Chapter 14 Lecture
Income Taxes, Unusual Income
Items, and Investments in Stocks
P.H.
Corporate Income Taxes
Corporations are legal entities that must
pay federal income taxes

depending on the state, they may also be
required to pay state and local income
taxes
Most corporations are required to make
quarterly installments based on
estimated taxes
Corporate Income Taxes
Because income taxes often represent
a significant amount, they are normally
reported on the income statement as a
special deduction

earnings are reported before income
taxes, income taxes are deducted, and
earnings are restated after income taxes
Corporate Income Taxes
Payment of Income Taxes
March 15 Income Tax Expense
Cash
To record quarterly
payment of estimated income tax
21,000
21,000
Corporate Income Taxes
Allocation of Income Taxes
Taxable income is determined according to
the tax laws
Taxable income is often different from
“income before income taxes” as reported
on the Income Statement
There are several reasons for the differences,
including using the straight-line method of
depreciation for financial reporting purposes,
and using MACRS (Modified Accelerated
Cost Recovery System) for tax purposes
Corporate Income Taxes
Allocation of Income Taxes
The difference between “income
before income and taxes” as reported
on the income statement (which is
calculated based on GAAP) and
taxable income (which is calculated
according to tax laws), may need to be
allocated between various financial
statement periods.
Corporate Income Taxes
Allocation of Income Taxes
The total amount of taxes paid does not
not change. Only the timing of the
payment of taxes is affected.
This is because many managers use
tax-planning strategies to delay
(postpone, or defer) the payment of
taxes to later years.
Corporate Income Taxes
Allocation of Income Taxes Illustrated
To illustrate, assume that a corporation
reports $300,000 income before income
taxes on its income statement. If the
income tax rate is 40%, the income tax as
reported on the income statement is
$120,000 ($300,000 x .4).
Corporate Income Taxes
Allocation of Income Taxes Illustrated
The corporation uses tax planning
strategies to lower their taxable income to
$100,000 so that the amount of income
taxes they will pay in the current period is
$40,000 ($100,000 x .4).
The $80,000 difference ($120,000 $40,000) is created by timing differences
in recognizing revenue. This amount is
deferred to future years.
Corporate Income Taxes
Allocation of Income Taxes Illustrated
To match the current year’s expense
($120,000) against the current year’s
revenue, income tax is allocated between
periods as follows:
Income Tax Expense (income tax expense for the period)
120,000
Income Tax Payable (income tax due in the period)
40,000
Deferred Income Tax Payable (portion of income tax
80,000
for the period that is postponed to a future period)
To record income tax for the period.
Unusual Items that Affect the
Income Statement
1.
2.
3.
Discontinued operations
Extraordinary items that result in a
gain or loss
A change from one generally
accepted accounting principle to
another
These items are all reported separately in the income
statement.
Unusual Items that Affect the
Income Statement
Discontinued Operations
When a business segment (a major line
of business for the corporation) is
disposed of (discontinued), the resulting
gain or loss must be reported
separately from income from continuing
operations
A business segment could be a
department, a division, or a class of
customer
Unusual Items that Affect the
Income Statement
Extraordinary Items
Extraordinary items are events and
transactions that:
1.
2.
are unusual for the corporation and
occur infrequently
both conditions
must be true
Gains* and losses from extraordinary items
must be reported separately on the income
statement
Examples of extraordinary items include
floods, earthquakes, and fires (unless these
are normal for the area)
*It is possible to have a gain from an extraordinary item
Unusual Items that Affect the
Income Statement
Changes in Accounting Principles
A business may be required to change
its accounting principles based on a
new accounting standard issued by
FASB
A business may voluntarily change
from one generally accepted
accounting principle to another:


from FIFO to LIFO
from the straight line method to the units of production
method of depreciation
Unusual Items that Affect the
Income Statement
Changes in Accounting Principles
Changes in generally accepted accounting principles
should be disclosed on the face of the financial
statements or in the notes to the statements in the
period in which they occur
The disclosure should include the following
information:




