Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 1 of 17

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1 Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 1 of 17

2 Introduction Taxes are a significant expense for most companies and must be considered when analyzing a company. Differences in tax rates between industries can result from tax regulations unique to certain industries. In addition to taxes, generally accepted accounting principles, or GAAP, require that one report certain unusual items separately on the current or prior period s income statement. These items can be classified into those affecting the current period income statement, and those affecting prior period income statements as shown below: Unusual items affecting the current period s income statement: fixed asset impairments restructuring charges discontinued operations extraordinary items Unusual items affecting the prior period s income statement: errors change in accounting principles Most corporations are required to pay estimated federal income taxes in four installments throughout the year. In addition to discussing the above, this lesson will also discuss investments in stocks and bonds. Corporations not only issue stock, but they also purchase stocks of other companies for investment purposes. Like individuals, businesses have a variety of reasons for investing in stocks, called equity securities. Taxable Income and Income before Taxes Under the U.S. tax code, corporations exist as taxable entities that must pay federal income taxes. Depending upon its location, a corporation may also be required to pay state and local income taxes. Most corporations are required to pay estimated federal income taxes in four installments throughout the year. For example, assume that a corporation with a calendar-year accounting period estimates its income tax expense for the year as $84,000. The entry to record the first of the four estimated tax payments of $21,000 (¼ of $84,000) reads as follows: Apr. 15 Income Tax Expense 21,000 Cash 21,000 Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 2 of 17

3 At year-end, one determines the actual taxable income and the related tax. If one owes additional taxes, the additional liability is recorded. If the total estimated tax payments prove greater than the tax liability based on actual taxable income, the overpayment should be debited to a receivable account and credited to Income Tax Expense. The taxable income of a corporation is determined according to the tax laws and is reported to taxing authorities on the corporation s tax return. This amount often differs from the income before income taxes reported in the income statement according to generally accepted accounting principles. As a result, the income tax based on taxable income usually differs from the income tax based on income before taxes. This difference may need to be allocated between various financial statement periods, depending on the nature of the items causing the differences. Some differences between taxable income and income before income taxes emerge because items are recognized in one period for tax purposes and in another period for income statement purposes. Such differences, called temporary differences, reverse or turn around in later years. Some examples of items that create temporary differences are listed below: Revenues or gains are taxed after they are reported in the income statement. Example: In some cases, companies that make sales under an installment plan recognize revenue for financial reporting purposes when a sale is made but defer recognizing revenue for tax purposes until cash is collected. Expenses or losses are deducted in determining taxable income after they are reported on the income statement. Example: Product warranty expense estimated and reported in the year of the sale for financial statement reporting is deducted for tax reporting when paid. Revenues or gains are taxed before they are reported in the income statement. Example: Cash received in advance for magazine subscriptions is included in taxable income when received but included in the income statement only when earned in a future period. Expenses or losses are deducted in determining taxable income before they are reported in the income statement. Example: MACRS depreciation is used for tax purposes, and the straight-line method is used for financial reporting purposes. Since temporary differences reverse in later years, they do not change or reduce the total amount of taxable income over the life of the business. To illustrate, assume that at the end of operations, a corporation reports $300,000 income before income taxes on its income statement. If one assumes an income tax rate of 40%, the income tax expense reported on the income statement is $120,000 ($300,000 x 40%). However, to reduce the amount owed for current income taxes, the corporation uses tax planning, which provides strategies significant in minimizing taxes, to reduce the taxable income to $100,000. Thus, the income tax actually due for the year is only $40,000 ($100,000 x 40%). The $80,000 ($120,000 $40,000) difference between the two tax amounts emerges as a result of temporary differences in recognizing revenues. This amount is deferred to future years. One can summarize this example as follows: Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 3 of 17

