chapter 14 lecture income taxes, unusual income items, and investments in stocks p.h

Chapter 14 Lecture

Income Taxes, Unusual Income Items, and Investments in Stocks

P.H.

Corporate Income Taxes

Corporations are legal entities that must pay federal income taxesdepending on the state, they may also be

required to pay state and local income taxes

Most corporations are required to make quarterly installments based on estimated taxes

Corporate Income Taxes

Because income taxes often represent a significant amount, they are normally reported on the income statement as a special deductionearnings are reported before income

taxes, income taxes are deducted, and earnings are restated after income taxes

Corporate Income TaxesPayment of Income Taxes

March 15 Income Tax Expense

Cash

To record quarterly payment of estimated income tax

21,000

21,000

Corporate Income TaxesAllocation of Income Taxes

Taxable income is determined according to the tax lawsTaxable income is often different from “income before income taxes” as reported on the Income StatementThere are several reasons for the differences, including using the straight-line method of depreciation for financial reporting purposes, and using MACRS (Modified Accelerated Cost Recovery System) for tax purposes


The difference between “income before income and taxes” as reported on the income statement (which is calculated based on GAAP) and taxable income (which is calculated according to tax laws), may need to be allocated between various financial statement periods.


The total amount of taxes paid does not not change. Only the timing of the payment of taxes is affected.

This is because many managers use tax-planning strategies to delay (postpone, or defer) the payment of taxes to later years.

Corporate Income TaxesAllocation of Income Taxes Illustrated

To illustrate, assume that a corporation reports $300,000 income before income taxes on its income statement. If the income tax rate is 40%, the income tax as reported on the income statement is $120,000 ($300,000 x .4).


The corporation uses tax planning strategies to lower their taxable income to $100,000 so that the amount of income taxes they will pay in the current period is $40,000 ($100,000 x .4).The $80,000 difference ($120,000 - $40,000) is created by timing differences in recognizing revenue. This amount is deferred to future years.


To match the current year’s expense ($120,000) against the current year’s revenue, income tax is allocated between periods as follows:

Income Tax Expense (income tax expense for the period) 120,000

Income Tax Payable (income tax due in the period) 40,000

Deferred Income Tax Payable (portion of income tax for the period that is postponed to a future period)

80,000

To record income tax for the period.

Unusual Items that Affect the Income Statement

1. Discontinued operations

2. Extraordinary items that result in a gain or loss

3. A change from one generally accepted accounting principle to another

These items are all reported separately in the income statement.


Discontinued Operations

When a business segment (a major line of business for the corporation) is disposed of (discontinued), the resulting gain or loss must be reported separately from income from continuing operations A business segment could be a department, a division, or a class of customer

Unusual Items that Affect the Income StatementExtraordinary Items

Extraordinary items are events and transactions that:

1. are unusual for the corporation and2. occur infrequently

Gains* and losses from extraordinary items must be reported separately on the income statementExamples of extraordinary items include floods, earthquakes, and fires (unless these are normal for the area)

both conditions must be true

*It is possible to have a gain from an extraordinary item


Changes in Accounting PrinciplesA business may be required to change its accounting principles based on a new accounting standard issued by FASBA business may voluntarily change from one generally accepted accounting principle to another: from FIFO to LIFO from the straight line method to the units of production

method of depreciation


Changes in Accounting PrinciplesChanges in generally accepted accounting principles should be disclosed on the face of the financial statements or in the notes to the statements in the period in which they occur

The disclosure should include the following information: 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


Changes in Accounting PrinciplesNote that errors in calculating a prior period’s income due mistakes in applying accounting principles do not fall under the category of changes in accounting principles and are not reported on the income statement as an unusual item. This type of error falls under the category of a prior period adjustment, and is reported in the retained earnings statement“Changes in Accounting Principles” applies only to a change from one generally accepted accounting principle to another generally accepted accounting principle


Note the order of the three unusual items as they appear in the income statement for Jones Corporation in your text:

1. Discontinued Operations2. Extraordinary Items3. Changes in Accounting Principles

first

next

last


Why do you suppose these unusual items should be reported separately from continuing operations?


Because it allows investors to make decisions about the corporation based on continuing (normal) operations, without consideration for activities that are unusual and therefore unlikely to re-occur

Earnings per Common Share

Net income is often used by investors to evaluate a company’s profitability.

