Transcript Chapter 10 Other Items That Affect Net Income and Owners

Chapter 10
Other Items That Affect Net
Income and Owners’ Equity
McGraw-Hill
© 2004 The McGraw-Hill Companies, Inc. All rights reserved.
Components of Owners’ Equity
 Common
stock.
 Preferred stock.
 Direct debits.
 Direct credits.
10-2
Topics in chapter
 Nonowner
transactions affecting OE.
 Disclosure requirements.
 Extraordinary items.
 Discontinued operations.
 Accounting changes.
 Accounting errors.
 Foreign currency translation adjustments.
 Derivatives.
10-3
Reporting Requirement
 Total
nonowners changes in owners’
equity (OE), which is sum of:


Net income.
Other nonowner changes in OE.
• Accumulated balances of unrealized gains and
losses on available-for-sale securities (Chapter 5).
• Net investment translation adjustments.
• Gains and losses on certain derivatives.
• Other items (not addressed).
 Considerable
leeway in reporting format.
10-4
Extraordinary Items
 Criteria:


Unusual: highly abnormal and unrelated to
ordinary activities of entity.
Infrequent: not reasonably expected to recur
in foreseeable future.
 Reported


on Income Statement:
After income from continuing operations and
Net of income tax effect .
10-5
Not Extraordinary items
 Write-downs
or write-offs of AR, inventory,
or intangible assets.
 Gains or losses from exchange rate
changes.
 Gains or losses on disposal of segment of
a business.
 Gains or losses from disposal of fixed
assets.
 Effects of a strike.
10-6
Discontinued Operations
 Discontinuance
of a division or other
identifiable segment of a business.
 Must involve a whole business unit, not
one asset or a product line.
 May be abandoning segment and selling
off assets (usually at a loss) or
 Selling off the segment (for a gain or a
loss).
10-7
Accounting for Discontinuance
 If


loss is expected:
Record in period in which decision is made.
Estimation of loss requires estimating:
• Revenues less expenses until disposition.
• Proceeds of sale.
• Book value of assets disposed of.
 If
gain is expected: do not recognize until
realized.
10-8
Discontinued Operations
Income Statement Presentation
 Reported


net of tax in 2 amounts:
Net income or loss attributable to operations
of segment until it is sold.
Estimation of gain or loss on disposal arising
from all aspects of sale.
10-9
Change in Accounting Principles
 Consistency
concept requires using same
accounting principle year after year.
 Can change only if there is a sound
reason.
 Retained earnings adjusted to reflect
cumulative effect.
 Shown on income statement as
nonrecurring item.
10-10
Adjustments to Retained Earnings
 Prior
period adjustments to Retained
Earnings:

Limited by FASB to only corrections of
accounting errors defined as:
• Mathematical mistakes, mistakes in the application
of accounting principles, or oversight or misuse of
facts that existed at the time the financial
statements were prepared.
• A change from a principle that is not generally
accepted to one that is … is a correction of an
error.
10-11
Personnel Costs
 Wages
and salaries earned by employees
and other costs related to their services.
 Deducted from gross earnings before
payment (and not a cost of the employer):



FICA contributions for Social Security and
Medicare.
Withholding for federal and state income
taxes.
Deductions for union dues, ….
10-12
Fringe Benefits
 Provided
and paid for by employer to
employees. Possibilities include:

Pensions, life insurance, health care, sick pay,
vacations.
10-13
Pensions
 Payments
received by employees after
they retire.
 Typically
5%-10% of payroll.
 Regulated

under ERISA.
In most cases pensions must be partially
funded.
10-14
Types of Pension Plans
 Defined


Employer contributes an agreed amount.
No promise as to how much benefits will be.
 Defined

contribution plan:
benefit plan:
Employer agrees to contribute an amount so
that employees will receive a specified
amount.
10-15
Pension Cost

Complicated determination for a defined benefit
plan. Must estimate:








How many years employees will work.
Employee turnover.
Average employee earnings.
How many years employees live after retirement.
Inflation.
Earnings on invested pension funds.
Other factors.
Determination is extremely complicated and
uses present value (PV) concept.
10-16
Components of Pension Cost

Service cost: PV of future benefits employees
earned during year.
 Interest cost: amount by which plan’s beginning
of year obligations has increased.
 Return on plan assets: Offsetting element,
assumed gain on plan assets over the long run.
 Prior service cost: considers employees service
prior to initiation (or change) of plan.
10-17
Pension Plan Entries

Cost is $500,000:
Net pension cost
Accrued pension cost (liability)

