BY R A C H E L L E A G AT H A , C PA , M B A

Income Taxes, Unusual Items, Investments in

Stocks

Slides by Rachelle Agatha, CPA, with excerpts from Warren, Reeve, Duchac

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1. Journalize the entries for corporate income taxes, including deferred income taxes.2. Describe and illustrate the reporting of unusual items on the income statement.

Objectives:

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3. Prepare an income statement reporting earnings per share data.4. Describe the concept and the reporting of comprehensive income.

5. Describe the accounting for investments in stocks.

Objectives:

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Journalize the entries for

corporate income taxes, including deferred income

taxes.

Objective 1

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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 00Cash 21 000 00

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Automobiles 33%Banking 35Computers 23Food 35Integrated oil 39Pharmaceuticals 30Retail 39Telecommunication 37Transportation 38

Ratio of Reported Income Tax Expense to Earnings Before Taxes for Selected Industries

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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.

Allocating Income Taxes

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1. Revenues or gains are taxed after they are reported in the income statement.

Examples of Items That Create Temporary Differences

2. Expenses or losses are deducted in determining taxable income after they are reported in the income statement.

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3. Revenues or gains are taxed before they are reported on the income statement.4. Expenses or losses are deducted in determining taxable income before they are reported in the income statement.

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Year 1 Ye

ar 2 Ye

ar 3 Ye

ar 4

MACRS (tax depreciation)

Straight-line (financial statement depreciation)

Year 5 Ye

ars1-5

Total

Exhibit 1 Temporary Differences

Total depreciation is the same for tax and financial purposes.

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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 00Deferred Income Tax Payable80 000 00

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If $48,000 of the deferred tax reverses and becomes due in the second year, the entry will reflect this fact.

Deferred Income Tax Payable48 000 00Income Tax Payable 48 000 00

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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 year’s taxes.

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Income Tax Expense 80,000Income Tax Payable 52,000Deferred Income Tax Payable 28,000

Income tax expense based on $200,000 reported income at 40% $80,000

Income tax payable based on $130,000taxable income at 40% 52,000

Income tax deferred to future years $28,000

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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.

Permanent Differences

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Describe and illustrate the reporting of

unusual items on the income statement.

Objective 2

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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 impairmentsRestructuring charges

Reporting Unusual Items on the Income Statement

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A fixed asset impairment occurs

when the fair value of a fixed asset falls

below its book value and is not expected to

recover.

Fixed Asset Impairment

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1. Decrease in market price of fixed assets.

2. Significant changes in the business or regulations related to fixed assets.

3. Adverse conditions affecting the use of fixed assets.

4. Expected cash flow losses using fixed assets.

Examples of Events That Might Cause an Asset Impairment

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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 Impairment750 000 00

To record impairment of fixed assets due to plant closing.

Equipment750 000 00

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Reporting of Unusual Items on the Income Statement

Fixed asset impairments

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Unusual Items in the Income Statement

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Unusual items subtracted from gross profit in determining income from continuing operations are:

Fixed asset impairmentsRestructuring charges

Reporting Unusual Items on the Income Statement

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Restructuring charges are costs incurred with

actions such as canceling contracts, laying off or relocating employees,

and combining operations.

Restructuring Charges

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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

To record impairment of fixed assets due to plant closing.

Employee Termination Obligation 1,000 000 00

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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 Obligation125 000 00

To record payment to 25 employees as severance compensation.

Cash125 000 00

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Reporting of Unusual Items on the Income Statement

Restructuring charges

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Unusual Items in the Income Statement

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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. 32

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Dec. 20 Loss on Fixed Asset Impairment 180,000

Equipment 180,000

20 Restructuring Charge 560,000*Employee Termination Obligation 560,000

*80 employees x $7,000

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Unusual items that may add or subtract income from continuing operations in determining net income are:

Discontinued operationsExtraordinary items

Reporting Unusual Items on the Income Statement

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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.

Discontinued Operations

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Reporting of Unusual Items on the Income Statement

Discontinued operations

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Unusual Items in the Income Statement

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Reporting Unusual Items on the Income Statement

Unusual items that adjust income from continuing operations in determining net income are:Discontinued

operationsExtraordinary items

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Extraordinary Items

Extraordinary items result from events and transactions that—(1)are significantly different

(unusual) from the typical or the normal operating activities of the business, and

(2)occur infrequently.

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14-2Insert Exhibit 2 here also, p.

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Reporting of Unusual Items on the Income Statement

Extraordinary items

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Unusual Items in the Income Statement

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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:

Retroactive Restatement

1. errors in the recognition, measurement, presentation, or disclosure of financial statements, and

2. changes from one generally accepted accounting principle to another generally accepted accounting principle.

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Reporting of Unusual Items on the Income Statement

Unusual items affecting prior period income statements

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Prepare an income

statement reporting

earnings per share data.

Objective 3

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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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Earnings per common share =

Net IncomeNumber of common shares outstanding

If there is no preferred stock:

If there is preferred stock:Earnings per common share =

Net Income – Preferred stock dividendsNumber of common shares outstanding

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Income Statement with Earnings per Share

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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.

