Selected Topics first

1
Selected Topics first

• I want to cover some of the more difficult topics
  first
• If dont get to all the slidesthe entire
  lecture will be posted to the course web site

2
EQUIPMENT

• What depreciation methods does the Company use
  for these assets? What estimated useful lives
  have been used for these assets in the past? Are
  depreciation methods the same for book and tax?
• For book purposes, a straight-line basis over 5
  years for equipment and over 6 years for crew
  trucks is used. For tax purposes, the client
  records depreciation using MACRS for the trucks.
• The Net Book Value of the trucks exceeds the tax
  basis at the end of Year 20X3--resulting in a
  Deferred Tax Liability (long-term) that will soon
  start reversing!

3
LEASED ASSETS

• Why has the lease been recorded (capitalized) as
  an asset of 380,000 and a liability of
  380,000?
• GAAP Rule The lease has been recorded as an
  asset because SFAS No. 13 requires that leases
  with terms that exceed 75 of the estimated
  economic life receive such treatment.(Lease life
  and building life are both 20 years)
• Conceptually this is like an installment loan
  to purchase the assets with rewards and risks
  of ownership passing to Hydromaintthe leasee
• What type of asset is being leased?
• Shop and office building

4
LEASED ASSETS

• Is the asset being depreciated (amortized)? If
  so, how and over what period of time? Is the
  depreciation the same for book and tax? How are
  deferred taxes impacted?
• Yes, the capital lease asset is depreciated on a
  straight line basis at 19,000 per year over the
  20 years.
• For tax purposes the leases are operating, so no
  depreciation is allowed.
• Deferred tax ASSET (long-term) created by the
  temporary difference related to the lease
• the net book value of the capitalized lease (net
  book value of lease asset less both principal
  balance on lease obligation and less Accrued
  Interest Payable) is less than the tax basis
  (Prepaid Rent) of the lease at the end of 20X3 OR
• Depreciation Expense Interest Expense
  deductions on Books is GREATER than Rent Expense
  on Tax Return in Early years of Leasethus the
  Government Owes Hydromaint some future tax
  deductions.
• This is similar to Bad Debt Expense

5
ACCRUED PENSION LIABILITY

• Is this the Projected Benefit Obligation (PBO)?
• NO, the PBO (and the plan assets) only appears in
  the note disclosure
• How is this Accrued Pension Liability
  calculated?
• Normally Cumulative Pension Expense that has
  been recorded over the years vs. Cumulative
  Employer Cash Contributions to Plan Trustee
  
• However in Year 3 needed to Increase the
  recorded Accrued Pension Liability amount to
  get the liability up to the Minimum Pension
  Liability (excess of ABO over plan assets). ABO
  (Accumulated Benefit Obligation using existing
  salary rates is only used to compute the
  Minimum Pension Liability

6
DEFERRED PENSION COSTS

• How does the client get the amount to record this
  asset?
• This amount is the difference between the Accrued
  Pension Liability that exists from the regular
  pension entry and the minimum pension liability
  that must be reported (excess of ABO vs. Fair
  market value of pension fund assets)
• What exactly is this asset? Is it a tangible
  asset?
• This is an intangible asset that represents the
  future benefit that Hydromaint expects to receive
  from its employees for the work that they will
  perform in the future. The increase in the
  intangible asset (other side of entry to increase
  Accrued Pension Liability up to amount needed to
  meet Minimum Liability Requirement) is
  supposedly due to not yet funding all the Prior
  Service Cost. The prior service retirement
  benefits given to existing employees for their
  past work is suppose to make them happy
  employees and supposedly do good work in the
  future (i.e., intangible asset).

7
DEFERRED PENSION COSTS

• Is this Deferred Pension Costs asset amortized?
• No, it is adjusted annually based on the required
  change needed for the minimum pension liability
  in the Accrued Pension Liability account.
• Are there any book/tax differences related to
  this asset?
• No, per Linda Dirkee the tax treatment is the
  same as the book treatment

8
DEFERRED TAXES

• How is the Deferred Tax Liability or Asset
  journal entry for the year calculated?
• This amount represents the change in the
  difference between book and tax basis between
  years multiplied by the tax rate.
  OR
• Temporary differences between current years tax
  return revenue and expenses VS. current years
  Income Statement revenue and expenses multiplied
  by the tax rate
• Has the client had any problems recording this
  liability in the past?
• Yes, the client has had problems with tax entries
  in every year of the engagement.

9
DEFERRED TAXES

• What permanent and temporary differences has
  Hydromaint encountered in the past?
• Temporary differences
• accounts receivable (why?)
• truck depreciation (why?)
• Building lease (why?)
• trading securities (why?)
• Permanent differences
• dividends received deduction (why?)