the nature of the change
the justification for the change
the effect on the current year’s net income
the cumulative effect of the change on the net income of
prior periods
Unusual Items that Affect the
Income Statement
Changes in Accounting Principles
Note that errors in calculating a prior period’s income
due mistakes in applying accounting principles do
not fall under the category of changes in
accounting principles and are not reported on the
income statement as an unusual item. This type of
error falls under the category of a prior period
adjustment, and is reported in the retained
earnings statement
“Changes in Accounting Principles” applies only to a
change from one generally accepted accounting
principle to another generally accepted
accounting principle
Unusual Items that Affect the
Income Statement
Note the order of the three unusual
items as they appear in the income
statement for Jones Corporation in
your text:
first
1.
next
2.
last
3.
Discontinued Operations
Extraordinary Items
Changes in Accounting Principles
Unusual Items that Affect the
Income Statement
Why do you suppose these unusual
items should be reported separately
from continuing operations?
Unusual Items that Affect the
Income Statement
Because it allows investors to make
decisions about the corporation based
on continuing (normal) operations,
without consideration for activities that
are unusual and therefore unlikely to
re-occur
Earnings per Common Share
Net income is often used by investors to
evaluate a company’s profitability.
However, net income by itself is difficult to
use when comparing companies of
different sizes, or when using trend analysis
to compare this year’s results to prior
years’ results for the same company when
there have been significant changes in
stockholders’ equity.
Earnings per Common Share
Thus, the profitability of companies is
often expressed as earnings per
share.
Earnings per common share (EPS) is
the net income per share of common
stock outstanding during a period.
Earnings per Common Share
EPS =
Net income
Number of common shares outstanding*
or, if a company has preferred stock outstanding:
EPS =
Net income – Preferred stock dividends
Number of common shares outstanding
*When the number of common shares outstanding has changed
during a period, a weighted number of shares outstanding is used.
Earnings per Common Share
Corporations whose stock is traded on a public exchange
must report earnings per share on their income statements.
When unusual items exist, earnings per share should be
reported for those items separately.


However, only earnings per share for income from continuing
operations is required to be reported on the face of the income
statement.
The other per share amounts may be presented in the notes to the
financial statements.
When corporations have complex capital structures with
convertible preferred stock, options, warrants, etc., they are
required to also report diluted earnings per share, which
indicates the effect on earnings per share if such securities
are converted to common shares.
Reporting Retained Earnings
Changes in retained earnings could be
reported in any of the following ways:
 in a separate retained earnings
statement
 in a combined income and retained
earnings statement
 in a statement of stockholders’ equity
Reporting Retained Earnings
When a separate retained earnings
statement is prepared, the beginning
balance in retained earnings is
presented first. Next, if there are any
“prior period adjustments” (material
errors in a prior period’s net income that
are not discovered until the current
period), they are added or deducted
from this beginning balance.
Reporting Retained Earnings
Net income is then added (or net loss
deducted)
Dividends declared are deducted, and
The ending balance in retained
earnings is reported.
The retained earnings statement resembles the
statement of owner’s equity from Accounting 1.
Comprehensive Income
In 1997, FASB issued an accounting
standard requiring corporations to report
comprehensive income.
Comprehensive income is defined as
all changes to stockholders’ equity
during a period except those resulting
from dividends and stockholders’
investments.
Comprehensive Income
Under this standard, companies must
report traditional net income plus or
minus other comprehensive income
items.
These items include foreign currency
items, pension liability adjustments, and
unrealized gains and losses on
investments*.
unrealized gains and losses on investments is covered under short-term investments
in stock later in the chapter
Comprehensive Income
Companies must report comprehensive
income



on the income statement or
in a separate statement of comprehensive income,
or
in the statement of stockholders’ equity
Note that comprehensive income does not
affect the determination of net income or
retained earnings
Accounting for Investments in Stocks
Corporations may purchase the stock of
other companies for a number of
reasons:
short-term
long-term
to earn a return on excess cash
 to develop or maintain a business
relationship
 to gain control of another company

Accounting for Investments in Stocks
Short-Term Investments
A business may invest excess cash in
income-producing equity securities
(stock)
These investments may be quickly sold
and converted to cash as needed
These investments are recorded in a
current asset account called
Marketable Securities
Accounting for Investments in Stocks
Short-Term Investments: Journal Entries
June 1
Marketable Securities
Cash
180,000
180,000
Purchased 2,000 shares of
XYZ Corp. stock at $89.75 plus
$500 commission
Nov. 30 Cash
Dividend Revenue
Received dividend on XYZ
stock (2,000 shares x $.90)
1,800
1,800
Accounting for Investments in Stocks
Short-Term Investments
On the balance sheet, temporary
investments are reported at their fair market
value