4 Income tax expense based on $300,000 reported income at 40% $120,000 Income tax payable based on $100,000 taxable income at 40% 40,000 Income tax deferred to future years $ 80,000 One reports the balance of Deferred Income Tax Payable at the end of a year as a liability. The amount due within one year is classified as a current liability. The remainder is classified as a long-term liability or reported in a deferred credits section following the long-term liability section. Differences between taxable income and income (before taxes) reported on the income statement may also arise because certain revenues exist as exempt from tax and certain expenses are not deductible in determining taxable income. Such differences, which will not reverse with the passage of time, are sometimes called permanent differences. For example, interest income on municipal bonds may be exempt from taxation. Such differences create no special financial reporting problems, since the amount of income tax determined according to the tax laws stands as the same amount reported on the income statement. Unusual Items Reported on the Income Statement Generally accepted accounting principles, or GAAP, require that certain unusual items be reported separately on the current or prior period s income statement. Fixed asset impairments. A fixed asset impairment occurs when the fair value of a fixed asset falls below its book value (cost less accumulated depreciation) and is not expected to recover. Examples of events that might cause an asset impairment include 1) decreases in the 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, or 4) expected cash flow losses from using fixed assets. For example, on March 1, assume that Jones Corporation consolidates operations by closing a factory. As a result of the closing, plant and equipment is impaired by $750,000. The journal entry to record the impairment reads as follows: Mar. 1 Loss on Fixed Asset Impairment 750,000 Equipment 750,000 One reports the loss on fixed asset impairment as a separate expense item deducted from gross profits in determining income from continuing operations. In addition, note disclosure should describe the nature of the asset impaired and the cause of the impairment. The loss reduces the book value of the fixed asset and thus reduces the depreciation expenses for future periods. If the asset is later sold, the gain or loss on the sale will be based on the lower book value. Thus, asset impairment accounting recognizes the loss when it is first identified, rather than when the asset is later sold. Restructuring Charges. Restructuring charges refer to costs incurred with actions, such as canceling contracts, laying off or relocating employees, and combining operations. Often, these events incur initial one-time costs to obtain long-term savings. For example, terminated employees often receive a one-time termination or severance benefit at the time of their Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 4 of 17

5 dismissal. Employee termination benefits are normally the most significant restructuring charges; thus, this section will focus on them. Employee termination benefits arise when a plan specifying the number of terminated employees, the benefit, and the benefit timing has been authorized by senior management and communicated to the employees. To illustrate, assume that the management of Jonas Corporation communicates 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. Once the plan is communicated to employees, they possess the legal right to work for 60 days but may elect to leave the firm earlier. That is, employees may be paid severance at the end of 60 days or at any time in between. The expense and liability to provide employee benefits should be recognized at fair value on the planned communication date. The fair value of this plan would be $1,000,000 (200 employees x $5,000), which stands as the aggregate expected cost of terminating the employees. Thus, the $1,000,000 restructuring charge would be recorded as follows: Mar. 1 Restructuring Charge 1,000,000 Employee Termination Obligation 1,000,000 One reports the restructuring charge as a separate expense deducted from gross profit in determining income from continuing operations. One would show the employee termination obligation as a current liability. If the plan called for expected severance payments beyond one year, then a long-term liability would be recognized. In addition, a note should disclose the nature and cause of the restructuring event and the costs associated with the type of restructuring event. The actual benefits paid to terminated employees should be debited to the liability as employees leave the firm. For example, assume that 25 employees find other employment and leave the company on March 25. The entry to record the severance payment to these employees would read as follows: Mar. 25 Employee Termination Obligation 125,000 Cash 125,000 Discontinued Operations. One reports a gain or loss from disposing of a business segment or component of an entity on the income statement as a gain or loss from discontinued operations. The term business segment refers to a major line of business for a company, such as a division, department, or certain class of customer. A component of an entity exists as the lowest level at which the operations and cash flows can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. Examples include a store for a retailer, a territory for a sales organization, or a product category for a consumer products company. To illustrate the disclosure, assume that Jonas Corporation includes separate divisions that produce electrical products, hardware supplies, and lawn equipment. Jonas sells its electrical products division at a loss. This loss would be deducted from Jonas income from continuing operations (income from its hardware and lawn equipment divisions). In addition, a note should disclose the identity of the segment sold, the disposal date, a description of the segment s assets and liabilities, and the manner of disposal. Extraordinary Item. An extraordinary item results from events and transactions that 1) are significantly different (unusual) from the typical or the normal operating activities of the business Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 5 of 17

