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Chapter 14

Income Taxes, Unusual


Income Tax Items, and
Investments in Stocks
Accounting, 21st Edition
Warren Reeve Fess
© Copyright 2004 South-Western, a division
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Professor Emeritus of Accounting
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Objectives
Objectives
1. Journalize the entries for corporate income
taxes, including deferred
After income
studying this taxes.
After studying this
2. Prepare an income statement reporting the
chapter,
chapter,
following unusual you should
youfixed
items: should
asset
be
be able
able to:
impairments, restructuring to:
charges,
discontinued operations, extraordinary items,
and changes in accounting principles.
3. Prepare an income statement reporting earnings
per share data.
Objectives
Objectives
4. Describe the concept and the reporting
of comprehensive income.
5. Describe the accounting for
investments in stocks.
6. Describe alternative methods of
combining businesses and how
consolidated financial statements are
prepared.
7. Compute and interpret the price-
earnings ratio.
Corporate
Corporate Income
Income Taxes
Taxes
Corporate
Corporate Income
Income Taxes
Taxes

A
AAssume
corporation
Assume that
that amakes
corporation corporation
amakes four
corporation
four
income
estimates
income tax
tax installment
estimates its
its taxes
taxespayments
installment for
for the
payments
the
throughout
year
year toto be
throughout bethe
$84,000.
the year.
$84,000.
year.
Corporate
Corporate Income
Income Taxes
Taxes
On
On April
April 15,
15, the
the first
first of
of four
four estimated
estimated
annual
annual tax
tax payments
payments of of $21,000
$21,000 isis made.
made.

Apr. 15 Income Tax Expense 21 000 00


Cash 21 000 00
To record quarterly payment of
estimated income tax.
Corporate
Corporate Income
Income Taxes
Taxes
Ratio of Reported Income Tax Expense to Earnings
Before Taxes for Selected Industries
Automobiles 33%
Banking 35
Computers 35
Food 35
Integrated oil 39
Pharmaceutical 30
Retail 39
Telecommunication 17
Transportation 38
Allocating
Allocating Income
Income Taxes
Taxes
1. Revenues or gains are taxed after they are
reported in the income statement.
2. Expenses or losses are deducted in
determining taxable income after they are
reported in the income statement.
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.
Temporary Differences
 Differences in tax law and GAAP create some
temporary differences that reverse in later
years.
 Temporary differences do not change or
reduce the total amount of tax paid, they
affect only the timing of when the taxes are
paid.
Temporary
Temporary Differences
Differences
MACRS (tax
depreciation)
Straight-line (financial
statement depreciation)

Total

s
ar ar ar ar ar ar
e
Y 1 e
Y 2 Ye
3
e
Y 4 Ye
5 Ye
-5
1
Temporary
Temporary Differences
Differences
Temporary Differences in Reporting Revenues
Financial Tax
Revenue
Reporting Reporting
Reporting
Report Now Taxable Later

EXAMPLE: Income Point-of-Sale Installment


reporting methods. Method Method

Report Later Taxable Now

EXAMPLE: Cash When When


collected in advance. Earned Collected
Temporary
Temporary Differences
Differences
Temporary Differences in Reporting Expenses
Financial Tax
Expense
Reporting Reporting
Deductions
Deduct Now Deduct Later

EXAMPLE: Product When When


warranty expense. Estimated Paid

Deduct Slower Deduct Faster

EXAMPLE: Methods Straight-Line MACRS


of depreciation. Method Method
Temporary
Temporary Differences
Differences
At the end of the first year of operations, a
corporation reports $300,000 income before income
taxes. With a 40% tax rate, the firm faces a tax of
$120,000. Using tax planning, the net income is
reduced to $100,000 and the actual income tax due is
$40,000. The difference is deferred to future years.
Temporary
Temporary Differences
Differences

The
The entry
entry to
to record
record income
income taxes
taxes on
on April
April 15
15
reflects
reflects the
the deferred
deferred amount
amount of
of $80,000.
$80,000.

