chapter 10 other items that affect net income and owners’ equity mcgraw-hill © 2004 the...
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Chapter 10Chapter 10
Other Items That Affect Net Other Items That Affect Net Income and Owners’ EquityIncome and Owners’ Equity
McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved.
10-10-22
Components of Owners’ EquityComponents of Owners’ Equity
Common stock.Common stock. Preferred stock.Preferred stock. Direct debits.Direct debits. Direct credits.Direct credits.
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Topics in chapterTopics in chapter
Nonowner transactions affecting OE.Nonowner transactions affecting OE. Disclosure requirements.Disclosure requirements. Extraordinary items.Extraordinary items. Discontinued operations.Discontinued operations. Accounting changes.Accounting changes. Accounting errors.Accounting errors. Foreign currency translation adjustments.Foreign currency translation adjustments. Derivatives.Derivatives.
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Reporting RequirementReporting Requirement
Total nonowners changes in owners’ Total nonowners changes in owners’ equity (OE), which is sum of:equity (OE), which is sum of: Net income.Net income. Other nonowner changes in OE.Other nonowner changes in OE.
• Accumulated balances of unrealized gains and Accumulated balances of unrealized gains and losses on available-for-sale securities (Chapter 5).losses on available-for-sale securities (Chapter 5).
• Net investment translation adjustments.Net investment translation adjustments.• Gains and losses on certain derivatives.Gains and losses on certain derivatives.• Other items (not addressed).Other items (not addressed).
Considerable leeway in reporting format.Considerable leeway in reporting format.
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Extraordinary ItemsExtraordinary Items
Criteria:Criteria: Unusual: highly abnormal and unrelated to Unusual: highly abnormal and unrelated to
ordinary activities of entity.ordinary activities of entity. Infrequent: not reasonably expected to recur Infrequent: not reasonably expected to recur
in foreseeable future.in foreseeable future. Reported on Income Statement:Reported on Income Statement:
After income from continuing operations andAfter income from continuing operations and Net of income tax effect .Net of income tax effect .
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Not Extraordinary itemsNot Extraordinary items
Write-downs or write-offs of AR, inventory, Write-downs or write-offs of AR, inventory, or intangible assets.or intangible assets.
Gains or losses from exchange rate Gains or losses from exchange rate changes.changes.
Gains or losses on disposal of segment of Gains or losses on disposal of segment of a business.a business.
Gains or losses from disposal of fixed Gains or losses from disposal of fixed assets.assets.
Effects of a strike.Effects of a strike.
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Discontinued OperationsDiscontinued Operations
Discontinuance of a division or other Discontinuance of a division or other identifiable segment of a business.identifiable segment of a business.
Must involve a whole business unit, not Must involve a whole business unit, not one asset or a product line.one asset or a product line.
May be abandoning segment and selling May be abandoning segment and selling off assets (usually at a loss) oroff assets (usually at a loss) or
Selling off the segment (for a gain or a Selling off the segment (for a gain or a loss).loss).
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Accounting for DiscontinuanceAccounting for Discontinuance
If loss is expected:If loss is expected: Record in period in which decision is made.Record in period in which decision is made. Estimation of loss requires estimating:Estimation of loss requires estimating:
• Revenues less expenses until disposition.Revenues less expenses until disposition.• Proceeds of sale.Proceeds of sale.• Book value of assets disposed of.Book value of assets disposed of.
If gain is expected: do not recognize until If gain is expected: do not recognize until realized.realized.
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Discontinued OperationsDiscontinued OperationsIncome Statement PresentationIncome Statement Presentation
Reported net of tax in 2 amounts:Reported net of tax in 2 amounts: Net income or loss attributable to operations Net income or loss attributable to operations
of segment until it is sold.of segment until it is sold. Estimation of gain or loss on disposal arising Estimation of gain or loss on disposal arising
from all aspects of sale.from all aspects of sale.
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Change in Accounting PrinciplesChange in Accounting Principles
Consistency concept requires using same Consistency concept requires using same accounting principle year after year.accounting principle year after year.
Can change only if there is a sound Can change only if there is a sound reason.reason.
Retained earnings adjusted to reflect Retained earnings adjusted to reflect cumulative effect.cumulative effect.