6 and 2) occur infrequently. The gains and losses resulting from natural disasters that occur infrequently, such as floods, earthquakes, and fires, stand as extraordinary items. Gains or losses from condemning land or buildings for public use are also extraordinary. Such gains or losses, other than those from disposing of a business segment, should be reported on the income statement as extraordinary items. Gains and losses on the disposal of fixed assets are not considered extraordinary items. This is because 1) they are not unusual and 2) they recur from time to time in the normal operations of a business. Likewise, gains and losses from the sale of investments exist as usual and recurring for most businesses. In addition to unusual items impacting the income statement, two major items require a retroactive restatement of prior period earnings. These two items are: 1. Errors in the recognition, measurement, presentation, or disclosure of financial statements 2. Changes from one generally accepted accounting principle to another generally accepted accounting principle A retroactive restatement requires the adjustment of previously issued financial statements for the impact of errors and changes in accounting principle. If an error is discovered, which impacts a prior period financial statement, the prior period statement, and all following statements, it should be restated to reflect the correction. If a change from one generally accepted accounting principle to another occurs, the change is applied to prior period financial statements. That is, the prior period financial statements are restated as if the new accounting principle had always been used. In both cases, these changes do not impact current period earnings but will impact the earnings reported in past periods. As a result, the present Retained Earnings and other balance sheet accounts will be restated to reflect these prior period changes. Earnings per Common Share Investors and creditors often use the amount of net income in evaluating a company s profitability. However, net income by itself proves difficult to use in comparing companies of different sizes. Also, trends in net income may be difficult to evaluate Investors and creditors often use the amount of net income in evaluating a company s profitability. using only net income if significant changes have occurred in a company s stockholders equity. Thus, the profitability of companies is often expressed as earnings per share. Earnings per common share (EPS), sometimes called basic earnings per share, refer to the net income per share of common stock outstanding during a period. Corporations whose stock is traded in a public market must report earnings per common share on their income statements. If no outstanding preferred stock exists, the earnings per common share are calculated as follows: Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 6 of 17

7 Earnings per Common Share = Net Income Number of Common Shares Outstanding When the number of common shares outstanding changes during the period, a weighted average number of shares outstanding is used. If a company has preferred stock outstanding, the net income must be reduced by the amount of any preferred dividends, as shown below: Earnings per Common Share = Net Income Preferred stock Dividends Number of Common Shares Outstanding Comparing the earnings per share of two or more years, based on only the net incomes of those years, could be misleading. For example, assume that Jonas Corporation reported $700,000 net income for Also assume that the company reported no extraordinary or other unusual items in Jonas has no preferred stock outstanding and has 200,000 common shares outstanding in 2007 and The earnings per common share is $3.50 ($700, ,000 shares) for 2007 and $3.70 ($740, ,000 shares) for Comparing the two earnings per share suggests improvement of operations. When unusual items reported below income from continuing operations exist, earnings per common shares should be reported for those items. To illustrate, consider the partial income statement for Jonas Corporations showing earnings per common share below. In this income statement, Jonas reports all the earnings per common share amounts on the face of the income statement. However, only earnings per share amounts for income from continuing operations and net income are required to be presented on the face of the statement. The other per share amounts may be presented in the notes to the financial statements. Comprehensive Income Comprehensive income refers to all changes in stockholders equity during a period, except those resulting from dividends and stockholders investments. Companies must report traditional net income, plus or minus other comprehensive income items, to arrive at comprehensive income. Other comprehensive income items include foreign currency items, pension liability adjustments, and unrealized gains and losses on investments. Generally accepted accounting Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 7 of 17

