FAR 2 Flashcards
List the five steps of revenue recognition.
Five Steps of Revenue Recognition Step 1—Identify the contract with a customer. Step 2—Identify the performance obligation(s) in the contract. Step 3—Determine the transaction price. Step 4—Allocate the transaction price to the performance obligation(s) in the contract. Step 5—Recognize revenue when the entity satisfies the performance obligation(s).
What are revenues?
“Inflows or other enhancements of assets of an
entity or settlements of its liabilities (or a
combination of the two) from delivering or
producing goods, rendering services, or other
activities that constitute the entity’s ongoing
major or central operations.” (606-10-20
Glossary
Describe the criteria used to identify separate
performance obligations.
A contract may include more than one
performance obligation. For a performance
obligation to be separate, the good or service
must be distinct from other goods or services in
the contract. A good or service is distinct if a
customer can benefit from the good or service
on its own.
What methods may be used to recognize
revenue when the performance obligation is
satisfied over time?
- Input method
2. Output method
How is a transaction price allocated across
multiple performance obligations?
The transaction price should be allocated to
the separate performance obligations
proportionately based on the stand-alone
pricing of the goods or services identified as
separate performance obligations.
A CPA has been asked by a client to describe revenue. Which of the following statements would be best for the CPA to use in his/her description?
Revenue is the inflows or other enhancements of assets of an entity or settlements of its liabilities from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.
Correct! Revenue is generated by the entity engaging in its central operations, which may include the sale of goods or the providing of services. Revenue may result in an enhancement of assets (e.g., receiving cash for goods or services) or the reduction or settlement of a liability.
FASB ASC 606, commonly referred to as the revenue recognition standard, includes all of the following in its five-step process to recognize revenue except
Recognize revenue when (or as) the entity is paid for a performance obligation.
Recognizing revenue as an entity receives payment is not part of the revenue recognition process and is in conflict with accrual accounting. This is not a step in the revenue recognition standard.
The following information is available about a signed agreement between two entities:
The entities have agreed to specific performance obligations.
The entities have agreed on a price related to the performance obligations.
No work has begun on the performance obligations, and the contract is cancelable without payment of penalty or other consideration.
It is probable that the company completing the work will collect the agreed-upon consideration.
Does a contract exist between the entities to which the revenue recognition criteria may be applied?
A contract to which the revenue recognition criteria applies does not exist because it is cancelable without penalty and no work on the performance obligations has begun.
A contract to which the revenue standard may be applied does not exist at this time, because of the ability to cancel the contract without penalty or payment of consideration and because work has not begun on the contract performance obligations. At this point, the entities should disregard revenue guidance to contracts.
Stacy Company enters into a contract with Molly Company on February 5. The contract requires Stacy to deliver 100 units of Product A and 250 units of Product B to Molly by September 1. Stacy is entitled to payment for Product A after 125 units of Product B have been delivered. The following deliveries are made by Stacy to Molly:
On March 15, Stacy delivers 100 units of Product A.
On May 21, Stacy delivers 100 units of Product B.
On August 1, Stacy delivers an additional 150 units of Product B.
The amounts related to Product A to be reported on Stacy’s March 31 balance sheet, June 30 balance sheet, and September 30 balance sheet, respectively, should be presented as a:
Contract Asset with conditional rights; Contract Asset with conditional rights; Accounts Receivable.
Stacy reports a Contract Asset on March 31 because it delivered Product A, but payment is conditional upon delivery of 125 units of Product B. Stacy continues to report a Contract Asset related to Product A on the June 30 balance sheet because 125 units of Product B have not yet been delivered. Stacy reports Accounts Receivable on the September 30 balance sheet because it satisfied the performance obligation related to the delivery of Product B that entitles Stacy to payment for Product A.
Kinnamont Company manufactures farming equipment that includes navigational systems as part of the standard equipment package and offers optional training on any navigational systems for an additional fee. Smith Company enters into a contract with Kinnamont that includes a combine, a navigational system, and training. Identify the performance obligations to which Smith should allocate the transaction price:
The combine including the navigational system and the training as two separate performance obligations.
Because the navigational system comes standard on the combine, the navigational system is not distinct from the combine and would not have a stand-alone price. The training is optional and is an additional fee, thereby giving it a stand-alone price. The contract has two performance obligations.
What are the two methods of determining
transaction price when a contract includes
variable consideration?
- Expected value approach
2. Most likely amount approach
Provide an example of a constraint on
estimating revenue based on variable
consideration.
If earning the variable consideration is based
on an uncertainty that is out of the company’s
control, such as weather or the volatility of the
stock market, then variable consideration is
constrained.
