SU 3.1 Property, Plant, and Equipment

Transcription

1 Part 1 Study Unit 3

2 SU 3.1 Property, Plant, and Equipment Overview Property, plant and equipment are also referred to as fixed assets, or capital assets. Last more than 1 year. Are for production or benefit the main operation of the firm. Initial Measurement Booked at historical cost, which are all the costs and fees necessary to bring it to use. Interest (borrowing costs) attributable to the acquisition, construction or production of asset for internal use. continued

3 SU 3.1 Property, Plant, and Equipment Subsequent to acquisition Net Asset Value = Historical cost Accumulated Depreciation Impairment Cost Also called carrying value Additional expenditures on asset Capitalized and depreciated provide additional benefits by improving the quality of service, extending the useful life, or increasing output. Expensed as incurred maintain normal service capacity, such as routine maintenance and repairs.

4 SU 3.1 Property, Plant, and Equipment Depreciation Process of systematically and rationally allocating base of an asset over its expected useful life. Depreciable base = Historical cost Salvage value Recognized impairment loss Estimated useful life time over which economic benefits are expected to be obtained from the assets. Land is indefinite. Salvage value Residual value after its useful life has expired. Depreciation method reflect pattern of economic benefits are expected to be received. Know IFRS difference continued

5 SU 3.1 Property, Plant, and Equipment Depreciation Methods Straight-line simplest, linear See example page 85 Units-of-output allocates cost based on production See example page 85 continued

6 SU 3.1 Property, Plant, and Equipment Depreciation Methods Accelerated depreciation methods Declining balance Sum-of-the-years-digits Group and composite depreciation See IFRS differences shown on page 87

7 SU 3.1 Property, Plant and Equipment Practice question 1 An entity installed an assembly line in Year 1. Four years later, $100,000 was invested to automate the line. The automation increased the market value and productive capacity of the assembly line but did not affect its useful life. Proper accounting for the cost of the automation should be to A Report it as an expense in Year 5. B Establish a separate account for the $100,000. C D Allocate the cost of automation between the asset and accumulated depreciation accounts. Debit the cost to the property, plant, and equipment account.

8 SU 3.1 Property, Plant and Equipment Practice question 1 answer Correct Answer: D Subsequent costs are added to the carrying amount of an item of PPE if it is probable that, as a result, future economic benefits will be received, and the costs are reliably measurable. An extended useful life, improved output quantity or quality, and reduced operating costs are all future economic benefits. Incorrect Answers: A The cost should be capitalized. B C The same account should be used. Allocation is not an accepted procedure.

9 SU 3.1 Property, Plant and Equipment Practice question 2 In making a cash flow analysis of property, plant, and equipment (PPE), the internal auditor discovered that depreciation expense for the period was $10,000. PPE with a cost of $50,000 and related accumulated depreciation of $30,000 was sold for a gain of $1,000. If the carrying amount of PPE increased by $80,000 during the period, how much PPE was purchased this period? A $91,000 B $100,000 C US $110,000 D $119,000

10 SU 3.1 Property, Plant and Equipment Practice question 2 answer Correct Answer: C The carrying amount of the PPE account, net of accumulated depreciation, is increased by the cost of purchases and decreased by the carrying amount of items of PPE sold and depreciation. The net PPE decreased by the carrying amount of items sold, or $20,000 ($50,000 cost $30,000 accumulated depreciation), and by the $10,000 of depreciation. If PPE still increased by $80,000, $110,000 ($30,000 total decrease + $80,000 increase) of equipment must have been purchased. Incorrect Answers: A The amount of $91,000 results from ignoring the carrying amount of items sold and from including the gain in the computation. B D The amount of $100,000 results from ignoring the depreciation expense for the period. The amount of $119,000 results from double counting depreciation expense and from deducting the gain.

11 SU 3.1 Property, Plant and Equipment Practice question 3 A new machine has an initial cost of $300,000, an estimated useful life of 2,000 hours of use over a 3-year period, and an estimated residual value of $70,000. Usage rates are estimated as 500 hours in the first year, 700 hours in the second year, and 800 hours in the third year. Depreciation expense in Year 2 under the units-of-production method of depreciation will be A $57,500 B $75,000 C $80,500 D $105,000

12 SU 3.1 Property, Plant and Equipment Practice question 3 answer Correct Answer: C Depreciation expense equals cost minus residual value, times the estimated hours of use in Year 2 divided by the total estimated hours of use. Thus, depreciation expense is $80,500 [($300,000 $70,000) (700 hours 2,000 hours)]. Incorrect Answers: A The depreciation expense for Year 1 is $57,500. B The expense for Year 1 calculated without subtracting the residual value is $75,000. D Failing to subtract the residual value results in $105,000.

13 SU 3.1 Property, Plant and Equipment Practice question 4 The board of directors of Ingold Industries, Inc., authorized Don Burger, president of Ingold, to pay as much as $90,000 to purchase a tract of land adjacent to the main factory. Burger negotiated a price of $75,800 for the land, and legal fees for closing costs amounted to $820. A contractor cleared, filled, and graded the land for $6,800, and dug the foundation for a new building for $4,300. A prefabricated building was erected at a cost of $181,000. The building has an estimated useful life of 20 years with no residual value. The contractor s bill indicated that the cost of the parking lot and driveways was $7,060. The parking lot and the driveways will need to be replaced in 15 years. The proper amount to be recorded in Ingold s land account is A $76,620 B $83,420 C $87,720 D $90,480

14 SU 3.1 Property, Plant and Equipment Practice question 4 answer Correct Answer: B The cost of acquiring and preparing land for its expected use is capitalized. The amount to be recorded in the land account is $83,420, consisting of the $75,800 purchase price, the $820 closing costs, and the $6,800 site preparation costs. Incorrect Answers: A The amount of $76,620 results from excluding the cost of clearing, grading, and filling. C D The amount of $87,720 results from including the cost of the building s foundation. The amount of $90,480 results from including the cost of the parking lot and driveways. This cost should be recognized in the land improvements account.