8 principles (GAAP) require that these items are disclosed separately from earnings. The cumulative effects of other comprehensive income items must be reported separately from retained earnings and paid-in capital on the balance sheet and as accumulated other comprehensive income. Companies may report comprehensive income on the income statement, on a separate income statement of comprehensive income, or on the statement of stockholders equity. In addition, companies may use terms other than comprehensive income, such as total non-owner changes in equity. To illustrate reporting for comprehensive income, assume that Triple-D Enterprises, Inc. reported comprehensive income on a separate statement, called the statement of comprehensive income, as follows: The Stockholders Equity section of the balance sheet for Triple-D Enterprises is as follows: Accumulated other comprehensive income refers to the cumulative effect of other comprehensive income items. Thus, the additional other comprehensive income of $90 for 2008 is added to the accumulated other comprehensive income on December 31, 2007, to yield the December 31, 2008, balance of $1, Note that comprehensive income does not affect net income or retained earnings. The next section will illustrate the determination of other comprehensive income, using unrealized gains and losses on investments. Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 8 of 17

9 Short-term and Long-term Investments in Stocks A business may purchase stocks as a means of earning a return (income) on excess cash that it does not need for normal operations. Such investments are usually short-term. In other cases, a business may purchase the stock of another company as a long-term investment. Such investments may serve as a means of developing or maintaining business relationships with another company. Sometimes, a business will purchase most, if not all, of the common stock of another company for purposes of owning and controlling another entity. This is termed a business combination. The equity securities in which a business invests may be classified as trading securities or available-for-sale securities. Trading securities refers to securities that management intends to actively trade for profit. Businesses holding trading securities are those whose normal operations involve buying and selling securities. Examples of such businesses include banks and insurance companies. Available-for-sale securities are securities that management expects to sell in the future but that are not actively traded for profit. Short-term investments in stock. Rather than allow excess cash to rest idle until needed, a business may invest in available-for-sale securities. These investments are classified as temporary investments or marketable securities. Although such investments may be retained for several years, they continue under temporary classification, provided they meet two conditions. First, the securities remain readily marketable and able to be sold for cash at any time. Second, management intends to sell the securities when the business needs cash for operations. Temporary investments in available-for-sale securities are recorded in a current asset account, Marketable Securities, at their cost. This cost includes all amounts spent to acquire the securities, such as broker s commissions. Any dividends received on the investments are recorded as a debit to Cash and a credit to Dividend Revenue. To illustrate, assume that on June 1, Crabtree Co. purchased 2,000 shares of Iris Corporation common stock at $89.75 per share plus a brokerage fee of $500. On October 1, Iris declared a $0.90 per share cash dividend payable on November 30. Crabtree s entries to record the stock purchase and the receipt of the dividend read as follows: June 1 Marketable Securities 180,000 Cash 180,000 Purchased 2,000 shares of Iris Corporation common stock [($89.75 x 2,000 shares) + $500] Nov. 30 Cash 1,800 Dividend Revenue 1,800 Received dividend on Iris Corporation common stock (2,000 shares x $0.90) On the balance sheet, one reports temporary investments at their fair market value. Market values are normally available from stock quotations in financial newspapers, such as the Wall Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 9 of 17

10 Street Journal. Any difference between the fair market values of the securities and their cost stands as an unrealized holding gain or loss. This gain or loss is termed unrealized because a transaction (the sale of the securities) is necessary before a gain or loss becomes real (realized). To illustrate, assume that Crabtree Co. s portfolio of temporary investments was purchased in 2008 and has the following fair market values and unrealized gains and losses on December 31, 2008: If income taxes of $18,000 are allocated to the unrealized gain, Crabtree s temporary investments should be reported at their total cost of $690,000, plus the unrealized gain (net of applicable income tax) of $42,000 ($60,000 $18,000). The unrealized gain should also be reported as other comprehensive income item. Long-term investments in stocks. Long-term investments in stocks 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. One reports these investments on the balance sheet under the caption Investment, which usually follows the Current Assets section. One treats long-term investments in stock as availablefor-sale securities, as illustrated previously for shortterm available-for-sale securities. Therefore, a longterm investment treated as an available-for-sale security is recorded at cost and reported at fair market value net of any applicable income tax effects. In addition, one reports any unrealized gains and losses as part of the comprehensive income. However, if the investor (the buyer of the stock) holds significant influence over the operating and financing activities of the investee (the company whose stock is owned), the equity method is used. When one uses the equity method, a stock purchase is recorded at cost, as shown previously. Evidence of significant influence includes the percentage of ownership, the existence of intercompany transactions, and the interchange of Long-term investments in stocks 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. Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 10 of 17

