1. Electronic Presentation by Douglas Cloud Pepperdine University
Chapter 12
Special Income and Investment Reporting Issues
Electronic Presentation by Douglas Cloud Pepperdine University

2. After studying this chapter, you should be able to:
Learning Goals
1. Describe the accounting for and interpretation of deferred income taxes.
2. Prepare an income statement reporting the following unusual items: discontinued operations, extraordinary items, and changes in accounting principles.
3. Describe the accounting for and interpretation of fixed asset impairments and restructuring charges.
After studying this chapter, you should be able to:
Continued

3. Learning Goals
4. Prepare an income statement reporting earnings per share data.
5. Describe the concept and the reporting of comprehensive income.
6. Describe the accounting for investments in stocks.
7. Describe alternative methods of combining businesses and how consolidated financial statements are prepared.
Continued

4. Learning Goals
8. Describe financial statement presentations of stockholders’ equity.

5. Learning Goal 1
Describe the accounting for and interpretation of deferred income taxes.

6. Payment of Income Taxes
At year-end, the actual taxable income and the related taxes are determined. If additional taxes are owed, the additional liability is recorded.
Most corporations are required to pay estimated federal income taxes in four installments throughout the year.

7. Payment of Income Taxes
Year Ended June 30, (Amounts in millions)
Net Sales $39,244
Cost of products sold 22,102
Marketing, research, and administrative expenses 12,406
Operating income $ 4,736
Interest expense 794
Other income, net
Earnings Before Income Taxes $ 4,616
Income taxes 1,694
Net earnings $ 2,922

8. 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 and gains are taxed before they are reported in the income statement.
Expenses or losses are deducted in determining taxable income before they are reported in the income statement.

10. Allocation of Income Taxes
A corporation has $300,000 of income before income taxes, a 40% tax rate, and $100,000 of taxable income.
Income Tax Expense 120,000
Income Taxes Payable 40,000
Deferred Income Taxes Payable 80,000
$300,000 x .40
$100,000 x .40

11. Allocation of Income Taxes
In the second year, $48,000 of the deferred tax reverses and becomes due.
Deferred Income Taxes Payable 48,000
Income Taxes Payable 48,000

12. A corporation’s taxable income and its income before taxes may also differ because certain revenues are exempt from taxes…

13. Interest on municipal bonds Fines for overloading delivery trucks
…and certain expenses are not deducted in determining taxable income. Such differences are called permanent differences.
Examples
Interest on municipal bonds
Fines for overloading delivery trucks

14. Learning Goal 2
Prepare an income statement reporting the following unusual items: discontinued operations, extraordinary items, and changes in accounting principles.

15. 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.
A business segment refers to a major line of business for a company.
A component of an entity is the lowest level at which the operations and cash flows can be clearly distinguished from the rest of the entity.

16. Extraordinary Item
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.

17. Changes in Accounting Principles
Changes in GAAP disclosures should include the following:
The nature of the change.
The justification for the change.
The effect on the current year’s net income.
The cumulative effect of the change on the net income of prior periods.

18. Learning Goal 3
Describe the accounting for and interpretation of fixed asset impairments and restructuring charges.

19. Fixed Asset Impairment
Such impairments should be recognized on the income statement as a loss at the time of the impairment. 
Fixed asset impairment occurs when the fair value of a fixed asset that is held or used falls below its book value and is not expected to recover.

20. Restructuring Charges
Restructuring charges are the accrued employee termination benefits associated with a management-approved employee termination plan.
Restructuring Charge xxxxx
Employee Termination Benefit
Obligation xxxxx
An expense
A current or long-term liability

21. Restructuring Charges
Later, the actual benefits are paid to the terminated employees.
Employee Termination Benefit
Obligation xxxxx
Cash xxxxx

22. Learning Goal 4
Prepare an income statement reporting earnings per share data.

23. Earnings per Common Share
No preferred stock outstanding
EPCS =
Net income
Number of common shares outstanding
Preferred stock outstanding
EPCS =
Net income – Preferred stock dividend
Number of common shares outstanding

24. For the Year Ended December 31, 2005
Jones Corporation
Income Statement
For the Year Ended December 31, 2005
Earnings per common share:
Income from continuing operations $3.45
Loss on discontinued operations (Note A)
Income before extraordinary items and cumulative
effect of a change in accounting principle $2.95
Extraordinary item:
Gain on condemnation of land, net of applicable
income tax of $65,
Cumulative effect on prior years of changing to a
different depreciation method (Note B)
Net income $4.16

25. Learning Goal 5
Describe the concept and the reporting of comprehensive income.

26. Comprehensive income is defined as all changes in stockholders’ equity during a period except those resulting from dividends and stockholders’ investments.
Foreign currency items
Pension liability adjustments
Unrealized gains and losses on investments

27. Note that the “other comprehensive income” items do not affect net income or retained earnings.

28. Learning Goal 6
Describe the accounting for investments in stocks.

29. Trading securities are securities that management intends to actively trade for profit.

30. Available-for-sale securities are securities that management expects to sell in the future, but are not actively traded for profit.

