Galilee College
Intermediate Accounting II
Course No. ACC 211
Galilee Corporate Centre
• Joe Farrington Road
P.O. Box EE 16507 - Nassau, Bahamas
Tel. (242)364-1776 Fax (242)364-1778
Email: galilee@coralwave.com www.gcollege.org
Dr. Willis L. Johnson, Ph.D.
Certified Public Accountant
Master Financial Professional (MFP)
Certified Counselor
Galilee College © 2007
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TABLE OF CONTENTS
ABOUT THE ACCOUNTING LECTURER
Intermediate Accounting II SYLLABUS
Chapter 1: Property, Plant, and Equipment
Chapter 2: Intangibles and Other Assets
Chapter 3: Payables and Accruals
Chapter 4: Accounting for Income Taxes
Chapter 5 Employee Benefits
Chapter 6 Long-Term Liabilities
Chapter 7 Leases and Contingencies
Chapter 8 Shareholders’ Equity: Contributed Capital
Chapter 9 Shareholders’ Equity: Retained Earnings
Appendix 1: Accounting Terms
Appendix 2: Associate Degree Program (Accounting)
Appendix 3: Bachelor’s Degree in Accounting
Appendix 4: Accounting Courses Description
Appendix 5: Accounting News
Supplies Needed
 Current Accounting Principles Text
 Calculator
 Note Book/Pencil/Pen
 Ten columnar pad
 Four columnar pad
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ABOUT THE ACCOUNTING LECTURER
Dr. Willis L. Leon Johnson, CPA
Dr. Willis L. Johnson is a Chartered Accountant and a renowned veteran educator. For the past five years
he has been directing the Galilee CPA Review program. Dr. Johnson has nurtured scores of Certified
Public Accountants in the Bahamas.
He received his early education at Sandilands Primary School and R.M. Bailey Senior High School,
Nassau, Bahamas. Having an earnest quest for knowledge, Dr. Willis Johnson, pursued studies in
Accounting at Brewster Adult Technical Institute and Tampa College in Tampa Florida. He further went
on to Tiffin Ohio, where he enrolled at Tiffin University. At the completion of his study tenure at Tiffin
University, he became the first student in the School’s history to simultaneously earn three Bachelor of Arts Degrees.
Additionally, he has acquired a Master of Business Administration degree, a Master of Theology degree and a Doctorate
degree in Philosophy.
Dr. Johnson’s vocational background showcases a tenure at Coopers and Lybrand Accounting Firm where he served as a Staff
Accountant. Following his departure from Coopers and Lybrand he served as the Chief Accountant at Blanco Chemicals. Dr.
Johnson was climbing higher, after serving Blanco Chemicals for five years, he moved on to Bahamas Telecommunications
Corporation where he was appointed Cost and Budget Accountant. At Batelco he moved through the ranks of Accountant to
Manager, then Senior Manager and finally Executive Manager. Dr. Johnson retired in 1999 and took on full-time oversight of
the Galilee Education System which comprises of Galilee Academy, Galilee College and Galilee CPA Review and Galilee
Professional Institute. In 2005, Dr. Johnson established the Bahamas Association of Christian Counselors.
Dr. Johnson passed the Certified Public Accountant’s Exam in 1986 and become a member of the Colorado Society of
Accountants, Colorado State Board of Accountancy and the American Institute of Certified Public Accountants. He became a
member of The Bahamas Institute of Chartered Accountants in 1989, and has subsequently served on the executive committee
as; Chairman of the Continuing Education Committee, Treasurer and Second Vice President. Dr. Johnson is also a member of
the American Academy of Financial Management where he serves on the Board of and The American Institute of Certified
Public Accountants. Dr. Johnson is a Master Financial Professional and serves on Global Board of Academic Advisors and
Professors of the American Academy of Financial Management . Dr. Johnson is also a Certified Marriage and Family
Counselor. He currently serves an the treasurer for the Association of Tertiary Institutions of the Bahamas.
Called to the gospel ministry, Dr. Johnson is an ordained Minister. He is the founding Pastor of Galilee Ministries
International, a locally mission based entity that is designed to bringing relief to persons who are bereft of precious
commodities such as food, clothing, shelter and education.
For the past five years he has been engaged in directing the Galilee CPA Review program. He is known for his profound
academic theatrics as he delivers the CPA curriculum.
His success rate is phenomenal and measures alongside in the region. Dr. Johnson was the guest of the AICPA and NASBA at
a joint meeting in New York, New York on December 15, 2003 as they announced the final changes to the new computerbased CPA exam. During this joint meeting in New York, Dr. Johnson played an integral part in the discussions, as well as,
other prominent Review providers, such as Dr. Irvin Gleim, and Dr. Jim Rigos. The AICPA invited him again to attend the
joint meeting and follow-up session on December 6, 2004 in Jersey City, New Jersey. During that session, Dr. Johnson
advocated for the AICPA to consider its Prometric testing outside the of the U.S. such as the Bahamas. A committee has been
appointed to present a paper on this possibility.
Dr. Johnson is married to the former Yvette M. Bethell. The couple has five children, Jeremiah, Joshua, Joel, Jude and Jamés.
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Galilee College
Course Outline
COURSE NUMBER:
ACC 212
DEPARTMENT: Accounting
COURSE TITLE:
Intermediate Accounting II
CREDIT VALUE: 3.0
COURSE DURATION: 1 SEMESTER DATE PREPARED: July 2007
PREREQUISITES
ACC 211, Intermediate Accounting I
PROGRAM COORDINATOR _________________________________
REQUIRED TEXTS:
INTERMEDIATE ACCOUNTING Notes II, Dr. Willis L. Johnson, Galilee College © 2006
SUPPLEMENTAL MATERIALS
None
COURSE DESCRIPTION
Theories and problems involved in proper recording of transactions and preparation of financial
statements. Review of the accounting cycle, discussion of financial statements, analysis of
theory as applied to transactions relating to current assets, current liabilities, long-term
investment and presentation on the Balance Sheet.
COURSE OBJECTIVES
Students will be expected to understand the environment of accounting; basic accounting
theory; the recording process; the income statement and statement of retained earnings; the
balance sheet; the time value of money; cash and short-term investments; current receivables
and liabilities; inventory valuation, cost flow assumptions and estimating techniques; property
plant and equipment acquisitions, subsequent expenditures, disposals, depreciation and
depletion; intangible assets, and current liabilities.
Program Context:
This course is a second year course in the Accounting program.
Course Learning Outcomes:
Learning outcomes identify the knowledge, skills and attitudes that successful students will
have developed and reliably demonstrated as a result of the learning experiences and
evaluations during this course.
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Evaluation Strategies and Grading:
Class Attendance
Full participation and attendance is expected for this course. Students who miss a class are
responsible for any information discussed, assigned or distributed in that class period.
Four exams are scheduled during the semester. The lowest exam score will be dropped. If an
exam is missed for ANY REASON, that will be the exam dropped. If a second exam is missed
for ANY REASON, a ZERO will be assigned to the second missed exam. There will be no
make-up exams. Everyone is required to take the final exam. Calculators may be used on all
exams, but you may NOT share calculators.
Final Project
Home Work
Quiz/Exams
50%
30%
40%
100%
Note that violation of academic honesty can affect the course grade. "Cheating" on an exam
(i.e., the giving or receiving of aid) will result in a course grade of "F."
Note that classroom behavior (for example, talking to other students during lecture) can
negatively affect course grades by as much as three letter grades, e.g., an "A" can become a
"D."
GRADING SYSTEM:
A 94% 100% Excellent
B 87% 93% Good
C 75% 86% Average
4.00
3.00
2.00
D 68% - 74% Passed 1.00
F 0% - 67% Failed 0.00
COVERAGE
Chapter 1: Property, Plant, and Equipment
Chapter 2: Intangibles and Other Assets
Chapter 3: Payables and Accruals
Chapter 4: Accounting for Income Taxes
Chapter 5 Employee Benefits
Chapter 6 Long-Term Liabilities
Chapter 7 Leases and Contingencies
Chapter 8 Shareholders’ Equity: Contributed Capital
Chapter 9 Shareholders’ Equity: Retained Earnings
Additional Information:
1. MISSED TESTS WILL RESULT IN A ZERO GRADE; SEE YOUR INSTRUCTOR TO
DISCUSS THIS.
2. Texts, working papers and calculators are to be brought to every class.
3.
Some details of your course schedule may vary by section/teacher or change as a result
of unforeseen circumstances, such as weather, cancellations, College and student
activities and class timetabling.
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INTERMEDIATE ACCOUNTING I
ACC 212
Professor: Dr. Willis L. Johnson, Chartered Accountant
Course Instructions
1. Read through the chapters in each unit
2. Complete all class questions for practice for each unit
3. Complete all home work questions for each unit
4. The home work questions should be presented in report form as listed below.
Should you require additional information, please go to the following website and review related materials:
www.gcebooks.cjb.net. or
Email any questions that you may have to galilee@coralwave.com, addressed to Professor
Johnson.
a. Your “completed” Work must be typed and presented in a clear faced folder addressed as
follows:-
Galilee College
INTERMEDIATE ACCOUNTING II
______________ Semester 2008
Your Name_________________
Presented to
Professor
Dr. Willis L. Johnson, Ph.D
Chartered Accountant
Nassau, Bahamas
Date:_________
Note: Your work should be completed between 3 – 8 weeks. Presentation after 8 weeks will cause the reduction of grade,
the maximum time with permission for extension is 10 weeks. (There is no final exam for this course)
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Galilee College ©2007
Chapter 1 Property, Plant, and Equipment
Initial Measurement of Property, Plant and Equipment (PPE) = Tangible Assets
1. Record at historical cost (cash or its equivalent paid to acquire asset
- Excess of cash paid over cash equivalent = interest expense
2. Land obtained as a plant SITE should be recorded at its acquisition cost, which includes:Purchase Price, Legal Fees, Title Insurance, Recording Fees, Assumption of Encumbrance,
other cost to prepare the property for intended use..
 Other assets would include Freight, Installation and assembling, insurance and Testing
Cost
 Land held by developers is classified as investment inventory
3. Donated Assets – Credit donated capital (a Paid in Capital Account) Do not record as a
revenue or gain.
4. Improvements to leasehold is capitalized and amortized over the remaining lease term or
asset life, whichever is shorter.
 If useful life extends beyond least term, use lease term if decision to renew is certain.
4. Relative Sales Value – allocates cost based on the relative value of assets in a group.
Special Measurement Issue – Internally Constructed Assets (ICAs)
1. Interest should be capitalized for:a. Assets constructed or produced for own use (even if constructed or produced by others
b. Assets constructed or produced as discrete projects for sale or lease
Criteria for capitalization”i.
Relevant expenditures have been made
ii.
Activities are in progress
iii.
Interest is being incurred
 No interest capitalization after construction completed.
2. Capital of capitalized interest:a. Average qualifying expenditures accumulated during period x interest rate
 = Expenditures incurred in this period + those incurred in previous periods.
 I.e. Interest rate on new borrowings x accumulated expenditures
 If cost incurred evenly throughout the year, divide cost by two x rate
 May not exceed total incurred during the period
 Interest capitalized = interest avoidable if expenditure was not made.
Subsequent Expenditures for PPE
1. If improvement benefits future periods, it should be capitalized.
2. Betterment/Improvement – (replacement asset is substituted for existing asset) Increase
productivity, capacity or expected useful life
 When substantial portion of productive asset is replaced, and if
- Accumulated depreciation is identified (substitution method of accounting is used)
- Reduce Asset A/C, Reduce Accum. Depreciation, recognize gain or loss
- Any cost to refurbish is capitalized.
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-
Expenditures to increase the quality or quantity of a machine’s output should be
capitalized.
(Whether or not its useful life is extended)
3. Rearrangement – (Movement of existing assets to provide greater efficiency or to reduce
production cost.
i.
If will benefit future period = capitalize
ii.
If modification improves future period – capitalize
4. Repair and Maintenance – Incurred to maintain plant assets in operating condition
i.
Expense: continuing, frequent, and low cost repairs
ii.
Capitalize amount to benefit future periods.
Disposals Other Than by Exchange
Non-reciprocal transfer – transfer of assets or services in one direction
 To shareholder or other entity: record at fair value of asset transferred
 record any gain or loss
Exception
To owners in spin-off, reorganization, liquidation, plan in substance the rescission of a prior
business combination.
1. Accounting for Involuntary Conversions of Nonmonetary Assets to Monetary Assets
 PPE is involuntarily converted when it is lost through a casualty (flood, earthquate, fire,
etc.), expropriated, condemned.
i.

Gain/Loss be recognized even though an enterprise reinvests or is obligated to
reinvest monetary assets in replacement nonmonetary assets.
(proceeds – carrying value)
- Separate caption of income statement if extraordinary
- Replacement property should be recorded at cost
Replacement cost over condemned carrying value will increase the carrying cost.
Exchanges of Nonmonetary Assets
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Notes:
1. For similar Assets: If BV given exceed FV received, then record at FV received.

No gain is recognized unless boot is received

Loss is recognized if BV given up exceeds FV received (even if boot is given up)