11 management personnel. Generally, if the investor owns 20% or more of the voting stock of the investee, it is assumed that the investor holds significant influence over the investee. To illustrate, assume that on January 2, Holly, Inc. pays cash of $350,000 for 40% of the common stock and net assets of Brook Corporation. Assume also that for the year ending December 31, Brook Corporation reports net income of $105,000 and declares and pays $45,000 in dividends. Using the equity method, Holly, Inc. (the investor) records these transactions as follows: Jan. 2 Investment in Brook Corporation Stock 350,000 Cash 350,000 Purchased 40% of Brook Corporation stock Dec. 31 Investment in Brook Corporation Stock 42,000 Income of Brook Corporation 42,000 Recorded 40% share of Brook Corporation net income of $105,000 Dec. 31 Cash 18,000 Investment in Brook Corporation Stock 18,000 Recorded 40% share of Brook Corporation dividends The combined effect of recording 40% of Brook Corporation s net income and dividends is to increase Holly s interest in the net assets of Brook by $24,000 ($42,000 $18,000). The equity method causes the investment account to mirror the proportional changes in the book value of the investee. Thus, Brook Corporation s book value increased by $60,000 ($105,000 $45,000), while the investment in Brook Corporation stock account increased by Holly s proportional share of that increase, or $24,000 ($60,000 x 40%). Thus, both the book value of Brook Corporation and Holly s investment in Brook increased at the same rate from the original cost. The Pricing of Bonds Payable and Different Types of Bonds A bond is simply a form of an interest-bearing note. Like a note, a bond requires periodic interest payments, and the face amount must be repaid at the maturity date. Bondholders are creditors of the issuing corporation, and their claims on the assets of the corporation rank ahead of stockholders. In addition to their face values, interest rates, interest payment dates, and maturity dates, bonds may differ in a variety of ways. A corporation that issues bonds enters into a contract called a bond indenture with the bondholders. A bond issue is normally divided into a number of individual bonds. Usually, the face value of each bond, called the principal, stands as $1,000 or a multiple of $1,000. The interest on bonds may be payable annually, semi-annually, or quarterly. Most bonds pay interest semi-annually. The prices of bonds are quoted as a percentage of the bonds Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 11 of 17

12 face value. Thus, investors could purchase or sell bonds quoted at for $1, Likewise, bonds quoted at 109 could be purchased at $1, When all bonds of an issue mature at the same time, one refers to them as term bonds. If the maturities are spread over several dates, one refers to them as serial bonds. For example, one-tenth of an issue of $1,000,000 bonds, or $100,000, may mature 16 years from the issue date, another $100,000 in the 17 th year, and so on, until the final $100,000, matures in the 25 th year. Bonds that may be exchanged for other securities, such as common stock, are called convertible bonds. Callable bonds refer to bonds that a corporation reserves the right to redeem before their maturity. Bonds issued on the basis of the general credit of the corporation are called debenture bonds. When a corporation issues bonds, the price that buyers are willing to pay for the bonds depends upon the following three factors: 1. The face amount of the bonds, which is the amount due at the maturity date 2. The periodic interest to be paid on the bonds 3. The market rate of interest The face amount and the periodic interest to be paid on the bonds are identified in the bond indenture. The periodic interest is expressed as a percentage of the face amount of the bond. This percentage or rate of interest is called the contract rate or coupon rate. Transactions between buyers and sellers of similar bonds determine the market or effective rate of interest. The market rate of interest is affected by a variety of factors, including investors assessments of current economic conditions, as well as future expectations. If the contract rate of interest equals the market rate of interest, the bonds will sell at their face amount. If the market rate of interest is higher than the contract rate, the bonds will sell at a discount, or less than their face amount. In contrast, if the market rate is lower than the contract rate, the bonds will sell at a premium, or more than their face amount. The face amount of the bonds and the periodic interest on the bonds represents cash to be received by the buyer in the future. The buyer determines how much to pay for the bonds by computing the present value of these future cash receipts using the market rate of interest. The concept of present value is based on the time value of money. The time value of money concept recognizes that an amount of cash to be received today is worth more than the same amount of cash to be received in the future. For example, what would you rather have: $100 today or $100 one year from now? Many would rather have the $100 today because one could invest the money to earn income. For example, if the $100 could be invested to earn 10% per year, the $100 would accumulate to $110 ($100 plus $10 earnings) in one year. In this sense, you can think of the $100 in hand today as the present value of $110 to be received a year from today. Future value stands as a related concept to present value. In the preceding example, the $110 to be received a year from today is the future value of $100 today, assuming an interest rate of 10%. Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 12 of 17