Apr. 15 Income Tax Expense 120 000 00


Income Tax Payable 40 000 00
Deferred Income Tax Payable 80 000 00
To record income tax for the
year.
Temporary
Temporary Differences
Differences

IfIf$48,000
$48,000of ofthe
thedeferred
deferredtax
taxreverses
reversesand
andbecomes
becomesdue due
in
inthe
thesecond
secondyear,
year,the
theentry
entrywill
willreflect
reflectthis
thisfact.
fact.

Apr. 15 Deferred Income Tax Payable 48 000 00


Income Tax Payable 48 000 00
To record current liability for
deferred tax.
Permanent
Permanent Differences
Differences
Differences
Differences between
between taxable
taxable income
income
and
and income
income before
before taxes
taxes reported
reported on on
the
the income
income statement
statement may
may bebe the
the result
result
of
of differences
differences that
that never
never reverse.
reverse.
Permanent
Permanent Differences
Differences
These
These differences
differences areare referred
referred to
to as
as
permanent
permanent differences.
differences. Interest
Interest on
on
municipal
municipal bonds
bonds isis an
an example
example of of
this
this type
type of
of timing
timing difference.
difference.
Unusual
Unusual Items
Items Affecting
Affecting the
the
Income
Income Statement
Statement
Unusual
Unusual Items
Items Affecting
Affecting
Income
Income from
from Continuing
Continuing
Operations
Operations
Unusual
Unusual Items
Items Affecting
Affecting the
the
Income
Income Statement
Statement
Fixed
Fixed Asset
Asset Impairments
Impairments
 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
Unusual
Unusual Items
Items Affecting
Affecting the
the
Income
Income Statement
Statement
Fixed
Fixed Asset
Asset Impairments
Impairments

On
On March
March 1, 1, Jones
Jones Company
Company consolidates
consolidates
operations
operations by by closing
closing aa factory.
factory. As
As aa
result
result of
of thethe closing,
closing, plant
plant and
and equipment
equipment
isis impaired
impaired byby $750,000.
$750,000.
Unusual
Unusual Items
Items Affecting
Affecting the
the
Income
Income Statement
Statement
Fixed
Fixed Asset
Asset Impairments
Impairments

Mar. 1 Loss on Fixed Asset Impairment 750 000 00


Fixed Assets—Plant 400 000 00
Fixed Assets—Equipment 350 000 00
To record impairment of fixed
assets due to plant closing.
Jones Corporation
Partial Income Statement
For the Year Ended December 31, 2006
Net sales $12,350,000
Cost of merchandise sold 5,800,000
Gross profit $ 6,550,000
Operating expenses $3,490,000
Restructuring charge 1,000,000
Loss from asset impairment 750,000 5,240,000
Income from continuing operations
before income tax $ 1,310,000
Income tax expense 620,000
Income from continuing operations $ 690,000
Unusual
Unusual Items
Items Affecting
Affecting the
the
Income
Income Statement
Statement
Restructuring
Restructuring charges
charges are
are costs
costs associated
associated
with
with involuntarily
involuntarily terminating
terminating employees,
employees,
terminating
terminating contracts,
contracts, consolidating
consolidating
facilities,
facilities, or
or relocating
relocating employees.
employees.
Unusual
Unusual Items
Items Affecting
Affecting the
the
Income
Income Statement
Statement
Fixed
Fixed Asset
Asset Impairments
Impairments

The
The management
management of of Jones
Jones Company
Company
communicate
communicate aa plan
plan to
to terminate
terminate 200
200
employees
employees from
from the
the closed
closed manufacturing
manufacturing
plant
plant on
on March
March 1.1. The
The plan
plan calls
calls for
for aa
termination
termination benefit
benefit of
of $5,000
$5,000 per
per employee.
employee.
Unusual
Unusual Items
Items Affecting
Affecting the
the
Income
Income Statement
Statement
Restructuring
Restructuring Charges
Charges

Mar. 1 Restructuring Charge 1000 000 00


Employee Termination
Obligation 1000 000 00
To record restructuring charge
due to plant closing.
Unusual
Unusual Items
Items Affecting
Affecting the
the
Income
Income Statement
Statement
Restructuring
Restructuring Charges
Charges