15 SU 3.2 Impairment and Disposal of Long-Lived Assets Two-Step Impairment Test Applies to fixed and intangible assets with a finite useful lives, when events or changes in circumstances indicate that carrying amounts of assets are recoverable from market price decreases or physical condition has changed adversely. Step 1 Recoverability test Test to see if carrying amount exceeds the sum of undiscounted future cash flows from use and disposition. Step 2 If answer from step 1 is yes, recognize loss equal to the excess of the carrying amount over its fair value. Loss is recognized immediately from income from continuing operations, and the adjusted value is the carrying amount. See example and IFRS difference on page 88

16 SU 3.2 Impairment and Disposal of Long-Lived Assets Disposal of Long-Lived Assets Gain or loss of disposal is the difference between carrying amount and net proceeds. See example on page 89

17 SU 3.2 Impairment & Disposal of Long-Lived Assets Practice question 1 An entity purchased a machine on January 1, Year 1, for $1,000,000. The machine had an estimated useful life of 9 years and a residual value of $100,000. The company uses straight-line depreciation. On December 31, Year 4, the machine was sold for $535,000. The gain or loss that should be recorded on the disposal of this machine is A B C D $35,000 gain. $65,000 loss. $365,000 loss. $465,000 loss.

18 SU 3.2 Impairment & Disposal of Long-Lived Assets Practice question 1 answer Correct Answer: B The accumulated depreciation was $400,000 {[($1,000,000 historical cost $100,000 residual value) 9 years estimated useful life] 4 years}, so the carrying amount was $600,000 ($1,000,000 $400,000). Thus, the loss was $65,000 ($600,000 carrying amount $535,000 sales price). Incorrect Answers: A C D Selling price, minus carrying amount, plus residual value equals a $35,000 gain. Cost, minus selling price, minus residual value equals a $365,000 loss. Cost minus selling price equals a $465,000 loss.

19 SU 3.2 Impairment & Disposal of Long-Lived Assets Practice question 2 Which of the following statements is true regarding impairment of long-lived assets? A B C D U.S. GAAP requires a one-step impairment test, and IFRS requires a two-step impairment test. Both IFRS and U.S. GAAP permit reversal of an impairment loss in subsequent periods. Both IFRS and U.S. GAAP prohibit reversal of an impairment loss in subsequent periods. Under U.S. GAAP, but not IFRS, reversal of an impairment loss in subsequent periods is prohibited.

20 SU 3.2 Impairment & Disposal of Long-Lived Assets Practice question 2 answer Correct Answer: D Under IFRS, an impairment loss on an asset may be reversed in subsequent periods if a change in the estimates used to measure the recoverable amount has occurred. But an impairment loss recognized for goodwill must not be reversed. Under U.S. GAAP, a previously recognized impairment loss must not be reversed. Incorrect Answers: A B C U.S. GAAP requires a two-step impairment test, and IFRS requires a one-step impairment test. Under U.S. GAAP, a previously recognized impairment loss may not be reversed. Under IFRS, an impairment loss may be reversed in subsequent periods.

21 SU 3.2 Impairment & Disposal of Long-Lived Assets Practice question 3 An impairment loss on a long-lived asset (asset group) to be held and used is reported by a business enterprise in A B C D Discontinued operations. Extraordinary items. Other comprehensive income. Income from continuing operations.

22 SU 3.2 Impairment & Disposal of Long-Lived Assets Practice question 3 answer Correct Answer: D An impairment loss is included in income from continuing operations before income taxes by a business enterprise (income from continuing operations in the statement of activities by a not-forprofit organization). When a subtotal for income from operations is reported, the impairment loss is included. Incorrect Answers: A B C A long-lived asset (asset group) to be held and used is not a discontinued operation. An impairment loss does not meet the criteria for an extraordinary item (unusual in nature and infrequent in the environment in which the entity operates). An impairment loss is reported in the income statement. Items reported in OCI have bypassed the income statement.

23 SU 3.3 Intangible Assets Intangible Assets Identifiable, nonmonetary assets lacking physical substance. Initial Recognition Either externally acquired or internally developed Externally acquired recorded at cost plus any additional cost Internally developed (other than goodwill) are recorded initially at the additional costs other those for R&D R&D expensed as incurred See example and IFRS difference on page 89 & 89-90

24 SU 3.3 Intangible Assets Intangible Assets Finite useful live Total cost minus residual valued amortized over useful life Carrying amounts Impairment test Indefinite useful live Not amortized, but instead periodically tested for impairment (all except goodwill) Qualitative assessment 1st Quantitative assessment only if findings from qualitative testing deems so Nonreversible continued

25 SU 3.3 Intangible Assets Impairment test for indefinite useful life Reviewed (tested) at least annually Qualitative If potential impairment is found quantitative test must be performed Quantitative Carrying amount is compared with fair value Nonreversible

26 SU 3.3 Intangible Assets Intangible Assets - Goodwill Not finite Tested at the reported-unit level Similar that qualitative test is performed first If fair value is greater then carrying amount, then no impairment If fair value is less, recognize at reported-unit level; non-reversible

27 SU 3.3 Intangible Assets Intangible Assets - Patents Lesser of the useful life or legal life Treatment of the cost associated with the legal defense of a patent depends on the outcome Successful litigation are capitalized to the cost of the patent because they will benefit future use of the patent. Unsuccessful litigation are expensed as incurred, and could actually lead to impairment recognition.