13 The present value of the face amount of bonds refers to the value today of the amount to be received at a future maturity date. For example, assume that one is to receive the face value of a $1,000 bond in one year. If the market rate of interest is 10%, the present value of the face value of the $1,000 bond is $ ($1, ). If one is to receive the face value of $1,000 in two years, with interest of 10% compounded at the end of the first year, the present value is $ ($909.09/1.10). One can determine the present value of the face amount of bonds to be received in the future by a time line and a series of divisions. In practice, however, it is easier to use a table of present values. One can use the present value of $1 table to find the present value factor for $1 to be received after a number of periods in the future. One then multiplies the face amount of the bonds by this factor to determine its present value. The present value of the periodic bond interest payments refers to the value today of the amount of interest to be received at the end of each interest period. Such a series of equal cash payments at fixed intervals is called an annuity. The present value of an annuity is the sum of the present values of each cash flow. To illustrate, assume that the $1,000 bond in the previous example pays interest of 10% annually and the market rate of interest is also 10%. In addition, assume that the bond matures at the end of two years. The present value of the two interest payments of $100 ($1,000 x 10%) is $ Separate present value tables are normally used for annuities. This shows the present value of $1 to be received at the end of each period for various compound rates of interest. For example, the present value of $100 to be received at the end of each of the next two years at 10% compounded interest per period is $ ($100 x ). This amount is the same amount computed previously. As stated earlier, the amount buyers are willing to pay for a bond is the sum of the present value of the face value and the periodic interest payments, calculated by using the market rate of interest. In this example, the calculation reads as follows: The market rate and the contract rate of interest are the same. Thus, the present value is the same as the face value. Accounting Entries for Bonds Payable for Corporations Bonds issued at face amount. To illustrate the journal entries for issuing bonds, assume that on January 1, 2007, a corporation issues for cash $100,000 of 12%, five-year bonds, with interest of $6,000 payable semiannually. The market rate of interest at the time of the bond s issuance is 12%. Since the contract rate and the market rate of interest are the same, the bonds will sell at their face amount. This amount is the sum of (1) the present value of the face amount of $100,000 to be repaid in five years and (2) the present value of 10 semiannual interest payments of $6,000 each. This computation is shown below: Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 13 of 17

14 The following entry records the issuing of the $100,000 bonds at their face amount: Jan. 1 Cash 100,000 Bonds Payable 100,000 Issued $100,000 bonds payable at face amount Every six months after the bonds have been issued, interest payments of $6,000 are made. The first interest payment is recorded as follows: June 30 Interest Expense 6,000 Cash 6,000 Paid six months interest on bonds At the maturity date, the payment of the principal of $100,000 is recorded as follows: Dec. 31 Bonds Payable 100,000 Cash 100,000 Paid bond principal at maturity date Bonds issued at a discount. What if the market rate of interest is higher than the contract rate of interest? If the market rate of interest is 13% and the contract rate is 12% on the five-year, $100,000 bonds, the bonds will sell at a discount. One calculates the present value of these bonds as follows: The two present values that make up the total are both less than the related amounts in the preceding example. This results because the market rate of interest was 12% in the first example, while the market rate of interest is 13% in this example. The present value of a future Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 14 of 17

