Chapter 11
Expenditure Cycle:
Other Operating
Items
Financial Statement Items
Covered in this Chapter
Balance Sheet
Income
Statement
Statement of
Cash Flows
Employee Compensation Operating
Expense
Net Pension Asset
Cash paid for:
Deferred income tax Research and
Employee
Development
Expense
asset
Compensation
Advertising Expense
Long-Term
Research and
Losses/Gains on
Development
Liabilities:
contingent Items
Advertising
Net pension liability Income Tax Expense
Income Taxes
Deferred income tax
liability
Contingent liabilities
Long-Term Assets:
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Employee
Compensation
Employee Compensation Timeline
Payroll
Compensated
Absences
Stock Options
and Bonuses
Postemployment
Benefits
Pensions and
Postretirement
Benefits Other
Than Pensions
The employee compensation time line
illustrates that issues relating to
employee compensation can extend
long after the employee stops working
for the company
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Payroll
and Payroll Taxes
Employee payroll taxes:
Payroll:
– Federal income tax
– salaries and
– State income tax
wages earned by
– FICA taxes
employees for
work done in
Employer payroll taxes:
the current
– FICA taxes
period
– Federal unemployment
taxes
– State unemployment
taxes
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Compensated Absences
A company pays employees for a
certain number of days when the
employees do not work
– vacation leave days
– sick leave days
The expense should be recognized in
the period in which the days are
earned, not in the period in which the
actual cash payment occurs
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Bonuses
Allow employees to receive additional
compensation if certain earnings
objectives are met
These plans are usually restricted to
top management
Potential that managers will attempt to
manipulate reported earnings
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Employee Stock Options
Managers are given the option of
purchasing shares of the company’s
stock in the future at a price that is
specified today (option price)
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Accounting for
Employee
Stock
Options
Employee Stock Options
Intrinsic value method
based on the assumption that the value of
an option, if any, is measured on the day
it is granted (market price minus the
option price)
Fair value method
based on the assumption that the value of
the option lies in the chance that the stock
price will increase above the exercise
price
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Employee Stock Options:
Intrinsic Value Method
M
a
r
$
$
k
Option price < market value
Option price > market value
e
results in expense to issuing
results in no expense to
company t issuing company
Most companies set the option price above the
market price at the date of grant so that no
compensation expense is measured and
recorded
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Employee Stock Options:
Fair Value Method
The fair value is estimated by a formula
that considers several factors including
the expected volatility of the stock price
and the length of the exercise period
The fair value of the options is reported
as compensation expense on the income
statement
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Employee Stock Options:
FASB’s Treatment
Companies are encouraged, but not
required, to adopt the fair value method
The intrinsic value method is allowed, but
if used, companies must disclose what net
income would have been under the fair
value method
Stay tuned for further FASB action
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HW #11-4
12
Postemployment Benefits
Benefits that occur after an employee
has ceased to work for an employer but
before an employee retires
– Example: a severance pay package
The cost must be estimated and
reported when the decision is made
– Example: to downsize the labor force
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Pensions
Cash compensation received by an
employee after the employee has
retired
Two types of pension plans:
– Defined contribution plan
– Defined benefit plan
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Pensions:
Defined Contribution Plan
Requires the company to contribute a
fixed amount of money to a pension
fund each year on behalf of the
employee
The amount of cash contributed to the
pension fund during the year is
reported as pension expense
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Pensions:
Defined Benefit Plan
Requires the company to pay
employees a fixed monthly cash
amount after they retire based on a
pension formula that considers years
of service and highest salary
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Pensions:
Defined Benefit Plan
Estimation of the pension liability
– The amount that would have to be
deposited in a bank today to accumulate
enough interest to pay employees their
pension benefits at retirement (actuarial
present value)
– Called the projected benefit obligation
(PBO)
– The PBO is offset against the plan assets fair
value when reported on the balance sheet
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Pensions:
Defined Benefit Plan
Three components of pension expense:
+ Interest cost
+ Service cost
– Expected return on pension fund assets
= Net pension expense
HW # E11-9
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Pensions:
Defined Benefit Plan
Interest cost
– The increase in the PBO due to the
passage of time (PBO × discount rate)
– The discount rate used is the settlement
rate
•The implicit rate of interest necessary to
purchase annuity contracts settling the
pension obligation
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Pensions:
Defined Benefit Plan
Service cost
– The increase in the PBO from service
provided by employees during the current
period
Expected return on pension fund assets
– The return that the company earns on the
assets in the pension fund
– A negative (off-set) component of pension
expense
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Postretirement Benefits
Other Than Pensions
Other employee benefits provided after
retirement include
– Health care plans
– Life insurance plans
U.S. GAAP requires that these benefits
be recognized as an expense and a
liability as they are incurred
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Income Taxes
Income Taxes
Income tax expense and the amount
paid for income tax during a period are
different for two reasons:
– Income taxes are not paid in the same
year in which they are incurred
– A firm may choose one accounting
method for tax purposes and another
for financial reporting purposes
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Financial Income vs Taxable Income