Mar. 1 Restructuring Charge 1000 000 00


Employee Termination
Obligation 1000 000 00
Mar. 25 Employee Termination Obligation 125 000 00
Cash 125 000 00
Unusual
Unusual Items
Items Not
Not Affecting
Affecting Income
Income
From
From Continuing
Continuing Operations
Operations

Closed
Discontinued
Discontinued Operations
Operations

AA gain
gain or
or loss
loss from
from disposing
disposing of
of aa
business
business segment
segment isis reported
reported as
as aa gain
gain
or
or loss
loss from
from discontinued
discontinued operations.
operations.
Jones Corporation
Income Statement
For the Year Ended December 31, 2006
Net sales $12,350,000

Income from continuing operations


before income tax $ 1,310,000
Income tax 620,000
Income from continuing operations $ 690,000
Loss on discontinued operations (Note B) 100,000
Income before extraordinary items and cumulative
effect of a change in accounting principle $ 590,000
Extraordinary item:
Gain on condemnation of land, net of
applicable income tax of $65,000 150,000
Cumulative effect on prior years of changing to
different depreciation method (Note C) 92,000
Net income $ 832,000
Extraordinary
Extraordinary Items
Items
Extraordinary
Extraordinary items
items result
result from
from events
events and
and
transactions
transactions that
that (1)
(1) are
are significantly
significantly
different
different from
from the
the typical
typical oror the
the normal
normal
operating
operating activities
activities of
of the
the business
business AND
AND
(2)
(2) occur
occur infrequently.
infrequently.
Jones Corporation
Income Statement
For the Year Ended December 31, 2006
Net sales $12,350,000

Income from continuing operations


before income tax $ 1,310,000
Income tax 620,000
Income from continuing operations $ 690,000
Loss on discontinued operations (Note B) 100,000
Income before extraordinary items and cumulative
effect of a change in accounting principle $ 590,000
Extraordinary item:
Gain on condemnation of land, net of
applicable income tax of $65,000 150,000
Cumulative effect on prior years of changing to
different depreciation method (Note C) 92,000
Net income $ 832,000
Accounting
Accounting Changes
Changes

Accounting
Accounting changes
changes occur
occur when
when aa
business
business voluntarily
voluntarily change
change from
from one
one
generally
generally accepted
accepted accounting
accounting
principle
principle to
to another.
another.
Accounting
Accounting Changes
Changes
Another
Another type
type of
of accounting
accounting change
change occurs
occurs
when
when businesses
businesses areare required
required to
to change
change the
the
way
way they
they treat
treat an
an accounting
accounting situation
situation when
when
the
the FASB
FASB issues
issues aa new
new accounting
accounting standard.
standard.
Jones Corporation
Income Statement
For the Year Ended December 31, 2006
Net sales $12,350,000

Income from continuing operations


before income tax $ 1,310,000
Income tax 620,000
Income from continuing operations $ 690,000
Loss on discontinued operations (Note BA) 100,000
Income before extraordinary items and cumulative
effect of a change in accounting principle $ 590,000
Extraordinary item:
Gain on condemnation of land, net of
applicable income tax of $65,000 150,000
Cumulative effect on prior years of changing to
different depreciation method (Note C) 92,000
Net income $ 832,000
Earnings
Earnings per
per Common
Common Share
Share
Earnings per share (EPS) is the net income per
share of common stock outstanding. When
unusual items exist, EPS should be reported for:
 Income from continuing operations
 Income before extraordinary items and the cumulative
effect of a change in accounting principle
 Extraordinary items and the cumulative effect of a
change in accounting principle
 Net income
Earnings
Earnings per
per Common
Common Share
Share
If there is no preferred stock:
Earnings per Net Income
=
common share Number of common shares outstanding

If there is preferred stock:


Earnings per Net Income – Preferred stock dividends
=
common share Number of common shares outstanding
Jones Corporation
Income Statement
For the Year Ended December 31, 2006