Recording value of new asset = (BV given up – boot received not recognized as gain)
Special Update:
According to Emerging Issues Task Force Issue 86-29, the foregoing
treatment of boot does not apply if it is at least 25% of the fair value of the exchange. In such a
transaction, both parties should record a monetary exchange at fair value, with gains and losses
recognized in full.
Impairment or Disposal or Long-Lived Assets
1. SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, applies to
the long-lived assets of an entity (a business enterprise or a not-for-profit organization)
that are to be held and used or disposed of.
2. The unit of accounting for such a long-lived asset is the group.
i.
If a long-lived asset is to be held and used, the group is the lowest level at
which identifiable cash flows are largely independent of those of other groups.
3. A Long-lived asset (asset group) to which SFAS 144 applies is tested for recoverability
whenever events or changes in circumstances indicate that its carrying amount may not
be recoverable.
 The carrying amount is not recoverable when it exceeds the sum of the undiscounted
cash flows expected to result from the use and disposition of the asset (asset group).
 If the carrying amount is not recoverable, an impairment loss is recognized equal to
the excess of the carrying amount over the fair value.
 Fair value may in appropriate circumstances be based on
a. The prices of similar assets or groups
b. Present value estimates
 The estimates are made for the remaining useful life as determined from the
perspective of the entity. The remaining useful life is that of the primary asset of the
group.
REMEMBER: An impairment loss is included in income from continuing operations before
income taxes by a business enterprise.
 Also remember that a long-lived asset is not depreciated while it is classified as held for
sale and measured at the lower of carrying amount or fair value minus cost to sell.
 A loss is recognized for a write-down to fair value minus cost to sell.
 A gain is recognized for any subsequent increase but only to the extent of previously
recognized losses for write-downs.
 The loss or gain adjusts only the carrying amount of a long-lived asset even if it is
included in a disposal group.
i.
Changes to a plan of sale may occur because of circumstances previously regarded
as unlikely that result in a decision not to sell.
 In these circumstances the asset (disposal group) is reclassified as held and used.
 A reclassified long-lived asset is measured individually at the lower of Carrying
amount – depreciation or fair value at date of decision not to sell.
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
In classifying a long-lived asset or disposal group , if a disposal group is held for
sale, its assets and liabilities are reported separately in the balance sheet and are
not offset and presented as a single amount.
Depreciation
Straight line = lowest amount of depreciation (highest book value)
Accelerated Depreciation = Highest amount of depreciation and (lowest book value)
1. Sum-Year-Digit = N x(N+1)/2
2. DDB ignores salvage value (however asset is not depreciated below salvage value)
* DDB rate = (100 divided by Straight line rate x 2)
Units of production – allocates asset cost based on the level of production. This is used when
asset service potential declines with passage of time
Both Composite and group depreciation use the straight line method.
 Net Carrying value is decreased by cash proceeds of asset retired.
Depletion
Successful-efforts method – capitalizes only those exploration costs that lead to the location of
resources that can be feasibly developed.
Full-cost method – capitalizes the cost of both successful and unsuccessful efforts on the theory
that the latter are necessary to the discovery of productive resources
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Chapter 1 Questions – Property, Plant, and Equipment
A. Initial Measurement of Property, Plant and Equipment (PPE) = Tangible Assets
Class 1: During 2005 Klip Klippy had the following transactions pertaining to its new office building:- purchased price of land
$60,000, legal fees for contracts to purchase land $2,000, architects’ fees $8,000, demolition of the old building on site $5,000,
sale of scrap form old building $3,000, construction cost of new building $350,000. What amount should reflect the cost of land
and building on the balance sheet?
Home 1: During 2005 Slip Slippy had the following transactions pertaining to its new office equipment:- purchased price of land
$50,000, insurance 5% of purchased price, Duty and Stamp, 20% of cost of purchased price and insurance, legal fees for
contracts to purchase equipment $3,000, architects’ fees for design of new office for equipment $10,000, demolition of the old
office building on site $7,000, sale of scrap from old office building $5,000, construction cost of new office building $2250,000.
What amount should reflect the cost of equipment and office building on the balance sheet?
B. Special Measurement Issue – Internally Constructed Assets (ICAs)
Class 2: Zed Zeddy completed the construction of a new building in 2004 at a total cost $2,5 million, $2,000,000 was incurred
throughout 2004, incremental borrowing rate was $12%, interest incurred in 2004 was $102,000. What amount should be
reported as capitalized interest?
Home 2: Zim Zimmy was in the second year of the construction of its new equipment. In 2005 $2,5 million was evenly spent,
incremental borrowing rate $10%, interest incurred in 2005 was $130,000. What amount should be reported as capitalized
interest?
C. Subsequent Expenditures for PPE
Class 3: Paul Pauly replaced the roof on its 20 year old building which had a historical cost of $300,000 and accumulated
depreciation of $170,000. The replacement cost of $100,000 was not expected to increase the life of the building, only the
quality for production purposes. What is the entry to record the $100,000?
Home 3: In 2005 Sill Silly paid $20,000 for a chip for it’s bottling machine, this was 10% of the total cost of the machine prior
to the chip replacement. The chip had did not improve productivity, quality, nor the useful life of the machine. However it
provided for an increase in the quantity of production. What is the value of the bottling machine immediately after the chip
replacement?
D. Disposals Other Than by Exchange
Home 3a: How is a gain or loss recognized on an involuntary conversion?
E. Exchanges of Nonmonetary Assets
Class 4: Scrip Scrippy, exchanged a truck with a carrying amount of $12,000 and a fair value of $20,000 for a truck and $5,000
cash. The fair value of the truck received was $15,000. a. At what amount should Scrip Scrippy record the truck received? b.
What is the entry to record the transaction?
Home 4: Plack Placky exchanged an equipment with a carrying amount of 50,000 and a fair value of $60,000 for a truck and
$10,,000 cash. The fair value of the truck received was $70,000. a. At what amount should Plack Placky record the equipment
received? b. What is the entry to record the transaction?
F. Impairment or Disposal or Long-Lived Assets
Home 4a: In your own research, compile the entire SFAS 144. The information must be organized, and not just a clipping from
the internet. You must focus on a. Measurement of impairment, b. the recoverability test, c. Asset groups. And d. the disposal
group.
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G. Depreciation
Class 5: Jeff Jeffy purchased a new equipment on January 1, 2003 for $100,000. The equipment had an estimated life of 5
years and a salvage value of $10,000. Find the Depreciation expense at December 2004 under the following methods (1)
Straight-line, (B) Sum-of-year Digit, (C) Double Declining Balance. D. If the equipment was sold on December 31, 2004 for
$50,000, what is the entry to record the gain or loss using the straight-line method?
G. Depreciation
Home 5: Yuk Yuky purchased a new truck January 1, 2003 for $75,000. The truck had an estimated life of 6 years and a
salvage value of $15,000. Find the Depreciation expense at December 2005 under the following methods (1) Straight-line, (B)
Sum-of-year Digit, (C) Double Declining Balance. If the equipment was sold on December 31, 2005 for $40,000, what is the
entry to record the gain or loss using the straight-line method under (D) Straight-line (E) Sum-of-year digit and (F) Double
Declining Balance.
H. Depletion
Class 6: On January 1, 2004 Explore Explorey purchased a mineral mine for $2,640,000 with removable ore estimated at 1.2
million tons. After it has extracted all the ore, Explore Explorey will be required by law to restore the land to its original condition
at an estimated cost of $180,000. Explore Explorey believes it will be able to sell the property afterwards for $300,000. During
2004, Explore Explorey incurred $360,000 of development costs preparing the mine for production and removed and sold
60,000 tons of ore. In its 2004 income statement, what amount should be reported as depletion?
Home 6: On January 1, 2005 Dig Diggy purchased a coal mine for $10,000,000 with removable coal estimated at 4million tons.
Dig Diggy believes it will be able to sell the property afterwards for 10% of its cost at the end of it’s life. During 2005, Dig Diggy
removed and sold 100,000 tons of coal. In its 2005 income statement, what amount should be reported as depletion?
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Galilee College © 2007
Chapter 2– Intangible and Other Assets
A. Goodwill and Other Intangible Assets
1. SFAS 142, Goodwill and Other Intangible Assets, applies to the initial recognition and
measurement of intangible assets acquired with other assets or singly but not in a
business combination.
 A recognized intangible asset is amortized over its useful life it that useful live is
finite, that is, unless the useful life is determined to be indefinite.
 An intangible asset is recorded at its cost at the date it is acquired externally.
- In an exchange transaction, cost is measured by the cash paid, otherwise,
the fair value of the more clearly evident of the consideration given or the
asset acquired is the basis for measurement.
- Goodwill is tested for impairment at least annually but is never amortized.
(Goodwill is not recorded except when a business is purchased.)
- Goodwill is defined as the excess of the cost of an acquired entity over
the net of the amounts assigned to assets acquired and liabilities
assumed.
- The default method of amortization of intangible assets is the straight line
method.
- The cost of developing, maintaining or restoring intangible assets should
be expensed as incurred.
2. Legal fees and other costs incurred in successfully defending a suit are to be charged
capitalized as part of the cost over the remaining useful life of the intangible asset.
3. Legal fees incurred in an unsuccessful suit defense should be expensed.
Statement of Financial Accounting Standards (SFAS) No. 142
a. Goodwill and Other Intangible Assets
b. Issued in June 2001
c. Supersedes APB Opinion No. 17, "Intangible Assets".
Acquired intangible assets
a. An acquired intangible asset
--> recognized based on its fair value.
Intangible assets not specifically identifiable
a. Internally developed intangible assets
--> not recognized as an asset on the balance sheet.
--> rules of SFAS No. 142 are same as APB Opinion No. 17
b. Cost of internally developing intangible assets
(not specifically identifiable)
--> recognized as an expense when incurred.
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Amortization of intangible assets
a. An intangible asset with a finite useful life
--> amortized over its useful life.
b. If the useful life is not limited
--> by legal, economic or other factors,
--> useful life is indefinite (not infinite).
c. Amount to be amortized
= cost - residual value
d. If the pattern of economic benefits can be determined
--> Amortization method should reflect such pattern.
e. If the pattern of economic benefits cannot be determined
--> Straight-line amortization
Goodwill
a. Goodwill is not amortized.
--> Goodwill is tested for impairment
b. Impaired
--> fair value < carrying amount
c. Test for impairment
--> on an annual basis
d. If certain events would reduce fair value below carrying amount,
--> test for impairment is done
between annual tests.
B. Intangible Assets Distinct from Goodwill
1. Royalties paid should be reported as expense in the period incurred.
2. Research and Development (R&D) cost are expensed as incurred. R&D excludes legal
work in connection with patent applications or litigation and the sale or licensing of
patents.
3. Franchise fee revenue should ordinarily be recognized at the earliest ime when the
franchisor has:
 substantially performed or satisfied all material services, or conditions relating to
the franchise sale.
- The earliest time usually is the commencement of operations by the
franchisee unless it can be demonstrated that substantial performance of
all obligations occurred previously.
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-
If fees are received and the franchisor has not substantially performed,
then unearned revenue should be recorded.
REMEMBER: Long term payables and receivables should be recorded at PV.
4. Broadcasters (licensees) should report the rights acquired and obligations incurred under
a license agreement when the license period begins and when:
a. The cost of each program is known or determinable
b. The program material has been accepted by the licensee
c. The program is available for viewing or telecast.
5. For financial reporting purposes, organizational cost should be expensed as incurred.
But, amortized over 5 years for tax purposes.
C. Research and Development
= Planned search or critical investigation aimed at discovery of new knowledge useful in
developing a new product, service, process, or technique, or in bringing about a significant
improvement of an existing product.
 Development = translation of research findings or other knowledge into a plan or design
for a new or improved product or process
 R&D expense = R&D performed under contract by others; design, construction, and
testing of prototypes; and testing in search for new products.
1. These are expensed because you are not certain of the outcome or future benefit. Dr. J’s
Question: can you imagine as a CPA you are capitalizing uncertainty? Expense it)
 However, if R&D has future benefit, these should be expensed. (alternative future uses)
2. Legal fees for filing patent should be capitalized.
3. Periodic design changes to existing products is not R&D
D. Prepayments
Current Assets include prepayment expenses. These will be realized in cash, sold, or
consumed within the longer of 1 year or the normal operating cycle.
Remember (accrual –future cash flow vs. deferral – past cash flow)
E. Special Issues
1. Development stage enterprise use GAAP as operating enterprises.
 Revenues and expenses is treaded same as for operating enterprises.
2. Software Production Cost
i.
Cost incurred until available for general release to customers
 Should be capitalized
a. Subsequently, report at lower of unamortized cost or net realizable value
- Amortization of Capitalized Cost
i. Based on ratio of:
Current Gross Revenues
Anticipated Future Gross Revenues
ii. Minimum Amortizaton =
SL Amortization over Remaining
Estimated economic life of product
 Capitalization happens after tecnnological feasibility has been established.
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
Inventory cost include:
i.
Cost of duplicating software
ii.
Documentation
iii.
Training materials from product masters
iv.
Physically packaging product for distribution
Note: This is in addition to information pertaining to Development stage enterprises: An enterprise is considered to be in the development stage if planned principal
operations have not yet commenced or if they have not yet begun to generate significant
revenue.
i.
Cost incurred during this period may be deferred
ii.
Asset may be recognized and expense deferred if the incurrence of the cost is
expected to provide economic benefits in future periods.
1. REMEMBER: use same GAAP as established operating enterprises
FOOTNOITE Disclosure is the only difference
a. Must present certain additional information accumulated since the firm’s inception.
b. Cumulative net losses must be disclosed in the SHE section of the balance sheet (deficits)
c. Cumulative amounts of revenue and expenses in the income statement
d. Cumulative amount of cash inflows and outflows in the statement of cash flows. (from
inception)
e. Information about each issuance of stock in the SHE section.
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Chapter 2 Questions – Intangible and Other Assets
A. Goodwill and Other Intangible Assets
CLASS 1: On January 1, 2003, Quick Quicky purchased Shelf Co. at a cost that resulted in recognition of goodwill of $200,000
having an expected benefit period of 10 years. On January 1, 2004, Quick Quicky spent another $80,000 to maintain goodwill,
which extended the life of goodwill to 40 years. How much should be reported as goodwill at December 31, 2005?
CLASS 2: On June 30, 2004, Finn Finny Inc. exchanged 2,000 shares of Edlow Corp. $30 par value common stock for a patent
owned by Bisk Co. The Edlow stock was acquired in 2000 at a cost of $50,000. At the exchange date, Edlow common stock had
a fair value of $40 per share, and the patent had a net carrying amount of $100,000 on Bisk’s books. At what amount
shouldFinn record the patent?
HOME 1: Chick Chicky Corp. purchased Tink Corp. on January 1, 2004 for $100,000, incurring goodwill of $50,000. Tink
Corp. became worthless on December 1, 2004. How much should be reported as goodwill at December 31, 2005?
HOME 2: What is Goodwill, according to SFAS 142?
B. Intangible Assets Distinct from Goodwill
CLASS 1: Deck Decky Co. was granted a patent on January 2, 2001 and appropriately capitalized $45, 00 of related costs.
Deck Decky was amortizing the patent over its estimated useful life of 15 years. During 2004, Deck Decky paid $15,000 in legal
costs in successfully defending an attempted infringement of the patent. After the legal action was completed, Deck Decky sold
the patent to the plaintiff for $75,000. Deck Decky’s policy is to take no amortization in the year of disposal. In its 2004 income
statement, what amount should Deck Decky report as gain from sale of patent?
CLASS 2: Stuck Stucky Corp. Bought Patent A for $40,000 and Patent B for $60,000. Stuck Stucky also paid acquisition costs
of $5,000 for Patent A and $7,000 for Patent B. both patents were challenged in legal actions. Stuck Stucky paid $20,000 in
legal fees for a successful defense of Patent A and $30,000 in legal fess for an unsuccessful defense of Patent B. what
amounts should Stuck Stucky capitalize for patents?
HOME 1: On July 1, 2003 Wall Wally Co. was granted a patent valued $300,000 with a life of 30 years. During that time Wall
Wally paid $30,000 in legal costs in unsuccessfully defending an attempted infringement of the patent. In its 2004 income
statement, what amount should Wall Wally report as amortization of patent at December 31, 2005?
HOME 2: Web Webby Corp. Bought Patent A for $80,000 and Patent B for $130,000. Web Webby also paid acquisition costs
of $20,000 for Patent A and $40,000 for Patent B. both patents were challenged in legal actions. Web Webby paid $20,000 in
legal fees for an unsuccessful defense of Patent A and $40,000 in legal fess for an unsuccessful defense of Patent B. what
amounts should Web Webby capitalize for patents?
C. Research and Development
CLASS 1: Wiz Wizzy Co. purchased two machines for $250,000 each on January 2, 2004. The machines were put into use
immediately. Machine A has a useful life of 5 years and can be used in only one research project. Machine B will be used for 2
years on a research and development project and then used by the production division for an additional 8 years. Wiz Wizzy
uses the straight-line method of depreciation. What amount should Wiz Wizzy include in 2004 research and development
expense?
HOME 1: Blist Blisty Co. purchased two machines for $280,000 each on January 1, 2001. The machines were put into use
immediately. Machine A has a useful life of 4 years and can be used in only one research project. Machine B will be used for 4
years on a research and development project and then used by the production division for an additional 4 years. Blist Blisty
uses the straight-line method of depreciation. What amount should Blist Blisty include in 2005 (a) research and development
expense? (b) depreciation?
17
D. Prepayments
CLASS 1: Port Porty Inc. paid $7,200 to renew its only insurance policy for 3 years on March 1, 2004, the effective date of the
policy. At March 31, 2004, Port Porty’s unadjusted trial balance showed a balance of $300 for prepaid insurance and$7,200 for
insurance expense. What amounts should be reported for prepaid and insurance expense in Port Porty’s financial statements
for 3 months ended March 31, 2004?
CLASS 1: On October 1, 2004 Ed Eddy Inc. paid $60,000 for its five year insurance. At December 31, 2004, what amount
should Ed Eddy report as (a) Insurance Expense for 2004 and (b) the balance in Prepaid Insurance.?. At December 31, 2005,
what amount should Ed Eddy report as (c) Insurance Expense for 2005 and (d) the balance in Prepaid Insurance.?.
E. Special Issues
CLASS 1: During 2004, Pit Pity Corp. incurred costs to develop and produce a routine, low-risk computer software product, as
follows:
Completion of detail program design
$13,000
Costs incurred for coding and testing to establish technological feasibility $10,000
Other coding costs after establishment of technological feasibility
$24,000
Other testing costs after establishment of technological feasibility
$20,000
Costs of producing product masters for training materials
$15,000
Duplication of computer software and training materials from product
masters (1,000 units)
$25,000
Packaging product (500 units)
$ 9,000
1. In Pit Pity’s December 31, 2004 balance sheet, what amount should be capitalized as software costs subject to
amortization?
2. In Pit Pity’s December 31, 2004 balance sheet, what amount should be reported in inventory?
3. In Pit Pity’s December 31, 2004 Income Statement, what amount should be expensed?
CLASS 1: If Coding and testing cost incurred prior to the establishment of technological feasibility, what would and answers be
for questions 1, 2 and 3 above?
18
Galilee College © 2007
Chapter 3 - Payables and Accrual
Accounts Payable
Accounts Payable – Commonly termed trade accounts payables, are
 Liabilities reflecting the obligations to sellers that are incurred when an entity purchases
- INVENTOY, SUPPLIES OR SERVICES ON CREDIT.
 A/P should be recorded at their settlement value.
 Usually no interest expense on short-term liabilities unless amount is paid after due date.
 A/P are not usually secured by collateral
1. Gross Method – records purchases and accounts payable without regard to discounts
2. Net Method – records purchases and accounts payable net of discounts
3. FOB Shipping Point – Title and risk of loss pass to buyer at time and place of shipment
4. FOB Destination – Title and risk of loss pass to buyer when goods are tendered for shipment
Accrued Expenses
Accrued Expense – future cash flow of expense already incurred
Interest Method –(accrued interest ) = Beg. Face amount of note x stated rate x time
 Working Capital (Current Assets – Current Liabilities) If liabilities are not accrued, current
liabilities will be understated, and working capital will be overstated.
- This impact has no bearing on cash.
- If this transaction relates to an asset, the asset will be understated
- If this transaction relates to an expense
i.
Expense will be understated
ii.
Income will be overstated
iii.
Retained earnings will be overstated
Taxes Payable
Note: This area was covered in Unit 13, but will be reviewed at the conclusion of CHAPTER
along with other areas.
1. Federal Unemployment Tax and FICA taxes are expenses incurred as employee earn
wages.
I.
These are paid to the federal government on a periodic basis.
ENTRY
Debit: FUT & FICA Tax Expenses
Credit: Tax payable
(Taxes withheld are accrued as taxes payable)
2. Property taxes – expense and accrue monthly
3. Sales taxes – paid by customer, and collected by seller, and remitted monthly or quarterly
Contingent Liability – Accrue when it is probable and reasonably estimated
19
Deposits and Other Advances
1. Current Liability – Obligation that will either be liquidated using current assets or replaced by
another current liability.
2. Customer deposit is a liability (like Security Deposit) – This involves a probable future
sacrifice of economic benefit arising from a current obligation of a particular entity to transfer
assets or provide service to another entity in the future as a result of a past transaction.
Coupons and Premiums
To increase sales, sellers include stamps, coupons, special labels and other strategies with the
merchandise. Customers can redeem these for premiums (goods or cash)
1. Matching – associating cause and effect.
2. Expense and revenue recognize in same period
 Premiums must be purchased and recorded as inventory
UPON REDEMPTION2
Debit: Redemption expense
Credit: Liability (estimate at end of accounting period)
Warranties
Warranty – written guarantee of the integrity of a product or service and an undertaking by the
seller to repair or replace a product, refund all or part of the price, or provide additional service.
i. Accrued liability is recognized when the product is sold.
1. Accrue warranty liability for probable and reasonably estimated expenditures
ENTRY
Debit Warranty Expense
Credit: Estimated Liability
ACTUAL
Debit: Estimated Liability
Credit: Cash/Payable etc.
20
Chapter 3 Questions – Payables & Accruals
A. Accounts Payable
CLASS: Step Steppy’s accounts payable balance at Dec. 31, 2003 was $2.2 million before considering the following:- 1.
Goods shipped F.O. B Shipping Point for $40,000 received Jan 2, 1004. 2. Goods shipped F.O.B Destination for $60,000
received Jan 3, 2004. 3. Good shipped F.O. B Shipping Point rec. Dec. 29, 2003. 4. $50,000 A/P written in Dec, but mailed
out on Jan 1, 2004 was debited to Accounts Payable in Dec 2003. What amount should Step Steppy report as Accounts
Payable in its December 31, 2003 Balance Sheet?
HOME: Drip Drippy’s accounts payable balance at Dec. 31, 2004 was $1,200,000 after accounting for the following:- 1. Goods
shipped F.O. B Shipping Point for $75,000 received Jan 2, 1005. 2. Goods shipped F.O.B Destination for $90,000 received Jan
3, 2005. 3. Good shipped F.O. B Shipping Point rec. Dec. 29, 2004. 4. $100,000 A/P written in Dec, but mailed out on Jan 1,
2005. What amount should Drip Drippy report as Accounts Payable in its December 31, 2004 Balance Sheet?
B. Accrued Expenses
CLASS: Cross Crossy Co. pays all salaried employees on a Monday for the 5-day workweek ended the previous Friday. The
last payroll recorded for the year ended December 31, 2004 was for the week ended December 25, 2004. The payroll for the
week ended January 1, 2005 included regular weekly salaries of $100,000 and vacation pay of $25,000 for vacation time
earned in 2004 not taken by December 31, 2004. Cross Crossy had accrued a liability of $25,000 for vacation pay December
31, 2003. In its December 31, 2004 balance sheet, what amount should Cross Crossy report as accrued salary and vacation
pay? What is the entry to record accrued salary?
HOME: Muck Mucky Co. pays all salaried employees on a Monday for the 6-day workweek ended the previous Friday. The last
payroll recorded for the year ended December 31, 2004 was for the week ended December 27, 2004. The payroll for the week
ended January 4, 2005 included regular weekly salaries of $120,000 and vacation pay of $25,000 for vacation time earned in
2004 not taken by December 31, 2004. Muck Mucky had accrued a liability of $45,000 for vacation pay December 31, 2003. In
its December 31, 2004 balance sheet, what amount should Muck Mucky report as accrued salary and vacation pay? What is
the entry to record accrued salary?
C. Taxes Payable
CLASS: Lim Limmy Co.’s payroll for the month ended January 31, 2004 is summarized as follows:
Total wages $30,000, Federal income tax withheld $1,200. All wages paid were subject to FICA tax rates were 7% each for
employee and employer. Lim Limmy remits payroll taxes on the 15th of the following month. In its financial statements for the
month ended January 31, 2004, what amounts should Lim Limmy report as total payroll tax liability and as payroll tax expense?
HOME: Tab Tabby Co.’s payroll for the month ended December 31, 2004 is summarized as follows:
Total wages $45,000, Federal income tax withheld $2,000 related only to November 2004. All wages paid were subject to
FICA tax rates were 7% each for employee and employer. Tab Tabby will remit its payroll taxes on the 15th of January 2005. In
its financial statements for the month ended December 31, 2004, what amounts should Tab Tabby report as its payroll tax
liability and what is its payroll tax expense?
D. Deposits and Other Advances
CLASS: Seep Seepy Inc. operates a retail store that is required by law to collect refundable deposits of $.07 on malta bottles.
Information for 2004 follows:
Liability for refundable deposits, 12/31/03 ……….……………………$350,000
Bottles of malta sold in 2004……………………………………………15,000,000
Matla bottles returned in 2004…………………………………………..13,000,000
On December 1, 2004, Seep Seepy subleased space and received $30,000 deposit to be applied toward rent at the expiration
of the lease in 2008. In Seep Seepy’s December 31, 2004 balance sheet, what were the current and noncurrent liabilities?
21
HOME: In 2005 Seep Seepy recognized its 2004 liabilities. However, Seep Seepy increased the refundable deposit to $.08
and sold 20% more malta than in 2004, and there was a 25% increased in bottles returned than in 2004. In Seep Seepy’s
December 31, 2005 balance sheet, what were the current and noncurrent liabilities?
E. Coupons and Premiums
CLASS: In December 2004, Milk Milky Co. began including one coupon in each package of candy that it sells and offering a toy
in exchange for $0.60 and fen coupons. The toys cost Milk Milky $1.00 each. Eventually, 70% of the coupons will be redeemed.
During December, Milk Milky sold 250,000 packages of candy and no coupons were redeemed. In its December 31, 2004
balance sheet, what amount should Milk Milky report as estimated liability for coupons?
HOME: In December 2005, Coke Cokey Co. began including one coupon in each case of soda that it sells and offering a TShirt in exchange for $0.75 and five coupons. The T-Shirts cost Coke Cokey $1.50 each. Eventually, 60% of the coupons will be
redeemed. During December, Coke Cokey sold 900,000 cases of soda and no coupons were redeemed. In its December 31,
2005 balance sheet, what amount should Coke Cokey report as estimated liability for coupons?
F. Warranties
CLASS: During 2003, West Westy Co. introduced a new product carrying a 2-year warranty against defects. The estimated
warranty costs related to dollar sales are 2% withing 12 month following sale. Sales and actual warranty expenditures for the
years ended December 31, 2003 and 2004 are as follows:Actual Warranty
Sales
Expenditures
2003
$ 900,000
$12,000
2004
1,300,000
90,000
$2,200,000
$102,000
At December 31, 2004, West Westy should report an estimated warranty liability of?
HOME: If West Westy Co. had sales of $2,000,000 and actual warranty payments of $$150,000 in 2005, what should be
reported as estimated warranty liability, considering 5% of 2005 sales were returned to West Westy Co.
22
Galilee College © 2007
Chapter 4 – Accounting for Income Taxes
Overview
Accounting for Income Taxes
I. Introduction
is 9).
Chapter 20 addresses the issues related to accounting for income taxes. It is a very difficult chapter (difficulty level
Taxable income is computed in accordance with prescribed tax regulations and rules, whereas accounting income
is measured in accordance with generally accepted accounting principles. Due to the fact that tax regulations and generally
accepted accounting principles differ in many ways, taxable income and financial income frequently differ, which frequently
results in deferred tax liabilities/assets
II. Deferred Tax Liability
A deferred tax liability is the amount of deferred tax consequence attributable to the temporary differences that will
result in net taxable amounts (taxable amounts less deductible amounts) in future years. The liability is the amount of taxes
payable on these net taxable amounts in future years based on existing provisions of the tax law.
The following example is presented to demonstrate the deferred tax liability concept. Assume that Bobbie
Company earns $50,000 of net operating income before depreciation for each of five consecutive years. The company
depreciates its fixed assets using the straight-line method for accounting purposes and an acceptable accelerated method for
tax purposes over this five-year period. The following schedule shows taxable income, income tax payable, accounting income,
and income tax expense for the five-year period assuming a 40% tax rate.
Year
1
2
3
4
5
Totals
Taxable
Income
$ 40,000
42,000
44,000
46,000
48,000
$220,000
Income
Tax
Payable
$16,000
16,800
17,600
18,400
19,200
$88,000
Accounting
Income
$ 44,000
44,000
44,000
44,000
44,000
$220,000
Income
Tax
Expense
$17,600
17,600
17,600
17,600
17,600
$88,000
At the end of year one the entry to recognize the tax expense and the tax liability is:
Income Tax Expense
Income Tax Payable
Deferred Tax Liability
17,600
16,000
1,600
Each year (two through five) the entry is made debiting the tax expense account and crediting the tax liability for the amounts
indicated. Note that the Deferred Tax Liability account will increase in years one and two, remain unchanged in year three,
and then decrease in years four and five so that a zero balance results at the end of the five-year period which represents the
assets' useful life.
23
III. Deferred Tax Asset
1. what’s a deferred tax asset?
Due to the fact that deductible amounts can arise in the future as a result of temporary differences at the end of
the current year, the deferred tax consequences of these deductible amounts should be recognized as a deferred tax asset. A
deferred tax asset is the amount of taxes (computed in accordance with provisions of the tax law) that will be refundable in
future years as a result of these deductible amounts. A key issue in accounting for income taxes is whether a deferred tax asset
should be recognized in the financial records. Previously, the FASB took a strong position against recording deferred tax
assets. In their most recent pronouncement, the FASB reversed their position noting that deferred tax assets meet the definition
of an asset and should be reported in the financial statements. The three main conditions for an item to be reported as an asset
are: (a) it results from past transactions; (b) it gives rise to a probable benefit in the future; and (c) the company controls access
to the benefits. These conditions are met by the deferred tax asset.
2. Recognition of deferred tax assets
A deferred tax asset is recognized for all deductible temporary differences. However, deferred tax assets should be
reduced by a valuation allowance if, based on available evidence, it is more likely than not that some portion or all of the
deferred tax asset will not be realized. For example, assume Angie Company has a deductible temporary difference of
$2,500,000 at the end of its initial year of operations. Its tax rate is 45%, which means a deferred tax asset of $1,125,000
($2,500,000 X .45) is recorded. Assuming taxes payable are $2,000,000, the required journal entry is:
Income Tax Expense
Deferred Tax Asset
Income Tax Payable
875,000
1,125,000
2,000,000
If, after further consideration, it is considered more likely than not that $300,000 of this deferred tax asset will not be realized
then the following entry is appropriate.
Income Tax Expense
Allowance to Reduce Deferred Tax Asset
to Expected Realizable Value
300,000
300,000
The Allowance account is a contra account and is deducted from the Deferred Tax Asset account in the financial statements.
3. Accounting for Tax Losses ( a deferred tax asset)
A net operating loss occurs for tax purposes in a year when tax-deductible expenses exceed taxable revenues.
Under certain circumstances the federal tax laws permit taxpayers to use the losses of one year to offset the profits of other
years. This income-averaging provision is accomplished through the carryback and carryforward of net operating losses.
Under these rules, a company pays no income taxes for a year in which it incurs a net operating loss.
A company may carry a net operating loss back three years and receive refunds for income taxes paid in those
years. The loss must be applied to the earliest year first and then sequentially to the second and third year. Any loss remaining
after the three year carryback may be carried forward up to 15 years to offset future taxable income. A company may elect the
loss carryforward only, offsetting future taxable income for up to 15 years.
When a company carries a tax loss back, the tax loss gives rise to a refund that is both measurable and currently
realizable; therefore, the associated tax benefit should be recognized in the current loss period. When a company carries a tax
loss forward, a deferred tax asset should be established for the benefits of future tax savings. If it is more likely than not that the
24
entire future tax loss will not be realized in future years, a valuation allowance is required.
IV. Temporary and Permanent Differences
Differences between taxable income and accounting income can be categorized as either (a) temporary
differences or (b) permanent differences. Temporary differences arise when the tax basis of an asset or liability and its
reported amount in the financial statements differ. This difference will reverse and result in taxable or deductible amounts in
future years as the asset is recovered or the liability is settled at its reported amount.
(1). Temporary differences originate in one period and reverse or "turn around" in one or more subsequent periods.
For example, when a company records a product warranty liability an expense is recognized for accounting purposes but not for
tax purposes. In future years when the product warranty liability is settled, tax deductible amounts result which reverse the
effect of the original timing differences. Other examples include: (a) depreciation computed on a straight-line basis for financial
reporting purposes and on an accelerated basis for tax purposes, and (b) income recognized on the accrual basis for financial
reporting purposes and on the installment basis for tax purposes.
Two concepts related to temporary differences are, originating differences and reversing differences. An
originating difference is the initial temporary difference between the book basis and the tax basis of an asset or liability
regardless of whether the tax basis of the asset of liability exceeds or is exceeded by the book basis of the asset or liability. A
reversing difference, on the other hand, occurs when a temporary difference that originated in a prior period is eliminated and
the tax effect is removed from the deferred tax account. In the depreciation example presented in paragraph 5 above, the
originating difference was $1,600 and $800 in the first two years, and the reversing difference was $800 and $1,600 in the final
two years.
(2). Permanent differences are items that (a) enter into financial income but never into taxable income, or (b) enter into
taxable income but never into financial income. Examples of permanent differences include interest received on state and
municipal obligations, proceeds from life insurance on key executives, and compensation expense associated with certain
employee stock options. These items are not included in the computation of taxable income, and the profession has concluded
that the tax consequences of these differences should not be recognized.
**** Note that when recording deferred income taxes consideration must be given to the tax rate in effect when the
timing differences reverse. Normally, the current tax rate is used to compute deferred income taxes. However, future tax rates,
other than the current rate should be used when such rates have been enacted into law. When an unexpected change in the
tax rate has been enacted into law, its effect on deferred income tax and related tax expense should be recorded immediately.
The effects are reported as an adjustment to tax expense in the period of the change.
V.
F/S Presentation
(1) Balance Sheet Presentation
Deferred income taxes are reported on the balance sheet as assets and liabilities. An individual deferred tax
liability or asset is classified as current or noncurrent based on the classification of the related asset or liability for financial
reporting purposes. A deferred tax asset or liability is considered to be related to an asset or liability if reduction of the asset or
liability will cause the temporary difference to reverse or turn around. A deferred tax liability or asset that is not related to an
asset or liability for financial reporting shall be classified according to the expected reversal date of the temporary difference.
The balance in the deferred income tax account should be analyzed into its components and classified on the balance sheet
into two categories: one for net current amount and one for net noncurrent (or long-term) amount.
accounts.
The following is a summarization of the considerations related to balance sheet presentation of deferred tax
a.
Classify the amounts as current or noncurrent. If they are related to a specific asset or liability, they should be
25
b.
c.
classified in the same manner as the related asset or liability. If not so related, they should be classified on
the basis of the expected reversal date.
Determine the net current amount by summing the various deferred tax assets and liabilities classified as
current. If the net result is an asset, report on the balance sheet as a current asset; if a liability, report as a
current liability.
Determine the net noncurrent amount by summing the various deferred tax assets and liabilities classified as
noncurrent. If the net result is an asset, report on the balance sheet as a noncurrent asset; if a liability, report
as a long-term liability.
(2). Income Statement Presentation
19. Income tax expense (or benefit) should be allocated to continuing operations, discontinued operations,
extraordinary items, the cumulative effect of accounting changes, and prior period adjustments. This approach is referred to as
intraperiod tax allocation. In addition, the significant components of income tax expense attributable to continuing operations
should be disclosed. Companies are also required to reconcile income tax expense on continuing operations with the amount
that results from applying domestic federal statutory tax rates to pretax income from continuing operations. The amounts of any
operating loss carryforwards not recognized in the loss period, along with the expiration of these loss carryforwards, should be
disclosed.
VI. Special Issues: Asset-Liability method v. Deferred method
Asset-Liability Method (required by GAAP)
The FASB believes that the asset-liability viewpoint (balance sheet approach) is the most consistent method for accounting for
income taxes. One objective of this approach is to recognize the amount of taxes payable or refundable for the current year. A
second objective is to recognize deferred tax liabilities and assets for the future tax consequences of events that have been
recognized in the financial statements or tax returns. To implement the objectives, the following basic principles are applied in
accounting for income taxes at the date of the financial statements:
a. A current tax liability or asset is recognized for the estimated taxes payable or refundable on tax returns for
the current year.
b. A deferred tax liability or asset is recognized for the estimated future tax effects attributed to temporary
differences and carryforwards.
c. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax
law; the effects of future changes in tax laws or rates are not anticipated.
d. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that,
based on available evidence, are not expected to be realized.
A. Scope and Principles
1. SFAS 109
i.
An objective of accounting for income taxes is to recognize deferred tax liabilities and
assets for the future tax consequences of events that have been recognized in an
enterprise’s financial statements or tax returns.
a. This justification is the recognition of assets and liabilities
ii.
The principles and requirements are applicable to domestic federal income taxes.
These are; U.S. Federal Income Taxes for U.S. Enterprises.
iii.
Establishes standards of financial accounting and reporting for income taxes currently
payable and tax consequences of:
26
iv.
a. Revenues, expenses, gains, losses included iin taxable income of an earlier or
later year than the year in which they are recognized for financial reporting
purposes
Interperiod Tax Allocation – Differences that include tax consequences of some
events that are recognized in the financial income in an earlier year or later year.
a. Difference between income tax currently payable and income tax expense is that
income tax currently payable may differ from income tax expense
B. Temporary and Permanent Differences
1. Temporary Differences – when statements differs form the tax basis of that asset or liability,
and
i.
the difference will result in taxable or deductible amounts in future years when asset is
recovered or liability is settled at its reported amount
ii.
T/D may also exist although it cannot be identified with a specific asset of liability
recognized for financial reporting purposes.
iii.
Expenses or revenues are recognized for tax purposes either earlier of later than in
the determination of financial income.
iv.
T/D exists when expenses are deductible for tax purposes
a. After they are recognized in Financial Income, as well as,
b. Before they are recognized in Financial Income
2. Permanent Differences – Recognized in pretax financial income or taxable income, but never
in both.
Note: No deferred tax asset or liability
Not included in Taxable Income: Municipal bond interest, premiums on insurance policies
for key executives, and insurance proceeds., Dividends received deduction and percentage
of depletion.
 Goodwill acquired after Aug. 10, 1993 is tax deductible on a pro rata basis over a 15-year
period
 Goodwill acquire prior to Aug 10, 1993 is not tax deductible and results a permanent
difference
3.
4.
5.
6.
7.
Income Tax Expense = Tax Rate x Book Income (Pretax Income)
Income Tax Payable = Tax Rate x Tax Return Income
Deferred Tax liability = Book income is higher than taxable income
Deferred Tax Asset = Book income is less than Taxable income
Deferred tax expense (liability) or benefit (asset) recognized is the sum of the net changes in
the deferred tax assets and deferred tax liabilities.
C. Recognition and Measurement
1. Graduate Tax Rates – measure a deferred tax liability or asset using the average graduated
tax rate applicable to the amount of estimated annual taxable income in the periods in which
the enterprise estimates the deferred tax liability or asset will be settled or recovered.
Calculation of average graduated tax rate:Taxable income x Tax Rate (tax rate amount / taxable income amount)
2. Valuation Allowance – Contra account for deferred tax asset
27
i.
ii.
iii.
iv.
should reduce deferred tax asset if more likely than not that some portion will not be
realized. (probability is greater than 50%)
VA should suffice to reduce deferred tax asset to amount is more likely than not to be
realized.
Evidence must be positive or negative evidence
NOL carryback – 2 years NOL Carryforward – 20 years
D. Additional Issues
1. Intraperiod income tax allocation – items included in the determination of income may be
presented in different sections of the financial statements.
 Income tax for period to be allocated among
i.
Income from continuing operations
ii.
Discontinued operations
iii.
Extraordinary items
iv.
Items charged or credited directly to SHE
2. Loss Carryforward or carryback is reported in the same manner as the source of the income\
or loss in the current year.
3. Change in the tax law or rates – adjustment is made to recognize effect on deferred tax
liability or asset in the period that includes the enactment date of the change.
a. Adjustment is allocated to income from continuing operations in first F/S issued during
that period of enactment.
4. Change from nontaxable partnership to taxable corporation – DTA or DTL should be
recognized for taxable or deductible temporary differences or carryforwards existing at the
date of tax change.
5. Changing from taxable to nontaxable, asset or liability should be eliminated at the date of tax
status change.
6. Deferred taxes should be classified as current or noncurrent based on the related asset or
liability. Net current items or noncurrent items. E.g. CL & CA, or NCA & NCL
28
Chapter 4 Questions – Accounting for Income Taxes
Scope and Principles of Income Tax Accounting (SFAS 109)
Class 1: In its 2002 income statement, Wood Woody Co. reported income before income taxes of $300,000. Wood Woody
estimated that, because of permanent differences, taxable income for 2002 would be $280,000. During 2002, Wood Woody
made estimated tax payments of $50,000, which were debited to income tax expense. Wood Woody is subject to a 30% tax
rate.
1. What amount should Wood Woody report as income tax expense?
2. What amount should Wood Woddy report as deferred income taxes?
Home 1: In its 2005 income statement, Stood Stoody Co. reported income before income taxes of $500,000. Stood Stoody
estimated that, because of permanent differences, taxable income for 2005 would be $300,000. During 2005, Stood Stoody
made estimated tax payments of $100,000, which were debited to income tax expense. Stood Stoody is subject to a 30% tax
rate.
3. What amount should Stood Stoody report as income tax expense?
4. What amount should Stood Stoddy report as deferred income taxes?
CLASS 2: Tax Taxy Co., a cash-basis taxpayer, prepares accrual-basis financial statements. Tax Taxy’s had a Deferred Tax
Asset of $300,000 from another transaction last year. During 2005, Tax Taxy had net income before taxes of $600,000.
Additionally, it received rent for next year of $200,000. The income tax rate is 30% for 2004 and 2005. After a favorable review,
it was determined that only 40% of the Deferred Tax Asset will be realized.
1. What is the entry to record the tax expense for 2005?
2. What is the entry to record the valuation allowance for 2005?
HOME 2: Cash Cashy Co., a cash-basis taxpayer, prepares accrual-basis financial statements. Cash Cashy’s had a Deferred
Tax Asset of $500,000 from another transaction last year. During 2005, Cash Cashy had income before taxes of $1,000,000.
The income before taxes had a warranty obligation expense of $100,000. Additionally, it prepaid 2006 insurance in the amount
of $300,000. The income tax rate is 30% for 2004 and 2005. After a negative review, it was determined that only 60% of the
Deferred Tax Asset will be realized.
1. What is the entry to record the tax expense for 2005?
2. What is the entry to record the valuation allowance for 2005?
Class 3: Mobe Mobey Co. reported the following amounts of taxable income (operating loss) for its first 3 years of operations:
2000
$ 300,000
2001
(700,000)
2002
1,200,000
For each year, Mobe Mobey had no temporary differences, and its effective income tax rate was 30% at all relevant times. In its
2001 income tax return, Mobe Mobey elected to carry back the maximum amount of loss possible. Furthermore, Mobe Mobey
determined that it was more likely than not that the full benefit of any loss carryforward would be realized. In its 2002 income
statement, what is the entry to record the income tax expense for 2002?
29
Home 3: Sobe Sobey Co. reported the following amounts of taxable income (operating loss) for its first 3 years of operations:
2004
$ 200,000
2004
$ 400,000
2005
(1,000,000)
2006
1,700,000
For each year, Sobe Sobey had no temporary differences, and its effective income tax rate was 30% at all relevant times. In its
2005 income tax return, Sobe Sobey elected to carry back the maximum amount of loss possible. Furthermore, Sobe Sobey
determined that it was more likely than not that the full benefit of any loss carryforward would be realized. In its 2006 income
statement, what is the entry to record the income tax expense for 2006?
30
Galilee College © 2007
Chapter 5 – Employee Benefits
OVERVIEW
Accounting for Pensions and Postretirement Benefits
I. Introduction
1. Chapter 21 discusses the various aspects of accounting for the cost of pension plans. Accounting for
pension costs is very complicated because of the variety of social concepts, legal considerations,
actuarial techniques, income tax regulations, and varying business philosophies that affect the
development and maintenance of pension plans. This chapter relates these issues to the recommended
accounting treatment for the costs associated with a pension plan as described in FASB Statement No.
87. The difficulty level of this chapter is 10.
2. Nature of Pension Plans A pension plan is an arrangement whereby an employer provides benefits
(payments) to employees after they retire for services they provided while they were working. In the
accounting for a pension plan, consideration must be given to accounting for the employer and
accounting for the pension plan itself. A pension plan is said to be funded when the employer sets
funds aside for future pension benefits by making payments to a funding agency that is responsible for
accumulating the assets of the pension fund and for making payment to the recipients as the benefits
come due. In an insured plan, the funding agency is an insurance company; in a trust fund plan, the
funding agency is a trustee.
3. Pension plans can be contributory or noncontributory. In a contributory plan, the employees bear
part of the cost of the stated benefits or voluntarily make payments to increase their benefits. If the plan
is noncontributory, the employer bears the entire cost. Because the problems associated with pension
plans involve complicated actuarial considerations, actuaries are engaged to ensure that the plan is
appropriate for all employee groups covered. Actuaries make predictions (actuarial assumptions) of
mortality rates, employee turnover, interest and earnings rates, early retirement frequency, future
salaries, and other factors necessary to operate a pension plan. Thus, accounting for defined benefit
pension plans is highly reliant upon information and measurements provided by actuaries.
4. Types of Pension Plans The most common types of pension arrangements are defined contribution
plans and defined benefit plans. In a defined contribution plan, the employer agrees to contribute a
certain sum each period based on a formula. The formula might consider such factors as age, length of
service, employer's profits, and compensation level. The accounting for a defined contribution plan is
straightforward. The employer's responsibility is simply to make a contribution each year based on the
formula established in the plan. Thus, the employer's annual cost is the amount it is obligated to
contribute to the pension trust. If the contribution is made in full each year no pension asset or liability is
reported on the balance sheet.
A defined benefit plan defines the benefits that the employee will receive at the time of retirement. The
formula that is typically used provides for the benefits to be a function of the level of compensation near
retirement and of the number of years of service. The accounting for a defined benefit plan is complex.
Because the benefits are defined in terms of uncertain future variables, an appropriate funding pattern must
be established to insure that enough monies will be available at retirement to meet the benefits promised.
**** This chapter deals primarily with defined benefit plans.
II. Three Measures of Liability
31
Most accountants agree that an employer's pension obligation is the deferred compensation obligation
it has to its employees for their services under the terms of the pension plan. However, there are three ways to
measure this liability.
1. One approach is to base the obligation on the vested benefits current employees are entitled to.
The vested benefits pension obligation is computed using current salary levels and includes only
vested benefits.
2. A second approach to the measurement of the pension obligation is to base the computation on all
years of service performed by employees under the plan-both vested and nonvested—using current
salary levels. This measurement of the pension obligation is called the accumulated benefit
obligation.
3. A third measurement technique bases the computation on both vested and nonvested service using
future salaries. Because future salaries are expected to be higher than current salaries, this
approach, known as the projected benefit obligation, results in the largest measure-ment of the
pension obligation.
Regardless of the approach used, the estimated future benefits to be paid are discounted to present
value. While the accumulated benefit obligation is used in certain situations, the profession generally has adopted
the projected benefit obligation to measure the liability for the pension obligation.
Prior to issuance of FASB Statement No. 87, accounting for pension plans followed a noncapitalization
approach. Noncapitalization, often referred to as off-balance-sheet financing, was achieved because the balance
sheet reported an asset or liability for the pension plan arrangement only if the amount actually funded during the
year by the employer was different from the amount reported by the employer as pension expense for the year.
FASB Statement No. 87 adopted an approach that leans toward a capitalization approach. Under a capitalization
approach, the employer has a liability for pension benefits that it has promised to pay for employee services already
performed. As pension expense is incurred--as the employees work--the employer's liability increases. The
pension liability is reduced through the payment of benefits to retired employees. FASB Statement No. 87
represents a compromise that combines some of the features of capitalization with some of the features of
noncapitalization.
III. Components of Pension Expense
There is now broad agreement that pension cost should be accounted for on the accrual basis.
Accounting for pension plans requires measurement of the cost and its identification with the appropriate time
periods. The determination of pension cost is very complicated because it is a function of a number of factors.
These factors are identified and described below.
1. Service Cost. The expense caused by the increase in pension benefits payable (the projected benefit
obligation) to employees because of their services rendered during the current year. Actuaries compute service
cost as the present value of the new benefits earned by employees during the year.
2. Interest. Because a pension is a deferred compensation arrangement, it is recorded on a discounted basis.
Interest expense accrues each year on the projected benefit obligation based on a selected interest rate called the
settlement rate.
3. Actual Return on Plan Assets. Annual expense is adjusted for interest and dividends that accumulate within
the fund as well as increases and decreases in the market value of the fund assets. Computation of the actual
return on plan assets is illustrated by the following schedule:
Fair value of plan assets at end of the period
Deduct: Fair value of plan assets at beginning of period
Increase/decrease in fair value of plan assets
Deduct: Contributions to plan during period
Less benefits paid during the period
$2,500,000
1,800,000
700,000
$275,000
120,000
155,000
32
Actual return on plan assets
$ 545,000
If the actual return on the plan assets is positive (gain) during the period, it is subtracted in the computation of
pension expense. If the actual return is negative (loss) during the period, it is added in the computation of pension
expense.
4. Amortization of Unrecognized Prior Service Cost. Because plan amendments are granted with the
expectation that the employer will realize economic benefits in future periods, the cost (prior service cost) of
providing these retroactive benefits is allocated to pension expense in the future, specifically to the remaining
service-years of the affected employees.
5. Gain or Loss. Two items comprise gain or loss: (1) the difference between the actual return and the expected
return on plan assets and (2) amortization of the unrecognized net gain or loss from previous periods.
IV.
A Comprehensive Pension Example
The Pension Work Sheet
In illustrating the accounting for these factors the text material makes use of a work sheet approach.
The work sheet is unique to pension accounting and is utilized to record both the formal entries and memo entries
that are necessary to keep track of all the employer's relevant pension plan items and components. The format of
the work sheet is as follows:
Pension Work Sheet
General Journal Entries
Items
Annual
Pension
Expense Cash
Prepaid/
Accrued
Cost
Memo Record
Projected
Benefit
Obligation
Plan
Assets
The left-hand "General Journal Entries" columns of the work sheet record entries in the formal general ledger
accounts. The right-hand "Memo Record" columns maintain balances on the unrecognized (noncapitalized)
pension items. On the first line of the work sheet, the beginning balances (if any) are recorded. Subsequently,
transactions and events related to the pension plan are recorded, using debits and credits and using both sets of
records as if they were one for recording the entries. For each transaction or event, the debits must equal the
credits. The balance in the Prepaid/Accrued Cost column should equal the net balance in the memo record. The
work sheet approach to accumulating balances for pension accounting is a most effective means of keeping track
of complicated computations.
(1). 1999 Entries and Work Sheet
To illustrate the use of a work sheet, the following facts apply to Oehler Company for the year 1999:
Plan assets, 1/199
Projected benefit obligation, 1/1/99
Annual service cost for 1999
Settlement rate for 1999
Actual return on plan assets for 1999
$450,000
$450,000
27,000
7%
30,000
33
Contributions (funding) in 1999
Benefits paid to retirees in 1999
The work sheet would be completed as follows:
32,000
17,000
Oe hle r Company
Ge neral Journa l Entries
Items
Balance, 1/1/99
(a) Service Cos t
(b) Interest Cost
(c) Actual Return
Annual
Pension
Expense
Ca sh
Projecte d
Be nefit
Obligation
450,000 Cr.
27,000 Dr.
450,000 Dr.
30,000 Dr.
30,000 Cr.
32,000 Cr.
17,000 Dr.
28,500 Dr.
Plan
Assets
27,000 Cr.
31,500 Cr.
*31,500 Dr.
(d) Contributions
(e) Benefits
Journal Entry for
1999
Pre paid/
Acc rued
Cost
Memo Record
32,000 Cr.
Balance, 12/31/99
32,000 Dr.
17,000 Cr.
3,500 Dr.
3,500 Dr.
491,500 Cr.
495,000 Dr.
*$450,000 X .07
(2). 2000 Entries and Work Sheet
To illustrate the use of a work sheet with amortization of unrecognized prior service costs, the following
facts apply to Oehler Company for the year 2000:
Present value of prior service benefits granted l/l/00
Annual service cost for 2000
Settlement rate for 2000
Actual return on plan assets for 2000
Contributions (funding) in 2000
Benefits paid retirees in 2000
Amortization of prior service costs
$42,000
28,000
7%
31,000
29,000
24,000
17,500
The work sheet would be completed as follows:
34
Oe hle r Company
Memo Record
General Journal Entries
Annual
Pension
Expense
Items
Balance, 12/31/99
Cas h
(f) Prior Service Cost
Balance, 1/1/00
Prepaid/
Accrued
Cos t
Projected
Benefit
Obligation
3,500 Dr.
491,500 Cr.
3,500 Dr.
42,000 Cr.
533,500 Cr.
(g) Service Cost
28,000 Dr.
28,000 Cr.
(h) Interest Cost
(i) Actual Return
*37,345 Dr.
37,345 Cr.
(j) Amortization of
PSC
17,500 Dr.
29,000 Cr.
51,845 Dr.
495,000 Dr.
42,000 Dr.
495,000 Dr.
42,000 Dr.
17,500 Cr.
29,000 Dr.
(l) Benefits
Journal Entry for 2000
Unrecognized Prior
Service
Cos t
31,000 Dr.
31,000 Cr.
(k) Contributions
Plan
As sets
24,000 Dr.
24,000 Cr.
574,845 Cr.
531,000 Dr.
29,000 Cr. 22,845 Cr.
Balance, 12/31/00
19,345 Cr.
24,500 Dr.
*$533,500  .07
The pension reconciliation schedule is as follows:
Projected benefit obligation (Credit)
Plan assets at fair value (Debit)
Funded status (43,845)
Unrecognized prior service cost (Debit)
Prepaid/accrued pension cost (Credit)
$(574,845)
531,000
24,500
$ (19,345)
Gain or Loss
Because of the concern to companies that pension plans would have uncontrollable and unexpected
swings in pension expense, the profession decided to reduce the volatility by using smoothing techniques. Asset
gains (occurring when actual return is greater than expected return) and asset losses (occurring when actual return
is less than expected return) are recorded in an Unrecognized Net Gain or Loss account and combined with
unrecognized gains and losses accumulated in prior years. Liability gains (resulting from unexpected decreases in
the liability balance) and liability losses (resulting from unexpected increases) are deferred and combined in the
same Unrecognized Net Gain or Loss account used for asset gain or losses.
The Unrecognized Net Gain or Loss account can continue to grow if asset gains and losses are not
offset by liability gains and losses. To limit this potential growth, the FASB invented the corridor approach for
amortizing the accumulated balance in the Unrecognized Gain or Loss account when it gets too large. The
unrecognized net gain or loss account balance gets too large and must be amortized when it exceeds the arbitrarily
selected FASB criterion of 10% of the larger of the beginning balance of the projected benefit obligation or
the market-related value of plan assets. Any systematic method of amortizing the excess may be used but it
cannot be less than the amount computed using straight-line amortization over the average remaining service-life of
35
all active employees. Amortization of the excess unrecognized net gain or loss should be included as a component
of pension expense only if as of the beginning of the year, the unrecognized net gain or loss exceeded the
corridor.
To illustrate the amortization of unrecognized gains and losses, assume the following information related
to Scott Inc.'s pension plan:
Beginning of the Year
Projected Benefit Obligation
Market-Related Asset Value
Unrecognized- Net Loss
1999
$3,600,000
4,100,000
-0-
2000
$4,100,000
4,300,000
900,000
2001
$4,400,000
4,200,000
800,000
If the average remaining service life of all remaining employees is 8 years, the schedule to amortize the
unrecognized net loss is as follows:
Corridor Test and Gain/Loss Amortization Schedule
Year
1999
2000
2001
Projected
Benefit
Obligation
$3,600,000
4,100,000
4,400,000
Plan
Assets
$4,100,000
4,300,000
4,200,000
Corridor
$410,000
430,000
440,000
Cumulative
Unrecognized
Net Loss
$ -0900,000
1,641,250(b)
Minimum
Amortization
of Loss
(Current Year)
$ -058,750(a)
150,156(b)
(a) $900,000 – 430,000 = $470,000; $470,000/8 = $58,750
(b) $900,000 – 58,750 + 800,000 = $1,641,250
$1,641,250 – 440,000 = $1,201,250; $1,201,250/8 = $150,156
The loss recognized in 1999 would increase pension expense by $58,750. This amount is far less than the
$900,000 that would be recognized if the corridor method was not applied. The rationale for the corridor is that
gains and losses result from refinements in estimates as well as real changes in economic value and that over time
some of these gains and losses-will offset one another.
(3). 2001 Entries and Work Sheet
Continuing the Oehler Company illustration into 2001, the following facts apply to the pension plan:
Annual service cost for 2001
Settlement rate is 7%; expected earnings rate is 7%
Actual return on plan assets for 2001
Amortization of PSC in 2001
Contributions (funding) in 2001
Benefits paid to retirees in 2001
Changes in actuarial assumptions establish
the end-of-year projected benefit obligation
$29,000
28,000
21,000
32,000
20,000
640,000
The work sheet would be completed as follows:
36
Oehler Company
General Journal Entries
Annual
Pension
Expense
Items
M emo Record
Cash
Balance, 12/31/00
Benefit
Obligation
Assets
Unrecognized Prior
Service
Cost
574,845 Cr.
531,000 Dr.
24,500 Dr.
Projected
Prepaid/
Accrued
Cost
19,345 Cr.
(m) Service Cost
29,000 Dr.
29,000 Cr.
(n) Interest Cost
40,239 Dr.
40, 239 Cr.
(o) Actual Return
28,000 Cr.
(p) Unexpected loss
*9,170 Cr.
(q) Amortization of
P SC
21,000 Dr.
9,170 Dr.
21,000 Cr.
32,000 Dr.
20,000 Dr.
(s) Benefits
20,000 Cr.
**15,916 Cr.
(t) Liability increase
Journal Entry for 2001
53,069 Dr.
Balance, 12/31/01
Unrecognized
Net Gain
or Loss
28,000 Dr.
32,000 Cr.
(r) Contributions
Plan
32,000 Cr.
15,916 Dr.
21,069 Cr.
40,414 Cr.
640,000 Cr.
571,000 Dr.
3,500 Dr.
25,086 Dr.
*($531,000  .07) – $28,000 = $9,170
**$574,845 + $29,000 + $40,239 – $20,000 = $624,084
$640,000 – $624,084 = $15,916
The pension reconciliation schedule is as follows:
Projected benefit obligation (Credit)
Plan assets at fair value (Debit)
Funded status
Unrecognized prior service cost (Debit)
Unrecognized net loss (Debit)
Prepaid/accrued pension cost (Credit)
$(640,000)
571,000
(69,000)
3,500
25,086
$ (40,414)
(4). Minimum Liability
FASB Statement No. 87 requires immediate recognition of a liability (called the minimum liability) when
the accumulated benefit obligation exceeds the fair value of plan assets. The purpose of this minimum liability
requirement is to insure that if a significant plan amendment or actuarial loss occurs, the recognition of a liability is
necessitated at least for the accumulated benefit obligation not funded. The Board does not permit the recording of
an asset if the fair value of the pension plan assets exceeds the accumulated benefit obligation.
If a liability for accrued pension cost is already reported, only an additional liability equal to the required
minimum liability (unfunded accumulated benefit) less accrued pension cost is recorded. Recognition of a net
investment in the pension plan when the plan assets exceed the pension obligation is not allowed. When it is
necessary to adjust the accounts to recognize a minimum liability, the debit should be to an intangible asset called
Intangible Asset-Deferred Pension Cost. However, when additional liability exceeds the amount of unrecognized
prior service cost, the excess should be debited to Excess of Additional Pension Liability Over Unrecognized Prior
Service Cost (which is reported as accumulated other comprehensive income in the stockholders' equity section).
The minimum liability approach to Oehler Company for the years 1999, 2000, and 2001 is illustrated in
37
the following schedule (values are assumed for the accumulated benefit obligation):
Oehler Company
Accumulated benefit obligation
Plan assets at fair value
Unfunded accumulated benefit
obligation (min. liability)
Accrued pension cost
Additional liability
Unrecognized prior service cost
Contra equity charge
1999
$(450,000)
495,000
$
-0-
December 31
2000
$(560,000)
531,000
2001
$(670,000)
571,000
(29,000)
19,345
(9,655)
24,500
$
-0-
(99,000)
40,414
(58,586)
3,500
$ (55,086)
When a company recognizes a minimum liability, the work sheet will have to be modified. See the text for
an example of how the work sheet is modified.
V. Financial Statement Disclosure
If the amount paid (credit to Cash) by the employer to the pension trust is less than the annual provision
(debit to Pension Expense), a credit balance accrual in the amount of the difference arises. This accrued pension
cost usually appears in the long-term liability section and should be titled Accrued Pension Cost, Liability for
Pension Expense Not Funded, or Due to Pension Fund. Classification as a current liability occurs when the liability
requires the disbursement of cash within the next year. When the cash paid to the pension trust during the period
is greater than the amount charged to expense, a deferred charge equal to the difference arises. This deferral
should be reported as Prepaid Pension Cost, Deferred Pension Expense, or Prepaid Pension Expense in the
current assets section if it is current in nature and in the other assets section if it is long-term in nature.
The current financial statement disclosure requirements for pension plans are as follows:
a.
b.
c.
d.
A description of the plan including employee groups covered, type of benefit formula, funding
policy, type of assets held, and the nature and effect of significant matters affecting comparability of
information for all periods presented.
The components of net periodic pension expense for the period.
A schedule reconciling the funded status of the plan with amounts reported in the employer's
statement of financial position.
The weighted-average discount rate and rate of compensation increase used to measure the
projected benefit obligation and the weighted-average expected long-run rate of return on plan
assets.
In addition, companies must disclose the individual pension expense components (1) service cost, (2) interest cost,
(3) actual return on assets and (4) all other costs combined. Also, disclosure of the reconciling schedule of the offbalance sheet assets, liabilities and unrecognized gains and losses with the on-balance sheet asset or liability
should be provided.
V.
Other Issues
1. Pension Reform Act
The Pension Reform Act of 1974 (ERISA) set out specific requirements for companies providing a
pension plan for their employees. These requirements are designed to safeguard employees' pension rights,
specifically in the areas of funding, participation, and vesting. The Act also created the Pension Benefit Guaranty
Corporation (PBGC) to administer terminated plans and to impose liens on the corporate assets for certain
unfunded pension liabilities.
38
2. Multiemployer Plans
Multiemployer pension plans are plans sponsored by two or more different employers. They are often
negotiated as part of labor union contracts in the trucking, coal mining, construction, and entertainment industries.
Congress has allowed the PBGC to cover for insolvent plans, but not for terminated plans, and the PBGC can
impose substantial obligations for a part of the plan's unfunded vested benefits on companies that withdraw from
multiemployer plans.
3. Pension Terminations
ERISA prevents companies from recapturing excess assets (pension plan assets in excess of projected
benefit obligations) unless they pay participants what is owed to them and then terminate the plan. The accounting
issue that arises from these terminations is whether a gain should be recognized by the corporation when these
assets revert back to the company. Up to this point the profession has required that these gains be reported if the
companies switched from a defined benefit plan to a defined contribution plan. Otherwise, the gain is deferred and
amortized over at least 10 years in the future.
4. Post-Retirement Benefits
Health care and other postretirement benefits (other than pensions) for current and future retirees and
their dependents are forms of deferred compensation earned through employee service and subject to accrual
during the years an employee is working. The period of time over which the postretirement benefit is accrued,
called the attribution period, is the period of service during which the employee earns the benefits under the terms
of the plan. The attribution period generally begins when an employee is hired and ends on the date the employee
is eligible to receive the benefits and ceases to earn additional benefits by performing service, called the vesting
date.
Accounting for postretirement benefits other than pensions is the subject of FASB Statement No. 106.
This standard requires employers to account for post retirement benefits other than pensions on an accrual basis.
Like pension accounting, the accrual basis necessitates measurement of the employer's obligation to provide future
benefits and accrual of the cost during the years that the employee provides service.
A. Pensions
1. Net Periodic Pension Cost (NPPC) – Annual Pension Expense (SIRAAA)
All SIRAAA for annual pension expense:
 Service Cost
 Interest Cost (Increase in PBO resulting from passage of time)
 Return on Plant Assets
 Amortization of Unrecognized Net Gain or Loss from Prior Periods **
 Amortization of Prior Service Cost
 Amortization of any Unrecognized Net Obligation or Net Asset Arising when SFAS 87 is
First Applied
REMEMBER: Unexpected G/L will not be included in the Current calculation. This will be
amortized and included in future periods.
i.
Prior Service Cost – Amortized to future periods (included this year & future years)
Amortization is systematic and rational
ii.
Actual Return on Plan Assets
39
FV at end of year
- FV at beginning of year
= Increase in Plan Assets FV
- Employer Contribution
+ Benefits Paid
.
Return on Plan Assets
iii.
This is a deduction in the SIRAAA Calculation
Gain/Loss on Plant Assets (Actual Returns – Expected Returns)
a. If Actual Return > Expected Return:: Credit/Reduction of NPPC
b. Actual Return – Expected Return = Difference
Debit: NPPC
Credit: Unrecognized Gain
2. Projected Benefit Obligation (PBO)– Actuarial PV of all benefits of employee service
rendered prior to actuarial date
i. Discounted amount of benefits to be paid
 Uses assumptions as to future salary levels.
 PBO Calculation
Beginning PBO Balance
+ Service Cost
See Below (i) below
+ Interest Cost
Interest = PBO Beginning Balance x discount rate (ii)
- Benefits Paid
.
= Ending PBO Balance
Note: Disclose reconciliation of the beginning & ending balances of the PBO