Earnings per share =$250,000 – $18,000*

580,000$0.40 per

share=

*2,000 shares x $100 par value x 9% = $18,000

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Describe the concept and the reporting

of comprehensive

income.

Objective 4

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Comprehensive income is defined as all changes in stockholders’ equity during a period, except

those resulting from dividends and stockholders’ investments.

Comprehensive Income

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Other comprehensive income items include foreign currency items,

pension liability adjustments, and

unrealized gains and losses on investments.

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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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Statement of Comprehensive Income

Triple-A Enterprises, Inc. reported comprehensive income on a separate statement as follows:

Net income $8 500 00Other comprehensive income, net of tax 90 00 Total comprehensive income $8 590 00

Triple-A Enterprises, Inc.Statement of Comprehensive Income

For the Year Ended December 31, 2008 Net income $8 500 00Other comprehensive income, net of tax 90 00 Total comprehensive income $8 590 00

Triple-A Enterprises, Inc.Statement of Comprehensive Income

For the Year Ended December 31, 2008

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2008 2007

Stockholders’ Equity Section of Triple-A Enterprises’ Balance Sheet

Triple-A Enterprises, Inc.Stockholders’ Equity

For the Year Ended December 31, 2008

Stockholders’ equity: Common stock $ 20 000 00 $ 20 000 00Paid-in capital in excess of par 36 000 0036 000 00Retained earnings 165 500 00 157 000 00Accumulated other

comprehensive income 1 290 00 1 200 00Total stockholders’ equity $222 790 00 $214 200 00

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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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a) $86,500 = $74,000 + $12,500b) $499,000 = $425,000 + $74,000c) $69,500 = $57,000 + $12,500

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Describe the accounting for investments in

stocks.

Objective 5

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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:1. The securities must be

readily marketable, and can be sold for cash at any time.

2. Management must intend to sell the securities when the business needs cash for operations.

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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

Purchased 2,000 shares of Inis Corporation common stock.

Cash 180 000 00

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Nov 30 Cash 1 800 00

Received dividends on Inis Corporation common stock (2,000 shares x $0.90).

Dividend Revenue 1 800 00

On October 1, Inis declared a $0.90 per share dividend payable on November

30.

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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.

Unrealized Holdings Gain or Loss

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UnrealizedCommon Stock Cost Market Gain (Loss)Edwards Inc. $150,000 $190,000 $40,000SWS Corp. 200,000 200,000 —Inis Corporation 180,000 210,000 30,000Bass Co. 160,000 150,000 (10,000) Total $690,000 $750,000 $60,000

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.

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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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a. Initial costs$ 75,000

Unrealized gain ($110,000 – $75,000) $35,000Less: Tax on unrealized gain ($35,000 x 40%) 14,000Unrealized gain, net of tax 21,000Reported amount of marketable securities $ 96,000

b. Net income$180,000

Unrealized gain ($110,000 – $75,000) $35,000Less: Tax on unrealized gain ($35,000 x 40%) 14,000Other comprehensive income, net of tax 21,000Net income $201,000

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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.

Long-Term Investments in Stocks

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Account for the investment by using the equity method

Accounting for Long-Term Stock Investments

Is there a significant influence over the investee?

No Yes

Account for the investment as an available-for-sale

security

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Jan. 2 Investment in Brock Corp. Stock 350 000 00

Purchased 40% of Brock Corp. common stock.

Cash 350 000 00

On January 2, Hally Inc. pays cash of $350,000 for 40% of the common

stock and net assets of Brock Corporation.

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Dec. 31 Investment in Brock Corp. Stock 42 000 00

Recorded 40% share of Brock Corp. net income of $105,000.

Income of Brock Corp.42 000 00

For the year ending December 31, Brock Corporation reports net income of

$105,000.

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Dec. 31 Cash 18 000 00

Recorded 40% share of Brock Corp. dividends.

Investment in Brock Corp.Stock18 000 00

On December 31, Brock Corporation pays $45,000 in

dividends.

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Investments and Dividends

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Mar. 1 Cash 17 500 00 Investment in Drey Inc. Stock

15 700 00Gain on Sale of Investments1 800 00

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.

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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 CompanyStock $22,500

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A firm’s growth potential and future earnings prospects are

indicated by how much the market is willing to pay per

dollar of a company’s earnings. This ratio, called

the price-earnings ratio, or P/E ratio, is commonly

included in stock market quotations.

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Financial Analysis and Interpretation

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Earnings Per Share

Net IncomeCommon Shares

Earnings per Share of Common

Stock=

Price - Earnings Ratio

Market Price Per Shareof Common Stock

Earnings Per Share ofCommon Stock

Price-Earnings

Ratio=

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The price-earnings ratio represents how much the

market is willing to pay per dollar of a company’s

earnings. This indicates the market’s assessment of a

firm’s growth potential and future earnings prospects.

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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.

An example: 2008 2007Market price per share $24.60 $16.20Earnings per share $1.64 $1.35 Price-earnings ratio 15.0 12.0

Summary J/E’s for corporate income tax Unusual Items Income statement for EPS Comprehensive Income Accounting for Investments in stock