28 SU 3.3 Intangible Assets Practice question 1 A recognized intangible asset is amortized over its useful life A B C D Unless the pattern of consumption of the economic benefits of the asset is not reliably determinable. If that life is determined to be finite. Unless the precise length of that life is not known. If that life is indefinite but not infinite.

29 SU 3.3 Intangible Assets Practice question 1 answer Correct Answer: B A recognized intangible asset is amortized over its useful life if that useful life is finite, that is, unless the useful life is determined to be indefinite. The useful life of an intangible asset is indefinite if no foreseeable limit exists on the period over which it will contribute, directly or indirectly, to the reporting entity s cash flows. Incorrect Answers: A C D An intangible asset is amortizable if its useful life is finite. If the pattern of consumption of the economic benefits of such an intangible asset is not reliably determinable, the straight-line amortization method is applied. If the precise length of the useful life is not known, an intangible asset with a finite useful life is amortized over the best estimate of its useful life. A recognized intangible asset is not amortized if its useful life is indefinite.

30 SU 3.3 Intangible Assets Practice question 2 Hansen, Inc., purchased a patent at the beginning of Year 1 for $22,100 that was to be amortized over 17 years. On July 1 of Year 8, Hansen incurred legal costs of $11,400 to successfully defend the patent. The amount of amortization expense that Hansen should record for Year 8 is A $2,500 B $1,971 C $1,900 D $1,300

31 SU 3.3 Intangible Assets Practice question 2 answer Correct Answer: C Hansen will amortize the cost of the patent on a straight-line basis at the rate of $1,300 per year ($22,100 17). The costs of a successful legal defense of a patent are capitalized and amortized over the shorter of the remaining legal life or the estimated useful life of the patent. Because the legal costs to defend the patent were incurred when the patent had 9.5 years of life remaining, they will be amortized at a rate of $1,200 per year ($11, ). Because Year 8 only includes a half year s depreciation for the legal costs, total amortization expense for that year is $1,900 ($1,300 + $600). Incorrect Answers: A The amount of $2,500 results from improperly including a full year s amortization of the legal costs. B The amount of $1,971 results from improperly amortizing the legal costs over the life of the patent. D The amount of $1,300 results from failing to include any amortization of the legal costs.

32 SU 3.3 Intangible Assets Practice question 3 On July 1, Broadstreet Corporation acquired a patent on its new manufacturing process, which streamlines its production operation. The cost of the patent was $17,000, and Broadstreet expects that the useful life of the new process will be 10 years, although the legal life of the patent is 17 years. Broadstreet is a calendar-year corporation and is preparing its December 31 Statement of Financial Position. At which amount should the patent be reported at December 31 of the year of acquisition? A $15,300 B $16,000 C $16,150 D $16,500

33 SU 3.3 Intangible Assets Practice question 3 answer Correct Answer: C A patent is amortized over the shorter of its useful life or legal life, so annual amortization on this patent is $1,700 ($17, years). The depreciation expense for the year of acquisition is $850 [$1,700 (6 12 months)]. The patent should therefore be reported at December 31 at $16,150 ($17,000 $850). Incorrect Answers: A B D The amount of $15,300 results from improperly taking a full year of depreciation. The amount of $16,000 results from improperly using the legal life of the patent rather than its useful life and improperly taking a full year of depreciation. The amount of $16,500 results from improperly using the legal life of the patent rather than its useful life.

34 SU 3.3 Intangible Assets Practice question 4 Which one of the following statements is correct about the reconciliation of U.S. GAAP and International Financial Reporting Standards (IFRS)? A B C D The costs of development must be expensed under U.S. GAAP, but are capitalized under IFRS if they meet specific criteria. The costs of research must be expensed under U.S. GAAP, but are capitalized under IFRS if they meet specific criteria. All costs of research and development must be expensed under both U.S. GAAP and IFRS. Internally generated goodwill may not be capitalized under U.S. GAAP, but it may be capitalized under IFRS.