Shown on income statement as Shown on income statement as nonrecurring item.nonrecurring item.
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Adjustments to Retained EarningsAdjustments to Retained Earnings
Prior period adjustments to Retained Prior period adjustments to Retained Earnings:Earnings: Limited by FASB to only corrections of Limited by FASB to only corrections of
accounting errors defined as:accounting errors defined as:• Mathematical mistakes, mistakes in the application Mathematical mistakes, mistakes in the application
of accounting principles, or oversight or misuse of of accounting principles, or oversight or misuse of facts that existed at the time the financial facts that existed at the time the financial statements were prepared.statements were prepared.
• A change from a principle that is not generally A change from a principle that is not generally accepted to one that is … is a correction of an accepted to one that is … is a correction of an error.error.
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Personnel CostsPersonnel Costs
Wages and salaries earned by employees Wages and salaries earned by employees and other costs related to their services. and other costs related to their services.
Deducted from gross earnings before Deducted from gross earnings before payment (and not a cost of the employer): payment (and not a cost of the employer): FICA contributions for Social Security and FICA contributions for Social Security and
Medicare.Medicare. Withholding for federal and state income Withholding for federal and state income
taxes.taxes. Deductions for union dues, ….Deductions for union dues, ….
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Fringe BenefitsFringe Benefits
Provided and paid for by employer to Provided and paid for by employer to employees. Possibilities include:employees. Possibilities include:
Pensions, life insurance, health care, sick Pensions, life insurance, health care, sick pay, vacations.pay, vacations.
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PensionsPensions
Payments received by employees after Payments received by employees after they retire.they retire.
Typically 5%-10% of payroll.Typically 5%-10% of payroll.
Regulated under ERISA.Regulated under ERISA. In most cases pensions must be partially In most cases pensions must be partially
funded.funded.
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Types of Pension PlansTypes of Pension Plans
Defined contribution plan:Defined contribution plan: Employer contributes an agreed amount.Employer contributes an agreed amount. No promise as to how much benefits will be.No promise as to how much benefits will be.
Defined benefit plan:Defined benefit plan: Employer agrees to contribute an amount so Employer agrees to contribute an amount so
that employees will receive a specified that employees will receive a specified amount.amount.
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Pension CostPension Cost
Complicated determination for a defined benefit Complicated determination for a defined benefit plan. Must estimate:plan. Must estimate: How many years employees will work.How many years employees will work. Employee turnover.Employee turnover. Average employee earnings.Average employee earnings. How many years employees live after retirement.How many years employees live after retirement. Inflation.Inflation. Earnings on invested pension funds.Earnings on invested pension funds. Other factors.Other factors.
Determination is extremely complicated and Determination is extremely complicated and uses present value (PV) concept.uses present value (PV) concept.
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Components of Pension CostComponents of Pension Cost
Service cost: PV of future benefits employees Service cost: PV of future benefits employees earned during year.earned during year.
Interest cost: amount by which plan’s beginning Interest cost: amount by which plan’s beginning of year obligations has increased.of year obligations has increased.
Return on plan assets: Offsetting element, Return on plan assets: Offsetting element, assumed gain on plan assets over the long run.assumed gain on plan assets over the long run.
Prior service cost: considers employees service Prior service cost: considers employees service prior to initiation (or change) of plan.prior to initiation (or change) of plan.
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Pension Plan EntriesPension Plan Entries
Cost is $500,000:Cost is $500,000:
Net pension costNet pension cost 500,000 500,000Accrued pension cost (liability)Accrued pension cost (liability) 500,000500,000
Employer contributions are $450,000:Employer contributions are $450,000:
Accrued pension costAccrued pension cost 450,000 450,000CashCash 450,000 450,000
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Pension DisclosuresPension Disclosures
Period’s net pension cost.Period’s net pension cost. Unfunded plan position for each defined Unfunded plan position for each defined
benefit plan.benefit plan. Four components of net pension cost.Four components of net pension cost. Assumptions of calculations of a plan’s Assumptions of calculations of a plan’s
funding position.funding position.
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Other Post Retirement BenefitsOther Post Retirement Benefits
E.g., healthcare, life insurance.E.g., healthcare, life insurance.
