Chapter 17 Investments in stocks and bonds

When individual securities are acquired, they are first classified as one of the following classes (bonds are either Trading, Available-for-sale, or Held-to-maturity securities; stocks are either Trading, Available-for-sale, Equity method, or Consolidation securities). 1. When individual securities are acquired, they are recorded at cost and kept at cost (stocks are at acquisition cost and bonds are at amortized cost).
2.

The amortized costs of bonds are calculated by preparing amortization schedule. The amortization schedule shows how premium or discount on bonds is amortized (i.e., reduced) over time as interests are received.

3. When individual securities are disposed of, they are recorded at cost.
4.

Trading and Available-for-sale securities are shown on B/S at fair value by setting up a Fair value adjustment a/c for aggregate securities (e.g. one for Trading and one for Available-for-sale [Debt and Equity] securities). (Fair value adjustment) At the end of each fiscal year, the balances of Fair value adjustment accounts are adjusted to reflect the aggregate fair value of the securities on hand at the end of the fiscal period.

5.

6. When FV adj a/c is debited or credited, the opposing entry is always Unrealized holding gain or loss (Uhg/l).
1

7.

Uhg/l for Trading securities is an I/S item and flows through I/S and shows up on I/S at the amount of the FV adj journal entry. In contrast, Uhg/l for Available-for-sale securities is a component of other comprehensive income (B/S item) and shows up on B/S in the SE section at the amount generally different from the amount of the journal entry (because the journal entry represents a change and B/S records the cumulative balance).

Recording transactions of Equity method securities Investees earnings: Increases Investment a/c [No recording for Trading or Afs securities] (eg) Investee Company (investor owns 40%) announces earnings of $5M.

Receipt of cash dividends: Decreases Investment a/c [Dividend revenue for Trading or Afs securities] (eg) Receives $200,000 cash dividends.

Fair value option to report financial instrument at fair value Company can use this option at acquisition: not revocable This includes Afs and Equity method method securities and also bonds issued (liabilities). Unrealized holding gain or loss is a part of income. Impairment If decline of value is permanent irreversible (IFRS: reversible) Transfers between categories Recorded as if the securities were sold at fair value (thus, the unrealized holding gain/loss at the transfer date flows to I/S) and purchased back and classified in the new category. Fair value measurements and disclosures Level 1 (price of identical instrument), Level 2 (price of similar instrument), and Level 3 (requiring assumptions) assets or liabilities Disclosure: required for financial instruments

Derivatives (e.g.) Forward contract, option contract Report derivatives at fair value (assets or liabilities). Recognize gains and losses (including unrealized gains and losses) in income. For derivatives used to hedge (offset or counterbalance), the gains and losses are both recognized in income even for Afs securities. (formal documentation is needed at the inception of the hedge) (e.g.) stocks and put option, a futures contract when purchase is necessary in the future, interest rate swap (a bond issuer receives fixed rate and pays variable rate)

Exercise, Investments, 311, Kim Strathmore Company has the following securities on 12/31/09. Acquisition Cost Trading Securities 10,000 shares of Purdue Inc. Available-for-sale Securities 30,000 shares of Merv Co. 1,200,000 1,800,000 1,170,000 630,000 600,000 12/31/09 Fair Value

$1M, 10%, GE bonds 1,216,478 (purchased on 1/1/09 effective rate = 5% interest payment at 12/31 matures at 12/31/13) Held-to-maturity Securities

$1M, 4%, TGI bonds 922,779 920,000 (purchased on 1/1/08, effective rate = 5%, interest payment at 12/31, matures at 12/31/17) Equity Method Securities 300,000 shares of Ericsson (30% interest) 1,500,000 3,600,000

In 2010 the following transactions/events occurred. (a) On 5/1/10 the entire Merv shares were sold for $2,000,000. (b) On 10/1/10 all Purdue shares were sold for $500,000 cash. (c) The fair market values of securities on 12/31/10 were: GE bonds TGI bonds Ericsson shares 1,240,000 900,000 2,800,000 Ericsson shares on 7/1/06. During 2010 $1,200,000 and Ericsson declared and $400,000. The Ericsson shares were the 2009 balance sheet.