Income from continuing operations $690,000

Net income $832,000


Earnings per common share:
Income from continuing operations $ 3.45
Loss on discontinued operations (Note B) .50
Income before extraordinary item and cumulative
effect of a change in accounting principle $2.95
Extraordinary item .75
Cumulative effect on prior years of changing
to a different depreciation method .46
Net income $ 4.16
Jones Corporation
Income Statement
For the Year Ended December 31, 2006

Income from continuing operations $690,000

Net income $832,000


Earnings per common share:
Income from continuing operations $ 3.45
Loss on discontinued operations (Note B) .50
Income before extraordinary item and cumulative
effect of a change in accounting principle $2.95
Extraordinary item .75
Cumulative effect on prior years of changing
to a different depreciation method .46
Net income $ 4.16
Jones Corporation
Income Statement
For the Year Ended December 31, 2006

Income from continuing operations $690,000

Net income $832,000


Earnings per common share:
Income from continuing operations $ 3.45
Loss on discontinued operations (Note B) . 50
Income before extraordinary item and cumulative
effect of a change in accounting principle $2.95
Extraordinary item .75
Cumulative effect on prior years of changing
to a different depreciation method .46
Net income $ 4.16
Jones Corporation
Income Statement
For the Year Ended December 31, 2006

Income from continuing operations $690,000

Net income $832,000


Earnings per common share:
Income from continuing operations $ 3.45
Loss on discontinued operations (Note B) .50
Income before extraordinary item and cumulative
effect of a change in accounting principle $2.95
Extraordinary item .75
Cumulative effect on prior years of changing
to a different depreciation method .46
Net income $ 4.16
Jones Corporation
Income Statement
For the Year Ended December 31, 2006

Income from continuing operations $690,000

Net income $832,000


Earnings per common share:
Income from continuing operations $ 3.45
Loss on discontinued operations (Note B) .50
Income before extraordinary item and cumulative
effect of a change in accounting principle $2.95
Extraordinary item .75
Cumulative effect on prior years of changing
to a different depreciation method .46
Net income $ 4.16
Comprehensive
Comprehensive Income
Income
Companies
Companies maymay report
report comprehensive
comprehensive
income
income on
on the
the income
income statement,
statement, inin aa
separate
separate statement,
statement, or or in
in the
the statement
statement
of
of stockholders’
stockholders’ equity.
equity.
Comprehensive
Comprehensive Income
Income

However,
However, comprehensive
comprehensive income income
Comprehensive
Comprehensive
does not include income
income
changes isis defined
defined
caused by
does not include changes caused by
as all changes
asissuing
all changes in
in stockholders’
stockholders’
issuing dividends or
dividends or from
from
equity
equity during
stockholders’during a
a period.
period.
stockholders’ investments.
investments.
Stockholders’
Stockholders’ Equity
Equity Section
Section

Stockholders’ equity: 2006 2005


Common stock $ 20,000 $ 20,000
Paid-in capital in excess of par 36,000 36,000
Retained earnings 165,500 157,000
Accumulated other
comprehensive income 1,290 1,200
Total stockholders’ equity $222,790 $214,200
Accounting for Investments in
Stocks
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.
Short-Term
Short-Term Investments
Investments in
in Stocks
Stocks
Temporary
Temporary investments
investments are are
recorded
recorded in
in the
the current
current
asset
asset account,
account, Marketable
Marketable
Securities,
Securities, at
at their
their cost.
cost.
Short-Term
Short-Term Investments
Investments in
in Stocks
Stocks
On
On June
June 1,
1, Crabtree
Crabtree Company
Company purchased
purchased 2,000
2,000
shares
shares of
of Inis
Inis Corporation
Corporation common
common stock
stock at
at
$89.75
$89.75 per
per share
share plus
plus aa brokerage
brokerage fee
fee of
of $500.
$500.

$89.75
June x 2,000Securities
1 Marketable shares + $500 180 000 00
Cash 180 000 00
Purchased 2,000 shares of Inis
Corporation common stock.
Short-Term
Short-Term Investments
Investments in
in Stocks
Stocks

On
On October
October 1,
1, Inis
Inis declared
declared aa $0.90
$0.90 per
per
share
share dividend
dividend payable
payable on
on November
November 30.30.