Also, if it is probable that a significant reversal
of revenue would occur, then variable
consideration is constrained.
Describe the journal entry to record sales
revenue when noncash consideration is
received.
The company will debit an asset account
consistent with the noncash consideration
received (e.g., a patent or investment) and
credit sales revenue. The amount will reflect
the fair value of the noncash consideration.
What type of account is Sales Discounts
Forfeited and what is its natural balance?
Revenue account presented as “Other Income”
Natural credit balance
When a significant financing component is
present in a sales contract, what revenue in
addition to sales revenue does the company
record?
Interest Revenue
Holt Company enters into a contract to build a new plant facility for Segal Company for $2,500,000. In the contract, Segal will pay a performance bonus of $100,000 if Holt is able to complete the facility by October 1, 20X6. The performance bonus is reduced by 50% for each of the first two weeks after October 1, 20X6. If the completion is delayed more than two weeks, then Holt forfeits the entire performance bonus. Holt’s prior experience with performance bonuses on similar contracts indicates the following probabilities of completion outcomes:
The image shows the following text: Completed by October 1, 2006 and its probability is 80%, Completed by October 8, 2006 and its probability is 10%, Completed by October 15, 2006 and its probability is 5%, and Completed after October 15, 2006 and its probability is 5%.
How much should Holt record as the transaction price of the contract and why?
$2,586,250 because Holt should use the expected value method
Because Holt has prior experience with similar contracts, Holt should use the expected value method, also referred to as the probability-weighted method, to estimate the variable consideration associated with this contract. Holt determines the transaction price using the following probabilities and amounts:The slide shows the following calculation:
80% chance of $2,600,000 = $2,080,000. 10% chance of $2,550,000 = $255,000. 5% chance of $2,525,000 = $126,250. 5 chance of $2,500,000 = $125,000. The result is $2,586,250.
The total transaction price, using the probability-weighted method is $2,586,250.
What method does a company use to determine the transaction price for a contract that includes variable consideration when the company has numerous other contracts with similar characteristics and there are more than two possible results?
Expected value method
A company should use the expected value method when there are more than two possible outcomes and the company has experience with contracts with similar characteristics. The company can use its experience to appropriately weight the probability of each outcome to calculate the expected value of the variable consideration.
Foghorn Company entered into a sales transaction in which it agreed to receive common stock from Leghorn Corporation as payment for services provided to Leghorn Corporation. The journal entry to record the receipt of payment for the sales transaction will include a
Debit to Leghorn Investment.
Foghorn will record the noncash consideration to an asset account reflective of the type of asset received. In this case, Foghorn is receiving another company’s stock as consideration and will record the receipt of the common stock by debiting an investment account.
ClipClop Company sells horseshoes to customers at a discount of 4% if the customer orders more than 10,000 horseshoes in a year. The price per shoe is $2. In April, Oats Company orders 4,000 horseshoes from ClipClop. Based on past experience with Oats Company, ClipClop expects Oats to meet the volume threshold of 10,000 horseshoes by the end of the year. What amount of revenue should ClipClop record in connection with the April sale?
$7,680
ClipClop should factor in the 4% volume discount because, based on past experience, Oats will meet the volume threshold to qualify for the discount. If Oats does not meet the volume discount, then ClipClop will record Sales Discounts Forfeited at a future date.
Describe how a single total transaction price is
allocated to multiple separate performance
obligations.
The total transaction price is allocated based
on the proportion of the total standalone
selling price represented by each performance
obligation. The proportion is found by dividing
the standalone price for the performance
obligation by the total of the standalone prices
for the performance obligations. The
proportion for each performance obligation is
then multiplied by the total transaction price to
determine the amount of the total transaction
price that will be allocated to each
performance obligation
List the two criteria required for a performance
obligation to be considered distinct.
- The customer must be able to benefit
from the good or service on its own or
with resources readily available. - The good or service must be able to be
separately identified from other promises
in the contract.
How is the transaction price allocated for a
contract with performance obligations that are
not distinct from each other?
If a contract contains promises that are not
distinct from each other, then the goods or
service promised in the contract represent a
single performance obligation. The total
contract price is allocated to the single
performance obligation.
If the standalone selling prices for performance
obligations are not directly observable, what
steps should a company take?
When the standalone selling prices are not
directly observable, then a company should
estimate the standalone selling prices.
The total standalone selling price for three
separate performance obligations in a contract
is $100,000. The first performance obligation
has a standalone selling price of $45,000. What
proportion of the total contract transaction
price should be allocated to the first
performance obligation?
