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Chapter 12
Income Taxes, Unusual Income
Tax Items, and Investments in
Stocks
Financial and Managerial Accounting
8th Edition
Warren Reeve Fess
PowerPoint Presentation by Douglas Cloud
Professor Emeritus of Accounting
Pepperdine University
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Objectives
1. Journalize the entries for corporate
income taxes,
deferred income
Afterincluding
studying this
taxes.
chapter, you should
2. Prepare an income
reporting
be ablestatement
to:
the following unusual items: fixed asset
impairments, restructuring charges,
discontinued operations, extraordinary
items, and changes in accounting
principles.
3. Prepare an income statement reporting
earnings per share data.
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 priceearnings ratio.
Corporate Income Taxes
Corporate Income Taxes
A corporation
Assume that
makes
a corporation
four income
tax
estimates
installment
its taxes
payments
for the
throughout
year to bethe
$84,000.
year.
Corporate Income Taxes
On April 15, the first of four estimated
annual tax payments of $21,000 is made.
Apr. 15 Income Tax Expense
Cash
To record quarterly payment of
estimated income tax.
21 000 00
21 000 00
Corporate Income 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 Income 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 Differences
MACRS (tax
depreciation)
Straight-line (financial
statement depreciation)
Total
Temporary Differences
Temporary Differences in Reporting Revenues
Revenue
Reporting
Financial
Reporting
Report Now
EXAMPLE: Income
reporting methods.
EXAMPLE: Cash
collected in advance.
Point-of-Sale
Method
Tax
Reporting
Taxable Later
Installment
Method
Report Later
Taxable Now
When
Earned
When
Collected
Temporary Differences
Temporary Differences in Reporting Expenses
Expense
Deductions
Financial
Reporting
Deduct Now
EXAMPLE: Product
warranty expense.
EXAMPLE: Methods
of depreciation.
When
Estimated
Tax
Reporting
Deduct Later
When
Paid
Deduct Slower
Deduct Faster
Straight-Line
Method
MACRS
Method
Temporary 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 Differences
The entry to record income taxes on April 15
reflects the deferred amount of $80,000.
Apr. 15 Income Tax Expense
Income Tax Payable
Deferred Income Tax Payable
To record income tax for the
year.
120 000 00
40 000 00
80 000 00
Temporary Differences
If $48,000 of the deferred tax reverses and becomes due in
the second year, the entry will reflect this fact.
Apr. 15 Deferred Income Tax Payable
Income Tax Payable
To record current liability for
deferred tax.
48 000 00
48 000 00
Permanent Differences
Differences between taxable income and
income before taxes reported on the
income statement may be the result of
differences that never reverse.
Permanent Differences
These differences are referred to as
permanent differences. Interest on
municipal bonds is an example of this
type of timing difference.
Unusual Items Affecting the
Income Statement
Unusual Items Affecting
Income from Continuing
Operations
Unusual Items Affecting the
Income Statement
Fixed Asset 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 Items Affecting the
Income Statement
Fixed Asset Impairments
On March 1, Jones Company consolidates
operations by closing a factory. As a
result of the closing, plant and equipment
is impaired by $750,000.
Unusual Items Affecting the
Income Statement
Fixed Asset Impairments
Mar. 1 Loss on Fixed Asset Impairment
750 000 00
Fixed Assets—Plant
400 000 00
Fixed Assets—Equipment
To record impairment of fixed
assets due to plant closing.
350 000 00
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 Items Affecting the
Income Statement
Restructuring charges are costs associated
with involuntarily terminating employees,
terminating contracts, consolidating facilities,
or relocating employees.
Unusual Items Affecting the
Income Statement
Fixed Asset Impairments
The management of Jones Company
communicate a plan to terminate 200
employees from the closed manufacturing
plant on March 1. The plan calls for a
termination benefit of $5,000 per employee.