i.
Display separately the following:Service Cost, ii. Interest Cost, iii. Participants’ Contribution, iv. Actuarial Gains and
Losses, v. Foreign Currency Exchange Rate Changes, vi. Benefits Paid, vii. Plan
Amendments, viii. Business Combinations, ix. Divestitures, x. Curtailments, xi.
Settlements, xii. Termination Benefits.
3. Accumulated Benefit Obligation (ABO) – Same as PBO, except (based on past and current
compensation levels only)
i.
Service Cost: Actual PV of benefits as a result of services rendered during the
period
a. unaffected by funded status of the plan
ii.
Discount Rate: Rate at which benefits can be settled
a. Consider current prices of annuity contracts that could be used to settle pension
obligations as well as the rates on high-quality fixed investments
4. The cost of retroactive benefits is the increase in the PBO at the date of the amendment and
should be amortized by assigning an equal amount to each future period of service of each
employee active at the date of the amendment who is expected to receive benefits under the
plan.
40
REMEMBER: Amortization of Prior Service Cost should be recognized as a component of
NPPC during the future service period so those employees active at the date of the plan
amendment and who are expected to receive benefits under the plan.
Cumulative Net Pension Cost
5. Prepaid Pension Cost (Contributions – NPPC) = Asset
6. Accrued Pension Cost (NPPC – Contributions) = Liability
7. NPPC (SIRAAA) – Contributions = unfunded accrued pension cost
 Prepaid/accrued cost should be added or deducted from employer contributions
 When FV of Plan Assets exceed ABO, do not recognized additional liability
 When ABO exceed FV of Plan Asset, recognize additional liability
 Additional Pension Liability – Unrecognized Prior Service Cost = Excess is SHE
8. Settlement – Irrevocable action relieving employer/plan of PBO responsibility and risks
relating to pension obligation, and assets used to effect settlement
 Significant Risk will be eliminated
9. Settlement G/L = Unrecognized Net G/L prior to SFAS 87 + Remaining Unrecgnized Net
Asset at Transition. X settlement rate (VBO/PBO)
10. Curtailment – Event that significantly reduces expected years of future service of present
employees, or
Eliminates accrual of some or all benefits from future service
11. Curtailment Net G/L = combined amounts of
i.
Unrecognized prior service cost associated with years of service no longer expected
to be rendered
ii.
Change in PBO that does not represent a reversal of previously unrecognized net G/L
12. Special Termination Benefits –Recognize liability and expense when employer accepts
employees offer and the amount can be reasonably estimated.
 This includes (Lump-sum payments & PV of future payments)
B. Employers’ Accounting for Postretirement Benefits Other than Pensions
Principles are similar to those of pension accounting.
1. Net Periodic Postretirement Benefit Cost (NPPBC) – SERAAT
 Service Cost (Portion of EPBO attributed to employee service for a period)
 Interest Cost (Increase in APBO resulting from passage of time)
 Return on Plant Assets
 Amortization of Prior Service Cost (I)
 Amortization of the transition obligation or asset
 The gain or loss component
i.