35 SU 3.3 Intangible Assets Practice question 4 answer Correct Answer: A Under IFRS, (1) costs incurred during the research phase of an internal project are expensed as incurred since the company cannot demonstrate that an intangible asset exists that will generate probable future economic benefits; and (2) costs incurred during the development phase of an internal project can be capitalized and recognized as an intangible asset if, and only if, the company can demonstrate all of the following: 1.The technical feasibility to complete the intangible asset 2.Its intention to complete and use or sell the intangible asset 3.Its ability to sell or use the intangible asset 4.Availability of resources to complete and use or sell the intangible asset 5.The way in which the asset will generate probable future economic benefits 6.Its ability to reliably measure expenditures attributable to the asset

36 SU 3.4 Leases Leases Any long-term contract in which the owner of property (the lessor) allows another party (the lessee) to use the property for a stated period in exchange for a stated payment. The question that must be answered is, who will substantially gain the benefits and risk of ownership? If yes, then it is a capital lease, and should include: Transfer of ownership. Bargain purchase option Provides 75% or more of the estimated economic life of the leased property PV of min. lease payments equals 90% of the fair value of the leased property. Lease is a purchase-and-financing agreement. Both assets and liabilities are recognized at the present value (implicit rate or lessor s incremental borrowing rate) of the minimum lease payments, which includes rental payments plus the amount of residual value. continued

37 SU 3.4 Leases Leases - Operating leases If no, then an operating lease and the lessor retains substantially all the benefits and risks. Lessee reports period rental expense. Off-balance sheet financing Consider why there may be a motivation to consider a lease an operating lease in lieu of a capital lease.

38 SU 3.4 Leases Leases Capital leases - Lessee: Periodic payments have two components: Interest expense, and a reduction of the lease liability. Interest expense is calculated using the effective-interest method. Lessee must depreciate the asset either over the: Estimated economic life, or Term of the lease. continued

39 Leases Capital leases - Lessor: SU 3.4 Leases Lessor removes asset from financial statement and books receivable for the present value of minimum lease payments to be received. Does not depreciate. Each payment has two components: Interest revenue Reduction of the lease receivables Classifies lease as either a: Direct financing lease Economic interest is in financing; no dealer s profit or loss. Sales-type lease Recognizes dealer s profit Subsequent to the inception of the lease, the accounting is the same. continued

40 SU 3.4 Leases Leases Capital leases - Lessor: No depreciation is recognized. Each payment has two components: Interest revenue Reduction of the lease receivables Debit gross lease receivable Credit to unearned interest income See example on page 95

41 SU 3.4 Leases Practice question 1 Which one of the following statements with respect to leases is correct? A B C D An operating lease is treated like a rental contract between the lessor and lessee. A lease that does not transfer ownership from the lessor to the lessee by the end of the lease is automatically an operating lease. Sales and direct financing leases pertain more to lessees than lessors. Unpredictability of lease revenues or expenses can transform what would otherwise be a capital lease for the lessee into an operating lease for the lessee.

42 SU 3.4 Leases Practice question 1 answer Correct Answer: A An operating lease is a transaction in which the lessee rents the right to use the lessor s assets without acquiring a substantial portion of the benefits and risks of ownership. Thus, an operating lease is treated like a rental contract between the lessor and lessee. Incorrect Answers: B C D The transfer of ownership test is only one of four tests that are used to determined whether a lease is classified as a capital lease. Sales-type leases and direct financing leases are reported by lessors, not lessees. The degree of unpredictability of lease revenues or expenses is not a factor for the lessee in the classification of the lease as a capital or operating lease.

43 SU 3.4 Leases Practice question 2 Keller Corporation signed a 3-year lease for an automobile on December 1. The automobile had a list price of $17,000 and an estimated useful life of 8 years. The lease called for payments of $500 per month for 36 months. The present value of the $500 payments was $15,054 at Keller s incremental borrowing rate and $15,496 at the lessor s implicit rate, which is known to the lessee. Based on the above information, Keller should record the lease as a(n) A B C D Capital lease. Operating lease. Sale-leaseback. Sales-type lease.

44 SU 3.4 Leases Practice question 2 answer Correct Answer: A A lessee must report a lease as a capital lease if the present value of the minimum lease payments (MLP) is at least 90% of the fair value of the asset. If the lessor s implicit rate is known to the lessee, that is the appropriate rate for discounting the MLP. Dividing the present value of the MLP by the list price of the automobile yields a result > 90% ($15,496 $17,000 = 91.2%). Thus, this lease must be classified by Keller as a capital lease. Incorrect Answers: B A lease in which the present value of the minimum lease payments equals or exceeds 90% of the fair value of the asset must be classified by the lessee as a capital lease. C D No provision for a sale-leaseback arrangement was mentioned. Only lessors report sales-type leases.

45 SU 3.4 Leases Practice question 3 On January 1, Year 4, Harrow Co., as lessee, signed a 5-year noncancelable equipment lease with annual payments of $100,000 beginning December 31, Year 4. Harrow treated this transaction as a capital lease. The five lease payments have a present value of $379,000 at January 1, Year 4, based on interest of 10%. What amount should Harrow report as interest expense for the year ended December 31, Year 4? A $37,900 B $27,900 C $24,200 D $0

46 SU 3.4 Leases Practice question 3 answer Correct Answer: A Under the effective-interest method, interest expense for the first year is $37,900 ($379,000 lease obligation 10% effective interest rate). Incorrect Answers: B The amount of $27,900 assumes the initial payment was made immediately. C D The amount of $24,200 is one-fifth of the total interest ($500,000 $379,000 PV). Interest must be accrued.

47 SU 3.4 Leases Practice question 4 Leases should be classified by the lessee as either operating leases or capital leases. Which of the following statements best characterizes operating leases? A B C D The benefits and risks of ownership are transferred from the lessor to the lessee. The lessee records leased property as an asset and the present value of the lease payments as a liability. Operating leases transfer ownership to the lessee, contain a bargain purchase option, are for more than 75% of the leased asset s useful life, or have minimum lease payments with a present value in excess of 90% of the fair value of the leased asset. The lessor records lease revenue, asset depreciation, maintenance, etc., and the lessee records lease payments as rental expense.

