted accounting principle.

Unusual items affecting prior period income statements Reporting of Unusual Items on the Income Statement Unusual items affecting prior period income statements

Prepare an income statement reporting earnings per share data. Objective 3 Prepare an income statement reporting earnings per share data.

Earnings per Common Share The profitability of companies is often expressed as earnings per share. Earnings per common share (EPS), sometimes called basic earnings per share, is the net income per share of common stock outstanding during a period.

If there is no preferred stock: 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

Income Statement with Earnings per Share

*2,000 shares x $100 par value x 9% = $18,000 Manning Company had net income of $250,000 during the year. There were 580,000 common shares outstanding during the year. There were 2,000 shares of $100 par value, 9% preferred stock outstanding during the year. Determine the basic earnings per share. Earnings per share = $250,000 – $18,000* 580,000 $0.40 per share = *2,000 shares x $100 par value x 9% = $18,000

Describe the concept and the reporting of comprehensive income. Objective 4 Describe the concept and the reporting of comprehensive income.

Comprehensive Income Comprehensive income is defined as all changes in stockholders’ equity during a period, except those resulting from dividends and stockholders’ investments.

Other comprehensive income items include foreign currency items, pension liability adjustments, and unrealized gains and losses on investments.

The cumulative effects of other comprehensive income items must be reported separately from retained earnings and paid-in capital, on the balance sheet as accumulated other comprehensive income.

Statement of Comprehensive Income Statement of Comprehensive Income Triple-A Enterprises, Inc. reported comprehensive income on a separate statement as follows: Net income $8 500 00 Other comprehensive income, net of tax 90 00 Total comprehensive income $8 590 00 Triple-A Enterprises, Inc. Statement of Comprehensive Income For the Year Ended December 31, 2008 Triple-A Enterprises, Inc. Statement of Comprehensive Income For the Year Ended December 31, 2008 Net income $8 500 00 Other comprehensive income, net of tax 90 00 Total comprehensive income $8 590 00

Stockholders’ Equity Section of Triple-A Enterprises’ Balance Sheet Stockholders’ Equity Section of Triple-A Enterprises’ Balance Sheet Triple-A Enterprises, Inc. Stockholders’ Equity For the Year Ended December 31, 2008 2008 2007 Stockholders’ equity: Common stock $ 20 000 00 $ 20 000 00 Paid-in capital in excess of par 36 000 00 36 000 00 Retained earnings 165 500 00 157 000 00 Accumulated other comprehensive income 1 290 00 1 200 00 Total stockholders’ equity $222 790 00 $214 200 00

Myers Company had a net income of $74,000, and other comprehensive income of $12,500 for 2008. On January 1, 2008 the Retained Earnings balance was $425,000 and the Accumulated Other Comprehensive Income balance was $57,000. Determine the (a) comprehensive income for 2008, (b) Retained Earnings balance on December 31, 2008, and (c) Accumulated Other Comprehensive Income balance on December 31, 2008.

$86,500 = $74,000 + $12,500 $499,000 = $425,000 + $74,000 c) $69,500 = $57,000 + $12,500

Describe the accounting for investments in stocks. Objective 5 Describe the accounting for investments in stocks.

Accounting for Investments in Stocks Like individuals, businesses have a variety of reasons for investing in stocks, called equity securities. A business may purchase stocks as a means of earning a return on excess cash that it does not need for its normal operations.

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.

When a business invests in available-for-sale securities, such investments are classified as temporary investments or marketable securities.

Marketable securities must meet two conditions: The securities must be readily marketable, and can be sold for cash at any time. Management must intend to sell the securities when the business needs cash for operations.

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. The firm paid $180,000 [($89.75 x 2,000 shares) + $500]. June 1 Marketable Securities 180 000 00 Cash 180 000 00 Purchased 2,000 shares of Inis Corporation common stock.

On October 1, Inis declared a $0.90 per share dividend payable on November 30. Nov 30 Cash 1 800 00 Dividend Revenue 1 800 00 Received dividends on Inis Corporation common stock (2,000 shares x $0.90).

Unrealized Holdings Gain or Loss On the balance sheet, temporary investments are reported at their fair market value. Any difference between the fair market value and their cost is an unrealized holding gain or loss.

The Crabtree Co.’s portfolio of temporary investments was purchased during 2008 and has the following fair market values and unrealized gains and losses on December 31, 2008. Unrealized Common Stock Cost Market Gain (Loss) Edwards 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

Temporary Investments on the Balance Sheet

Drew Company began operations on January 1, 2008 and purchased temporary investments in marketable securities during the year at a cost of $75,000. The end-of-period market value for these investments was $110,000. Net income was $180,000 for 2008. Determine (a) the reported amount of marketable securities on the December 31, 2008 balance sheet, and (b) the comprehensive income for 2008. Assume a tax rate of 40%.

Initial costs $ 75,000 Unrealized gain ($110,000 – $75,000) $35,000 Less: Tax on unrealized gain ($35,000 x 40%) 14,000 Unrealized gain, net of tax 21,000 Reported amount of marketable securities $ 96,000 Net income $180,000 Unrealized gain ($110,000 – $75,000) $35,000 Less: Tax on unrealized gain ($35,000 x 40%) 14,000 Other comprehensive income, net of tax 21,000 Net income $201,000

Long-Term Investments in Stocks Long-term investments are not intended as a source of cash in the normal operations of the business. Rather, such investments are often held for their income, long-term gain potential, or influence over another business entity.

Accounting for Long-Term Stock Investments Accounting for Long-Term Stock Investments Is there a significant influence over the investee? No Yes Account for the investment as an available-for-sale security Account for the investment by using the 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 00 Cash 350 000 00 Purchased 40% of Brock Corp. common stock.

For the year ending December 31, Brock Corporation reports net income of $105,000. Dec. 31 Investment in Brock Corp. Stock 42 000 00 Income of Brock Corp. 42 000 00 Recorded 40% share of Brock Corp. net income of $105,000.

On December 31, Brock Corporation pays $45,000 in dividends. 14-5 On December 31, Brock Corporation pays $45,000 in dividends. Dec. 31 Cash 18 000 00 Investment in Brock Corp.Stock 18 000 00 Recorded 40% share of Brock Corp. dividends.

Investments and Dividends

Sale of 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. 1 Cash 17 500 00 Investment in Drey Inc. Stock 15 700 00 Gain on Sale of Investments 1 800 00

Phillips Company purchased 30% of the outstanding stock of Singh Company on January 1, 2008. Singh reported net income of $90,000 and declared dividends of $15,000 during 2008. How much would Phillips adjust their investment in Singh Company under the equity method?

Phillips share of Singh reported net income (30% x $90,000) $27,000 Less: Phillips share of the Singh dividend (30% x $15,000) 4,500 Increase in Investment in Singh Company Stock $22,500

Financial Analysis and Interpretation 14-5 14-5 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. This ratio, called the price-earnings ratio, or P/E ratio, is commonly included in stock market quotations.

Earnings per Share of Common Stock Earnings Per Share Net Income Common Shares Earnings per Share of Common Stock = 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.

An example: 2008 2007 Market price per share $24.60 $16.20 Earnings per share $1.64 $1.35 Price-earnings ratio 15.0 12.0 The price-earnings ratio indicates that a share of common stock was selling for 12 times the amount of earnings per share at the end of 2007 and 15 times earnings per share at the end of 2008.

Summary J/E’s for corporate income tax Unusual Items Income statement for EPS Comprehensive Income Accounting for Investments in stock