Prior Service Cost – Effect of plan amendment attributed to each year of service in
that individual’s attribution period
May include years of service already rendered.
41
i.
General Rule: equal amounts of cost should be assigned to each year of
service remaining until the full eligibility date for each active plan participant
at the date of the amendment who was not yet fully elibible.
2. G/L – Immediately recognized G/L that do not offset previously recognized G/L must first
reduce any unrecognized transition obligation (asset)
 Transition Obligation/Asset – represents an underlying unfunded/(overfunded) APBO.
- FASB believes that gains/losses should not be recognized until the
unfunded/(overfunded) APBO is recognized.
i.

Transition Asset/Oligation = difference between:
a. APBO, and
b. FV of Plan Assets + any unrecognized accrued postretirement benefit cost, or –
any recognized prepaid postretirement benefit
Recognized in full in the period of change
3. A G/L from a temporary deviation from the substantive plan is immediately recognized in
income because:i.
Effect of temporary deviation is not deemed to provide future economic benefits
ii.
Effect of temporary deviation relates to benefits already paid
a. If G/L is not temporary – implication is that the substantive plan has been
amended.
i.
This amendment would require accounting for prior service cost.
4. Other PostRetirement Employee Benefits (OPEB) – Define in terms of monetary amounts
(e.g. amounts per day for hospitalization)
5. Expected PostRetirement Benefit Obligation (EPBO) – Actuarial PV at given date when
OPEB is expected to be paid.
i.
Anticipated amounts and timing of future benefits
ii.
The extent the costs are shared by the employee and others
6. Accumulated PostRetirement Benefit Obligation (APBO) – Actuarial PV at given date of
future benefits attributable to employee’s service as of that date
7. EPBO & APBO is equal when: The full eligibility date is reached when the employee has rendered all the services
necessary to earn all of the benefits expected to b received by that employee.
8. Employer’s obligation for postretirement benefits must be fully accrued by the date that
employee attains full eligibility for all the benefits, even if the employee is expected to render
additional service beyond that date.
C. Compensated Absences
1. Accounting for Compensated Absences, requires an accrual when four criteria are met:i.
Payment of compensation is probable
ii.
Amount can be reasonably estimated
iii.
Benefits are either vested or accumulated
42
iv.
Compensation relates to employees’ services that have already been rendered.
Exception:
Sick pay benefits must be accrued only if the rights vest.
D. Stock-Based Compensation
1. Compensatory Stock Option Plan involves issuance of stock in whole or in part for
employee services.
 Accounting is based on an intrinsic-value-based method
 A plan is deemed to be compensatory unless it has four characteristics:
i.
All full-time employees participate
ii.
Stock available to each employee is equal or is based on salary
iii.
Option exercise period is reasonable
iv.
The discount from the market is not great:
a. Discount is similar to that in an offer of stock to shareholders or others
i.
Compensation Cost should be recognized in the income statement of the period in
which the services are rendered.
ii.
Measurement Date – First date on which both the number of shares to which an
employee is entitled and the option price or purchase price, if any, are known.
iii.
Measurement Date later than grant date – Compensation expense for periods prior to
measurement date is based on the stock'’ quoted market price at the end of each
period.

