Income Taxes, Unusual Income Items, and Investments in Stocks

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14
Income Taxes, Unusual Income Items, and
Investments in Stocks
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After studying this chapter, you should be able
to

• Journalize the entries for corporate income
  taxes, including deferred income taxes.

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

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After studying this chapter, you should be able
to

• 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.

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14-1
Objective 1
Journalize the entries for corporate income
taxes, including deferred income taxes.
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14-1
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
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Ratio of Reported Income Tax Expense to Earnings
Before Taxes for Selected Industries
Automobiles 33 Banking 35 Computers 23 Food 35 In
tegrated oil 39 Pharmaceuticals 30 Retail 39 Telec
ommunication 37 Transportation 38
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14-1
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.
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14-1
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.

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14-1

• 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.

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14-1
Exhibit 1 Temporary Differences
MACRS (tax depreciation)
Straight-line (financial statement depreciation)
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Total depreciation is the same for tax and
financial purposes.
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14-1
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.
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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
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14-1
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
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14-1
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 years taxes.
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14-1
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For Practice PE 14-1A, PE 14-1B
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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.

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14-2
Objective 2
Describe and illustrate the reporting of unusual
items on the income statement.
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14-2
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
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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.
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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.

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14-2
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.
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Reporting of Unusual Items on the Income Statement
Fixed asset impairments
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14-2
Unusual Items in the Income Statement
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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
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Restructuring Charges
Restructuring charges are costs incurred with
actions such as canceling contracts, laying off
or relocating employees, and combining
operations.
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14-2
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.
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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.
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14-2
Twenty five employees find employment elsewhere
and leave the company on March 25. Payment is
made to these employees on that date.
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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.
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14-2
Reporting of Unusual Items on the Income Statement
Restructuring charges
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14-2
Unusual Items in the Income Statement
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14-2
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.
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Dec. 20 Loss on Fixed Asset
Impairment 180,000 Equipment 180,000
20 Restructuring Charge 560,000 Employ
ee Termination Obligation 560,000
80 employees x 7,000
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For Practice PE 14-2A, PE 14-2B
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14-2
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
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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.
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14-2
Reporting of Unusual Items on the Income Statement
Discontinued operations
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14-2
Unusual Items in the Income Statement
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14-2
Reporting Unusual Items on the Income Statement
Unusual items that adjust income from continuing
operations in determining net income are
Discontinued operations Extraordinary items
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14-2
Extraordinary Items
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.

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

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14-2
14-2
Reporting of Unusual Items on the Income Statement
Unusual items affecting prior period income
statements
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14-3
Objective 3
Prepare an income statement reporting earnings
per share data.
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14-3
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.
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14-3
If there is no preferred stock
If there is preferred stock
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14-3
Income Statement with Earnings per Share
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14-3
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.
2,000 shares x 100 par value x 9 18,000
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For Practice PE 14-3A, PE 14-3B
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14-4
Objective 4
Describe the concept and the reporting of
comprehensive income.
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14-4
Comprehensive Income
Comprehensive income is defined as all changes in
stockholders equity during a period, except
those resulting from dividends and stockholders
investments.
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14-4
Other comprehensive income items include foreign
currency items, pension liability adjustments,
and unrealized gains and losses on investments.
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14-4
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.
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14-4
Statement of Comprehensive Income
Triple-A Enterprises, Inc. reported comprehensive
income on a separate statement as follows
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
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14-4
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

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14-4
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.
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14-4

• 86,500 74,000 12,500
• 499,000 425,000 74,000
• c) 69,500 57,000 12,500

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For Practice 14-4A, 14-4B
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14-5
Objective 5
Describe the accounting for investments in stocks.
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14-5
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.
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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.
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When a business invests in available-for-sale
securities, such investments are classified as
temporary investments or marketable securities.
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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.

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14-5
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.
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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).
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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.
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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 2
10,000 30,000 Bass Co. 160,000
150,000 (10,000) Total 690,000 750,000 60,00
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Temporary Investments on the Balance Sheet
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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.
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For Practice 14-5A, 14-5B
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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.
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Accounting for Long-Term Stock Investments
Is there a significant influence over the
investee?
No
Yes
Account for the investment by using the equity
method
Account for the investment as an
available-for-sale security
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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.
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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.
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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.
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14-5
Investments and Dividends
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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
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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?
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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
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For Practice 14-6A, 14-6B
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14-5
14-5
Financial Analysis and Interpretation
A firms growth potential and future earnings
prospects are indicated by how much the market is
willing to pay per dollar of a companys
earnings. This ratio, called the price-earnings
ratio, or P/E ratio, is commonly included in
stock market quotations.
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The price-earnings ratio represents how much the
market is willing to pay per dollar of a
companys earnings. This indicates the markets
assessment of a firms growth potential and
future earnings prospects.
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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.
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