Performance obligation 1 = 45,000/100,000 =
.45 or 45%
Wolf Company produces large pieces of machinery for use in the manufacturing industry. Blue Jay Manufacturing Company purchases a large piece of machinery from Wolf for use in Blue Jay’s new production plant. Although Blue Jay could install the equipment on its own, management decides to include installation of the machinery in its contract with Wolf. Blue Jay agrees to a total contract price of $850,000 for both the equipment and the installation. Wolf does not offer a discount on the machinery if it completes the installation. The fair value of the equipment is $850,000, and its cost is $760,000. The fair value of the installation is $50,000, and the cost of the labor to Wolf is $40,000. How much of the contract price should Wolf allocate to the equipment and installation respectively? If a proportion is necessary, round to the nearest one hundredth of a percent (e.g..####) and round all answers to the nearest dollar.
The table shows the following costs for Equipment and Installation:
A’s equipment is worth $850,000 and installation is worth $0.
B’s equipment is worth $800,000 and installation is worth $50,000.
C’s equipment is worth $807,500 and installation is worth $42,500.
D’s equipment is worth $802,740 and installation is worth $47,260.
Row D
Wolf should allocate the total contract price of $850,000 to the equipment and the installation based on the proportion of fair value each component represents. The total fair value of the transaction is $900,000 ($850,000 fair value of the equipment plus $50,000 fair value of the installation). The equipment represents 94.44% ($850,000 / $900,000) of the fair value of the transaction, and the installation represents 5.56% ($50,000 / $900,000) of the fair value of the transaction. To allocate the transaction price to the equipment, multiply the total contract price by the proportion of the fair value the equipment represents ($850,000 × .9444). To allocate the transaction price to the installation, multiply the total contract price by the proportion of the fair value the installation represents ($850,000 × .0556). Wolf should allocate $802,740 to sales revenue from the sale of the equipment and $47,260 to service revenue from the installation.
Mott Company purchases a machine from Janelle Company. Installation of the machine requires specialized knowledge that Mott Company does not possess. Janelle Company regularly includes installation as part of its sales contracts. The machine has a stand-alone price of $50,000, and the value of the installation is estimated to be $5,000. Mott agrees to purchase the machine for $50,000. How much of the contract price should be allocated to the machine and installation respectively?
The table shows the following costs for Machine and Installation:
A’s machine is worth $50,000 and installation is worth $5,000.
B’s machine is worth $50,000 and installation is worth $0.
C’s machine is worth $45,000 and installation is worth $5,000.
D’s machine is worth $45,455 and installation is worth $4,545.
Row B
Because the machine and the installation are interdependent (installation requires unique knowledge that only Janelle Company possesses), there is only one performance obligation in this contract. Installation is not a separate performance obligation so it is not allocated a portion of the transaction price.
Allocating a transaction price to multiple performance obligations includes which of the following steps:
Identify distinct goods and/or services as separate performance obligations.
Separate performance obligations should be identified based on goods and services that are distinct from each other. Once the separate performance obligations have been identified, then the transaction price may be allocated.
For a good or service to be considered distinct and identified as a separate performance obligation, it must be
Able to be used by the customer on its own or with resources readily available to the customer and able to be separately identified from other promises in the contract.
To be considered distinct, a good or service must meet two criteria. The customer must be able to benefit from the good or service on its own or with resources readily available, and the good or service must be distinguishable from other goods or services in the contract.
For a contract that contains multiple performance obligations, revenue is allocated to each performance obligation by
Calculating the proportion of the total stand-alone price represented by each performance obligation and multiplying the proportion by the total transaction price to allocate the transaction price to the separate performance obligations.
The stand-alone prices for the performance obligations are totaled, and each stand-alone price per performance obligation is divided by the total of the stand-alone prices to calculate the proportion of the transaction price that will be assigned to each performance obligation. The total transaction price is multiplied by each proportion, and the resulting amount is allocated to the performance obligation.
What type of account is Sales Returns and
Allowances?
What is its natural balance?
Sales Returns and Allowances is a contra-revenue
account.
SR&A has a natural debit balance.
When a consignee sells goods on consignment
from a consignor, what type of revenue will the
consignee most likely record?
Commission revenue
How are nonrefundable upfront fees accounted
for?
Revenue from nonrefundable up-front fees
should be recognized over the period that the
goods or services are expected to be delivered.
If the customer is expected to use the services
for two years, then the revenue from the
nonrefundable upfront fees is recognized
evenly over the two-year period.
List the criteria that must be met for an
arrangement to qualify as a bill-and-hold
arrangement.