31. Available-for-Sale Equity Investments
On June 1 Crabtree Co. purchased 2,000 shares of Inis Corporation common stock at $89.75 per share plus a brokerage fee of $500.
June 1 Marketable Securities 180,000
Cash 180,000
($89.75 x 2,000) + $500

32. Available-for-Sale Equity Investments
On October 1, Inis declared a $0.90 per share cash dividend payable on November 30.
Nov. 30 Cash 1,800
Dividend Revenue 1,800
2,000 x $0.90

33. Available-for-Sale Equity Investments
Unrealized
Common Stock Cost Market Gain (Loss)
Appears on both the balance sheet and the statement of income and comprehensive income
Edward, Inc. $150,000 $190,000 $40,000
SWS Corp. 200, ,000 —
Inis Corporation 180, ,000 30,000
Bass Co , ,000 (10,000)
Total $690,000 $750,000 $60,000
Appears on the balance sheet
$60,000 – (.30 x $60,000) = $42,000

34. Equity Method
The equity method is used for long-term investments in stocks where the investor has a significant influence over the activities of the investee.
Generally, if the investor owns 20% or more of the voting stock of the investee, the investor is assumed to have significant influence over the investee.
Equity

35. 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
Cash 180,000
Unless there is evidence to the contrary, this should give Hally Inc. significant influence over the operating or financial activities of Brock Corp.

36. Equity Method
For the year ending December 31, Brock Corporation reports net income of $105,000 and pays $45,000 in dividends.
Dec. 31 Investment in Brock Corp.
Stock 42,000
Income of Brock Corp. 42,000
$45,000 x 40%
$105,000 x 40%
31 Cash 18,000
Investment in Brock
Corp. Stock 18,000

37. Investment in Brock Corporation Stock
Equity Method
Investment in Brock Corporation Stock
Jan ,000
Dec ,000
Dec ,000
$374,000

38. Sale of Investments in Stocks
An investment in Drey Inc. stock has a carrying amount of $15,700 when it is sold on March 1 for $17,500.
Mar. 1 Cash 17,500
Investment in Drey. Inc.
Stock 15,700
Gain on Sale of Investment 1,800

39. Learning Goal 7
Describe alternative methods of combining businesses and how consolidated financial statements are prepared.

40. Mergers and Consolidations
When one corporation acquires all the assets and liabilities of another corporation, which is then dissolved, a merger has taken place.

41. Mergers and Consolidations
When one corporation acquires all the assets and liabilities of another corporation, which is then dissolved, a merger has taken place.

42. Parent and Subsidiary Corporations
The corporation owning all or a majority of the voting stock of the other corporation is called the parent company.

43. Parent and Subsidiary Corporations
The corporation that is controlled is called the subsidiary company.
Two or more corporations closely related through stock ownership are sometimes called the affiliated company.

44. Parent and Subsidiary Corporations
At the end of the year, the financial statements of the parent and subsidiary are combined and are referred to as consolidated financial statements.
If the parent owns less than 100% of the subsidiary stock, the other parties’ ownership is referred to as minority interest.

45. Learning Goal 8
Compute and interpret the price-earnings ratio and price-book ratios.

46. Price-Earnings Ratio
The price-earnings ratio indicates a firm’s growth potential and future earnings prospects.

47. Price-Earnings Ratio
It indicates how much the market is willing to pay per dollar of a company’s earnings.

48. Price-Earnings Ratio Dell Computer 30
Market price per share of common stock
Earnings per share of common stock
$26.10
P/E ratio = 30
$0.87
Market price per share = $26.10
Basic earnings per share = $0.87
Dell Computer
2001

49. Price-Book Ratio
The price-book ratio is the ratio of the market value of a share of common stock to the book value of a share of common stock.

50. Price-Book Ratio
The first step is to determine the book value per share of common stock.
Total stockholders’ equity
Common shares outstanding
$10,519,000,000
$12.32
BVS =
854,000,000
Alcoa, Inc.

51. The market price per share of Alcoa, Inc. was $34 on May 7, 2002.
Price-Book Ratio
The market price per share of Alcoa, Inc. was $34 on May 7, 2002.
Market price per share
Book value per share
$34
P-B ratio =
2.76
$12.32
Alcoa, Inc.’s market price is 2.76 times greater than the book value of the firm.
Alcoa, Inc.

52. Chapter 12
The End