15 amount becomes less and less as the interest rate used to compute the present value increases. The entry to record the issuing of the $100,000 bonds at a discount is shown below: Jan. 1 Cash 94,406 Discount on Bonds Payable 3,594 Bonds Payable 100,000 Issued $100,000 bonds at a discount The $3,594 discount may be viewed as the amount needed to entice investors to accept a contract rate of interest below the market rate. One may think of the discount as the market s way of adjusting a bond s contract rate of interest to the higher market rate of interest. Using this logic, generally accepted accounting principles require that bond discounts be amortized as interest expense over the life of the bond. Amortizing a bond discount. Two methods of amortizing a bond discount exist: (1) the straight-line method and (2) the effective interest method, often called the interest method. Both methods amortize the same total amount of discount over the life of the bonds. Because the straight-line method illustrates the basic concept of amortizing discounts and proves simpler, it will be used in this lesson. The straight-line method of amortizing a bond discount provides for amortization in equal periodic amounts. Applying this method to the previous example yields amortization of 1/10 of $3,594, or $359.40, each half year. The amount of the interest expense on the bonds is the same, $6, ($6,000 + $359.40), for each half year. The entry to record the first interest payment and the amortization of the related discount follow: June 30 Interest Expense 6, Discount on Bonds Payable Cash Paid semi-annual interest and amortized 1/10 of bond discount Bonds issued at a premium. If the market rate of interest is 11% and the contract rate is 12% on the five-year, $100,000 bonds, the bonds will sell at a premium. The present value of these bonds is computed below: Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 15 of 17

16 The entry to record the issuing of the bonds is as follows: Jan. 1 Cash 103,769 Bonds Payable 100,000 Premium on Bonds Payable 3,769 Issued $100,000 bonds at a premium Amortizing a bond premium. The amortization of a bond premium exists as basically the same as that for bond discounts, except that interest expense is decreased. In the above example, the straight-line method yields amortization of 1/10 of $3,769, or $376.90, each half year. The entry to record the first interest payment and the amortization of the related premium reads as follows: June 30 Interest Expense 5, Premium on Bonds Payable Cash 6, Paid semi-annual interest and amortized 1/10 of bond premium Glossary Annuity: A series of equal cash payments at fixed intervals. Available-for-sale securities: Securities that management expects to sell in the future but are not actively traded for profit. Bond indenture: Contract a corporation that issues bonds enters into with the bondholders. Bond: A form of an interest-bearing note. Business segment: A major line of business for a company, such as a division, department, or certain class of customer. Callable bonds: Bonds that a corporation reserves the right to redeem before their maturity. Comprehensive income: All changes in stockholders equity during a period, except those resulting from dividends and stockholders investments. Contract rate: Periodic interest is expressed as a percentage of the face amount of the bond. This percentage or rate of interest is called the contract rate, or coupon rate. Convertible bonds: Bonds that may be exchanged for other securities, such as common stock. Debenture bonds: Bonds issued on the basis of the general credit of a corporation. Discontinued operations: A gain or loss from disposing a business segment or component of an entity, which is reported on the income statement. Earnings per common share (EPS): Sometimes called basic earnings per share, the net income per share of common stock outstanding during a period. Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 16 of 17

17 Extraordinary item: Results 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. Fixed asset impairment: Occurs when the fair value of a fixed asset falls below its book value (cost less accumulated depreciation) and is not expected to recover. Restructuring charges: Costs incurred with actions such as canceling contracts, laying off or relocating employees, and combining operations. Serial bonds: Bonds whose maturities are spread over several dates. Term bonds: Bonds of an issue that have all matured at the same time. Trading securities: Securities that management intends to actively trade for profit. Businesses holding trading securities are those whose normal operations involve buying and selling securities. Copyright 2009 The Learning House, Inc. Income Taxes and Investments Page 17 of 17