Present value of a portion of these costs Present value of a portion of these costs are expensed.are expensed.
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Compensated AbsencesCompensated Absences
Future compensated absences:Future compensated absences: Vacation and sick leave earned this year but Vacation and sick leave earned this year but
taken next year.taken next year. Expensed in period earned. dr expense cr Expensed in period earned. dr expense cr
accrued liability.accrued liability.
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Income Tax ExpenseIncome Tax Expense
Tax expense for current year consists of:Tax expense for current year consists of: Current income tax expense (this year’s tax Current income tax expense (this year’s tax
bill) andbill) and Deferred income tax expense.Deferred income tax expense.
Income tax expenseIncome tax expense 100 100
Taxes payableTaxes payable 80 80
Deferred income taxes liabilityDeferred income taxes liability 20 20
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Book-to-Tax DifferencesBook-to-Tax Differences
Arises because for some items tax Arises because for some items tax accounting differs from book (GAAP).accounting differs from book (GAAP).
Taxable income: income reported to tax Taxable income: income reported to tax authorities to compute income tax.authorities to compute income tax.
Pretax accounting income = pretax book Pretax accounting income = pretax book income = income before taxes: income income = income before taxes: income before tax under GAAP.before tax under GAAP.
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Why Do Book and Taxable Income Why Do Book and Taxable Income Differ?Differ?
Objective of tax accounting: raise taxes Objective of tax accounting: raise taxes and encourage behavior. E.g., accelerated and encourage behavior. E.g., accelerated depreciation to encourage investment.depreciation to encourage investment.
Objective of GAAP/Financial reporting: Objective of GAAP/Financial reporting: Provide info useful to investors.Provide info useful to investors.
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Permanent Differences Between Permanent Differences Between Book and TaxBook and Tax
Do not reverse in future years.Do not reverse in future years. Expenses under GAAP that are not Expenses under GAAP that are not
deductible. (E.g., fines.)deductible. (E.g., fines.) Revenues excluded from taxable income. Revenues excluded from taxable income.
(E.g., revenue on municipal bonds)(E.g., revenue on municipal bonds) Does not create accounting problems.Does not create accounting problems.
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Temporary Difference between Temporary Difference between Book and TaxBook and Tax
Differences that reverse or turnaround in a Differences that reverse or turnaround in a later period.later period.
Revenues or expenses that are permitted Revenues or expenses that are permitted or required to be reported in a different or required to be reported in a different period. E.g., depreciation.period. E.g., depreciation.
Creates accounting complexities in order Creates accounting complexities in order to match income tax expense to period in to match income tax expense to period in which revenue or expense item is which revenue or expense item is recognized.recognized.
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Deferred Tax ReportingDeferred Tax Reporting
Deferred Income Taxes: liability account.Deferred Income Taxes: liability account. Shown separately from Taxes payable.Shown separately from Taxes payable.
Indicates the amount that future tax expense Indicates the amount that future tax expense will be reduced when differences between will be reduced when differences between book and tax reverse.book and tax reverse.
Interest free loan from the government.Interest free loan from the government. Increases as long as company grows.Increases as long as company grows.
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Deferred Tax AssetsDeferred Tax Assets
Temporary differences resulting in Taxable Temporary differences resulting in Taxable income higher than book:income higher than book: Warranty expensed when revenue Warranty expensed when revenue
recognized for book, when actually paid for recognized for book, when actually paid for tax.tax.
Subscription receipts recognized when Subscription receipts recognized when received for tax, when earned for book.received for tax, when earned for book.
Tax-loss carryforwards: cannot exceed Tax-loss carryforwards: cannot exceed amount of expected future tax benefits.amount of expected future tax benefits.
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Tax Rate Changes and DisclosuresTax Rate Changes and Disclosures
New deferrals recorded based on rates New deferrals recorded based on rates currently in tax law.currently in tax law.
Disclosures:Disclosures: Deferred tax asset and liability amounts Deferred tax asset and liability amounts
shown separately.shown separately. Must be classified appropriately as current or Must be classified appropriately as current or
noncurrent.noncurrent.