Differences in financial income and
taxable income are
– Permanent
– Temporary
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Permanent Differences
• Used to determine financial income,
but never taxable income
• Reflect statutory differences between
GAAP and the Internal Revenue
Code
– Example: interest on state and local
bonds is included in financial income,
but not in taxable income
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Temporary Differences
Some transactions affect taxable income
in a different period from financial
accounting income
– Depreciation methods
– Rent received in advance
Reported on the balance sheet as
– Deferred tax assets
– Deferred tax liabilities
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HW # E-10
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Tax Liabilities
Income taxes payable
– Based on taxable income on the tax
return
– An existing (current) legal liability
Deferred tax liability
– Requires a payment in the future
– Is the expected income tax on income
earned but not yet taxed
– Not an existing legal liability
HW # E-11-14
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Deferred Tax Liability
A typical entry for recording income
taxes with a Deferred Tax Liability
would be
Income Tax Expense
Income Taxes Payable
Deferred Tax Liability
12,000
4,000
8,000
• Income Tax Expense is reported on the income
statement
• Income Taxes Payable and Deferred Tax Liability
are reported on the balance sheet
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Deferred Tax Asset
• The expected benefit of a future tax
deduction for an expense item that
has already been incurred but is not
yet deductible for tax purposes
• Can only be recognized if it is“more
likely than not” that future income
will be realized against which the
deduction can be offset
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Deferred Tax Asset
A typical entry for recording income
taxes with a Deferred Tax Asset would
be
Income Tax Expense
Deferred Tax Asset
Income Taxes Payable
20,000
4,000
24,000
• Income Tax Expense is reported on the income
statement
• Income Taxes Payable and Deferred Tax Asset are
reported on the balance sheet
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Income Tax Disclosure
Provide details about
– Current and deferred federal taxes
– Current and deferred state taxes
– Taxes owed to foreign governments
– Taxes attributable to foreign operations
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Capitalize vs Expense
Expense/Asset Continuum
• An expenditure that is expected to benefit
future periods is capitalized as an asset
• All other expenditures are treated as expenses
Supplies
Used
Repairs
Research
and
Development
Expense
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Software
Development
Oil and
Gas
Exploration
Land and
Buildings
Asset
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Research and Development
Research
Those activities undertaken to discover
new knowledge that will be useful in
developing new products, services, or
processes or that will result in significant
improvement of existing products or
processes
Development
Applies the research findings to develop a
plan or design for new or improved
products and processes
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Research and Development
Research and development costs are
expensed in the period incurred due to
the uncertainty surrounding the future
economic benefits of R&D activities
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Research & Development:
Software
Point of technological
feasibility
Expense
Capitalize
Treat as R&D
(future benefit uncertain)
Uncertainty of future
benefit is decreased
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Oil and Gas Exploration Costs
Two methods of accounting for the cost
of “dry holes”
– Full cost method
•All exploratory costs are capitalized and
allocated to the cost of successful wells
– Successful efforts method
•Exploratory costs for dry holes are
expensed, and only exploratory costs for
successful wells are capitalized
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Advertising Costs
General treatment:
– expensed due to the uncertainty of their
future economic benefits
Exception:
– Capitalize if
– Future benefits are more certain
•Target customers who have purchased before
•Able to estimate degree of favorable response
HW # E11-16
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Contingencies
An uncertain circumstance involving a
potential gain or loss that will not be
resolved until some future event occurs
HW # E11-17
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Contingencies
Three important definitions:
– Probable
•Likely to occur
– Remote
•Not likely to occur
– Reasonably possible
•More than remote but less than likely
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Accounting for Contingencies
Losses
Gains
Probable
Recognize a probable
liability if the amount
can be reasonably
estimated.
Possible
Disclose a possible
liability in a note.
Remote
No recognition or
No recognition or disclosure
disclosure unless
contingency represents
a guarantee. Then, note
disclosure is required
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May be disclosed in the financial
statements by note, but should not
be reflected in income, because
doing so may result in recognizing
revenue prior to its realization.
Care should be exercised in
disclosing gain contingencies to
avoid misleading implications
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Accounting for Contingencies:
Lawsuits
If the facts of the case indicate that a
loss is probable and the amount of the
loss can be estimated, a loss should be
reported on the income statement and a
liability should be reported on the
balance sheet
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Accounting for Contingencies:
Environmental Liabilities
Most companies do not reflect these
loss contingencies as liabilities on the
balance sheet
– The future cost of the cleanup is very
difficult to estimate
– Accounting standards do not provide
disclosure guidance
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In Summary ...
• In addition to payroll, compensation takes the form
of bonuses, stock options, pensions, and other
benefits
• Taxable income and financial income are normally
different amounts; deferred taxes are recorded as
non-current assets and/or liabilities
• Capitalized expenses have future benefit and are
recorded as assets
• Contingencies are described as probable, possible,
and remote; accounting treatment depends on
likelihood and ability to estimate an amount
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