Compensation Expense = Market Price – Option Price (on measurement date)
a. The chare to expense is accrued over the service period
b. Accrued compensation expense is adjusted for changes in quoted market
value (but not below zero).
c. Recognize a portion of the expense each year. (MP-OP x Stock x time)
2. Stock Appreciation Rights – payment for past services and are exercisable immediately, no service period is
required.
 Compensation expense = New MP – Old MP x stock appreciation right
43
Chapter 5 Questions – Employee Benefits
CLASS 1: The following information pertains to Plick Plicky Co.’s defined benefit pension plan:
Prepaid pension cost, January 1, 2004
Service cost
Interest cost
$ 2,000 Actual return on plan assets
$19,000 Amort of unrecognized prior service cost
$ 38,000 Employer contributions
$ 22,000
$ 52,000
$ 40,000
The fair value of plan assets exceeds the accumulated benefit obligation (ABO). In its December 31, 2004 balance sheet, what
amount should Plick Plicky report as unfunded accrued pension cost?
HOME 1: The following information pertains to Drick Dricky Co.’s defined benefit pension plan:
Prepaid pension cost, January 1, 2005
Service cost
Interest cost
$ 5,000 Actual return on plan assets
$ 15,000
$30,000 Amort of unrecognized prior service cost
$ 40,000
$ 20,000 Employer contributions (Equal to 110% of return on plan assets)
The fair value of plan assets exceeds the accumulated benefit obligation (ABO). In its December 31, 2005 balance sheet, what
amount should Drick Dricky report as unfunded accrued pension cost?
Class 2: The following information pertains to Prock Procky Corp.'s defined benefit pension plan for 2002:
Service cost
$160,000
Actual and expected gain on plan assets
35,000
Unexpected loss on plan assets related to a
2002 disposal of a subsidiary
40,000
Amortization of unrecognized prior service cost
5,000
Annual interest on pension obligation
50,000
What amount should Prock Procky report as pension expense in its 2002 income statement?
Home 2: The following information pertains to Quot Quoty Co.'s defined benefit pension plan:
Prepaid pension cost, January 1, 2002
$ 2,000
Service cost
19,000
Interest cost
38,000
Actual return on plan assets
22,000
Amortization of unrecognized prior service cost
52,000
Employer contributions
40,000
The fair value of plan assets exceeds the accumulated benefit obligation (ABO). In its December 31, 2002 balance sheet, what
amount should Quot Quoty report as pension expense in its 2002 income statement?
44
Galilee College © 2007
Chapter 6- Long Term Liabilities
OVERVIEW
I. Definition: Long-Term Debt
1. Long-term debt consists of obligations that are not payable within the operating cycle or one year, whichever is longer.
2. These obligations normally require a formal agreement between the parties involved that often includes certain covenants
and restrictions for the protection of both lenders and borrowers. These covenants and restrictions are found in the bond
indenture or note agreement, and include information related to amounts authorized to be issued, interest rates, due
dates, call provisions, security for the debt, sinking fund requirements, etc. The important issues related to the long-term
debt should always be disclosed in the financial statements or the notes thereto.
3. Long-term liabilities include:
-
bonds payable,
mortgage notes payable,
long-term notes payable,
lease obligations,
deferred income tax payable,
pension obligations
II. Bonds Payable
1 Bonds payable represent an obligation of the issuing corporation to pay a sum of money at a designated maturity date plus
periodic interest at a specified rate on the face value. See the glossary for terms commonly used in discussing the various
aspects of corporate bond issues.
2. Bonds are debt instruments of the issuing corporation used by that corporation to borrow funds from the general public or
institutional investors. The use of bonds provides the issuer an opportunity to divide a large amount of long-term indebtedness
among many small investing units. Bonds may be sold through an underwriter who either (a) guarantees a certain sum to the
corporation and assumes the risk of sale or (b) agrees to sell the bond issue on the basis of a commission. Alternatively, a
corporation may sell the bonds directly to a large financial institution without the aid of an underwriter.
3. If an entire bond issue is not sold at one time, both the amount of the bonds authorized and the bonds issued should be
disclosed on the balance sheet or in a footnote. This discloses the potential indebtedness represented by the unissued bonds.
4. Bonds are issued with a stated rate of interest expressed as a percentage of the face value of the bonds. When bonds
are sold for more than face value (at a premium) or less than face value (at a discount), the interest rate actually earned
by the bondholder is different from the stated rate. This is known as the effective yield or market rate of interest and is
set by economic conditions in the investment market. The effective rate exceeds the stated rate when the bonds sell at a
discount, and the effective rate is less than the stated rate when the bonds sell at a premium.
5. To compute the effective interest rate of a bond issue, the present value of future cash flows from interest and principal
must be computed. This often takes a financial calculator or computer to calculate.
6. Discounts and premiums resulting from a bond issue are recorded at the time the bonds are sold. The amounts recorded
as discounts or premiums are amortized each time bond interest is paid. The time period over which discounts and
premiums are amortized is equal to the period of time the bonds are outstanding (date of sale to maturity date).
45
Amortization of bond premiums decreases the recorded amount of bond interest expense, whereas the amortization of
bond discounts increases the recorded amount of bond interest expense.
7.
To illustrate the recording of bonds sold at a discount or premium the following examples are presented. If Aretha
Company issued $100,000 of bonds dated January 1, 1999 at 98, on January 1, 1999, the entry would be as follows:
Cash ($100,000 x .98)
Discount on Bonds Payable
Bonds
98,000
2,000
100,000
If the same bonds noted above were sold for 102 the entry to record the issuance would be as follows:
Cash ($100,000 x 1.02)
Premium on Bonds Payable
Bonds Payable
102,000
2,000
100,000
It should be noted that whenever bonds are issued, the Bonds Payable account is always credited for the face amount of the
bonds issued.
8. When bonds are issued between interest dates, the purchase price is increased by an amount equal to the interest earned
on the bonds since the last interest payment date. On the next interest payment date, the bondholder receives the entire
semiannual interest payment. However, the amount of interest expense to the issuing corporation is the difference between the
semiannual interest payment and the amount of interest prepaid by the purchaser. For example, assume a 10 year bond issue
in the amount of $300,000, bearing 9% interest payable semi-annually is dated January 1, 1999. If the entire bond issue is sold
at par on March 1, 1999, the following journal entry would be made by the seller:
Cash
Bonds Payable
Bond Interest Expense
*($300,000 x .09 x 1/6)
304,500
300,000
4,500*
The entry for the semi-annual interest payment on July 1, 1999 would be as follows:
Bond Interest Expense
Cash
13,500
13,500
The total bond interest expense for the six month period is $9,000 ($13,500 – $4,500), which represents the correct interest
expense for the four month period the bonds were outstanding.
9. Bond discounts or premiums may be amortized using the straight-line method. To illustrate the amortization of the bond
discount or premium using straight-line method, assume the bonds sold in the example above are five year bonds. Since the
bonds are sold on the issue date (January 1, 1999) they will be outstanding for the full five years. Thus, the discount or
premium would be amortized over the entire life of the bonds. The entry to amortize the bond discount at the end of 1999 would
be:
Bond Interest Expense
Discount on Bonds Payable ($2,000/5)
400
400
The entry to amortize the premium would be:
46
Premium on Bonds Payable
Bond Interest Expense
400
400
Note that the amortization of the discount increases the bond interest expense for the period and the amortization of the
premium reduces bond interest expense for the period.
10. However, the profession's preferred procedure of premium/discount amortization is the effective interest method. This
method computes the bond interest using the effective rate at which the bonds are issued. More specifically, interest cost for
each period is the effective interest rate multiplied by the carrying value (book value) of the bonds at the start of the
period. The effective interest method is best accomplished by preparing a Schedule of Bond Interest Amortization. This
schedule provides the information necessary for each semiannual entry for interest and discount or premium amortization. The
chapter includes an illustration of a Schedule of Bond Interest Amortization for both a discount and premium situation. Also, the
demonstration problem at the end of the Chapter Review section illustrates the preparation of this schedule.
11. Unamortized premiums and discounts are reported with the Bonds Payable account in the liability section of the balance
sheet. Premiums and discounts are not liability accounts; they are merely liability valuation accounts. Premiums are added to
the Bonds Payable account and discounts are deducted from the Bonds Payable account in the liability section of the balance
sheet.
12. If the interest payment date does not coincide with the financial statement's date, the amortized premium or discount
should be prorated by the appropriate number of months to arrive at the proper interest expense.
13. Some of the costs associated with issuing bonds include engraving and printing costs, legal and accounting fees,
commissions, and promotion expenses. APB Opinion No. 21, "Interest on Receivables and Payables," indicates that these
costs should be debited to a deferred charge account entitled, Unamortized Bond Issue Costs. These costs are then amortized
over the life of the issue in a manner similar to that used for discount on bonds.
14. Treasury bonds are a corporation's own bonds that have been reacquired but not canceled. They should be shown on the
balance sheet at their par value as a deduction from the bonds payable issued to arrive at bonds payable outstanding.
III. Extinguishment of Debt
1. The extinguishment, or payment, of long-term liabilities can be a relatively straightforward process which involves a debit to
the liability account and a credit to cash. The process can also be a complicated one when the debt is extinguished prior to
maturity.
2. The reacquisition of debt can occur either by payment to the creditor or by reacquisition in the open market. At the time of
reacquisition, any unamortized premium or discount, and any costs of issue related to the bonds, must be amortized up to
the reacquisition date. If this is not done any resulting gain or loss on the extinguishment would be misstated. The
difference between the reacquisition price and the net carrying amount of the debt is a gain (reacquisition price lower) or
loss (reacquisition price greater).
The difference between the net carrying amount and the re-acquisition price is a gain or loss.
a.
Reacquistion price = price + call premium + reacquisition expenses
b.
Carrying amount = face value ± unamortized premium/discount
+ unamoritized issuance costs
c.
Gain on Redemption of Bonds: when carrying amount > Reacquistion price
47
d. Loss on Redemption of Bonds: when carrying amount < Redemption price
3. Gains and losses from extinguishment of debt should be aggregated and, if material, classified in the income statement as
an extraordinary item, net of related income tax effect. Extraordinary item treatment applies whether an extinguishment is early
or at a scheduled maturity date or later, without regard to the criteria of "unusual in nature" and infrequency in occurrence.
IV.
Other Topics (Other topics will not be tested except may appear as an extra credit problem)
1. Notes Payable
(1). The difference between current notes payable and long-term notes payable is the maturity date. Accounting for notes and
bonds is quite similar.
(2). Interest-bearing notes are treated the same as bonds—discount or premium is recognized if the stated rate is different than
the effective rate. Zero-interest-bearing notes represent a discount on the note and the discount is amortized similar to the
manner as discounts on interest-bearing notes.
(3). When a long-term note is issued solely for cash, the interest factor is assumed to be the stated or coupon rate plus or
minus the amortization of the discount or premium. In situations where a note is exchanged for cash and some additional
privilege, the difference between the present value of the payable and the amount of cash loaned should be recorded as a
discount on the note and as unearned revenue. This discount should be amortized by a charge to interest expense over the
term of the note using the effective interest method. The unearned revenue is prorated on the same basis as the privilege that
gave rise to the unearned revenue realized by the lender/customer. For example, the privilege may be a favorable merchandise
purchase agreement. In this case, the unearned revenue is prorated on the basis of the ratio between each period’s sales to
the lender/customer and the total sales to that customer for the term of the note.
(4). Mortgage notes are a common means of financing the acquisition of property, plant, and equipment in a proprietorship or
partnership form of business organization. Normally, the title to specific property is pledged as security for a mortgage note.
Points raise the effective interest rate above the stated rate. If a mortgage note is paid on an installment basis, the current
installment should be classified as a current liability.
2. Off-Balance Sheet Financing
(1) A significant issue in accounting today is the question of off-balance-sheet financing. Off-balance-sheet financing is an
attempt to borrow monies in such a way that the obligations are not recorded. Included in this chapter is a discussion of
the off-balance-sheet financing arrangement for project financing arrangements.
(2). Project financing arrangements arise when the following three conditions are present (a) two or more entities form a new
entity to construct an operating plant that will be used by both parties; (b) the new entity borrows funds to construct the project
and repays the debt from the proceeds received from the project; and (c) payment of the debt is guaranteed by the companies
that formed the new entity. The advantage of such an arrangement to the companies that form the new entity is that neither
company reports the liability on its books except to disclose that they guarantee debt repayment if the project's proceeds are not
enough to repay the liability.
(3) Many project financing arrangements are further formalized through the use of take-or-pay contracts or through-put
contracts. In take-or-pay contracts, a purchaser of goods signs an agreement with the seller to pay specified amounts
periodically in return for products or services. The purchaser must make specified minimum payments even if delivery of the
48
contracted products or services is not taken. Through-put contracts are similar to take-or-pay contracts, except that a service
instead of a product is provided by the asset under construction.
3. Presentation of Long-Term Debt
Companies that have large amounts and numerous issues of long-term debt frequently report only one amount in
the balance sheet and support this with comments and schedules in the accompanying notes to the financial statements. These
foot-note disclosures generally indicate the nature of the liabilities, maturity dates, interest rates, call provisions, conversion
privileges, restrictions imposed by the borrower, and assets pledged as security. Long-term debt that matures within one year
should be reported as a current liability unless retirement is to be accomplished with other than current assets.
4. Analysis of Long-Term Debt
1. Long-term creditors and stockholders are interested in a company's long-run solvency and the ability to pay interest when it
is due. Two ratios that provide information about debt-paying ability and long-run solvency are the debt to total assets ratio
and the times interest earned ratio.
a.
Solvency: ability to pay interest and principle on long-term debt as it comes due.
b.
total debt
Debt to total assets ratio = total assets
(1)
c.
The higher the percentage, the greater the risk that the company may be unable to pay its maturing debt.
Times interest earned ratio =
(1)
Income before interest and taxes
Interest expense
The ability to meet interest payments as they come due.
A. Issuance of Bonds at a Premium or Discount
Interest must reflect the prevailing market rate
1. Discount & Premium must appear as a direct deduction from or addition to the face amount
of bond payable to report the effective liability for the bonds
2. Bonds issued at a discount
Market Price =
PV of principal amount at Effective Market Rate
+ PV of all future interest payments at Market Rate
At date of issuance
Cash
Discount on bonds payable
Bond Issue Cost
Interest Expense
Bonds Payable
xx
xx
xx
xx
xx
49
Entry ( Interest Payment)
Interest Expense
Discount on Bonds Paid
Cash
xx
xx
xx
Note: Market rate is also yield rate
3. Bonds issued at a premium
At date of issuance
Cash
Bond Issue Cost
Premium on Bonds Payable
Interest Expense
Bonds Payable
Entry ( Interest Payment)
Interest Expense
Premium on bonds paid
Cash
xx
xx
xx
xx
xx
xx
xx
xx
4. Issue Price for each bond reflects Fair Value
 This = PV of future cash flows (Principal + Interest)
5. Price of Bond =
i.
PV of $1 for no. of periods at market/yield rate x bonds
ii.
+ PV of annuity for periods x bonds (Face)
iii.
= Bond Issue Price
(interest)
6. Bond issue between payment dates include accrued interest
 Interest expense for year will report only for period bond is outstanding.
7. Amortization of Discount/Premium
Interest Expense (CV x MRinterest x time) -/+
Interest Payable (FV x Stinterest x time) =amortization (if discount add to cv/if premium sub
from cv)
B. Issue Costs
1. Bond Issue Costs should be reported in the balance sheet as deferred charges to be
amortized over the life of the bonds.
 Do not commingle with bonds premium or discount
Include; lawyers, accountants, underwriters, engraving, printing, registration and
promotion cost.
2. Customarily amortized using the straight-line method
50

Income statement effects the two methods are identical if the same method is used to
amortize the discount or premium and the issue cost.
- The difference is only on the balance sheet
C. Types of Bonds
See page 464 for types of bonds
D. Conversion of Bonds
 Upon issuing convertible bonds, the liability is credited for the entire proceeds
1. Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants is that the
debt and equity aspects of the convertible are inseparable.
 Entire proceeds (usually cash) should be accounted for as a debt (liability) until
conversion
2. Use Book-Value Method or Market Value Method for conversion.
 Book-Value Method – Stock issued is recorded at carrying valued of bonds
Bonds Payable
xx
Common Stock
xx
Additional Paid in Capital
xx
(No gain or loss)

Market-Value Method – Stock is recorded at market value of stock (or bonds)
i.
G/L = (MV – CV of bonds payable)
E. Detachable Stock Warrants
1. Proceeds from debt securities issued with detachable warrants should be allocated between
debt securities and warrants based on their relative fair values at time of issuance.
 Warrant portion = paid-in capital.
 If only FV of warrants are known, warrants should be recorded at fair value with
remainder allocated to securities
F. Retirement of Bonds
NEW: All extinguishments of debt before scheduled maturities are fundamentally alike and
should be accounted for similarly.
I.
Gains or losses from early extinguishment should be recognized in income of the
period of extinguishment (APB 26). P L E A S E R E M E M B E R
II.
When bonds are issued at a discount and are retired early for more than the carrying
amount, a loss is incurred.
III.
Under APB 30, an event or transaction is perceived to be ordinary and usual absent
clear evidence to the contrary.
1. A debtor derecognizes a liability only if it has been extinguished.
 Debtor pays the creditor
 Released judicially or by creditor
51
G. Refinancing of Notes Payable
When entity intends to refinance short-term obligations on a long-term basis, and demonstrates
ability to consummate the financing:
 Reclassify as noncurrent.
 Disclose note financing
- After balance sheet date but before issuance
H. Other Notes Payable Questions
Noninterest bearing notes payable should be measured at their present value rather than face
value.
1. Discount/premium is not asset or liability separated form note.
 Report in balance sheet as a direct deduction form or addition to face amount of note.
I. Troubled Debt Restructuring
1. Debt restructuring involving only modification of terms = gain if cash flows is less than CV
2. No extraordinary gain is recognized.
3. Creditor must recognize impairment of loan when it is probable that creditor will not be able
to sell all amounts due in accordance with terms of loan.
 All amounts include both principal and interest
 Impairment is based on PV of expected future cash flows discounted at loan’s effective
rate.
 Creditor may use:i.
Loan’s observable market price, or
ii.
FV of collateral if the loan is collateral dependent.
J. Accounting for Asset Retirement Obligations (ARO)
1. SFAS 143 Accounting for Asset Retirement Obligations, which applies to all entities,
concerns an asset retirement obligation related to retirement of a tangible long-lived
asset. The associated asset retirement cost (ARC) is added to the carrying amount fo
the tangible long-lived asset when an ARO is recognized. The initial ARC debit equals
the initial ARO Credit.
2. An ARO is recognized for a legal obligation relating to the retirement of a tangible longlived asset. This obligation results from the acquisition, construction, or development or
normal operation of such an asset.
3. The fair value of the ARO liability is recognized when incurred. If a reasonable estimate
of the fair value cannot be made at that time, the ARO will be recognized when such an
estimate can be made.
a. Fair value is the amount at which the ARO could be settled in a current transaction
between willing parties, not in a forced or liquidation transaction.
b. A quoted price in an active market is the best evidence of fair value. If such a price
is not available, the best available information is used, such as the price of a
similar liability or the result of applying present value methods.
52
4. A change from one period to the next in the ARO due to passage of time is added to the
liability. It is measured by applying an interest method of allocation to the ARO's
beginning balance for the period.
 The rate is the credit-adjusted risk-free rate used at the ARO's initial measurement.
 The offsetting debit is to accretion expense, which is classified as an operating item.
 After the periodic change resulting from the passage of time has been recognized, the
periodic change in the ARO due to revised estimates of the timing or amount of the
undiscounted cash flows is accounted for as an adjustment of the capitalized ARC
and the carrying amount of the ARO.
 Increases in those estimated undiscounted cash flows are discounted using the
current CARF (credit-adjusted risk-free) rate, and decreases are discounted using
the original CARF rate)
53
Chapter 6 Questions – Long-Term Liabilities
A. Issuance of Bonds at a Premium or Discount
CLASS 1: Bond Bondy Corp. is authorized to issue $1,000,000 of 7%, ten-year bonds payable. On April 1, 2001 when the
market interest rate is 8%, the company issues $300,000 of the bonds at 99, and incurred bond issue cost of $10,000. Bond
Bondy measures interest expense by the effective-interest method. The bonds pay interest semi-annually on June 30th and
December 31st.
Required:
1. Prepare an entry on page 2 of the General Journal on April 1, 2001
2. Prepare an amortization table for the first four semiannual interest periods.
3. Record the first semiannual interest expense on June 30th
HOME 1: Strick Stricky Corp. is authorized to issue $2,000,000 of 8%, ten-year bonds payable. On Februaryl 1, 2002 when the
market interest rate is 6.75%, the company issues $400,000 of the bonds at 105, and incurred bond issue cost of $15,000.
Strick Stricky measures interest expense by the effective-interest method. The bonds pay interest semi-annually on June 30th
and December 31st.
Required:
1. Prepare an entry on page 2 of the General Journal on February 1, 2001
2. Prepare an amortization table for the first four semiannual interest periods.
3. Record the first semiannual interest expense on June 30th
D. Conversion of Bonds
Class 2: On July 1, 2002, after recording interest and amortization, York Yorky Co. converted $1 million of its 12% convertible
bonds into 50,000 shares of $1 par value common stock. On the conversion date the carrying amount of the bonds was $1.3
million, the market value of the bonds was $1.4 million, and York Yorky's common stock was publicly trading at $30 per share.
Using both the book-value method and the market-value method, prepare entries to record the conversion.
Home 2: On August 2, 2005, after recording interest and amortization, York Yorky Co. converted $2.5 million of its 9%
convertible bonds into 100,000 shares of $2 par value common stock. On the conversion date the carrying amount of the bonds
was $2 million, the market value of the bonds was $2.2 million, and York Yorky's common stock was publicly trading at $20 per
share. Using both the book-value method and the market-value method, prepare entries to record the conversion.
F. Retirement of Bonds
CLASS 3: On July 31, 2004, Stock Stocky Co. issued $1,000,000 of 10%, 15-year bonds at par and used a portion of the
proceeds to call its 600 outstanding 11%, $1,000 face amount bonds, due on July 31, 2014, at 102. On that date, unamortized
bond premium relating to the 11% bonds was $65,000. In its 2004 income statement, what amount should Stock Stocky report
as gain or loss from retirement of bonds?
HOME 3: On June 30, 2005, Check Checky Co. issued $2,000,000 of 9%, 20-year bonds at par and used a portion of the
proceeds to call its 700 outstanding 10%, $1,000 face amount bonds, due on June 30, 2015, at 103. On that date, unamortized
bond premium relating to the 10% bonds was $42,000. In its 2005 income statement, what amount should Check Checky report
as gain or loss from retirement of bonds?
54
Galilee College © 2007
Chapter 7 - Leases and Contingencies
OVERVIEW
I.
Introduction
Many businesses lease substantial portions of the property and equipment they use in their business
organization as an alternative to ownership. Because leasing provides some financial, operating and risk
advantages over ownership it has become the fastest growing form of capital investment. This increased
significance of lease arrangements in recent years has intensified the need for uniform accounting and complete
informative reporting of leasing transactions. Chapter 22 presents a discussion of the accounting issues related to
leasing arrangements from the point of view of both the lessee and the lessor. Among the issues discussed are:
(1) the classification of leasing arrangements, (2) the various methods used in accounting for leases, and (3) the
financial statement disclosure requirements when leases are present.
The difficulty level of this chapter is 9.
1. Basics of Leasing
A lease is a contractual agreement between a lessor and a lessee that gives the lessee the right to use
specific property, owned by the lessor, for a specified period of time. In return for this right, the lessee agrees to
make periodic cash payments (rents) to the lessor. An essential element of the lease conveyance is that the lessor
conveys less than the total interest in the property.
The particulars of a lease arrangement are dependent on the agreement entered into by the lessee and
lessor. Most lease contracts include provisions related to: (a) the duration of the lease, (b) the amount of periodic
rental payments, (c) the party required to pay taxes, insurance, and maintenance, (d) the restrictions imposed on
parties to the lease, (e) the cancellation terms, (f) default provisions, and (g) the alternatives of the lessee at the
time of lease termination.
2. Advantages of Leasing
In discussing the advantages of leasing arrangements, advocates point out that leasing allows for: (a)
100% financing, (b) protection against obsolescence, (c) flexibility, (d) less costly financing, (e) potential
avoidance of onerous alternative tax provisions, and (f) off-balance sheet financing.
II.
Accounting for lessees
A variety of opinions exist regarding the manner in which certain long-term lease arrangements should
be accounted for. These opinions range from total capitalization of all long-term leases to the belief that leases
represent executory contracts that should not be capitalized. The FASB Statements dealing with lease accounting
can be characterized as advocating capitalization of lease arrangements that are similar to installment purchases.
In short, lease arrangements that transfer substantially all of the risks and rewards of ownership of property should
be capitalized by the lessee.
1. Classification: Transfer of Ownership Criteria
For accounting purposes of the lessee, all leases may be classified as operating leases or capital
leases. For a lease to be recorded as a capital lease, the lease must be noncancelable, and meet one of the
following four criteria:
a. The lease transfers ownership of the property to the lessee.
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b.
c.
d.
The lease contains a bargain purchase option.
The lease term is equal to 75% or more of the estimated economic life of the leased property.
The present value of the minimum lease payments (excluding executory costs) equals or exceeds
90% of the fair value of the leased property.
If the lease meets none of the four criteria, the lease should be classified and accounted for as an operating lease.
The transfer of ownership criteria is straightforward and easy to apply in practice. A bargain
purchase option is a provision allowing the lessee to purchase the leased property for a price that is significantly
lower than the property's expected fair value at the date the option becomes exercisable. The 75% of economic
life test is based on the belief that when a lease period equals or exceeds 75% of the asset's economic life, the
risks and rewards of ownership are transferred to the lessee and capitalization is appropriate. The reason for the
90% of fair market value test is that if the present value of the minimum lease payments are reasonably close to
the market price of the asset, the asset is effectively being purchased. A major exception to the 75% and 90%
rules is when the inception of the lease occurs during the last 25% of the asset's life. When this occurs the 75%
and 90% tests should not be used.
2. Capital Leases for Lessees
Under the capital lease method the lessee treats the lease transaction as if an asset were being
purchased on time (installment basis). For a capital lease, the lessee records an asset and a liability at the lower of
(a) the present value of the minimum lease payments during the term of the lease or (b) the fair market value of the
leased asset at the inception of the lease.
In determining the present value of the minimum lease payments, three important concepts are involved:
(a) minimum lease payments, (b) executory costs, and (c) the discount rate.
a. Minimum lease payments include (a) minimum rental payments, (b) any guaranteed residual
value, (c) penalty for failure to renew or extend the lease, and (d) any bargain purchase option. Minimum
rental payments are the minimum payments the lessee is obligated to make to the lessor under the lease
agreement. A guaranteed residual value is the estimated fair (market) value of the leased property at the
end of the lease term. This allows the lessor to transfer the risk of loss in the fair value of the asset to the
lessee. The guaranteed residual value is (a) the certain or determinable amount at which the lessor has
the right to require the lessee to purchase the asset or (b) the amount the lessee or the third-party
guarantor guarantees the lessor will realize.
b. Executory costs include the cost of insurance, maintenance, and tax expense related to the
leased asset. If the lessor makes these payments, such amounts should reduce the present value of the
minimum lease payments. When the lease agreement specifies that executory costs are assumed by the
lessee, the rental payments can be used without adjustment in the present value computation.
c. The lessee uses its incremental borrowing rate (discount rate) to compute the present value
of the minimum lease payments. This rate, often determined by the exercise of professional judgment, is
defined as the rate that, at the inception of the lease, the lessee would have incurred to borrow the funds
necessary to buy the leased asset. There is one exception to use of the incremental borrowing rate by the
lessee in computing the present value of the minimum lease payments. If the lessee knows the implicit
rate computed by the lessor, and that rate is less than the lessee's incremental borrowing rate, then the
lessee must use the implicit rate.
When the lessee uses the capital lease method, each lease payment is allocated between a reduction of
the lease obligation and interest expense applying the effective interest method. The lessee should amortize the
leased asset by applying one of the conventional depreciation methods. During the term of the lease, assets
56
recorded under capital leases are separately identified in the lessee's balance sheet. Likewise, the related
obligations are separately identified with the portion due within one year or the operating cycle, whichever is longer,
classified with current liabilities and the balance with noncurrent liabilities.
A complete illustration of the accounting for a capital lease by the lessee is found in the text. It is
important to understand the preparation of the Lease Amortization Schedule. This schedule provides the basis for
the entire range of journal entries for the lease transaction. The basic entries include: (a) initial capitalization which
requires a debit to the asset and a credit to the liability, (b) annual lease payments which include a debit to the
liability and a credit to cash, and (c) the annual depreciation entry. Of course, any interest accrual or executory
costs would be included in the entries made for the lease obligation.
3. Operating Leases for Lessees
In accounting for an operating lease, the lessee would use the accounting method known as the
operating method. When the lessee uses the operating method, the periodic rent associated with the lease is
recognized in the period benefited by the leased asset. Under this method, the commitment to make future rental
payments is not recognized in the accounts. Only footnote recognition is given to the commitment to pay future
rentals. The journal entry the lessee would make to record operating lease payments includes a debit to Rent
Expense and a credit to Cash.
III. Accounting by Lessors
1. Lease classification for lessor accounting – three types
Three benefits available to the lessor are (a) competitive interest margins, (b) tax incentives, and (c)
high residual values. For lessor accounting purposes, all leases may be classified as: (a) operating leases, (b)
direct financing leases, or (c) sales-type leases. The lessor should classify and account for an arrangement as
a direct financing lease or a sales-type lease if at the date of the lease agreement one or more of the following
Group I criteria are met and both of the following Group II criteria are met.
Group I
a.
b.
c.
d.
The lease transfers ownership of the property to the lessee.
The lease contains a bargain purchase option.
The lease term is equal to 75% or more of the estimated economic life of the leased property.
The present value of the minimum lease payments (excluding executory costs) equals or exceeds
90% of the fair value of the leased property.
Group II
a.
b.
Collectibility of the payments required from the lessee is reasonably predictable.
No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the
lessor under the lease.
The distinction between a direct financing lease and a sales-type lease is that a sales-type lease
involves manufacturer's or dealer's profit (or loss) and a direct financing lease does not. The primary
difference between applying the financing method to a direct financing lease and applying it to a sales-type lease is
the recognition of the manufacturer's or dealer's profit at the inception of the lease. The profit or loss to the lessor
is evidenced by the difference between the fair value of the leases property at the inception of the lease and the
lessor's cost or carrying amount (book value). All leases that do not qualify as direct financing or sales-type leases
are classified and accounted for by the lessors as operating leases.
2. Lessor accounting for operating leases
A lessor should account for an operating lease using the operating method. Under the operating
57
method, each rental receipt of the lessor is recorded as rent revenue on the use of an item carried as a fixed asset.
The fixed asset is depreciated in the normal manner, with the depreciation expense of the period being matched
against the rental revenue.
3. Lessor accounting for Direct Financing Leases
When the lessor enters into a capital lease arrangement with a lessee, the lessor is, in substance,
financing an asset purchased by the lessee. This transaction requires the lessor to substitute a Lease Payments
Receivable account for the leased asset.
Lessor accounting under the direct financing method requires computation of
(a) gross investment in the lease,
(b) unearned interest revenue, and
(c) net investment.
The gross investment is the minimum lease payments plus the unguaranteed residual
value accruing to the lessor (lease payments receivable). Unearned interest revenue
is the difference between the gross investment (the receivable) and the fair market
value of the property. The net investment is the gross investment (the receivable)
less the unearned interest revenue included therein. The unearned interest revenue is
amortized to revenue over the lease term using the effective interest method.
The text material includes a complete illustration of the accounting entries a lessor would make for a
direct financing lease. The facts of the example are the same facts used in the earlier example which
demonstrated lessee accounting. As was the case in the lessee example, preparation of a Lease Amortization
Schedule is an effective way to provide all the information necessary for the required journal entries.
4. Sales-Type Leases
Under sales-type leases, the profit recorded by the lessor at the point of sale is the same whether the
residual value is guaranteed or unguaranteed, but the sales revenue and cost of goods sold amounts are different.
The present value of the unguaranteed residual value is deducted from sales revenue and cost of goods sold.
IV. Disclosure
The FASB requires that specific information with respect to operating leases and capital leases be
disclosed in the lessee's financial statements or in the footnotes as of the date of the latest balance sheet
presented. This section includes both a listing of lessee and lessor disclosure requirements and actual disclosure
illustrations. The general information required to be disclosed by the lessee for all leases includes, but is not
necessarily limited to, the following:
a. The basis on which contingent rental payments are determined.
b. The existence and terms of renewal or purchase options and escalation clauses.
c. Restrictions imposed by lease agreements, such as those concerning dividends, additional debt,
and future leasing.
58
V. Other Issues
1. Residual Value
The residual value of a leased asset is the estimated fair value of the asset at the end of the lease
term. The residual value may be guaranteed or unguaranteed by the lessee. A guaranteed residual value is said
to exist when the lessee agrees to make up any deficiency below a stated amount in the value of the asset at the
end of the lease term. A guaranteed residual value affects the lessee's computation of the minimum lease
payments and, therefore, the amounts capitalized as a leased asset and a lease obligation. The lessor assumes
the residual value will be realized at the end of the lease term whether guaranteed or unguaranteed.
To understand the accounting implications of a guaranteed residual value, assume a lessee guarantees
the residual value of an asset will be $8,000. If, at the end of the lease, the fair market value of the residual value is
less than $8,000, the lessee will have to record a loss for the difference. For example, if the lessee depreciated the
asset down to its residual value of $8,000 but the fair market value of the residual value was $4,000, the lessee
would have to record a loss of $4,000. If the fair market value of the asset exceeds the $8,000, a gain may be
recognized. Gains on guaranteed residual values may be apportioned to the lessor and lessee in whatever ratio
the parties initially agree.
2. Bargain Purchase Options
A bargain purchase option is a provision allowing the lessee, at his or her option, to purchase the
leased property at a price that is sufficiently lower than the expected fair value of the property at the date the option
becomes exercisable. When a bargain purchase option exists, the lessee must increase the present value of the
minimum lease payments by the present value of the option price. The only difference between accounting for a
bargain purchase option and a guaranteed residual value of identical amounts is in the computation of the annual
depreciation. In the case of a guaranteed residual value, the lessee depreciates the asset over the lease life.
When a bargain purchase option is present, the lessee uses the economic life of the asset in computing
depreciation.
3. Initial Direct Costs
Initial direct costs are the costs incurred by the lessor that are directly associated with negotiating, and
consummating a completed leasing transaction. There are two types of initial direct costs; incremental direct
costs and internal direct costs. Incremental direct costs are costs incurred in originating a lease arrangement
that are paid to third parties. Internal direct costs are costs directly related to specified activities performed by the
lessor on a given lease. When an operating lease is present, the initial direct costs are deferred and amortized
over the life of the lease in proportion to rental income. In a sales-type lease, these costs are expensed in the
period that profit on the sale is recognized. For direct financing leases, initial direct costs are added to the net
investment in the lease and amortized over the life of the lease as a yield adjustment.
4. Sale-Leaseback
A "sale-leaseback" transaction is one in which the owner of property sells it to another and
simultaneously leases it back from the new owner. The seller-lessee, in a sale-leaseback transaction, should apply
the same criteria mentioned earlier in deciding whether to account for the lease as a capital lease or an operating
lease. Likewise, the purchaser-lessor should apply the criteria mentioned earlier in deciding whether the saleleaseback transaction should be accounted for using the operating method or the financing method.
59
Part B: Contingencies
I.
Loss Contingencies
A. Involves an existing uncertainty as to whether a loss really exists, where the uncertainty will be resolved only when
some future event occurs
B. Accrued only if a loss is
1. Probable and
2. The amount can reasonably be estimated.
C. The contingent liability for product warranties almost always is accrued
D. The contingent liability for premiums (like cash rebates) almost always is accrued.
E. When the cause of a loss contingency occurs before the year-end, a clarifying event before financial statements are
issued can be used to determine how the contingency is reported.
II.
Unasserted Claims and Assessments
A. It must be probable that an unasserted claim or assessment or an unfiled lawsuit will occur before considering
whether and how to report the possible loss.
1. Is a claim or assessment probable? {If not, no disclosure is needed.}
2. Only if a claim or assessment is probable should we evaluate (a) the likelihood of an unfavorable outcome and
(b) whether the dollar amount can be estimated.
B. If the conclusion of step 1 is that the claim or assessment is not probable, no further action is required.
III.
Gain Contingencies
A. Gain contingencies are not accrued.
B. Conservatism
1. Lessee Accounting for Capital Lease
1. A lease is capitalized if, at its inception, one of the following is met (OWNS)
Ownership of leased property is transferable
With Bargain Purchase Option
Ninety percent is PV minimum lease payments of (FV –investment tax credit)
Seventy-five % of estimated economic life
Additional
i.
Collectibility of minimum lease payments is reasonably predictable
ii.
No important uncertainties surround the unreimbursable cost to be incurred by lessor
2. Capital lease = asset and a liability by lessee (PV of minimum lease payments) at inception
 Calculation: Lease Payments – Executory Cost x PV factor
 PV cannot exceed FV of leased asset at inception of lease
 Minimum Lease Payments (Minimum Rental Payment, exclude executory cost, + amount
of bargain purchase option)
Executory Cost: Insurance/Maintenance/Taxes
- If no BPO, MLP = Minimum rental payment + Amount of Residual Value Guaranteed
+ Nonrenewal penalty imposed.
- From Lessor’s Standpoint
i.
MLP includes Residual Value guaranteed by an unrelated, financially
capable third party
 Lessee should use its incremental borrowing rate unless,
i.
Lessee knows lessor’s implicit rate
ii.
Implicit rate is less than lessee’s incremental borrowing rate
(a) If both conditions are met, the lessee must use the implicit rate.
60
3. At end of Lease – (Guaranteed Residual Value – FV = gain or loss)
4. Interest will be recognize for direct-financing or sales-type lease
 Calculation (Beg. Lease Liability Carrying Value x Interest Rate)
i.
As carrying amount decreases, so will the interest
5. Disclose – Future minimum lease payments at latest balance sheet date in aggregate for
each of the f succeeding fiscal years.
 For capital or operating leases
6. Depreciation = (Cost –SV / life)
2. Lessor Accounting for Capital Lease
1. Direct-financing leases
 No profit is recognized
* Interest Revenue = Gross Lease Payments (annual payments x time)
- PV of Payments
2. Sales-type lease
 Profit is recognized
Gross Profit = (Sales Price: PV of MLP – Cost)
- Cost for sales type lease is not same as Fair Value.
3. Effective Interest Method: Interest Revenue = (Beg. Carrying Value x interest rate)
Remember: For capital lease, income is recognized in accordance with interest method.
4. Operating Leases
1. Lessee recognizes periodic rental expense (no asset or liability)
 Only liability is accrued rental at the end of the year.
 Include amortization of leasehold improvement as an expense
2. A lease Bonus (nonrefundable) should be considered part of the rental payments. Lessor
should recognize over lease term. (regardless of when payment is made)
3. Net rental income = (Annual rental payment – expenses)
4. Initial Indirect Cost: Deferred and amortize over lease term
4. Sale-Leaseback Transactions
1. If lease qualifies as capital lease
 G/L on sale is deferred and amortized by seller-lessee in proportion to amortization of
asset.
= (PV of lease asset – Carrying Value)
i. Deferred Gain = Total Gain – Amortized Portion recognize now
 When lease transfers substantially all risks of ownership (this is not a capital lease)
 Seller/Lessee has right to substantially all of remaining use of property.
2. Exception of Deferring Profit (for capital leases)
i.
Seller-lessee retains more than a minor part, but
Less than substantially all of the use of the property through the leaseback
61