However, net income by itself is difficult to use when comparing companies of different sizes, or when using trend analysis to compare this year’s results to prior years’ results for the same company when there have been significant changes in stockholders’ equity.


Thus, the profitability of companies is often expressed as earnings per share.

Earnings per common share (EPS) is the net income per share of common stock outstanding during a period.


Net income Number of common shares outstanding*

Net income – Preferred stock dividends Number of common shares outstanding

*When the number of common shares outstanding has changed during a period, a weighted number of shares outstanding is used.

EPS =

or, if a company has preferred stock outstanding:

EPS =

Earnings per Common ShareCorporations whose stock is traded on a public exchange must report earnings per share on their income statements.When unusual items exist, earnings per share should be reported for those items separately. However, only earnings per share for income from continuing

operations is required to be reported on the face of the income statement.

The other per share amounts may be presented in the notes to the financial statements.

When corporations have complex capital structures with convertible preferred stock, options, warrants, etc., they are required to also report diluted earnings per share, which indicates the effect on earnings per share if such securities are converted to common shares.

Reporting Retained Earnings

Changes in retained earnings could be reported in any of the following ways:

in a separate retained earnings statement

in a combined income and retained earnings statement

in a statement of stockholders’ equity


When a separate retained earnings statement is prepared, the beginning balance in retained earnings is presented first. Next, if there are any “prior period adjustments” (material errors in a prior period’s net income that are not discovered until the current period), they are added or deducted from this beginning balance.


Net income is then added (or net loss deducted)

Dividends declared are deducted, and

The ending balance in retained earnings is reported.

The retained earnings statement resembles the statement of owner’s equity from Accounting 1.

Comprehensive Income

In 1997, FASB issued an accounting standard requiring corporations to report comprehensive income.

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

Comprehensive IncomeUnder this standard, companies must report traditional net income plus or minus other comprehensive income items.These items include foreign currency items, pension liability adjustments, and unrealized gains and losses on investments*.

unrealized gains and losses on investments is covered under short-term investments in stock later in the chapter

Comprehensive Income

Companies must report comprehensive income on the income statement or in a separate statement of comprehensive income,

or in the statement of stockholders’ equity

Note that comprehensive income does not

affect the determination of net income or retained earnings

Accounting for Investments in Stocks

Corporations may purchase the stock of other companies for a number of reasons:

to earn a return on excess cash to develop or maintain a business

relationship to gain control of another company

long-term

short-term

Accounting for Investments in StocksShort-Term Investments

A business may invest excess cash in income-producing equity securities (stock)These investments may be quickly sold and converted to cash as neededThese investments are recorded in a current asset account called Marketable Securities

Accounting for Investments in StocksShort-Term Investments: Journal Entries

June 1 Marketable Securities 180,000

Cash 180,000 Purchased 2,000 shares of XYZ Corp. stock at $89.75 plus $500 commission

Nov. 30 Cash 1,800

Dividend Revenue 1,800

Received dividend on XYZ stock (2,000 shares x $.90)

Accounting for Investments in StocksShort-Term Investments

On the balance sheet, temporary investments are reported at their fair market value Any difference between the fair market value and

cost is an unrealized gain or loss* and must be added to or deducted from cost

The unrealized gain or loss must also be reported as other comprehensive income on the income statement

*The gain or loss is unrealized because the securities must be sold in order for there to be a realized gain or loss.

Accounting for Investments in StocksLong-Term Investments

Long-term investments are not intended as a source of cash in the normal operations of the business

They are reported on the balance sheet under the caption “Investments,” which usually follows the Current Assets section

Accounting for Investments in StocksLong-Term Investments

There are two methods of accounting for long-term investments:

1. the cost methodused when the buyer (the investor) has less than 20% of the voting stock of the investee

2. the equity methodused when the buyer has 20% or more of the voting stock of the investee (a “significant influence” over the investee)

Accounting for Investments in StocksLong-Term Investments: The Cost Method

Mar. 1 Investment in ABC Corp. Stock 5,940

Cash 5,940

Purchased 100 shares of ABC Corp. common stock at 59 plus brokerage fee of $40

June 15 Cash 200

Dividend Revenue 200

Received dividend of $2 per share on ABC Corp. stock

Accounting for Investments in StocksLong-Term Investments: The Cost Method

Note that the only difference in the journal entries between the cost method used for long-term investments in stock and the journal entries used for short-term investments in stock is the account debited for the purchase of the stock