(d) Strathmore purchased Ericssons earnings was paid cash dividends of reported at $2,000,000 on

Give all entries related to Strathmores securities for 2010 and show related sections of the 2010 B/S and I/S.

Chapter 19 Income Taxes

The Big Picture Taxable Income Actual Tax

Pretax Financial Income Income Tax Expense Steps to compute Income Tax Expense 1. Compute Actual Tax (From Taxable Income). 2. Compute changes in Deferred Tax Liability. 3. Compute changes in Deferred Tax Asset. 4. Income Tax Expense is the plug. Journal Entry Income Tax Expense (plug) Deferred Tax Asset Income Tax Payable (actual tax) Deferred Tax Liability

Changes in Deferred Tax Liability and Asset This comes from temporary differences between Pretax Financial Income and Taxable Income. Permanent Differences: do not create/change Deferred Tax Liab or Asset. (eg) Fines for violation of laws: not tax-deductible Interest received on municipal bonds: not taxable Percentage depletion of natural resources in excess of cost (e.g. about 15% of income from domestically produced oil and gas is tax-free) Dividend deduction from US corporations (not taxable up to 70 or 80%) Temporary Differences: create/change Deferred Tax Liab or Asset. A. Financial income now, Taxable revenue later (Less tax now and more later) (eg) Accrued installment sales revenue when installment method is used for tax purpose Long-term construction revenue based on percentageof-completion method when completed contract method is
7

used for tax purpose Revenue from investment on equity method for financial purpose and cost method for tax purpose Unrealized holding gain for financial purpose but deferred for tax purpose B. Financial expense now, Tax-deductible expense later (More tax now and less later) (eg) Estimated warranty expense Litigation accrual Bad-debt expense under allowance method for financial purpose and direct method for tax purpose Stock-based compensation expense Unrealized holding loss C. Taxable revenue now, Financial income later (More tax now and less later) (eg) Revenues received in advance D. Tax-deductible expense now, Financial expense later (Less tax now and more later) (eg) Straight-line method depreciation when MACRS for tax purpose
8

Prepaid expense Use two accounts: A and D: Create Deferred Tax Liab B and C: Create Deferred Tax Asset Income Statement Presentation Income Tax Expense Current: (actual tax) Deferred: (total [net] deferred) Balanced Sheet Presentation Current DTL or DTA (net current number) Noncurrent DTL or DTA (net noncurrent number) The (Non-) Currentness of Deferred Tax Asset or Liab Depends on the Non(currentness) of the related asset or liability (eg) Recognizing litigation expenses creates current DTA for expected litigation costs that are expected to incur within a year
9

and noncurrent DTA for costs that are expected to incur beyond one year. [Related Liability: Litigation Liability] (eg) Adopting MACRS for tax depreciation while using SL for financial purpose creates noncurrent Deferred Tax liab. even for the portion that is expected to reverse within a year. [Related Asset: PPE]

10

Exercise, Tax, Bmgt 311, Kim 1. The following facts apply to Tsover Company. (a) 2006 is the first year of operation for Tsover. Tax rates enacted by the end of 2006 are as follows: 2006 2007 2008 2009 and later 35% 30% 36% 40%

(b) For 2006, Tsover had pretax financial income of $400,000 and taxable income of $1,200,000. (c) The above difference (pretax financial taxable income) is due to the following: Litigation accruals (deductible in 2009, expense in 2006) Fine for pollution (not deductible, expense in 2006) Prepaid expenses (deductible in 2006, expense in 2007) income minus