Profit is recognize at date of sale if profit is in excess of either
a. PV of MLP over lease term if operating lease, or
b. Recorded amount of leased asset if leaseback is capital lease
ii.
Calculation: PV of Lease Rental, must be:
a. > 10% of lease property FV (sales value)
b. < 90% of lease property FV (Sales value)
if fits this criteria, defer PV of lease rentals
if it does not fit criteria, recognize all profit now
Note: if PV is not presented, the usual deferral is necessary


3. For sales-lease back of operating lease
 No asset is shown on balance sheet
- Report gain as deferred credit
4. Remember, a loss is deferred if Carrying Value > Sales price.
5. Contingencies
1. Loss contingency:
 Probable and Reasonably Estimable
 If a range is given, use the minimum in the range
 A contingency that is reasonably possible but not probable is disclosed, not accrued
A debt guarantee should be disclosed, even if the possibility of loss is remote.
 Discounting a notes receivable with recourse must be disclosed in the F/S
Debit: Loss
xx
Credit: Asset Valuation Allowance/Liability
xx
A. Gain Contingencies
1. Do not recognize until realize
2. It should be disclosed
 Also reflect the range of the gain
Chapter 7 Questions – Leases and Contingencies
62
1. Lease Accounting for Capital Lease
Class 1: Leasey Corp. entered into a 9-year capital lease on a warehouse on December 31, 2002. The land and building are
capitalized as a single unit. Lease payments of $52,000, which include real estate
taxes of $2,000, are due annually, beginning on December 31, 2003 and every December 31 thereafter. Leasey does not know
the interest rate implicit in the lease; Leasey's incremental borrowing rate is 9%.
The rounded present value of an ordinary annuity for 9 years at 9% is 5.6. What amount should Leasey report as capitalized
lease liability at December 31, 2002?
Home 1: Rent Renty entered into a 12 -year capital lease on a warehouse on December 31, 2005. The equipment have Lease
payments of $71,000, which include maintenance cost of $5,000real, are due annually, beginning on December 31, 2006 and
every December 31 thereafter. Rent Renty does not know the interest rate implicit in the lease; Rent Renty's incremental
borrowing rate is 7%. The rounded present value of an ordinary annuity for 9 years at 7% is 4.2. What amount should Rent
Renty report as capitalized lease liability at December 31, 2005?
Class 2: In the long-term liabilities section of its balance sheet at December 31, 2001, Jet Jetty Co. reported a capital lease
obligation of $75,000, net of current portion of $1,364. Payments of $9,000 were made on both January 2, 2002 and January 2,
2003. Jet Jetty's incremental borrowing rate on the date of the lease was 11% and the lessor's implicit rate, which was known to
Jet Jetty, was 10%. In its December 31, 2002 balance sheet, what amount should Jet Jetty report as capital lease obligation, net
of current portion?
Home 2: In the long-term liabilities section of its balance sheet at December 31, 2003, Proof Proofy Co. reported a capital
lease obligation of $125,000. Payments of $12,000 were made on both January 1, 2004 and January 1, 2005. Proof Proofy's
incremental borrowing rate on the date of the lease was 9% and the lessor's implicit rate, which was known to Proof Proofy, was
11%. In its December 31, 2004 balance sheet, what amount should Proof Proofy report as capital lease obligation, net of current
portion?
2. Lessor Accounting for Capital Lease
Class: 3 Glade Gladey Co. leases computer equipment to customers. The equipment has no residual value at the end of the
lease and the leases do not contain bargain purchase options. Glade Gladey wishes to earn 8% interest on a 5-year lease of
equipment with a fair value of $323,400. The The present value of an annuity due of $1 at 8% for 5 years is 4.312. What is the
total amount of interest revenue that Glade Gladey will earn over the life of the lease?
1. If this was a direct financing lease, how much interest revenue would Glade Glade earn over the life of the lease?
2. If this was a sales type lease, what is the selling price.
Home: 3 Blade Bladey Co. leases transportation buses to customers. The buses had no residual value at the end of the lease
and the leases do not contain bargain purchase options. Blade Bladey wishes to earn 9% interest on a 8-year lease of buses
with a fair value of $456,200. The present value of an annuity due of $1 at 9% for 8 years is 3.181. What is the total amount of
interest revenue that Blade Bladey will earn over the life of the lease?
1. If this was a direct financing lease, how much interest revenue would Blade Blade earn over the life of the lease?
2. If this was a sales type lease, what is the selling price.
3. Operating Leases
Home: 4 On January 1, 2002, Pill Pilly Co. signed a 7-year lease for equipment having a 10-year economic life. The present
value of the monthly lease payments equaled 80% of the equipment's fair value. The lease agreement provides for neither a
transfer of title to Pill Pilly nor a bargain purchase option. In its 2002 income statement, how should Pill Pilly calculate its rental
expense?
63
Class: 4 On December 1, 2002, Clark Clarky Company leased office space for 5 years at a monthly rental of $60,000. On that
date, Clark Clarky paid the lessor the following amounts:
First month's rent
$ 60,000
Last month's rent
60,000
Security deposit (refundable at lease expiration)
80,000
Installation of new walls and offices
360,000
How much should Clark Clarky's December 2002 expense relating to its use of this office space be?
Home: 5 On November 1, 2003, Lark Larky Company leased office space for 8 years at a monthly rental of $50,000. On that
date, Lark Larky paid the lessor the following amounts:
First month's rent
$ 50,000
Last month's rent
50,000
Security deposit (refundable at lease expiration)
40,000
Installation of new walls and offices
240,000
December’s Rental Payment
50,000
How much should Clark Clarky's 2003 expense relating to its use of this office space be?
4. Sale-Leaseback Transactions
Class: 5 On January 1, 2002, Hook Hooky Oil Co. sold equipment with a carrying amount of $100,000 and a remaining useful
life of 10 years to Maco Drilling for $150,000. Hook Hooky immediately leased the equipment back under a 10-year capital lease
with a present value of $150,000. It will depreciate the equipment using the straight-line method. Hook Hooky made the first
annual lease payment of $24,412 in December 2002. In Hook Hooky's December 31, 2002 balance sheet, the unearned gain on
the equipment sale should be?
Home: 6 On January 1, 2004, Nook Nooky Drinking Co. sold equipment with a carrying amount of $240,000 and a remaining
useful life of 15 years to Drook Co. for $300,000. Nook Nooky immediately leased the equipment back under a 15-year capital
lease with a present value of $300,000. It will depreciate the equipment using the straight-line method. Nook Nooky made the
first annual lease payment of $34.000 in December 2004. In Nook Nooky's December 31, 2004 balance sheet, the unearned
gain on the equipment sale should be?
B. If Nook Nooky had sold the equipment for $275,000 how much would be deferred to subsequent years?
Home: 7 In a sale-leaseback transaction, when should a gain resulting from the sale be deferred and subsequently?
5. Contingencies
Class: 8 On December 31, 2002, Mith Mithy Co. was a defendant in a pending lawsuit. The suit arose from the alleged defect
of a product that Mith Mithy sold in 1999. In the opinion of Mith Mithy's attorney, it is probable that Mith Mithy will have to pay
$50,000, and it is reasonably possible that Mith Mithy will have to pay $60,000 as a result of this lawsuit. In its 2002 financial
statements, Mith Mithy should report
Home: 8 Deep Deepy, Inc. has a self-insurance plan. Each year, retained earnings is appropriated for contingencies in an
amount equal to insurance premiums saved minus recognized losses from lawsuits and other claims. As a result of a 2002
accident, Deep Deepy is a defendant in a lawsuit in which it will probably have to pay damages of $190,000. What are the
effects of this lawsuit's probable outcome on Deep Deepy's 2002 financial statements?
64
Home: 9 Bus Bussy Co. has a probable loss that can only be reasonably estimated within a range of outcomes. No single
amount within the range is a better estimate than any other amount. How should the
loss accrual should be determined?
Home: 10 In 2002, a contract dispute between Dollis Co. and Brooks Co. was submitted to binding arbitration. In 2002, each
party's attorney indicated privately that the probable award in Dollis's favor could
be reasonably estimated. In 2003, the arbitrator decided in favor of Dollis. When should Dollis and Brooks recognize their
respective gain and loss?
Galilee College © 2007
Chapter 8 - Shareholders’ Equity: Contributed Capital
65
OVERVIEW
Stockholders' Equity:
Contributed Capital
Ch.15 is a relatively straight-forward chapter (difficulty level: 6)
Chapter 15 is the first of two chapters that focuses on the stockholders' equity section of the corporate form of
business organization. Stockholders' equity represents the amount that was contributed by the shareholders and the portion
that was earned and retained by the enterprise.
There is a definite distinction between liabilities and stockholders' equity that must be understood if one is to
effectively grasp the accounting treatment for equity issues. A basic distinction concerns the fact that a liability embodies an
obligation to sacrifice future economic benefits, whereas an equity instrument does not.
This chapter addresses the accounting issues related to capital contributed by owners of a business organization.
Next chapter deals with the issue related to retained earnings.
I. The Corporate Form of Entity
1 The corporate form of business organization begins with the submitting of articles of incorporation to the state in
which incorporation is desired. Assuming the requirements are properly fulfilled, the corporation charter is issued and the
corporation is recognized as a legal entity subject to the laws of the state of incorporation. The laws of the state of incorporation
that govern owners' equity transactions are normally set out in the state's business corporation act.
2 Within a given class of stock, each share is exactly equal to every other share. A person's percent of ownership in
a corporation is determined by the number of shares he or she possesses in relation
to the total number of shares owned
by all stockholders. In the absence of restrictive provisions, each share carries the right to participate proportionately in: (a)
profits, (b) management, (c) corporate assets upon liquidation, and (d) any new issues of stock of the same class
(preemptive right).
3 The transfer of ownership between individuals in the corporate form of organization is accomplished by one
individual's selling or transferring his or her shares to another individual. The only requirement in terms of the corporation
involved is that it be made aware of the name of the individual owning the stock. A subsidiary ledger of stockholders is
maintained by the corporation for the purpose of dividend payments, issuance of stock rights, and voting proxies. Many
corporations employ independent registrars and transfer agents who specialize in providing services for recording and
transferring stock.
4 The basic ownership interest in a corporation is represented by common stock. Common stock is guaranteed
neither dividends nor assets upon dissolution of the corporation. Thus, common stockholders are considered to hold a residual
interest in the corporation. However, common stockholders generally control the management of the corporation and tend to
profit most if the company is successful. In the event that a corporation has only one authorized issue of capital stock, that
issue is by definition common stock, whether or not it is so designated in the charter.
5 The amount an individual pays for shares of stock in a corporation represents the maximum amount that individuals
can lose in the event of corporate liquidation. This is known as the concept of limited liability.
II. Corporate Capital
1 Owner's equity in a corporation is defined as stockholders' equity, shareholders' equity, shareholders, or corporate
capital. The following categories normally appear as part of stockholders' equity.
a. Capital stock. (Ch.15)
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b. Additional paid-in capital. (ch.15)
c. Retained earnings. (ch.16)
Capital stock and additional paid-in capital constitute contributed (paid-in) capital; retained earnings represents the
earned capital of the enterprise. Contributed capital (paid-in capital) is the total amount paid in on capital stock. Earned
capital is the capital that develops if the business operates profitably.
2. Stockholders' equity is the difference between the assets and the liabilities of the enterprise—also known as
the residual interest. Stockholders' equity is not a claim to specific assets but a claim against a portion of the total
assets.
3. Profits of a corporation distributed to stockholders are referred to as dividends. In general, dividends can be paid
only out of accumulated profits in excess of accumulated losses. There are also legal matters which must be
considered when corporations distribute earnings to shareholders. The three basic legal considerations are as follows:
(a) distributions to owners must be in compliance with the state laws governing corporations, (b) distributions to
stockholders must be formally approved by the board of directors, and (c) dividends must be in full agreement with the
capital stock contracts as to preference, participation, and the like. These matters are further discussed in Chapter 16.
III. Accounting for the Issuance of Stock
Par value is an amount printed on each stock certificate. This establishes the nominal value per share and is the
minimum amount that must be paid by each stockholder if the stock is to be fully paid when issued. Stock issued for more than
par value is said to be issued at a premium. Conversely, stock issued for less than par value is said to be issued at a
discount. When stock is issued at a discount by the corporation, the holders of such stock are contingently liable to corporate
creditors for the amount of the discount. This contingency is realized only in the event of liquidation when creditor claims remain
unsatisfied.
1. Issuance of stock for cash
When par value stock is issued, the Capital Stock (common or preferred) account is credited for an amount equal
to par value times the number of shares issued. Any amount received in excess of par value is credited to a premium account
representing additional paid-in capital. For example, if 200 shares of common stock with a par value of $2 per share is sold
for $500, the following journal entry would be made:
Cash
Common Stock
Paid-in Capital in Excess of Par
500
400
100
Par value stock is always credited at issue date for its par value times the number of shares issued.
When no-par stock is issued, the Capital Stock account is credited for an amount equal to the value of the
consideration received. If no-par stock has a stated value, it may be accounted for in the same way as true no-par stock.
Alternatively, the stated value may be considered similar to par value with any excess above stated value being accounted for
as additional paid-in capital.
2. Subscribed Stock
When stock is sold on a subscription basis, the full price of the stock is not received initially. Normally only a
partial payment is made originally, and the stock is not issued until the full subscription price is received. When an individual
subscribes to a common stock issue, the corporation debits Subscriptions Receivable and credits Common Stock
Subscribed. If the subscription price exceeds the stock's par value, additional paid-in capital would be credited for the excess.
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For example, assume Rob Morley subscribes to purchase 300 shares of General Company common stock ($4 par value) for $9
per share on July 1. Morley pays $1,000 down and agrees to pay the remainder in 3 months. The journal entry General
Company would make is as follows:
Cash
Subscriptions Receivable
Common Stock Subscribed
Paid-in Capital in Excess of Par
1,000
1,700
1,200
1,500
Common Stock Subscribed should be presented in the stockholders' equity section below Common Stock. Under the contra
equity approach, Subscriptions Receivable should be reported as a deduction from stockholders' equity.
When the stock has been fully paid for, General Company would record the following journal
entries:
Cash
Subscriptions Receivable
1,700
1,700
and
Common Stock Subscribed
Common Stock
1,200
1,200
3. Lump Sum Sales
More than one class of stock is sometimes issued for a single payment or lump sum amount. Such a transaction
requires allocation of the proceeds between the classes of securities involved. The two methods of allocation used are (a) the
proportional method and (b) the incremental method. The former method is used when the fair market value for each class
of security is readily determinable.
4. Stock Issued in Noncash Transactions
Stock issued for consideration other than cash should be recorded by using the fair market value of the
consideration or the fair market value of the stock issued, whichever is more clearly determinable. In cases where the fair
market value of both items is not clearly determinable, the board of directors has the authority to establish a value for the
transaction.
5. Costs of Issuing Stock
The costs associated with issuing capital stock may be written off against additional paid-in capital or capitalized as
organization costs and amortized against future earnings. The SEC permits use of either method.
IV. Treasury Stock
1. Treasury stock is a corporation's own stock that (a) was outstanding, (b) has been reacquired by the
corporation, and (c) is not retired. Treasury stock is not an asset and should be shown in the balance sheet as a reduction of
stockholders' equity. Treasury stock is essentially the same as unissued stock. The reasons corporations purchase their
outstanding stock include: (a) to meet employee stock compensation contracts or meet potential merger needs, (b) to increase
earnings per share; (c) to thwart takeover attempts; (d) to make a market in the stock; and (e) to contract operations.
2. Cost method for treasury stock.
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Under the cost method, treasury stock is recorded in the accounts at acquisition cost. When the treasury stock is
reissued the Treasury Stock account is credited for the acquisition cost. If treasury stock is reissued for more than its
acquisition cost, the excess amount is credited to Paid-in Capital from Treasury Stock. If treasury stock is reissued for less
than its acquisition cost, the difference should be debited to any paid-in capital from previous treasury stock transactions. If the
balance in this account is insufficient, the remaining difference is charged to retained earnings. The following example shows
the accounting for treasury stock under the cost method.
10,000 shares of common stock with a par value of $5 per share was originally issued at $12 per share.
A.
2,000 shares of common stock are reacquired for $20,000.
Entry for Purchase
Treasury Stock
Cash
B.
20,000
20,000
1,000 shares of treasury stock are resold for $8,000.
Entry for Resale
Cash
8,000
Retained Earnings
Treasury Stock
accounts.
2,000
10,000
The cost of treasury stock is shown in the balance sheet as a deduction from the total of all owners' equity
3. Par Value Method for treasury stock
Treasury stock accounted for under the par value method is debited to the Treasury Stock account at the stock's
par value. Any original premium or discount related to the shares reacquired is removed from the accounts. Any excess of par
value and related premium or discount over the acquisition cost is credited to Paid-in Capital from Treasury Stock. When
acquisition cost exceeds par value and the related premium or discount, the difference is debited to Retained Earnings. If the
treasury shares accounted for under the par value method are reissued, the accounting treatment is the same as that accorded
any original issuance of stock. The following example shows the accounting for treasury stock under both the cost and par
value method.
10,000 shares of common stock with a par value of $5 per share was originally issued at $12 per share.
A.
2,000 shares of common stock are reacquired for $20,000.
Entry for Purchase-Par Value Method
Treasury Stock (2,000 ´ $5)
Paid-in Capital in Excess of Par
Cash
Paid-in Capital from Treasury Stock
10,000
14,000*
20,000
4,000
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*[$2,000 ´ (12 – 5)]
B.
1,000 shares of treasury stock are resold for $8,000.
Entry for Resale-Par Value Method
Cash
8,000
Paid-in Capital in Excess of Par
Treasury Stock
3,000
5,000
When the par value method is used, the total par value of treasury shares is shown as a deduction from the class of
stock to which they relate.
V. Preferred Stock
Preferred stock is the term used to describe a class of stock that possesses certain preferences or features not
possessed by the common stock. The following features are those most often associated with preferred stock issues:
a.
b.
c.
d.
e.
Receive preference as to dividends.
Receive preference as to assets in the event of liquidation.
Are convertible into common stock.
Are callable at the option of the corporation.
Nonvoting.
Some features used to distinguish preferred stock from common stock tend to be restrictive. For example,
preferred stock may be nonvoting, noncumulative, and nonparticipating. A corporation may attach whatever preferences or
restrictions in whatever combination it desires to a preferred stock issue so long as it does not specifically violate its state
incorporation law. The dividend preference of preferred stock is normally stated as a percentage of the preferred stock's par
value. For example, 9% preferred stock with a par value of $100, entitles its holder to an annual dividend of $9 per share.
following:
Certain terms are used to describe various features of preferred stock. These terms are the
a.
b.
c.
d.
Cumulative. Dividends not paid in any year must be made up in a later year before any profits can be
distributed to common stockholders. Unpaid annual dividends on cumulative preferred stock are referred to as
dividends in arrears.
Participating. Holders of participating preferred stock share with the common stockholders in any profit
distribution beyond a prescribed rate. This participation involves a pro rata distribution based on the total par
value of the outstanding preferred and common stock.
Convertible. Preferred stockholders may, at their option, exchange their preferred shares for common stock
on the basis of a predetermined ratio.
Callable. At the option of the issuing corporation, preferred shares can be redeemed at specified future dates
and at stipulated prices.
Sometimes, because of the features attached to it, an issue of preferred stock is more characteristic of debt than of
equity. At present, GAAP does not distinguish between preferred stocks and other classes of capital stock. The SEC, however,
has issued a rule that prohibits companies from combining preferred stock with common stock in financial statements, and the
general heading, stockholders' equity, should not include redeemable preferred stock.
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VI. Paid-in Capital Presentation
Additional paid-in capital arises from the issuance of capital stock. In addition, many other transactions result in
either an increase (credit) or decrease (debit) in additional paid-in capital. These transactions are indicated below.
Credits to Additional Paid-in Capital
a.
b.
c.
d.
e.
f.
Premiums on capital stock issued.
Sale of treasury stock above cost.
Additional capital arising in recapitalization or revisions in the capital structure (quasi reorganization).
Additional assessments on stockholders.
Conversion of convertible bonds or preferred stock.
Declaration of a "small" (ordinary) stock dividend.
Debits to Additional Paid-in Capital
a. Discounts on capital stock issued.
b. Sale of treasury stock below cost.
c. Absorption of a deficit in a recapitalization (quasi reorganization).
d. Declaration of a liquidating dividend.
1. Equity
1. See page 521 for presentation of SHE
2. On Converting: APIC is credited for MV – Par Value
 RE is Debited for (MV – BV of old shares)
3. Remember: Unrealized holding gains and losses on Available-for-sale securities that are
deemed to be temporary are ordinarily excluded from earnings.
i.
= OCI
4. Translation adjustments: G/L from translating Financial Statements from functional currency
to reporting currency.
= Other Comprehensive Income
 When foreign currency transactions results in a receivable or payable
i.
and is fixed in terms of the amount of foreign currency,
ii.
A change in exchange rate is gain or loss
= income from continuing operations in period of change
 G/L from hedge transaction = OCI
5. Remember that defined benefit pension plan?
i.
A liability must be recognized for any unfunded ABO (remember?)
ii.
Additional minimum liability is recognized if an unfunded ABO exist, and
a. an asset has been recognized as prepaid pension cost
b. Unfunded Accrued Pension Cost < Unfunded ABO
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c. No Accrued or prepaid pension cost exist.
Entry:

Debit: Intangible Asset
Credit: Liability
xx
xx
Additional Minimum Liability > Unrecognized Prior Service Cost = OCI
Calculation: (ABO-FV of PA = Unfunded + Prep. Cost = Addit. Min. Liab. – Urecog. PSC = OCI
2. Issuance of Stock
Accounting for Subscriptions of no-par stock.
 is same as for par value stock
i.
When stock is subscribed:
Debit: Subscription Receivable
Credit: Common Stock Subscribed
Credit: Additional PIC
xx
xx
xx
ii.
Subscription is paid for and stock is issued
Debit: Cash
xx
Debit: C/S Subscribed
xx
Credit: Sub. Receivables
xx
Credit: Common Stock
xx
Combined issuance of different classes of securities
 Allocate proceeds based on relative fair values of the securities
Stock issued for property or services:
i.
Record at FV of stock or of property or services received
3. Retirement
Debit: Contributed Capital (original amount)
Debit: Stock
Credit: Cash
xx
xx
xx
Chapter 8 Questions – Equity
Class 1: On February 1, 2002, Flap Flappy Corp., a newly formed company, had the following stock issued and outstanding:
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• Common stock, no par, $1 stated value, 10,000 shares originally
issued for $15 per share
• Preferred stock, $10 par value, 3,000 shares originally issued
for $25 per share
At February 1, 2002, how much should Flap Flappy’s Statement of Equity report for
a. Common Stock
b. Preferred Stock
c. Additional Paid-in Capital
a. Use Journal entries and T accounts to support your answer
Home 1: On June 1, 2004, Corp Corpy Corp., a newly formed company, had the following stock issued and outstanding:
• Common stock, $5.00 par value, 15,000 shares originally
issued for $10 per share
• Preferred stock, $25 par value, 10,000 shares originally issued
for $32 per share
At June 1, 2004, how much should Corp Corpy’s Statement of Equity report for
d. Common Stock
e. Preferred Stock
f. Additional Paid-in Capital
a. Use Journal entries and T accounts to support your answer
2. Issuance of Stock
Class 2: During 2001, Brad Brady Co. issued 5,000 shares of $100 par convertible preferred stock for $110 per share. One
share of preferred stock can be converted into three shares of Brad Brady's $25 par common stock at the option of the preferred
shareholder. On December 31, 2004, when the market value of the common stock was $40 per share, all of the preferred stock
was converted. What amount should Brad Brady credit to common stock and to additional paid-in capital -- common stock as a
result of the conversion?
Use Journal entries and T accounts to support your answer
Home 2: If Brad Braddy converted on 40% of its preferred stock at December 31, 2004 and the market price was $30 per
share, What amount should Brad Brady credit to common stock and to additional paid-in capital -- common stock as a result of
the conversion?
Use Journal entries and T accounts to support your answer
Class 3: East Easty Co. issued 1,000 shares of its $5 par common stock to Howe as compensation for 1,000 hours of legal
services performed. Howe usually bills $160 per hour for legal services. On the date of
issuance, the stock was trading on a public exchange at $140 per share. By what amount should the additional paid-in capital
account increase as a result of this transaction? Use Journal entries and T accounts to support your answer.
Home 3: If East Easty usually bills at $175 per hour and the stock is trading at $165, by what amount should the additional
paid-in capital account increase as a result of this transaction? Use Journal entries and T accounts to support your answer .
3. Retirement
Class 4: The following accounts were among those reported on Luna Corp.'s balance sheet at December 31, 2001:
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Securities (fair value $150,000)
$ 80,000
Preferred stock, $20 par value
20,000 shares issued and outstanding
400,000
Additional paid-in capital on preferred stock 30,000
Retained earnings
900,000
On January 20, 2002, Luna exchanged all of the securities for 5,000 shares of Luna's preferred stock. Fair values at the date of
the exchange were $150,000 for the securities and $30 per share for the preferred stock. The 5,000 shares of preferred stock
were retired immediately after the exchange. What is the entry to record this exchange?
Home 4: Stack Stacky Corp. had outstanding 2,000 shares of 11% preferred stock, $50 par. On August 8, 2002, Stack Stacky
redeemed and retired 25% of these shares for $22,500. On that date, Stack Stacky's additional paid-in capital from preferred
stock totaled $30,000. To record this transaction, Stack Stacky should debit (credit) its capital accounts as follows:
Preferred Additional
Retained
Stock Paid-in Capital Earnings
---------------------------------$25,000 $7,500
$0
What is the journal entry to support this transaction?
Galilee College © 2007
Chapter 9 – Shareholders’ Equity: Retained Earnings
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OVERVIEW
Stockholders' Equity: Retained Earnings
Chapter 16 concludes the discussion of stockholders' equity. In addition to contributed capital, which was
discussed in Chapter 15, the stockholders' equity section of a corporate balance sheet discloses the entity's earned capital. This
chapter focuses on the different types of dividends. It’s an easy chapter.
I. Retained Earnings
Basically, retained earnings is a credit balance that represents the excess of all corporate operating net incomes
over all corporate operating net losses, less any dividends distributed to stockholders. This account is an accumulation of all
the earnings a corporation has acquired since its inception reduced by losses and dividend distributions. The basic increases
and decreases that occur in retained earnings are represented by the items noted below.
Increases in Retained Earnings
a. Net income.
b. Prior period adjustments (error corrections) and certain changes in accounting principles.
c. Adjustments due to quasi-reorganization.
Decreases in Retained Earnings
a. Net loss.
b. Prior period adjustments (error corrections) and certain changes in accounting principles.
c. Cash or scrip dividends.
d. Stock dividends.
e. Property dividends.
f. Some treasury stock transactions.
II. Dividends – general discussion
1. Very few companies pay dividends in amounts equal to their legally available retained earnings. The major
reasons are: (a) agreements with creditors, (b) state corporation laws, (c) to finance growth or expansion, (d) to provide for
continuous dividends whether in good or bad years, and (e) to build a cushion. If a company is considering declaring a
dividend, two preliminary questions must be asked: (a) Is the condition of the corporation such that the dividend is legally
permissible? and (b) Is the condition of the corporation such that a dividend is economically sound?
2 Twenty-two states permit distributions to stockholders as long as the corporation is not insolvent-insolvency is
defined as the inability to pay debts as they come due in the normal course of business. Another 18 states permit distributions
when (a) the corporation is solvent and (b) the distributions do not exceed the fair value of the assets. The remaining states use
a variety of hybrid restrictions that consist of solvency and balance sheet tests of liquidity and risk.
3. Before a dividend is declared, management must consider availability of funds to pay the dividend. Directors must
also consider the effect of inflation and replacement costs before making a dividend commitment.
4. The SEC encourages companies to disclose their dividend policy in their annual report. For example, companies
that (a) have earnings but fail to pay dividends or (b) do not expect to pay dividends in the foreseeable future are encouraged to
report this information. In addition, companies that have had a consistent pattern of paying dividends are encouraged to
indicate whether they intend to continue this practice in the future.
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III. Types of Dividends
Dividends may be paid in cash (most common means), stock, scrip, or some other asset. Dividends other than a
stock dividend reduce the stockholders' equity in a corporation through an immediate or promised distribution of assets. When
a stock dividend is declared, the corporation does not pay out assets or incur a liability. It issues additional shares of stock to
each shareholder and nothing more.
1. Cash Dividends
The accounting for a cash dividend requires information concerning three dates: (a) date of declaration, (b) date of
record, and (c) date of payment. A liability is established by a charge to retained earnings on the declaration date for the amount of
the dividend declared. No accounting entry is required on the date of record. The stockholders who have earned the right to the
dividend is determined by who owns the shares on the date of record. The liability is liquidated on the payment date through a
distribution of cash. The following journal entries would be made by a corporation that declared a $50,000 cash dividend on March
10, payable on April 6 to shareholders of record on March 25.
Declaration Date (March 10)
Retained Earnings
Dividends Payable
50,000
50,000
Record Date (March 25)
No entry
Payment Date (April 6)
Dividends Payable
Cash
50,000
50,000
2. Property Dividends
Property dividends represent distributions of corporate assets other than cash. According to APB Opinion No. 29, a
property dividend is a nonreciprocal transfer of nonmonetary assets between an enterprise and its owners. Such transfers should
be recorded at the fair value of the assets transferred. Fair value is measured by the amount that would be realized in an outright
sale near the time of distribution. When the property dividend is declared, fair market value should be recognized in the accounts
with the appropriate gain or loss recorded. The fair market value then serves as the basis used in accounting for the property
dividend. For example, if a corporation held stock of another company that it intended to distribute to its own stockholders as a
property dividend, it would first be required to make sure the carrying amount reflected current market value. If on the date the
dividend was declared the difference between the cost and market value of the stock to be distributed was $75,000, the following
additional entry would be made.
Investment in Securities
Gain on Appreciation of Securities
75,000
75,000
3. Scrip Dividends
A scrip dividend means that instead of paying the dividend now, the corporation has elected to pay it at some later date.
Scrip dividends are normally declared when the corporation has a sufficient credit balance in retained earnings but is short of cash.
When a scrip dividend is declared, a special form of note is issued to stockholders.
4. Liquidating Dividends
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Liquidating dividends represent a return of the stockholders' investment rather than a distribution of profits. In a more
general sense, any dividend not based on profits must be a reduction of corporate capital, and to that extent, it is a liquidating
dividend.
5. Stock Dividends
A stock dividend can be defined as a capitalization of retained earnings that results in a reduction in retained earnings
and a corresponding increase in certain contributed capital accounts. Total stockholders' equity remains unchanged when a stock
dividend is distributed. Also, all stockholders retain their same proportionate share of ownership in the corporation.
When the stock dividend is less than 20-25% of the common shares outstanding at the time of the dividend declaration,
generally accepted accounting principles (GAAP) require that the accounting for stock dividends be based on the fair market value of
the stock issued. When a stock dividend is declared, Retained Earnings is debited at the fair market value of the stock to be
distributed. The entry includes a credit to Common Stock Dividend Distributable at par value times the number of shares, with any
excess credited to Paid-in Capital in Excess of Par. Common Stock Dividend Distributable is reported in the stockholders' equity
section between the declaration date and date of issuance. For example, consider the following set of facts. Vonesh Corporation,
which has 50,000 shares of $10 par value common stock outstanding, declares a 10% stock dividend on December 3. On the date of
declaration the stock has a fair market value of $25 per share. The following entry would be made when the stock dividend is declared:
Retained Earnings
(5,000 ´ $25)
Common Stock Dividend Distributable
Paid-in Capital in Excess of Par
125,000
50,000
75,000
When the stock is issued, the entry is:
Common Stock Dividend Distributable
50,000
Common Stock
50,000
If the number of shares issued in a stock dividend exceeds 20 or 25% of the shares outstanding, only the par
value of the shares issued is transferred from retained earnings.
IV. Stockholders’ equity presentation
An example of a comprehensive stockholders' equity section taken from a balance sheet is given in the textbook. A
company should disclose the pertinent rights and privileges of the various securities outstanding. Examples of information that
should be disclosed are dividend and liquidation preferences, participation rights, call prices and dates.
Statements of stockholders' equity are frequently presented in the following basic format:
a.
b.
c.
d.
V.
Balance at the beginning of the period.
Additions.
Deductions.
Balance at the end of the period.
Other Issues
1. Stock Split
A stock split results in an increase or decrease in the number of shares outstanding with a corresponding decrease or increase in
the par or stated value per share. No accounting entry is required for a stock split as the total dollar amount of all stockholders' equity
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accounts remains unchanged. A stock split is usually intended to improve the marketability of the shares by reducing the market price
of the stock being split.
2. Preferred Stock Dividends
Preferred stock generally has a preference in the receipt of dividends. Preferred stock can also carry certain features
which require consideration at the time a dividend is declared and at the time of payment. These features, which were presented in
Chapter 15 along with the discussion of preferred stock, are (a) the cumulative feature, and (b) the participating feature. The text
material includes computational examples of these features in various combinations showing their impact on dividend distributions
when both common and preferred stock are involved.
3. Appropriated-Retained Earnings
An appropriation of retained earnings serves to restrict retained earnings for a specific purpose. In general, the
reasons for retained earnings appropriations concern the corporation's desire to reduce the basis upon which dividends are
declared (unappropriated credit balance in retained earnings). In an indirect manner, this process serves to limit the outflow of
assets in the form of dividends. Retained earnings appropriations require approval by the board of directors of a corporation,
and, according to FASB Statement No. 5, must be clearly identified as appropriations of retained earnings in the stockholders'
equity section of the balance sheet.
To establish an appropriation of retained earnings, a corporation prepares a journal entry, debiting unappropriated
retained earnings and crediting a specific appropriations account (for example Retained Earnings Appropriated for Sinking
Fund). Notice that the entry is confined to stockholders equity accounts and does not directly affect corporate assets. The only
way to dispose of an appropriation of retained earnings is to reverse the entry that created the appropriation.
4. Ratios using stockholders’ equity:
Several ratios use stockholders' equity related amounts to evaluate a company's profitability and long-term
solvency. The following four ratios are discussed and illustrated in the chapter: (1) rate of return on common stock equity, (2)
payout ratio, (3) price earnings ratio, and (4) book value per share.
a.
Rate of return on
Net income – Preferred dividends
common stock equity = Average common stockholders' equity
(1)
Trading on the equity at a gain. When the return on total assets is lower than the rate of return on the
common stockholders' investment.
b.
Cash dividends
Payout ratio = Net income – preferred dividends
c.
Market price of stock
Price earnings ratio = Earnings per share
d. Book value per share =
Common stockholders' equity
Outstanding shares
5. Quasi-Reorganizations
Appendix 16-A discusses in detail quasi-reorganizations. A corporation that has accumulated a large debit
balance in retained earnings (deficit) may, under the law of certain states, enter into a process known as a quasi-
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reorganization. Two accounting procedures exist for a quasi-reorganization (a) deficit reclassification, and (b) accounting
reorganization. Deficit reclassification, the simpler of the two methods, results solely in eliminating a deficit in retained earnings
without restating assets or liabilities. The accounting procedure is limited to a reclassification of a deficit in reported retained
earnings as a reduction of paid-in capital.
The more complex accounting procedure used in a quasi-reorganization is the accounting reorganization. This
procedure consists of the following steps:
a. All assets are revalued at appropriate current values so the company will not be burdened with excessive
inventory or fixed asset valuations in following years. Any loss on revaluation increases the deficit.
b. Paid-in or other types of capital must be available or must be created, at least equal in amount to the deficit. If
no such capital exists, it is created through donation of stock to the corporation by stockholders, by reduction of
the par value of shares outstanding, or by some similar means.
c. The deficit is then eliminated by a charge against paid-in capital.
In addition to the steps above, a quasi-reorganization requires (1) approval by stockholders, (2) fair and unbiased valuation of
assets, (3) a zero balance in retained earnings at the conclusion of the reorganization, (4) the date of the quasi-reorganization
shown with retained earnings for the succeeding 10 years, and (5) that the amount of the deficit eliminated be disclosed in the
balance sheet for three years.
1. Cash Dividends
1. Stock Dividends can be rescinded, but not cash dividends
2. Declaration of cash Dividend
Payment of Dividend
Debit: R/E
xx
Div. Pay
xx
Credit: Dividends Payable
xx
Cash