Unusual Items Affecting the
Income Statement
Restructuring Charges
Mar. 1 Restructuring Charge
1000 000 00
Employee Termination
Obligation
To record restructuring charge
due to plant closing.
1000 000 00
Unusual Items Affecting the
Income Statement
Restructuring Charges
Mar. 1 Restructuring Charge
1000 000 00
Employee Termination
Obligation
Mar. 25 Employee Termination Obligation
Cash
1000 000 00
125 000 00
125 000 00
Unusual Items Not Affecting Income
From Continuing Operations
Closed
Discontinued Operations
A gain or loss from disposing of a
business segment is reported as a gain
or loss from discontinued operations.
Jones Corporation
Income Statement
For the Year Ended December 31, 2006
Net sales
Income from continuing operations
before income tax
Income tax
Income from continuing operations
Loss on discontinued operations (Note B)
Income before extraordinary items and cumulative
effect of a change in accounting principle
Extraordinary item:
Gain on condemnation of land, net of
applicable income tax of $65,000
Cumulative effect on prior years of changing to
different depreciation method (Note C)
Net income
$12,350,000
$ 1,310,000
620,000
$ 690,000
100,000
$
590,000
150,000
$
92,000
832,000
Extraordinary Items
Extraordinary items result from events and
transactions that (1) are significantly different
from the typical or the normal operating
activities of the business AND (2) occur
infrequently.
Jones Corporation
Income Statement
For the Year Ended December 31, 2006
Net sales
Income from continuing operations
before income tax
Income tax
Income from continuing operations
Loss on discontinued operations (Note B)
Income before extraordinary items and cumulative
effect of a change in accounting principle
Extraordinary item:
Gain on condemnation of land, net of
applicable income tax of $65,000
Cumulative effect on prior years of changing to
different depreciation method (Note C)
Net income
$12,350,000
$ 1,310,000
620,000
$ 690,000
100,000
$
590,000
150,000
$
92,000
832,000
Accounting Changes
Accounting changes occur when a
business voluntarily change from one
generally accepted accounting principle
to another.
Accounting Changes
Another type of accounting change occurs
when businesses are required to change the
way they treat an accounting situation when
the FASB issues a new accounting standard.
Jones Corporation
Income Statement
For the Year Ended December 31, 2006
Net sales
Income from continuing operations
before income tax
Income tax
Income from continuing operations
Loss on discontinued operations (Note BA)
Income before extraordinary items and cumulative
effect of a change in accounting principle
Extraordinary item:
Gain on condemnation of land, net of
applicable income tax of $65,000
Cumulative effect on prior years of changing to
different depreciation method (Note C)
Net income
$12,350,000
$ 1,310,000
620,000
$ 690,000
100,000
$
590,000
150,000
$
92,000
832,000
Earnings per Common 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 per Common Share
If there is no preferred stock:
Net Income
Earnings per
=
common share
Number of common shares outstanding
If there is preferred stock:
Net Income – Preferred stock dividends
Earnings per
=
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 Income
Companies may report comprehensive
income on the income statement, in a
separate statement, or in the statement of
stockholders’ equity.
Comprehensive Income
However, comprehensive income does
Comprehensive
income
is by
defined
as
not
include changes
caused
issuing
all
changes
in
stockholders’
equity
dividends or from stockholders’
during
a period.
investments.
Stockholders’ Equity Section
Stockholders’ equity:
Common stock
Paid-in capital in excess of par
Retained earnings
Accumulated other
comprehensive income
Total stockholders’ equity
2006
2005
$ 20,000 $ 20,000
36,000
36,000
165,500 157,000
1,290
1,200
$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 Investments in Stocks
Temporary investments are
recorded in the current
asset account, Marketable
Securities, at their cost.
Short-Term Investments in Stocks
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.
June
1 Marketable
$89.75
x 2,000 Securities
shares +
$500
Cash
Purchased 2,000 shares of Inis
Corporation common stock.