48 SU 3.4 Leases Practice question 4 answer Correct Answer: D Operating leases are transactions whereby lessees rent the right to use lessor assets without acquiring a substantial portion of the benefits and risks of ownership of those assets. Incorrect Answers: A When the benefits and risks of ownership are transferred from the lessor to the lessee, the transaction is a capital lease. B It describes the proper accounting for a lessee s capital lease. C Satisfaction of any one of these four criteria requires the lease to be treated as a capital lease.

49 Income Taxes Accounting Objective SU 3.5 Taxes The objectives of accounting for income taxes are to recognize the following: a. The amount of taxes currently payable or refundable b. Deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the financial statements or tax returns. To achieve these objectives, an entity uses the asset-and-liability approach to account for: 1. Income taxes currently payable or deductible and 2. Deferred taxes.

50 Definitions SU 3.5 Taxes Income tax expense or benefit is the sum of (1) current tax expense or benefit and (2) deferred tax expense or benefit. Current tax expense or benefit is the amount of taxes paid or payable (or refundable) for the year as determined by applying the enacted tax law to the taxable income or excess of deductions over revenues for that year. Current tax liability is equal to taxable income times the applicable tax rate. Deferred tax expense or benefit is the net change during the year in an entity s deferred tax amounts. continued

51 SU 3.5 Taxes Definitions Deferred tax liability (or asset) records the deferred tax consequences of taxable (or deductible) temporary differences. a. A deferred tax liability or asset is recognized for the estimated future tax effects of temporary differences and carryforwards. b. A deferred tax amount is measured using the enacted tax rate(s) expected to apply when the liability or asset is expected to be settled or realized. A temporary difference (TD) results when the GAAP basis and the tax basis of an asset or liability differ. a. Differences in the two bases arise when items of income and expenses are recognized in different periods under GAAP and under the tax code. continued

52 SU 3.5 Taxes Definitions b. The effect is that a taxable or deductible amount will occur in future years when the asset is recovered or the liability is settled. A permanent difference is an event that is recognized either in pretax financial income or in taxable income but never in both. It does not result in a deferred tax amount.

53 SU 3.5 Taxes Interperiod Tax Allocation Amounts in the entity s income tax return for a year include the tax consequences of most items recognized in the financial statements for the same year. But significant exceptions may exist. a. Temporary differences. Tax consequences of some items may be recognized in tax returns for a year different from that in which their financial-statement effects are recognized. The following are examples: 1. Different depreciation methods may be used for tax purposes and in the financial statements. Accelerated depreciation is allowed for tax purposes for certain assets, but they may be depreciated using the straight-line method in the financial statements. continued

54 SU 3.5 Taxes Interperiod Tax Allocation 2. Expenses for warranty liability are recognized in the financial statements on the date of the sale under the accrual method of accounting. For tax purposes, warranty expenses are recognized under the cash basis when actual payments of warranty costs are made. 3. Bad debit expense is recognized in the financial statements under the allowance method in accordance with the income- statement or balance-sheet approach. For tax purposes, bad debt expense is recognized when the debts are determined to be uncollectible using the direct write-off method. continued

55 Interperiod Tax Allocation SU 3.5 Taxes Permanent differences. Some items may have tax consequences or financialstatement effects but never both. The following are examples: a. Payments of fines or penalties are recognized as an expense in the financial statements but are never deducted in the tax return. b. Interest on state or municipal bonds is recognized as income in the financial statements but not in taxable income for tax purposes. When tax consequences and financial-statement effects differ, income taxes currently payable or refundable also may differ from income tax expense or benefit. a. The accounting for these differences is interperiod tax allocation.

56 Interperiod Tax Allocation SU 3.5 Taxes If intraperiodtax allocation is required. Income tax expense (benefit) is allocated to a. Continuing operations b. Discontinued operations c. Extraordinary items d. Other comprehensive income, and e. Items debited or credited directly to equity

57 Deferred Tax Assets and Liabilities SU 3.5 Taxes Deferred tax assets and liabilities result from temporary differences, not permanent differences. Taxable temporary differences result in future taxable amounts and deferred tax liabilities (DTL). a. DTLs arise when revenues or gains are recognized under GAAP before they are included in taxable income. 1. An example is income recognized under the equity method for financial statement purposes and at the time of distribution in taxable income. Continued

58 Interperiod Tax Allocation SU 3.5 Taxes Permanent differences. Some items may have tax consequences or financialstatement effects but never both. The following are examples: a. Payments of fines or penalties are recognized as an expense in the financial statements but are never deducted in the tax return. b. Interest on state or municipal bonds is recognized as income in the financial statements but not in taxable income for tax purposes. When tax consequences and financial-statement effects differ, income taxes currently payable or refundable also may differ from income tax expense or benefit. a. The accounting for these differences is interperiod tax allocation.