10
20X3 Correcting Entries
11
20X3 Correcting Entries
12
20X3 Correcting Entries
Accrued Pension Liability (411)
110,000 Pension Expense (604)

110,000 Correct Jerrys entry for
employers cash contribution. ____________________
___________________________________ Pension
Expense (604)
127,575 Accrued Pension Liability (411)
127,575
Record pension expense for year
3. _______________________________________________
________ Deferred Pension Cost (216)
80,499 Accrued Pension
Liability (411)
80,499 Increase Accrued Pension
Liability up to need Minimum Required
Liability balance of 98,074. ___________________
____________________________________

13
20X3 CORRECTING ENTRIES

• TAX Entries
• Current Taxes Payable (312) 23,047
• Income Tax Expense (821)
  23,047
• Reverse clients tax entry
• Income Tax Expense (821) 26,646
• Current Taxes Payable (312)
  12,983
• Deferred Income Taxes L-T (421) 12,103
• Deferred Income Taxes S-T (141) 1,560
• (See Year Threes Work Papers OR Correcting
  Journal Entries for Year 3 for supporting detail
  of Tax Entries)

14
REVIEW OF YEAR 3

• General Questions about our engagement and the
  client
• Review of Balance Sheet
• Review of Correcting Entries

15
Questions about Client CPA Firm

• Who are the two principal owners of Hydromaint?
• Nick Riley (mechanical engineer)
• Ray Ballard (former manager of City Water
  District)
• Other relatives provided angel capital
• What service does Hydromaint perform?
• Provide hydraulic maintenance services on a
  contract basis to water districts, oil pipe line
  companies, chemical plants, refineries
• Who is the controller?
• Jerry Loos (we recommended himindependence
  issue!)
• What is the name of the CPA firm we work for?
• Coe Lane (CL) St. Louis office of Regional
  CPA firm.

16
Questions about Client CPA Firm

• Who is the partner on the Hydromaint engagement?
  How did he get this client?
• Tom Lockhart (play tennis racquetball with Nick
  Riley, and estate work)
• Who is the tax person from our firm who is
  assigned to Hydromaint?
• Linda Dirkee
• What level of service are we providing for
  Hydromaint? Why does client require it?
• REVIEW through Year 3 (Starting in Year 4 it
  will be an AUDIT Why?)
• Bank Loan Agreement (to get financing for trucks)
  requires it
• Bank Loan Officer that Hydromaint deals with
• Roger Sontag

17
Questions about Client CPA Firm

• What two procedures does a REVIEW entail?
• Inquiries
• Analytical Procedures
• What are analytical procedures? What is an
  example of an analytical procedure for
  Hydromaint?
• Analytical Procedures ratio and trend analysis
• Compare over time the percentage of Allowance to
  Total A. R.
• What does a REVIEW report look like?
• Link to Boilerplate Report from SSARS 1

18
Questions about Client CPA Firm

• How would you determine the amount we charged
  Hydromaint for last years Review?
• Look in general ledger account 609 SELLING
  ADMIN PROFESSIONAL FEES and find our invoice
• Why else might we look at every invoice (even if
  not material in amount in that particular
  account)?
• Find invoices from attorneys the client engaged.
  We want to be aware of them and what cases they
  were working on.

19
ACCOUNTS RECEIVABLE

• Where do the Companys receivables come from?
• The receivables represent unpaid amounts owed to
  Hydromaint, Inc. for the rendering of maintenance
  services. These usually are related to the
  month-to-month operating agreements.

20
ACCOUNTS RECEIVABLE

• What is the correct method of valuing Accounts
  Receivable (i.e., what should the Balance Sheet
  show for Accounts Receivable)?
• Net Realizable Value (NRV)
• Therefore, which related account have we been
  dealing with because of the VALUATION issue for
  Hydromaints Accounts Receivable?
• Adequacy of the allowance for uncollectible
  accounts
• Is there a tax issue related to the Receivables?
• YES, Hydromaint uses Allowance method of
  estimating bad debt expense on the books but
  uses the Direct write-off method for tax
  purpose.
• Thus, deferred tax asset (current asset) exists
  because Hydromaint is entitled to future tax
  deductions

21
INVENTORY

• What does the client include in this asset
  classification?
• Shop supplies held for use in providing
  maintenance services.
• Pumps and Valves for SALE starting in Year 4
• Has the client previously had any problems
  accounting for this asset in the past?
• Yes, in Year 1 the client did not inventory these
  at year-end and expensed all items purchased.
• What is the proper method for VALUATION of
  Inventories?
• LCM

22
SUPPLIES

• What cost flow assumptions does the client use
  with respect to this asset?
• FIRST IN, FIRST OUT (FIFO)