Nov.30 Cash 2,000 shares x $0.90 1 800 00


Dividend Revenue 1 800 00
Received dividend on Inis
Corporation common stock.
Short-Term
Short-Term Investments
Investments in
in Stocks
Stocks
On
On the
the balance
balance sheet,
sheet, temporary
temporary
investments
investments are
are reported
reported at
at their
their fair
fair market
market
value.
value. Any
Any difference
difference between
between the the fair
fair
market
market value
value and
and the
the cost
cost isis an
an unrealized
unrealized
holding
holding gain
gain or
or loss.
loss.
Short-Term
Short-Term Investments
Investments in
in Stocks
Stocks
At
At year-end,
year-end, thethe total
total cost
cost of
of Crabtree
Crabtree
Co.’s
Co.’s four
four temporary
temporary investments
investments isis
$690,000.
$690,000. TheThe current
current market
market for
for these
these
four
four items
items totaled
totaled $750,000
$750,000 at at year-end.
year-end.
Thus,
Thus, Crabtree
Crabtree Co.Co. had
had aa before
before tax
tax
unrealized
unrealized gain
gain ofof $60,000.
$60,000.
Short-Term
Short-Term Investments
Investments in
in Stocks
Stocks
Crabtree
CrabtreeCo.
Co.
Balance
BalanceSheet
Sheet
December
December31,
31,2006
2006
Current
Currentassets:
assets:
Cash
Cash $119,500
$119,500
Temporary
Temporaryinvestments
investmentsin in
marketable
marketablesecurities
securitiesatatcost
cost $690,000
$690,000
Plus
Plusunrealized
unrealizedgain
gain(net
(netofof
applicable
applicableincome
incometaxtaxofof
$18,000)
$18,000) 42,000
42,000 732,000
732,000
Stockholders’
Stockholders’Equity
Equity
Accumulated
Accumulatedother
othercomprehensive
comprehensiveincome
income 42,000
42,000
Short-Term
Short-Term Investments
Investments in
in Stocks
Stocks
Crabtree
CrabtreeCo.
Co.
Statement
Statementof
ofComprehensive
ComprehensiveIncome
Income
For
Forthe
theYear
YearEnded
EndedDecember
December31,
31,2006
2006

Net
Netincome
income $720,000
$720,000
Other
Othercomprehensive
comprehensiveincome:
income:
Unrealized
Unrealizedgain
gainonontemporary
temporaryinvestments
investments
in
inmarketable
marketablesecurities
securities(net
(netof
of
applicable
applicabletax
taxof
of$18,000)
$18,000) 42,000
42,000
Comprehensive
Comprehensiveincome
income $762,000
$762,000
Long-Term
Long-Term Investments
Investments in
in Stocks
Stocks
Long-term
Long-term investments
investments areare
those
those investments
investments mademade by
by aa
firm
firm that
that are
are not
not intended
intended as
as aa
source
source ofof cash
cash in
in the
the normal
normal
operations
operations ofof the
the business.
business.
Long-Term
Long-Term Investments
Investments in
in Stocks
Stocks
Ownership
%
100%

Controlling
With Interest
With less
Equity less than
than 20%
20% ownership
ownership the the buyer
buyer
does 50%
Methoddoes not usually
not usually have
have significant
significant
influence.
influence. The
The buyer
buyer uses the
the cost
Significant
uses cost method
method
to
to account
account for
for the investment.
theinfluence
investment.
20%
Cost Not significant
Method influence
0%
Long-Term
Long-Term Investments
Investments in
in Stocks
Stocks
Ownership
%
100%
Ownership
Ownership over
Controlling over 20%20%
usually
usually indicates
indicates significant
Interest significant
Equity influence.
influence. The
The buyer
buyer uses
uses
50%
Method the
the equity
equity method
method to to
Significant
account
account for
forthe
the investment.
investment.
influence
20%
Cost No significant
Method influence
0%
Long-Term
Long-Term Investments
Investments in
in Stocks
Stocks