59 Deferred Tax Assets and Liabilities SU 3.5 Taxes Deferred tax assets and liabilities result from temporary differences, not permanent differences. Taxable temporary differences result in future taxable amounts and deferred tax liabilities (DTL). a. DTLs arise when revenues or gains are recognized under GAAP before they are included in taxable income. 1. An example is income recognized under the equity method for financial statement purposes and at the time of distribution in taxable income. Continued

60 SU 3.5 Taxes a. DTLs also result when expenses or losses are deductible for tax purposes before they are recognized under GAAP. a. An example is accelerated tax depreciation of property Deductible temporary differences result in future deductible amounts and deferred tax assets (DTA). b. DTAs result when revenues or gains are included in taxable income before they are recognized under GAAP. a. Examples are unearned revenues such as rent and subscriptions received in advance. c. DTAs also result when expenses or losses are recognized under GAAP before they are deductible for tax purposes. a. Examples are bad debt expenses recognized under the allowance method and warranty costs. Continued

61 SU 3.5 Taxes Calculating Tax Expenses or Benefits Income tax expense or benefit reported on the income statement is the sum of the current component and the deferred component. a. Current tax expense or benefit is the amount of taxes paid or payable (or refundable) for the year based on the enacted tax law. b. Deferred tax expense or benefit is the net change during the year in an entity s deferred tax amounts. Current income tax expense is recorded as follows Continued

62 SU 3.5 Taxes Deferred income tax expense or benefit is recognized for the net change during the year in the deferred tax amounts (DTL and DTA). Continued

63 SU 3.5 Taxes Operating Loss Carrybacks and Carryforward Entities that incur net operating losses (NOLs) have two options for obtaining the tax benefit of the loss: a. Carry the loss back 2 years and forward 20 years or b. Carry the loss forward 20 years. Loss carryforward only. Under this option, the entity carries the entire loss forward 20 years. a. A carryforward results in a future deductible amount requiring recognition of a deferred tax asset. Continued

64 SU 3.5 Taxes b. The amount of net operating loss (NOL) carryforward is realized in future periods by reducing the taxable income for these periods. b. Upon realization, the deferred tax asset reduces the amount of income tax payable in future periods and does not affect the total amount of income tax expense recognized. Continued

65 SU 3.5 Taxes Operating Loss Carrybacks and Carryforward Loss carryback and carryforward. Under this option, the entity files an amended tax return that carries the loss back to the second prior year, offsetting some or all of that year s tax expense. a. If any of the current-year loss remains after exhausting the taxable income of the second prior year. The entity files an amended return offsetting some or all of the prior year s tax expense. b. Both the balance sheet and income statement are affected. Continued

66 SU 3.5 Taxes b. Carryforwards that cannot be used in the current year may be carried forward to reduce taxable income or taxes payable in a future year. 1. Thus, if any of the current-year loss remains after the 2-year carryback, the entity is allowed to carry it forward 20 years. Continued

67 Financial Statement Presentation SU 3.5 Taxes Deferred tax amounts must be classified as current or nocurrent based on the classification of the related or liability. a. Current deferred tax amounts are netted and presented as a single amount. Noncurrent deferred tax amounts are offset (netted) and presented as a single amount. A valuation allowance reduces deferred tax asset. It is recognized if it is more likely than not (probability > 50%) that some portion of the asset will not be realized. The allowance should reduced the deferred tax asset to the amount that is more likely than not to be realized.

68 SU 3.5 Income Taxes Practice question 1 On a statement of financial position, all of the following should be classified as current liabilities except A B C D Advances from customers for services to be performed. Salaries payable for work performed during the previous month. Deferred income taxes for differences based on depreciation methods. Accounts payable for inventory items to be shipped on consignment.

69 SU 3.5 Income Taxes Practice question 1 answer Correct Answer: C Deferred tax amounts are classified as current or noncurrent based on the classification of the related asset or liability (assuming such an asset or liability exists). Because depreciable assets are noncurrent, a deferred tax liability for differences based on depreciation methods is noncurrent. Incorrect Answers: A B D Advances from customers for services to be performed are classified as unearned revenue (current liabilities). Salaries payable for work performed during the previous month are accrued as current liabilities. Trade accounts payable for inventory, whether or not to be shipped on consignment, are current liabilities.

70 SU 3.5 Income Taxes Practice question 2 A liability that represents the accumulated difference between the income tax expense reported on the firm s books and the income tax actually paid is A B C D Capital gains tax. Deferred taxes. Taxes payable. Value-added taxes.

71 SU 3.5 Income Taxes Practice question 2 answer Correct Answer: B Deferred tax liabilities arise when temporary differences in book and taxable income result in future taxable amounts. Deferred tax assets arise when temporary differences in book and taxable income result in future deductible amounts. Incorrect Answers: A C D Capital gains taxes arise from transactions involving capital assets. Taxes payable arise from the tax liability due within the next fiscal year or operating cycle. Value-added taxes are taxes paid on the incremental increase in value of a good at each stage of production.

72 SU 3.5 Income Taxes Practice question 3 At the end of its first year in business, Pebbles Corporation reported pretax financial statement income of $50,000. Included in pretax income were $10,000 of revenue from installment sales and depreciation expense of $12,000. On the tax return, $5,000 of installment sales revenue was reported, and depreciation expense of $16,000 was deducted. The income tax rate was 40%. Pebbles reports installment sales receivables as current assets. On its year-end statement of financial position, Pebbles should report deferred tax balances of A B C D $2,000 as a current liability and $1,600 as a current asset. $4,000 as a current asset and $5,000 as a noncurrent asset. $2,000 as a current liability and $1,600 as a noncurrent liability. $4,000 as a noncurrent liability and $5,000 as a current liability.