23
TRADING SECURITIES

• At what VALUE are these securities reported?
• Market value under SFAS No. 115 since Hydromaint
  considers them to be trading securities.
• Actually they do NOT really appear to meet the
  requirements for Trading Securities
  classification. More likely they really belong
  in the Available for Sale classification.
• What are the similarities and differences between
  the accounting for the Trading Securities vs. the
  Available for Sale Securities?
• Both have asset value marked to market
• Trading Securities unrealized gain/loss through
  Income Statement
• Available for Sale Securities
• Unrealized gain/loss NOT included on Income
  Statement
• Unrealized gain/loss directly to Stockholders
  Equity on Balance Sheet (and also considered part
  of Comprehensive Income)

24
EQUIPMENT

• What types of equipment has the Company recorded
  on its books?
• Shop Equipment, Trucks and related improvements
• What problem has the client had in the past with
  recording the proper amounts in this asset
  category?
• Hydromaint has previously incorrectly expensed as
  Repair and Maintenance Expense costs of 30,000
  that should have been capitalized as an asset.
• World Com did just the opposite
• Auditors frequently test large amounts in both
  Asset RM Expense accounts looking for improper
  capitalization of costs

25
LICENSING COSTS

• What is this asset?
• Licensing fees incurred in 20X1 to obtain certain
  equipment usage rights.
• Is this asset depreciated? If so over what
  period of time?
• The asset is amortized over 5 years on a straight
  line basis.
• Are there any book/tax differences related to
  this asset?
• No, the treatment is the same for both book and
  tax.

26
ACCOUNTS PAYABLE

• What types of liabilities does the client include
  in this liability class?
• Principally, payables incurred for the
  acquisition of maintenance supplies inventory.
• Remember for the Direct Method of Calculating
  Cash from Operations The Cash Paid to Vendors
  Cost of Services Expense /- Change in Inventory
  /- Change in Accounts Payable

27
UNEARNED CONTRACT REVENUE

• What comprises this financial statement
  liability?
• The amount represents cash collected in advance
  on maintenance agreements for which future
  services must be rendered.
• Why is the amount constant between 20X2 and
  20X3?
• The amount is the same because all contracts with
  advance payments remained the same between the
  two years.

28
INCOME TAX PAYABLE

• What does this 6,041 liability actually
  represent? Is it the total tax liability due
  this year?
• It is the current tax liability due and unpaid in
  the current year.It is the beginning balance of
  1,210 plus the 12,983 increase for the year
  (per our tax entry) minus the 8,152 cash payment
  made during the year.
• Has the firm had any problems properly recording
  the income tax payable in the past?
• Yes. The client has needed assistance every year
  in recording tax expense and the related assets
  and liabilities correctly.

29
SHORT-TERM PORTION OF LONG TERM DEBT

• What liabilities does this category include?
• Principal payments for the bank note and the
  capital lease that are due in the next 12 months.
  The current amount is 55,534 (87,384 - 31,850
  interest) for the bank note and 6,503 (41,000 -
  34,497 interest) for the capital lease.

30
INTEREST PAYABLE

• Why is this classification necessary?
• This account is necessary to record the amount of
  interest that is due but unpaid at the end of the
  fiscal year. Recording accruals reflects the
  application of the matching principle.
• What liabilities does the category include?
• The bank note (29,196 for 11 months) and the
  capital lease (20,123 for 7 months).

31
NOTE PAYABLE

• To whom does the Company owe this money and why?
• Midwest National Bank loan to purchase Trucks
• What are the terms and covenants of the loan
  agreement?
• Five Annual payment of 87,384 beginning Feb. 1,
  20X3 (ordinary annuity)
• Annual financial statements must be reviewed by a
  CPA.
• Dividends may not be distributed unless earnings
  exceed five times interest.
• Loans may not be made to either Mr. Ballard or
  Mr. Riley.
• Salary increases for either Mr. Ballard or Mr.
  Riley must be approved by the bank.
• (WHY the last three loan covenants?)

32
CAPITAL LEASE LIABILITY

• To whom does the Company owe this money?
• The property lessor.
• What are the terms and covenants?
• There are no covenants, but the lease calls for
  annual payments of 41,000 for 20 years beginning
  on 6/1/X3 (annuity due)
• Are there any tax issues related to this debt?
• Yes. As previously noted, the lease is
  capitalized for book purposes, but not for tax
  purposes. This results in a temporary difference.

33
OTHER QUESTIONS

• What were the major accounting issues confronted
  by you during Hydromaints first three years?
• Accounting for Contingencies (Bad Debts)
• Trading securities
• Accounting for investments
• Lease Capitalization
• Interest capitalization
• Temporary differences for PPE and lease
  capitalization
• Bank debt and related covenants
• Pensions
• Contract revenue recognition
• (ALL OF THESE TOPICS YOU LEARNED BY
  ENCOUNTERING THEM IN A REAL-WORLD CONTEXTNOT THE
  TRADITIONAL LECTURE.
• THE LEARNING PROCESS SHOULD SERVE YOU WELL
  IN THE FUTURE!)