The entry to record the receipt of dividends is the same

Accounting for Investments in StocksShort-term vs. Long-term (cost method): Purchase

Marketable Securities XXX

Cash XXX

Investment in ABC Corp. Stock XXX

Cash XXX

short-term

long-term

(cost method)

Accounting for Investments in StocksShort-term vs. Long-term (cost method): Receipt of Dividends

Cash XX

Dividend Revenue XX

Cash XX

Dividend Revenue XX

short-term

long-term

(cost method)

Accounting for Investments in Stocks Long-Term Investments: The Equity Method

Under the equity method, a stock purchase is recorded in the same manner as it is under the cost method

The equity method differs from the cost method in the way in which net income and cash dividends of the investee are recorded


Purchase

Jan. 2 Investment in DEF Corp. Stock

350,000

Cash 350,000

Purchased 40% of DEF Corp. common stock.

Accounting for Investments in Stocks Long-Term Investments: The Equity MethodInvestee (DEF Corp.) Reports Net Income*

Dec. 31 Investment in DEF Corp. Stock

42,000

Income of DEF Corp. 42,000

Recorded our share (40%) of DEF Corp. net income of $105,000.

*This entry does not exist under the cost method of accounting for long-term investments in stock.


Investee (DEF Corp.) Pays Dividends

Dec. 31 Cash

18,000

Investment in DEF Corp. stock* 18,000

Recorded our share (40%) of dividends of $45,000 paid by DEF Corp.

*Under the cost method, the credit would be to Dividend Revenue.


Since the investor exerts a “significant influence” over the investee by owning 20% or more of the voting stock, the investor’s share of the periodic net income of the investee is recorded as an increase in the investment account and as revenue for the period AND

The investor’s share of cash dividends from the investee is recorded as an increase in the cash account and a decrease in the investment account

Accounting for Investments in StocksSale of Investments

The accounting for the sale of stock is the same for both short-term and long-term investments

When shares of stock are sold, the investment account is credited for the carrying amount (book value) of the shares sold, the cash or receivables account is debited for the proceeds, and any difference between the proceeds and the carrying amount is recorded as a gain or loss on the sale

Accounting for Investments in StocksPurchase of Investment

On Feb. 27, Gourmet Corp. acquired 3,000 shares of the 50,000 shares (less than 20%) of Goulash Co. common

stock at 58 plus a commission charge of $420.

Feb. 27 Investment in Goulash 174,420

Cash 174,240

Purchased 3,000 shares of Goulash Co. stock. [($58 x 3,000 shares) + $420]

Accounting for Investments in StocksReceipt of Dividends

On July 8, a cash dividend of $1 per share and a 2% stock dividend were received.

July 8 Cash 3,000

Dividend Revenue 3,000

Received dividend on Goulash Co. common stock ($1 x 3,000 shares)

No entry for stock dividends; carrying amount per share is now $57 ($174,240 / (3,000 shares + 60 shares from the stock dividend)

Accounting for Investments in StocksSale of Investment

On Dec. 7, 1,000 shares were sold at 62, less commission charges of $375.

Dec. 7 Cash 61,625

Investment in Goulash 57,000*

Gain on Sale of Investment 4,625

*1,000 shares x $57 carrying value per share

Business CombinationsMerger Consolidation Parent/

Subsidiary

dissolution acquired corp. is dissolved

original corps. dissolved, new one

formed

neither is dissolved

# of businesses after combination

1 1 2

# of financial statements prepared

1 1 consolidated (combined) statements

required

Price-Earnings Ratio

The assessment of a firm’s growth potential and future earnings prospects is indicated by how much the market is willing to pay per dollar of a company’s earnings

A high P/E ratio indicates that the market expects high growth and earnings in the future


The price-earnings ratio on common stock is computed by dividing the stock’s market price per share at a specific date by the company’s annual earnings per share:

P/E ratio = Market price per share

Earnings per share


A P/E ratio of 10 for a company indicates that the market was willing to pay ten times the earnings per share for a share of stock in this company

Chapter 13: New Accountsaccount category normal balance

Marketable Securities

Current Asset debit

Dividend Revenue

Revenue credit

Investment in X Co. Stock

Investment (non-current

asset)

debit

Gain on sale of investment

revenue credit

Loss on sale of investment

expense debit

chapter 14 lecture income taxes, unusual income items, and investments in stocks p.h

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