On
On January
January 2,
2, Hally
Hally Inc.
Inc. pays
pays cash
cash of
of $350,000
$350,000
for
for 40%
40% of
of Brock
Brock Corporation’s
Corporation’s common
common stock.
stock.
Jan. 2 Investment in Brock Corp. Stock 350 000 00
Cash 350 000 00
Purchased 40% of Brock Corp.
common stock.
Long-Term
Long-Term Investments
Investments in
in Stocks
Stocks

For
For the
the year
year ending
ending December
December 31,
31, Brock
Brock
Corporation
Corporation reports
reports net
net income
income of
of $105,000.
$105,000.
Dec. 31 Investment in Brock Corp. Stock 42 000 00
Income of Brock Corp. 42 000 00
Recorded share (40%) of Brock
Corp. net income of $105,000.
Long-Term
Long-Term Investments
Investments in
in Stocks
Stocks

On
On December
December 31,
31, Brock
Brock Corporation
Corporation declared
declared aa
$45,000
$45,000 dividend,
dividend, payable
payable on
on December
December 31.
31.
Dec. 31 Cash 18 000 00
Investment in Brock Crop. Stock 18 000 00
Recorded share (40%) of
dividends of $45,000 paid by
Brock Corp.
Long-Term
Long-Term Investments
Investments in
in Stocks
Stocks
On
On March
March 1,1, an
an investment
investment inin Drey
Drey Inc.
Inc.
stock
stock that
that had
had aa carrying
carrying amount
amount of
of
$15,700
$15,700 isis sold
sold for
for $17,500.
$17,500.
Mar. 1 Cash 17 500 00
Investment in Drey Inc. Stock 15 700 00
Gain on Sale of Investments 1 800 00
Sold investment in Drey Inc.
stock.
Business
Business Combinations
Combinations
Ownership
%
100%

Controlling
Interest
Equity
50%
Method
Significant
The
The corporation
corporation owning owning all
all or
or aa majority
majority ofof the
the voting
voting
influence
stock
stock isis called
called the the parent
parent company.
company. The
The controlled
controlled
20%
corporation
corporationCost isis the
thesubsidiary
subsidiary company.
company. Consolidated
Consolidated
No significant
financial
financial statements
statements are
are prepared
prepared which
which combines
combines the
the
Method influence
operating
operating results
results
0%
of
of the
the two
two entities.
entities.
Business
Business Combinations
Combinations
 A merger combines two corporations by one
acquiring the properties of another that is then
dissolved.
 Many businesses combine in order to produce
more efficiently or to diversify product lines.
 A consolidation is the creation of a new
corporation, to which the combined assets and
liabilities of the old corporations are transferred
to the new corporation.
Business
Business Combinations
Combinations
Mergers Consolidations

A A
C
B B
Mergers: Company A acquires company B. The assets
and liabilities of B are transferred to A and B is then
dissolved.
Consolidations: Company A acquires company B. The assets and liabilities of both A and B
are transferred to a new company C and A and B are then dissolved.
FINANCIAL
ANALYSIS AND
INTERPRETATION

A
A firm’s
firm’s growth
growth potential
potential and
and future
future
earnings
earnings prospects
prospects areare indicated
indicated by
by how
how
much
much the
the market
market isis willing
willing to
to pay
pay per
per
dollar
dollar of
of aa company’s
company’s earnings.
earnings.
Accounting: Earnings Per Share
Earnings per
Net Income
= Share of Common
Common Shares Stock

Investing: Price - Earnings Ratio

Market Price Per Share


Price-
of Common Stock
= Earnings
Earnings Per Share of Ratio
Common Stock
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.
An example: 2006 2005
Market price per share $20.50 $13.50
Earnings per share $1.64 $1.35
Price-earnings ratio 12.5 10.0
The price-earnings ratio indicates that a share of common
stock was selling for 10 times earnings for 2005 and 12.5
times for 2006.
Chapter 14

The
The End
End