Any difference between the fair market value and
cost is an unrealized gain or loss* and must be
added to or deducted from cost
The unrealized gain or loss must also be
reported as other comprehensive income
on the income statement
*The gain or loss is unrealized because the securities must be
sold in order for there to be a realized gain or loss.
Accounting for Investments in Stocks
Long-Term Investments
Long-term investments are not
intended as a source of cash in the
normal operations of the business
They are reported on the balance sheet
under the caption “Investments,” which
usually follows the Current Assets
section
Accounting for Investments in Stocks
Long-Term Investments
There are two methods of accounting
for long-term investments:
1.
the cost method
used when the buyer (the investor) has less
than 20% of the voting stock of the investee
2.
the equity method
used when the buyer has 20% or more of the
voting stock of the investee (a “significant
influence” over the investee)
Accounting for Investments in Stocks
Long-Term Investments: The Cost Method
Mar. 1
Investment in ABC Corp. Stock
5,940
Cash
5,940
Purchased 100 shares of
ABC Corp. common stock at 59
plus brokerage fee of $40
June 15 Cash
Dividend Revenue
Received dividend of $2 per
share on ABC Corp. stock
200
200
Accounting for Investments in Stocks
Long-Term Investments: The Cost Method
Note that the only difference in the journal
entries between the cost method used for
long-term investments in stock and the
journal entries used for short-term
investments in stock is the account debited
for the purchase of the stock
The entry to record the receipt of dividends is
the same
Accounting for Investments in Stocks
Short-term vs. Long-term (cost method): Purchase
Marketable Securities
XXX
short-term
Cash
XXX
Investment in ABC Corp. Stock XXX
long-term
(cost method)
Cash
XXX
Accounting for Investments in Stocks
Short-term vs. Long-term (cost method): Receipt of Dividends
Cash
XX
short-term
Dividend Revenue
Cash
long-term
(cost method)
XX
XX
Dividend Revenue
XX
Accounting for Investments in Stocks
Long-Term Investments: The Equity Method
Under the equity method, a stock
purchase is recorded in the same
manner as it is under the cost
method
The equity method differs from the cost
method in the way in which net income
and cash dividends of the investee
are recorded
Accounting for Investments in Stocks
Long-Term Investments: The Equity Method
Purchase
Jan. 2
Investment in DEF Corp. Stock
Cash
Purchased 40% of DEF
Corp. common stock.
350,000
350,000
Accounting for Investments in Stocks
Long-Term Investments: The Equity Method
Investee (DEF Corp.) Reports Net Income*
Dec. 31
Investment in DEF Corp. Stock
Income of DEF Corp.
42,000
42,000
Recorded our share
(40%) of DEF Corp. net income
of $105,000.
*This entry does not exist under the cost method of accounting for long-term
investments in stock.
Accounting for Investments in Stocks
Long-Term Investments: The Equity Method
Investee (DEF Corp.) Pays Dividends
Dec. 31 Cash
Investment in DEF Corp. stock*
18,000
18,000
Recorded our share
(40%) of dividends of $45,000 paid
by DEF Corp.
*Under the cost method, the credit would be to Dividend
Revenue.
Accounting for Investments in Stocks
Long-Term Investments: The Equity Method
Since the investor exerts a “significant
influence” over the investee by owning 20% or
more of the voting stock, the investor’s share of
the periodic net income of the investee is
recorded as an increase in the investment
account and as revenue for the period AND
The investor’s share of cash dividends from
the investee is recorded as an increase in the
cash account and a decrease in the
investment account
Accounting for Investments in Stocks
Sale of Investments
The accounting for the sale of stock is the
same for both short-term and long-term
investments
When shares of stock are sold, the investment
account is credited for the carrying amount
(book value) of the shares sold, the cash or
receivables account is debited for the
proceeds, and any difference between the
proceeds and the carrying amount is recorded
as a gain or loss on the sale
Accounting for Investments in Stocks
Purchase of Investment
On Feb. 27, Gourmet Corp. acquired 3,000 shares of the
50,000 shares (less than 20%) of Goulash Co. common
stock at 58 plus a commission charge of $420.
Feb. 27 Investment in Goulash
Cash
Purchased 3,000 shares
of Goulash Co. stock. [($58 x
3,000 shares) + $420]
174,420
174,240
Accounting for Investments in Stocks
Receipt of Dividends
On July 8, a cash dividend of $1 per share and a 2%
stock dividend were received.
July 8
Cash
Dividend Revenue
3,000
3,000
Received dividend on
Goulash Co. common stock ($1 x
3,000 shares)
No entry for stock dividends; carrying amount per share is now $57 ($174,240 /
(3,000 shares + 60 shares from the stock dividend)
Accounting for Investments in Stocks
Sale of Investment
On Dec. 7, 1,000 shares were sold at 62, less
commission charges of $375.
Dec. 7
Cash
Investment in Goulash
Gain on Sale of Investment
*1,000 shares x $57 carrying value per share
61,625
57,000*
4,625
Business Combinations
Merger
Consolidation
Parent/
Subsidiary
acquired corp.
is dissolved
original corps.
dissolved, new one
formed
neither is
dissolved
# of businesses
after
combination
1
1
2
# of financial
statements
prepared
1
1
consolidated
(combined)
statements
required
dissolution
Price-Earnings Ratio
The assessment of a firm’s growth
potential and future earnings
prospects is indicated by how much
the market is willing to pay per dollar of
a company’s earnings
A high P/E ratio indicates that the
market expects high growth and
earnings in the future
Price-Earnings Ratio
The price-earnings ratio on common
stock is computed by dividing the
stock’s market price per share at a
specific date by the company’s annual
earnings per share:
P/E ratio =
Market price per share
Earnings per share
Price-Earnings Ratio
A P/E ratio of 10 for a company
indicates that the market was willing to
pay ten times the earnings per share
for a share of stock in this company
Chapter 13: New Accounts
account
Marketable
Securities
category
normal balance
Current Asset
debit
Revenue
credit
Investment in X
Co. Stock
Investment
(non-current
asset)
debit
Gain on sale of
investment
revenue
credit
Loss on sale of
investment
expense
debit
Dividend
Revenue