180 000 00
180 000 00
Short-Term Investments in Stocks
On October 1, Inis declared a $0.90 per
share dividend payable on November 30.
Nov. 30 Cash 2,000
shares x $0.90
Dividend Revenue
Received dividend on Inis
Corporation common stock.
1 800 00
1 800 00
Short-Term Investments in Stocks
On the balance sheet, temporary
investments are reported at their fair market
value. Any difference between the fair
market value and the cost is an unrealized
holding gain or loss.
Short-Term Investments in Stocks
At year-end, the total cost of Crabtree
Co.’s four temporary investments is
$690,000. The current market for these
four items totaled $750,000 at year-end.
Thus, Crabtree Co. had a before tax
unrealized gain of $60,000.
Short-Term Investments in Stocks
Crabtree Co.
Balance Sheet
December 31, 2006
Current assets:
Cash
Temporary investments in
marketable securities at cost
Plus unrealized gain (net of
applicable income tax of
$18,000)
$119,500
$690,000
42,000 732,000
Stockholders’ Equity
Accumulated other comprehensive income
42,000
Short-Term Investments in Stocks
Crabtree Co.
Statement of Comprehensive Income
For the Year Ended December 31, 2006
Net income
$720,000
Other comprehensive income:
Unrealized gain on temporary investments
in marketable securities (net of
applicable tax of $18,000)
42,000
Comprehensive income
$762,000
Long-Term Investments in Stocks
Long-term investments are
those investments made by a
firm that are not intended as a
source of cash in the normal
operations of the business.
Long-Term Investments in Stocks
Ownership
%
100%
Controlling
Interest
With less than 20% ownership the buyer
Equity
50%
does
not
usually have significant
Method
influence. The buyer uses
the cost method
Significant
to account for theinfluence
investment.
20%
Cost
Method
Not significant
influence
0%
Long-Term Investments in Stocks
Ownership
%
100%
Equity
Method
Ownership over 20%
Controlling
usually
indicates significant
Interest
influence. The buyer uses
50%
the equity method to
Significant
account
for the investment.
influence
20%
Cost
Method
No significant
influence
0%
Long-Term Investments in Stocks
On January 2, Hally Inc. pays cash of $350,000
for 40% of Brock Corporation’s common stock.
Jan. 2 Investment in Brock Corp. Stock
Cash
Purchased 40% of Brock Corp.
common stock.
350 000 00
350 000 00
Long-Term Investments in Stocks
For the year ending December 31, Brock
Corporation reports net income of $105,000.
Dec. 31 Investment in Brock Corp. Stock
Income of Brock Corp.
Recorded share (40%) of Brock
Corp. net income of $105,000.
42 000 00
42 000 00
Long-Term Investments in Stocks
On December 31, Brock Corporation declared a
$45,000 dividend, payable on December 31.
Dec. 31 Cash
18 000 00
Investment in Brock Crop. Stock
Recorded share (40%) of
dividends of $45,000 paid by
Brock Corp.
18 000 00
Long-Term 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
Gain on Sale of Investments
Sold investment in Drey Inc.
stock.
15 700 00
1 800 00
Business Combinations
Ownership
%
100%
Equity
Method
Controlling
Interest
50%
Significant
The corporation owning all or a majority of the voting
influence
stock is called the parent company. The controlled
20%
corporation is the subsidiary company. Consolidated
Cost
No significant
financial statements are prepared which combines the
Method
influence
operating results
of
the
two
entities.
0%
Business 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 Combinations
Mergers
A
Consolidations
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 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.
Accounting: Earnings Per Share
Earnings per
Net Income
= Share of Common
Common Shares
Stock
Investing: Price - Earnings Ratio
Market Price Per Share
Priceof 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:
Market price per share
Earnings per share
Price-earnings ratio
2006
$20.50
$1.64
12.5
2005
$13.50
$1.35
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 12
The End