xx
For cumulative P/S ( disclose the aggregate and per share amount on b/s)
2. Property Dividends
(nonreciprocal transfer of nonmonetary assets to owners = FV of assets transferred.
Write up securities to Fair Values and recognize gain
On Declaration: Debit R/E & Credit Div. Payable
On Distribution: Debit Div. Payable & Credit investment
3. Scrip Dividends
Upon Declaration
R/E
S/D or N/P
1. Interest accrued
Interest Expense
Interest Payable
xx
xx
xx
xx
Liquidating Dividends
 Liquidating Dividends = distribution in excess of R/E
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-
Effect is to decrease contributed capital
= Return of capital
1. Once declared, a dividend must be paid (that is reason for crediting div. Payable)
2. Portion of cash that is not liquidating decreases R/E
Stock Dividends and Splits
1. .>20% - 25% (large stock divided) – Does not affect APIC
Debit: R/E (par/stated value)
xx
Credit: Stock (par/stated value)
xx
2. <20% - 25% (small stock dividend) – APIC is affected
Debit : R/E (FV of Stock)
xx
Credit: Stock (par/stated value)
xx
Credit: APIC (FV – Sock Val.)
xx
3. Recipient: No entry is made to record receipt of stock dividend, However
 Memo entry to record additional shares.
4. Stock Split = (increase shares and decrease par by number of split)
Appropriations of Retained Earnings
1. Amounts transferred from an appropriated R/E account will not be included in income.
2. Appropriation is shown in SHE section
 Purpose: to restrict R/E available for dividends, and not to set aside assets
1. if material, require:
i.
Separate recording of cash in balance sheet
ii.
Footnote Disclosure
iii.
Possibly reclassification as noncurrent
 When appropriation is no longer needed, please cancel out
Cost Method of Accounting for Treasury Stock
1. Remember: Treasury Stock is a contra SHE account
Debit: T/S (purchase price)
xx
Credit: Cash
xx
 If acquisition price is less than book value, book value will decrease
 Excess of proceeds over cost of t/s sold does not effect R/E
2. Donation of an entity’s shares to the entity is Treasury stock (measure at FV)
 No effect on SHE
Debit T/S
xx
Credit: Gain
xx
Par Value Method
Original Entry
Cash
12
80
C/S
APIC
Purchase T/S
Debit: T/S (par value)
Debit: APIC
Debit : R/E
Credit: Cash
10
2
10
2
3
15
Stock Rights
Remember: When issue P/Stock with detachable warrants for price > PV & MV
i.
Consideration must be allocated between P/Stock and D/W
ii.
Warrant allocation = APIC or Contributed capital
a. When Warrants are exercised
i.
Contributed Capital will reflect cash received and carrying value of warrants
 Total SHE will increase only by amount of cash received
- Carrying amount of warrants is already included in Total SHE
- Entries (upon exercising)
Cash
10
P/S
9
APIC
1
Note: Issuance of Rights without consideration
i.
Memorandum entry only
ii.
Upon Exercise
Cash
xx
C/S
xx
APIC
xx
1. Original cost of shares of stock should be allocated between
 stock & stock right
 based on relative fair values
Chapter 9 Questions – Shareholder’s Equity: Retained Earnings
1. Dividends
81
Class 1: On December 31, 2005. Peat Peaty declared and paid $250,000 of dividends. No dividends were declared in 2004.
Preferred Stock: 10,000, Par Value $10.00, 10%. Common Stock: 200,000, $2.00 Par Value. Prepared a schedules to
distribute dividend assuming the following: P/S i. (non cumulative and non participating, ii. (cumulative and non participating
and iii. (cumulative and participating).
Home 1 – On December 31, 2006. Hume Humey declared and paid $500,000 of dividends. No dividends were declared in
2003, 2004 and 2005. Preferred Stock: 50,000, Par Value $20.00, 8%. Common Stock: 400,000, $5.00 Par Value. Prepared
a schedules to distribute dividend assuming the following: P/S i. (non cumulative and non participating, ii. (cumulative and
non participating and iii. (cumulative and participating).
1. Property Dividends
Class 2: On December 1, 2002, Prop Propy Corp. declared a property dividend to be distributed on December 31, 2002 to
shareholders of record on December 15, 2002. On December 1, 2002, the property to be transferred had a carrying amount of
$60,000 and a fair value of $78,000. What is the effect of this property dividend on Prop Propy's 2002 retained earnings, after all
nominal accounts are closed? Show all journal entries and T Accounts.
Home 2: On December 1, 2004, Drop Dropy Corp. declared a property dividend to be distributed on December 31, 2004 to
shareholders of record on December 15, 2004. On December 1, 2004, the property to be transferred had a carrying amount of
$100,000 and a fair value of $150,000. What is the effect of this property dividend on Drop Dropy's 2002 retained earnings, after
all nominal accounts are closed? Show all journal entries and T Accounts.
3. Scrip Dividends
Class 3: West Westy East Corp., a calendar-year company, had sufficient retained earnings in 2002 as a basis for dividends
but was temporarily short of cash. West Westy declared a dividend of $100,000 on April 1, 2002 and issued promissory notes to
its shareholders in lieu of cash. The notes, which were dated April 1, 2002, had a maturity date of March 31, 2003 and a 10%
interest rate. How should West Westy account for the scrip dividend and related interest?
Home 3: Best Besty East Corp., a calendar-year company, had sufficient retained earnings in 2004 as a basis for dividends but
was temporarily short of cash. Best Besty declared a dividend of $150,000 on April 1, 2004 and issued promissory notes to its
shareholders in lieu of cash. The notes, which were dated July 1, 2005, had a maturity date of November 30, 2006 and a 10%
interest rate. How should Best Besty account for the scrip dividend and related interest?
4. Liquidating Dividends
Class 4: On January 2, 2004, Lake Lakey Mining Co.'s board of directors declared a cash dividend of $400,000 to
shareholders of record on January 18, 2004, payable on February 10, 2004. The dividend is permissible under law in Lake
Lakey's state of incorporation. Selected data from Lake Lakey's December 31, 2003 balance sheet are as follows:
Accumulated depletion
$100,000
Capital stock
500,000
Additional paid-in capital
150,000
Retained earnings
300,000
What is the entry to record the liquidating dividend?
Home 4: On March 31, 2003 Fake Fakey Manufacturing Co.'s board of directors declared a cash dividend of $1,000,000 to its
shareholders of record on March 31, 2003, payable on April 30, 2003. The dividend is permissible under law in Fake Fakey's
state of incorporation. Information from Fake Fakey's December 31, 2002 balance sheet are as follows:
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Capital stock
2,500,000
Additional paid-in capital
300,000
Retained earnings
400,000
What is the entry to record the liquidating dividend?
5. Stock Dividends and Splits
Class 5: On January 2, 2004, Lake Lakey Mining Co.'s board of directors declared a cash dividend of $400,000 to
shareholders of record on January 18, 2004, payable on February 10, 2004. The dividend is permissible under law in Lake
Lakey's state of incorporation. Selected data from Lake Lakey's December 31, 2003 balance sheet are as follows:
Accumulated depletion
$100,000
Capital stock
500,000
Additional paid-in capital
150,000
Retained earnings
300,000
What is the entry to record the liquidating dividend?
Home 5: On March 31, 2003 Fake Fakey Manufacturing Co.'s board of directors declared a cash dividend of $1,000,000 to its
shareholders of record on March 31, 2003, payable on April 30, 2003. The dividend is permissible under law in Fake Fakey's
state of incorporation. Information from Fake Fakey's December 31, 2002 balance sheet are as follows:
Capital stock
2,500,000
Additional paid-in capital
300,000
Retained earnings
400,000
What is the entry to record the liquidating dividend?
Class 6: Nest Nesty Co. issued 100,000 shares of common stock. Of these, 5,000 were held as treasury stock at December 31,
2001. During 2002, transactions involving Nest Nesty's common stock were as follows:
May 3
- 1,000 shares of treasury stock were sold.
August 6
- 10,000 shares of previously unissued stock were sold.
November 18
- A 2-for-1 stock split took effect.
Laws in Nest Nesty's state of incorporation protect treasury stock from dilution. At December 31, 2002, how many shares of
Nest Nesty's common stock were issued and how many were outstanding?
Home 6: Pest Pesty Co. issued 200,000 shares of common stock. Of these, 20,000 were held as treasury stock at December
31, 2003. During 2004, transactions involving Pest Pesty's common stock were as follows:
January 5th
- 5,000 shares of treasury stock were sold.
April 10th
- 15,000 shares of previously unissued stock were sold.
June 9th
- 3,000 shares of treasury stock were sold
August 15th
- A 3 -for-1 stock split took effect.
Laws in Pest Pesty's state of incorporation protect treasury stock from dilution. At December 31, 2004, how many shares of Pest
Pesty's common stock were issued and how many were outstanding?
6. Appropriations of Retained Earnings
Class 7: At December 31, 2001, Plick Plicy Corp. reported $1,750,000 of appropriated retained earnings for the construction of
a new office building, which was completed in 2002 at a total cost of $1.5 million. In 2002, Plick Plicy appropriated $1.2 million of
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retained earnings for the construction of a new plant. Also, $2 million of cash was restricted for the retirement of bonds due in
2003. In its 2002 balance sheet, Plick Plicy should report what amount of appropriated retained earnings?
Home 7: At December 31, 2004, Stick Plicy Corp. reported $2,000,000 of appropriated retained earnings for the construction of
a manufacturing plant, which was completed in 2004 at a total cost of $1,300,000. In 2005, Stick Plicy appropriated $1,000,000
million of retained earnings for the construction of a bottling plant. In its 2005 balance sheet, Stick Plicy should report what
amount of appropriated retained earnings?
7 & 8 Cost & Par Value Methods of Accounting for Treasury Stock
Class 8: The following relates to Ben Benny Corporation:On January 1, 2006 Ben Benny Corporation issued 200,000 shares of $5.00 Par Value stock for $7.00 per share.
On February 9, 2006 Ben Benny purchased 90,000 of the shares from shareholders at $9.00 each to hold as treasury stock.
On March 11, 2005, Ben Benny reissued the 90,000 share held in treasury at 10.00 per share.
Instruction:- Record all transactions using the (i) Cost Method, and (ii) Par Value Method.
Home 8: The following relates to Tren Trenny Corporation:On January 12, 2006 Tren Trenny Corporation issued 150,000 shares of $10.00 Par Value stock for $13.00 per share.
On March 18, 2006 Tren Trenny issued an additional 50,000 shares for $13.00 per share.
On May 15, 2006 Tren Trenny purchased 100,000 of the shares from shareholders at $8.00 each to hold as treasury stock.
On June 27, 2005, Tren Trenny reissued the 100,000 share held in treasury at 12.00 per share.
Instruction:- Record all transactions using the (i) Cost Method, and (ii) Par Value Method.
9. Stock Rights
Class 9: On March 4, 2002, Dret Dretty Co. purchased 1,000 shares of LVC common stock at $80 per share. On September
26, 2002, Dret Dretty received 1,000 stock rights to purchase an additional 1,000 shares at $90 per share. The stock rights had
an expiration date of February 1, 2003. On September 26, 2002, LVC's common stock had a fair value, ex-rights, of $95 per
share, and the stock rights had a fair value of $5 each. What amount should Dret Dretty record on September 26, 2002 for
investment in stock rights?
Home 9: On January 1, 2005, Bret Bretty Co. purchased 10,000 shares of Lip Lippy common stock at $100 per share. On June
3, 2005, Bret Bretty received 10,000 stock rights to purchase an additional 10,000 shares at $110 per share. The stock rights
had an expiration date of April 4, 2006. On November 2, 2005, Lip Lippy’s common stock had a fair value, ex-rights, of $90 per
share, and the stock rights had a fair value of $10 each. What amount should Bret Bretty record on November 2, 2005 for
investment in stock rights?
Appendix 1 – Accounting Terms
84
Accounts Payable: Accounts of money you owe. A liability that is usually created when you've made a purchase on credit.
Accounts Receivable: Accounts of money owed to you for the sale of goods or services.
Accrual basis: A method of accounting where transactions are recorded as they occur regardless of when payment for that
transaction is made or received
Accrued Assets: Assets from revenues earned but not yet received.
Accrued Expenses: A liability incurred during the accounting period for which payment has not been made.
Accrued Income: Income earned during an accounting period but not received/recorded by the end of the period.
Aging: The grouping of like transactions by date. Example - sorting invoices by due date.
Adjusting Entries: Special accounting entries that are made when you close the books at the end of an accounting period
to bring the ledger up to date.
Asset: Items that a business or individual owns or are owed.
Audit: The scrutinizing of accounting records and supporting documents for accuracy and completeness.
Audit trail: The information within the accounting system that reveals the effects of a transaction.
Bad Debt: An account or receivable that has been deemed unrecoverable and written-off.
Balance Sheet: A statement listing the total assets and liabilities; indicating the net worth of the company for the given time
period.
Capital: The right to assets of the owner of a business..
Cash basis: An accounting method where transactions are recorded when the actual change of payment occurs, regardless
of when the goods or services are delivered.
Certified Financial Statements: Financial statements that have been audited and certified by a CPA.
Chart of accounts: A numerical listing of a business’s accounts.
Closing Entries: Journal entries made at the end of the period to return the balance in all accounts to zero and ready the
account for the next reporting period..
Credit: An entry on the right side of an account - decreases assets or increases liabilities.
Debit: An entry on the left side of an account - increases assets or decreases liabilities.
Depreciation: The allocation of the cost of a tangible, long-term asset over its useful life.
Expenses: The daily costs incurred in running a business.
Fiscal: A 12 month accounting period. Not necessarily a calendar year.
General Ledger: The master record of all the balance sheet and income statement account balances.
Gross profit: The amount of net sales minus the amount of cost of sales
Income statement: A statement that summarizes revenues and expenses.
Invoice: A form, sent from the seller to the buyer, listing the items bought, price, terms etc..
Journal: A chronological record of transactions, also known as the book of original entry.
Ledger: A book containing accounts to which debits and credits are posted from books of original entry.
Liability: A debt or obligation.
Net sales: The amount left when returns, discounts, and allowances are deducted from sales revenue.
85
Operating Expenses: The expenses that are incurred from the daily operation of the business.
Owners' equity: The owners' right to the assets of an entity.
Prepaid Expenses: Amounts that are paid in advance for product is not used up during the accounting period.
Post: The process of transferring amounts from a journal to the appropriate ledger accounts.
Purchase order: Written instructions to a vendor to ship and bill for the listed items.
Reversing Entry: An entry made to reverse a prior entry..
Trial Balance: A work sheet showing the balances in each account; used to prove the equality of debits and credits.
Appendix 2
Associate Degree Program (Accounting)
86
Appendix 3
Bachelor’s Program (Accounting)
87
Appendix 4
88
Accounting Courses Description
COURSE DESCRIPTION
ACCOUNTING
ACC 111 ACCOUNTING PRINCIPLES I
Introduction to the fundamental Principles of Accounting and its relationship to business. Includes the
basic accounting procedures from the business transaction through the journals and ledgers to the
financial statements. Emphasis is placed on principles and procedures in accounting for receivables,
payables, inventories, plant assets and payroll.
3 Semester Hours
ACC 112 ACCOUNTING PRINCIPLES II
Major emphasis is placed on the procedures involved in accounting for capital structure of corporations.
Includes accounting principles for partnerships, departmental operations, home and branch activities and
bond issues. Also introduced is basic Accounting procedures, fundamentals of Financial Statement
Analysis and Tax Accounting.
Prerequisite: ACC 111 3 Semester Hours
ACC 211 INTERMEDIATE ACCOUNTING I
Theories and problems involved in proper recording of transactions and preparation of financial
statements. Review of the accounting cycle, discussion of financial statements, analysis of theory as
applied to transactions relating to current assets, current liabilities, long-term investment and
presentation on the Balance Sheet.
Prerequisite: ACC 112 3 Semester Hours
ACC 212 INTERMEDIATE ACCOUNTING II
Detailed presentation of theory applied to plant and equipment, intangible assets, long-term debt, capital
stock and surplus; correction of errors of prior periods; analysis of financial statements and statement of
application of funds.
Prerequisite: ACC 211 3 Semester Hours
ACC 214 COST ACCOUNTING I
A Comprehensive study of the Manufacturing Business using a job order Cost Accounting system.
Prerequisite: ACC 112 3 Semester Hours
ACC 215 COST ACCOUNTING II
A Comprehensive study of the Manufacturing Business using a process Cost Accounting system and a
standard Cost Accounting system. Also studied is cost data for planning, control and decision making.
Prerequisite: ACC 214 3 Semester Hours
ACC 221 QUICKBOOKS ACCOUNTING
This course will familiarize students with the basic concepts from in QuickBooks. First time users of
QuickBooks will be introduced to the various features this accounting software has to offer. Using a
Windows environment, students will receive hands-on instruction as they work through scenarios of
entering data and setting up accounts.
3 Semester Hours
ACC 311
MANAGERIAL ACCOUNTING
89
This course stresses the use of accounting for Managerial planning and control. Emphasis is placed on
the role of accounting in decision making. It covers retailing, wholesaling, manufacturing and
administrative operations.
Prerequisite: ACC 112 3 Semester Hours
ACC 312 ADVANCED ACCOUNTING I
Property Acquisition, Revaluation and Retirement, Depreciation Principles and practices are studied in
greater depth. Intangible Assets, Current and long-term Debt, Pension Plans, Corporation formation and
Capital Stock transactions are covered.
Financial Statement analysis, Funds flow and related
statements are given thorough treatment. Frequent reference is made to pronouncements by the
Securities and Exchange Commission and the American Institute of Certified Public Accountants
(AICPA).
Prerequisite: ACC 212 3 Semester Hours
ACC 313 ADVANCED ACCOUNTING II
Accounting theory and current practices are studied in depth with emphasis on the concepts and
standards prevailing in the accounting profession. Coverage is afforded such topics as Partnerships
formation, Dissolution and Liquidation, Installment and Consignment Sales, Home Office and Branch
Accounting Consolidations.
Prerequisite: ACC 312 3 Semester Hours
ACC 314 GOVERNMENTAL ACCOUNTING
Study of accounting for governmental entities including: budgets, general funds, capital project funds,
debt service funds, trust and agency funds, fixed assets, capital expenditures, property tax accounting,
and interfund relationships. Also includes accounting standards for voluntary health and welfare
organizations, colleges, hospitals, and other types of not-for-profit organizations.
Prerequisite: ACC 212 3 Semester Hours
ACC 315 PRINCIPLES OF AUDITING
A practical presentation of modern audit practices, emphasizing the principles and objectives of an audit.
Analysis of the audit basis, the best standards, objective reporting, the adoption of improved accounting
standards, business controls, professional ethics, and legal liability.
Prerequisite: ACC 212
3 Semester Hours
ACC 321 INDIVIDUAL INCOME TAXES
The Internal Revenue Code, the various income tax acts, and problems of the preparation of U.S. tax
returns are studied as they relate to the individual. Emphasis is placed on the determination of income
and statutory deductions in order to arrive at the net taxable income.
Prerequisite: ACC 212 3 Semester Hours
ACC 322 CORPORATE INCOME TAXES
The U.S. Internal Revenue Code and the various income tax acts are studied as they relate to
partnerships, estates, trusts, and corporations. Federal estate tax return problems are considered.
Methods of tax research are integrated into each of the areas studied.
Prerequisite: ACC 321 3 Semester Hours
Appendix 5
90
Accounting News
On December 6, 2004, the American Institute of Certified Public Accountants
held a significant joint meeting at the Harbor Side Financial Centre in Jersey
City, New Jersey. At this joint session which included the National Association of
State Boards of Accountancy and the Prometric Testing Center, certain CPA
Review Providers were invited, which included, Dr. Irvin Gleim of Gliem
Publication, Dr. Willis L. Johnson, of the Galilee CPA Review, and other leaders
in the provisioning of CPA education. Both Dr. Gleim and Dr. Johnson attended
the original meeting for the new Computer Based Examination on December 15,
2003 a the AICPA headquarters in New York.
Dr. Johnson called for local CPA testing in the Bahamas and other countries
outside the U.S. Supported by Dr. Gleim and other review providers, Dr.
Johnson substantiated his plea by referring to charges for hotel, airline, meals, transportation and excessive time in the U.S. He
indicated that although the exams can now be taken in Miami, CPA candidates have experienced numerous difficulties that are
financially and emotionally burdensome. Dr. Johnson presented cases where the Prometric system either crashed,
malfunctioned or encountered other administrative difficulties.
Further he said, that the state boards take an unusual long time before a candidate can receive his or her Notice to Schedule.
Some time at least four month. While he said that these problems might exist if testing is locally done, at least, candidates will
be at home and the cost of rescheduling will not be difficult to bear.
During the session it was reported that some 308 Bahamian candidates sat the CPA exam in 2003. While the 2004 statistics
were not completed, Dr. Johnson indicated that there will be an increase in numbers due to the increase in his volume of
candidates engaged in the Galilee CPA Review Program.
As a result of the widespread support for local testing outside the U.S. , a task force was appointed to present a white paper to
the AICPA by mid January 2005. This white paper will address the following issues:




International volume
Disadvantages if the Exam is not administered outside the U.S.
Additional testing administrative fee
Internationally security issues
Examination Frequency
David Ginsburg, President and CEO of Prometric, who supports local testing in the Bahamas and other countries outside the
U.S will address security issues.
Gleim CPA Publications
Irvin N. Gleim, Ph.D., CIA, CMA, CFM, CPA, CFII, is Professor Emeritus, at the Fisher School of Accounting, University of
Florida. He has been active in both pilot and accountant training for over 30 years. His knowledge transfer systems make
learning and understanding an intuitively appealing process.
Dr. Gleim is helping individuals attain higher levels of knowledge (analysis, synthesis, and evaluation) while they learn concepts
and problem solving techniques. Dr. Gleim’s mission is to maximize knowledge transfer while minimizing time, frustration, and
cost.
Galilee CPA Review
91
Willis L. Johnson, Ph.D., CPA, MFP, Certified Marriage and Family Counselor serves as president of Galilee College and
Galilee Professional Institute. Dr. Johnson is a veteran lecturer. For the past five years he has been engaged in directing the
Galilee CPA Review program. He is known for his profound academic theatrics as he delivers the CPA curriculum. His success
rate is phenomenal and measures alongside other giants in the region.
The Galilee CPA Review is newly fueled and well prepared to provide quality instruction by way of a sophisticated approach that
will catapult candidates to the levels of success that they aspire to.
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