500,000
500,000
Employer contributions are $450,000:
Accrued pension cost
Cash
450,000
450,000
10-18
Pension Disclosures
 Period’s
net pension cost.
 Unfunded plan position for each defined
benefit plan.
 Four components of net pension cost.
 Assumptions of calculations of a plan’s
funding position.
10-19
Other Post Retirement Benefits
 E.g.,
healthcare, life insurance.
 Present
value of a portion of these costs
are expensed.
10-20
Compensated Absences
 Future


compensated absences:
Vacation and sick leave earned this year but
taken next year.
Expensed in period earned. dr expense cr
accrued liability.
10-21
Income Tax Expense
 Tax


expense for current year consists of:
Current income tax expense (this year’s tax
bill) and
Deferred income tax expense.
Income tax expense
100
Taxes payable
80
Deferred income taxes liability
20
10-22
Book-to-Tax Differences
 Arises
because for some items tax
accounting differs from book (GAAP).
 Taxable
income: income reported to tax
authorities to compute income tax.
 Pretax
accounting income = pretax book
income = income before taxes: income
before tax under GAAP.
10-23
Why Do Book and Taxable Income
Differ?
 Objective
of tax accounting: raise taxes
and encourage behavior. E.g., accelerated
depreciation to encourage investment.
 Objective
of GAAP/Financial reporting:
Provide info useful to investors.
10-24
Permanent Differences Between
Book and Tax
 Do
not reverse in future years.
 Expenses under GAAP that are not
deductible. (E.g., fines.)
 Revenues excluded from taxable income.
(E.g., revenue on municipal bonds)
 Does not create accounting problems.
10-25
Temporary Difference between
Book and Tax
 Differences
that reverse or turnaround in a
later period.
 Revenues or expenses that are permitted
or required to be reported in a different
period. E.g., depreciation.
 Creates accounting complexities in order
to match income tax expense to period in
which revenue or expense item is
recognized.
10-26
Deferred Tax Reporting
 Deferred
Income Taxes: liability account.
 Shown separately from Taxes payable.



Indicates the amount that future tax expense
will be reduced when differences between
book and tax reverse.
Interest free loan from the government.
Increases as long as company grows.
10-27
Deferred Tax Assets
 Temporary
differences resulting in Taxable
income higher than book:


Warranty expensed when revenue
recognized for book, when actually paid for
tax.
Subscription receipts recognized when
received for tax, when earned for book.
 Tax-loss
carryforwards: cannot exceed
amount of expected future tax benefits.
10-28
Tax Rate Changes and Disclosures
 New
deferrals recorded based on rates
currently in tax law.
 Disclosures:


Deferred tax asset and liability amounts
shown separately.
Must be classified appropriately as current or
noncurrent.
10-29
Foreign Currency Transactions

Fluctuating foreign currency exchange rates
cause changes in values of receivable and
payables. Accounting requirements:



Transactions are recorded at the exchange rate in
effect at the time the transaction is recognized.
At each balance sheet date, recorded balances are
adjusted to the current (i.e., spot) exchange rate.
Gains and losses are included in net income in the
period in which they are incurred.
10-30
Foreign Currency Translation
 Foreign
subs records kept in local (foreign)
currency.
 To
consolidate with other operations, must
be translated into dollars (reporting
currency).
10-31
Functional Currency

Currency of the primary economic environment
in which the company operates.
 Selection of functional currency effectively
determines which translation method is used.
 If functional currency is the local currency:


Translate using the net investment or current rat
method.
If functional currency is the dollar:

Translate using the remeasurement or temporal
method.
10-32
Current Rate Method

All assets and liabilities translated at the
exchange rate at balance sheet date.
 All revenue and expense items are translated at
the weighted average exchange rate.
 Balance sheet differences arising from
translation do not go through income but are
recorded directly to stockholders’ equity in an
account such as “Cumulative Translation
Adjustment.”
10-33
Remeasurement
Objective: report foreign sub’s financial
statement amounts as if activities were carried
out by parent and recorded on parent’s books.
 Most items are translated at same rate as
current rate method. Exceptions:




Long-lived assets and inventory are translated using
the rate at date acquired (historical rate).
Expenses related to these assets (depreciation and
cost of goods sold) also translated at historical rate.
Gains and losses arising from remeasurement are
included in income.
10-34
Derivatives
 A financial
instrument or other contract
that derives its value by direct references
to the changes in value of one or more
underlyings.
 Underlyings can be: return or yield on
another security, price of a share, an
interest or exchange rate.
 Used to hedge risk of changes in interest
rates, commodities, exchange rates….
10-35
Accounting for Derivatives
 Recognized
as assets or liabilities and
measured at fair value.
 Underlying
gains and losses included in
net income except when designated as
and qualifying as a type of hedge.
Accounting can be complex.)
10-36
Pro Forma Earnings
 At
discretion of management.
 Supplements GAAP Income Statement.
 Excludes certain items such as merger
related charges, non-recurring items and
goodwill impairment write-offs.
 SEC insists they are not misleading.
10-37
Net Income
 Bottom
line of Income Statement.
 Never appears on any other line.
 Net addition to Retained Earnings during
accounting period whether arise from
operations or other times.
10-38