73 SU 3.5 Income Taxes Practice question 3 answer Correct Answer: C Temporary differences arise when the GAAP basis and the tax basis of an item of income or expense differ. Of the installment sales, all $10,000 was recognized for financial reporting, but only $5,000 was recognized for tax purposes, producing a temporary difference of $5,000. Since this amount will be recognized later for tax purposes than for financial reporting, it constitutes a deferred tax liability in the amount of $2,000 ($5,000 40%). The depreciation expense will also result in a deferred tax liability; since more expense was recognized for tax purposes than for GAAP reporting ($16,000 $12,000 = $4,000), a deferred tax liability of $1,600 ($4,000 40%) results. A deferred tax asset or liability is classified as current or noncurrent depending on the classification of the related asset or liability. The installment revenue is thus properly classified as current and, since depreciation expense relates to property, plant, and equipment, it is classified as noncurrent.

74 SU 3.6 Accounting for Bonds and Noncurrent Notes Payable A bond is a formal contract to pay an amount of money (face amount) at the maturity date plus interest at the stated rate at specific intervals. The proceeds received from the investors on the day the bonds are sold equal the present value of the sum of the future cash flows expected to be received from the bonds. These proceeds equal a. The present value of the face amount plus b. The present value of the annuity of interest payments

75 SU 3.6 Accounting for Bonds and Noncurrent Notes Payable The bonds are recognized in the financial statements as the amount of proceeds paid for them, i.e., the face amount of the bonds plus any premium or minus any discount. a. They are recorded as a debt in the issuer s financial statements and as an investment in the investors financial statements.

76 SU 3.6 Accounting for Bonds and Noncurrent Notes Payable Bond Issuance - The cash proceeds from the sale of bonds can be equal to, less than, or greater than the face amount of the bonds depending on the relationship of the bonds stated rate of interest to the market rate of interest on the date the bonds are sold. a. If the stated rate is equal to the market rate, the cash proceeds equal the face amount of the bonds. b. If the stated rate is greater than the current market rate, the cash proceeds are greater than the face amount, and the bonds are sold at a premium. c. If the stated rate is lower than the current market rate, the cash proceeds are lower than the face amount, and the bonds are sold at a discount. continued

77 SU 3.6 Accounting for Bonds and Noncurrent Notes Payable The current market rate of interest is used to discount the cash flows expected to be received by the investor (paid by the issuer) from the bonds.

78 SU 3.6 Accounting for Bonds and Noncurrent Notes Payable Amortization of Premium or Discount - Bond premium or discount must be amortized over the life of the bonds using the effective-interest method (the market interest rate on the date the bond was sold). Under this method, interest expense changes every period and equals the following: Annual interest expense = Carrying amount of the bond at the beginning of the period x Effective interest rate The annual interest expense consists of the cash interest paid plus the effect of amortization of premium or discount. a. When the bond is issued at a premium, annual interest expense equals cash interest paid minus the amount of premium amortized.

79 SU 3.6 Accounting for Bonds and Noncurrent Notes Payable b. When the bond is issued at a discount, annual interest expense equals cash interest paid plus the amount of discount amortized. c. The carrying amount of bonds as they are present in the financial statements equals the face amount plus the premium (or minus the discount). d. At the maturity date, the discount or premium is fully amortized, and the carrying amount of bonds equals the face amount.

80 Different Types of Bonds Maturity Pattern SU 3.6 Accounting for Bonds and Noncurrent Notes Payable a. A term bond has a single maturity date at the end of its term. The examples in this study unit are regular term bond. b. A serial bond matures in stated amounts at regular intervals. Repayment Provisions a. Income bonds pay interest contingent on the debtor s profitability. b. Revenue bonds are issued by governments and are payable from specific revenue sources. Securitization a. Mortgage bonds are backed by specific assets, usually real estate.

81 SU 3.6 Accounting for Bonds and Noncurrent Notes Payable b. Debentures are backed by the borrower s general credit but not by specific collateral. c. Guaranty bonds are guaranteed by a third party, e.g., the parent of the subsidiary that issued the bonds. d. Collateral trust bonds are secured by a financial asset, such as stock or other bonds. e. Equipment trust bonds are secured by a mortgage on movable equipment, such as airplanes or railroad cars.

82 Valuation SU 3.6 Accounting for Bonds and Noncurrent Notes Payable a. Variable (or floating) rate bonds pay interest that is dependent on market conditions. b. Zero-coupon or deep-discount bonds bear no stated rate of interest and thus involve no periodic cash payments; the interest component consists entirely of the bond s discount. c. Commodity-backed bonds are payable at prices related to a commodity such as gold.

83 Redemption provisions SU 3.6 Accounting for Bonds and Noncurrent Notes Payable a. Callable bonds (also called redeemable bonds) may be repurchased (redeemed) by the issuer at a specified price before maturity. i. During a period of failing interest rates, the issuer can replace high-interest debt with low-interest debt. b. Convertible bonds may be converted into equity securities of the issuer at the option of the holder (buyer) under specified conditions. Convertible bonds generally pay a lower yield than comparable nonconvertible bonds.

84 Noncurrent Notes Payable SU 3.6 Accounting for Bonds and Noncurrent Notes Payable Some notes require one principle payment at the end of the note s term plus periodic interest payments during the note s term (like a term bond). Other notes require equal periodic principal payments plus interest. Each periodic payment includes an equal amount of return of principal and an amount of interest accrued on the beginning carrying amount. A third type of note requires equal periodic cash payments. Each payment includes a principal component (i.e., return of principal) and an interest component.