$750,000 650,000 100,000

Depreciation difference 500,000 (deductible in 2006, expense in 2007: 100,000 in 2008: 150,000 in 2009: 250,000) A. Compute the amount of deferred taxes to appear on the balance sheet at 12/31/06, and indicate the proper classification(s) (current versus noncurrent and deferred asset versus deferred liability). B. Prepare the journal entry to record income deferred taxes, and income tax expense for 2006. tax payable,

11

Exercise (Tax), 311, Kim The following facts apply to Ibrahim Company. (a) 2008 is the first year of operation for Ibrahim. Applicable tax rates enacted by the end of 2006 are as follows: 2008 2009 2010 40% 36% 30%

(b) For 2008, Ibrahim had pretax financial income of $7,000,000 and taxable income of $5,500,000. (c) The above difference (pretax financial income minus taxable income) is due to the following: Unearned fee income (taxable in 2008, revenue in 2009: 120,000 in 2010: 90,000) Litigation (expense in 2008, deductible in 2010) Accrued installment sales (revenue in 2008, taxable in 2009: 650,000 in 2010: 450,000) Depreciation and depletion (deductible in 2008, expense in 2009: 950,000) 210,000

340,000 1,100,000

950,000

(d) Ibrahim expects to report $3,000,000 taxable income in each of the next two years.

A. Compute the amount of deferred taxes to appear on the balance sheet at 12/31/08, and indicate the proper classification(s) (current versus noncurrent and deferred asset versus deferred liability).

B. Prepare the journal entry to record income deferred taxes, and income tax expense for 2008.

tax

payable,

12

Net Operating Loss (NOL) Carryback and Carryforward NOL: Tax deductible expenses Taxable income Order: 2-year carryback and 20-year carryforward in the chronological order until NOL is reduced to zero Journal Entry: (eg) Denise Inc. reports the following pretax income (loss) for both book and tax purposes. Prepare the journal entry for year 2010. Year 2008 2009 2010 2011 Pretax Income (Loss) $120,000 90,000 (280,000) 120,000 Tax Rate 40% 35% 45% 45%

If the realizability of DTA is doubtful: Reduce DTA by crediting Allowance to reduce DTA a/c (contra to DTA) and debiting Income Tax Benefit a/c (eg) In the above 16,000 DTA may not be realized.

13

Exercise, Tax, Bmgt 311, Kim 1. Rymer Company reports the following pretax income (loss) for both book and tax purposes (assume the carryback provision is used where possible for a net operating loss). 2005 is its first year of operation. Rymer assumes in 2008 that 20% of the future tax savings due to loss carryforwards may not be realized. Year 2005 2006 2007 2008 2009 Pretax Income (Loss) $100,000 70,000 (130,000) (180,000) 240,000 Tax Rate 35% 32% 30% 30% 40%

Prepare the journal entry for year 2008.

14

Chapters 24 Full Disclosure

Full Disclosure Firms cannot be trusted to voluntarily disclose all useful information in a timely fashion. Mandated disclosure (accounting rules) Disclose what, how, and when? Financial statements (B/S, I/S, CF/S, SE/S) Including: notes, supplementary information, segment information, auditors report, MD&A, (Read Appendix 5B, an example of financial statements) Annually and quarterly Disclose significant information immediately Market often punishes those who hid facts that later become known. Convergence of U.S. and international accounting standards. (Examples of current differences are reporting assets at fair value, LIFO inventory valuation, cost-recovery method for long-term contracts)
*There are many sources of information about IFRS. (e.g.) http://www.pwc.com/usifrs

15

Post-Balance-Sheet events (Subsequent events) Events and transactions that occur after the fiscal year but before actually issuing financial statements 1. If the events provide additional evidence about conditions that existed at the balance sheet date Make adjustments to financial statements. (e.g.) Settlements of litigation, Bankruptcy 2. If the events provide additional evidence about conditions that did not exist at the balance sheet date Simply disclose the facts. (e.g.) Accidents, Natural disaster, Sale of bonds or stocks. Merger

16