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Foreign Currency TransactionsForeign Currency Transactions
Fluctuating foreign currency exchange rates Fluctuating foreign currency exchange rates cause changes in values of receivable and cause changes in values of receivable and payables. Accounting requirements:payables. Accounting requirements: Transactions are recorded at the exchange rate in Transactions are recorded at the exchange rate in
effect at the time the transaction is recognized.effect at the time the transaction is recognized. At each balance sheet date, recorded balances are At each balance sheet date, recorded balances are
adjusted to the current (i.e., spot) exchange rate.adjusted to the current (i.e., spot) exchange rate. Gains and losses are included in net income in the Gains and losses are included in net income in the
period in which they are incurred.period in which they are incurred.
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Foreign Currency TranslationForeign Currency Translation
Foreign subs records kept in local (foreign) Foreign subs records kept in local (foreign) currency.currency.
To consolidate with other operations, must To consolidate with other operations, must be translated into dollars (reporting be translated into dollars (reporting currency).currency).
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Functional CurrencyFunctional Currency
Currency of the primary economic environment Currency of the primary economic environment in which the company operates.in which the company operates.
Selection of functional currency effectively Selection of functional currency effectively determines which translation method is used.determines which translation method is used.
If functional currency is the local currency:If functional currency is the local currency: Translate using the net investment or current rat Translate using the net investment or current rat
method.method.
If functional currency is the dollar:If functional currency is the dollar: Translate using the remeasurement or temporal Translate using the remeasurement or temporal
method.method.
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Current Rate MethodCurrent Rate Method
All assets and liabilities translated at the All assets and liabilities translated at the exchange rate at balance sheet date.exchange rate at balance sheet date.
All revenue and expense items are translated at All revenue and expense items are translated at the weighted average exchange rate.the weighted average exchange rate.
Balance sheet differences arising from Balance sheet differences arising from translation do not go through income but are translation do not go through income but are recorded directly to stockholders’ equity in an recorded directly to stockholders’ equity in an account such as “Cumulative Translation account such as “Cumulative Translation Adjustment.”Adjustment.”
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RemeasurementRemeasurement
Objective: report foreign sub’s financial Objective: report foreign sub’s financial statement amounts as if activities were carried statement amounts as if activities were carried out by parent and recorded on parent’s books.out by parent and recorded on parent’s books.
Most items are translated at same rate as Most items are translated at same rate as current rate method. Exceptions:current rate method. Exceptions: Long-lived assets and inventory are translated using Long-lived assets and inventory are translated using
the rate at date acquired (historical rate).the rate at date acquired (historical rate). Expenses related to these assets (depreciation and Expenses related to these assets (depreciation and
cost of goods sold) also translated at historical rate.cost of goods sold) also translated at historical rate. Gains and losses arising from remeasurement are Gains and losses arising from remeasurement are
included in income.included in income.
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DerivativesDerivatives
A financial instrument or other contract A financial instrument or other contract that derives its value by direct references that derives its value by direct references to the changes in value of one or more to the changes in value of one or more underlyings.underlyings.
Underlyings can be: return or yield on Underlyings can be: return or yield on another security, price of a share, an another security, price of a share, an interest or exchange rate.interest or exchange rate.
Used to hedge risk of changes in interest Used to hedge risk of changes in interest rates, commodities, exchange rates….rates, commodities, exchange rates….
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Accounting for DerivativesAccounting for Derivatives
Recognized as assets or liabilities and Recognized as assets or liabilities and measured at fair value.measured at fair value.
Underlying gains and losses included in Underlying gains and losses included in net income except when designated as net income except when designated as and qualifying as a type of hedge. and qualifying as a type of hedge. Accounting can be complex.)Accounting can be complex.)
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Pro Forma EarningsPro Forma Earnings
At discretion of management.At discretion of management. Supplements GAAP Income Statement.Supplements GAAP Income Statement. Excludes certain items such as merger Excludes certain items such as merger
related charges, non-recurring items and related charges, non-recurring items and goodwill impairment write-offs.goodwill impairment write-offs.
SEC insists they are not misleading.SEC insists they are not misleading.
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Net IncomeNet Income
Bottom line of Income Statement.Bottom line of Income Statement. Never appears on any other line.Never appears on any other line. Net addition to Retained Earnings during Net addition to Retained Earnings during
accounting period whether arise from accounting period whether arise from operations or other times.operations or other times.