85 SU 3.6 Accounting for Bonds and Noncurrent Notes Payable Practice question 1 Fact pattern: On January 1, Evangel Company issued 9% bonds in the face amount of $100,000, which mature in 5 years. The bonds were issued for $96,207 to yield 10%, resulting in a bond discount of $3,793. Evangel uses the effective interest method of amortizing bond discount. Interest is payable annually on December 31. What is the amount of interest expense that should be reported on Evangel s income statement for the second year? A $8,779 B $9,000 C $9,559 D $9,683

86 SU 3.6 Accounting for Bonds and Noncurrent Notes Payable Practice question 1 answer Correct Answer: D An amortization schedule for the first 2 years of Evangel s bonds can be prepared as follows: Beginning Carrying Amount Times: Effective Rate Equals: Interest Expense Equals: Discount Amortized Ending Carrying Amount Year Cash Paid 1 $96,207 10% $9,621 $9,000 $621 $96, ,828 10% 9,683 9, ,510

87 SU 3.6 Accounting for Bonds and Noncurrent Notes Payable Practice question 2 Fact pattern: On January 1, Evangel Company issued 9% bonds in the face amount of $100,000, which mature in 5 years. The bonds were issued for $96,207 to yield 10%, resulting in a bond discount of $3,793. Evangel uses the effective interest method of amortizing bond discount. Interest is payable annually on December 31. What is the amount of Evangel s unamortized bond discount at the end of the first year? A $621 B $2,452 C $3,172 D $3,793

88 SU 3.6 Accounting for Bonds and Noncurrent Notes Payable Practice question 2 answer Correct Answer: C Total interest expense for the year equals the carrying amount of the bonds times the effective rate (yield), or $9,621 ($96,207 10%). Subtracting the cash interest payment from this leaves the amount of discount amortized, or $621 ($9,621 $9,000). Subtracting this amount from the previous unamortized discount ($3,793) leaves a remaining unamortized discount at the end of Year 1 of $3,172. Incorrect Answers: A The amount of $621 is the amount of discount amortized. B The amount of $2,452 results from reversing the face and yield rates of interest. D The amount of $3,793 is the unamortized discount on January 1.

89 SU 3.6 Accounting for Bonds and Noncurrent Notes Payable Practice question 3 Fact pattern: On January 1, Evangel Company issued 9% bonds in the face amount of $100,000, which mature in 5 years. The bonds were issued for $96,207 to yield 10%, resulting in a bond discount of $3,793. Evangel uses the effective interest method of amortizing bond discount. Interest is payable annually on December 31. The net carrying amount of Evangel s bonds payable at the end of the first year is A $94,866 B $95,586 C $96,828 D $97,548

90 SU 3.6 Accounting for Bonds and Noncurrent Notes Payable Practice question 1 answer Correct Answer: C Total interest expense for the year equals the carrying amount of the bonds times the effective rate (yield), or $9,621 ($96,207 10%). Subtracting the cash interest payment from this leaves the amount of discount amortized ($9,621 $9,000 = $621). Subtracting this amount from the previous unamortized discount ($3,793) leaves a remaining unamortized discount at the end of Year 1 of $3,172. Subtracting this amount from the face amount of the bonds ($100,000) provides a carrying amount of $96,828. Incorrect Answers: A B D The amount of $94,866 results from reversing the face and yield rates of interest. The amount of $95,586 results from increasing the unamortized discount rather than reducing it. The amount of $97,548 results from reversing the face and yield rates of interest and from increasing the unamortized discount rather than reducing it.

91 SU 3.7 Accounting for Pensions Definition A pension plan is a type of retirement plan to which an employer makes periodic contributions of assets to be set aside for employees future benefit. The two main types of pension plans are the defined contribution plan and the defined benefit plan.

92 SU 3.7 Accounting for Pensions Defined Contribution Plan A defined contribution plan provides an individual account for each participating employee. Benefits that the employees will receive during retirement depend on a. The amount contributed to the plan by the employer and employee and b. The returns earned on investments of those contributions. The employer s only obligation is to make periodic deposits of the amounts defined by the plan s formula in return for services rendered by employees. a. Thus, the employer does not guarantee the amount of benefits that the employees will receive during retirement.

93 SU 3.7 Accounting for Pensions b. The employees bear the investment risk (the benefit of gain or risk of loss from assets contributed to the plan). The employer s annual pension expense is the amount of the contribution required by the pension plan s formula.

94 SU 3.7 Accounting for Pensions A defined benefit plan defines an amount of pension benefit to be provided to each employee. The employer is responsible for providing the agreed benefits and, therefore, bears actuarial risk and investment risk. The benefits that the employer is required to pay depend on future events, such as how long an employee lives, how many years of service the employee renders, and the employee s compensation before retirement. Many of these events cannot be controlled by the employer. Thus, the total benefit is not precisely determinable and can only be estimated by using actuarial assumptions.

95 SU 3.7 Accounting for Pensions The projected benefit obligation (PBO) is the actuarial present value of all benefits attributed by the pension benefit formula to employee service rendered prior to that date. PBO is measured using assumptions about future salary levels. a. A reconciliation of the beginning and ending balance of the PBO must be disclosed in the notes to the financial statements. The PBO at the end of a period is calculated as follows: + Beginning PBO + Service cost + Interest cost + Prior service cost - Prior service credit - Benefits paid -/+ Changes in the PBO resulting from actuarial gains or losses Ending PBO