A bill-and-hold arrangement must meet the
following criteria:
1. Substantive reason for the arrangement
(e.g., customer’s facility is not ready to
receive the goods).
2. Seller separates the goods from other
inventory and identifies them as
belonging to the customer.
3. Goods are currently ready for transfer.
4. Goods cannot be used by or directed to
another customer.
In a principal-agent consideration, what service
does the agent provide?
The agent facilitates the sales of goods or
services to the customer. Goods or services are
provided by the principal directly to the
customer, and the agent facilitates the sale and
connection between the customer and the
principal. The agent will likely recognize
commission revenue for facilitating the sale.
Describe the journal entry to record a
customer’s purchase of a service-type warranty
at its inception and the journal entry to record
warranty revenue.
The journal entry at the inception of a servicetype warranty typically includes a: debit to cash or accounts receivable a credit to unearned warranty revenue (a liability account).
As the time covered by the servicetype
warranty passes, the entity recognizes
warranty revenue by:
debiting the unearned
warranty revenue account (this decreases the
liability account)
crediting warranty revenue
On January 1, 20X2, Dot Company sold a three-year, service-type extended warranty to Matrix Company for $36,000. The warranty took effect on the date of purchase (January 1, 20X2). What amount of Unearned Warranty Revenue should be reported on Dot’s December 31, 20X3, Balance Sheet?
$12,000
By December 31, 20X3, two out of three years covered by the warranty have passed. The Unearned Warranty Revenue account would have one-third of the original amount left in it because Dot would recognize $12,000 of warranty revenue in each of the previous two years. $36,000 – $24,000 = $12,000 OR $36,000 × 1/3 = $12,000. Therefore, $12,000 in unearned warranty revenue would remain at December 31, 20X3.
Lavender Corporation sells 100 jars of essential oil to Bed, Bath, and Relax on December 1, 20X5, for $10 each. Lavender offers a right to return the product for any reason. Based on past sales, Lavender expects Bed, Bath, and Relax to return 5 jars. What adjusting journal entry, if any, should Lavender record on December 31, 20X5, to reflect Bed, Bath, and Relax’s right of return?
Sales Returned and Allowances 50
Allowance for Sales Return and Allowances 50
Lavender expects 5 jars at $10 each ($50 total) to be returned. The adjusting journal entry on December 31 reflects the right of return by debiting Sales Returns and Allowances (a contra-revenue account) and crediting Allowance for Sales Returns and Allowances (a contra-asset account to Accounts Receivable).
A shoe retailer allows customers to return shoes within 90 days of purchase. The company estimates that 5% of sales will be returned within the 90-day period. During the month, the company has sales of $200,000 and returns of sales made in prior months of $5,000. What amount should the company record as net sales revenue for new sales made during the month?
$190,000
The effect of estimated returns is recognized in the month of sale. Net sales to be reported for the current month equal $200,000 less the returns expected on those sales (5%, or $10,000), or $190,000. The actual returns granted in the current month on previous months’ sales were recognized as reductions in net sales in those previous months.
Sara consigns goods to Lee Company who charges a 10% commission on consignment sales. Lee sells $750 worth of goods on Sara’s behalf. Assuming no other costs of selling, what amount of Accounts Receivable should Sara record from Lee Company for the consignment sales?
$675
Sara will recognize the $75 (10% of $750) commission expense and record the account receivable net of the commission expense amount.
Sally collects a nonrefundable up-front fee of $192 when a new customer signs up for a 24-month contract for services. A monthly fee of $32 is also assessed for each customer. How much revenue does Sally record on the date the contract is signed?
$0
Sally does not recognize revenue until services have been provided. The nonrefundable up-front fee of $192 is recognized over the life of the contract, in this case, over 24 months.
For a contract modification to result in a new
separate contract, two criteria must be met.
Describe the two criteria.
- The goods or services covered in the
modification must be distinct from the
original goods or services. - The consideration for the additional
goods or services must reflect standalone
pricing.
When a contract modification does not result in
a new contract, describe how an entity should
calculate the price to recognize as revenue for
the remaining goods to be transferred to the
customer.
An entity may use a blended price approach. To
calculate the blended price per product, the
entity should multiply the remaining quantity
of products from the original contract by the
price from the original contract. Then the entity
should multiply the additional quantity by the
new price. The two resulting amounts are
added together to calculate the total revenue
left from the original contract and the contract
modification. The total is divided by the total
remaining quantity of product to be
transferred.
When are costs to fulfill a contract recorded as
an asset and amortized over the contract
period (i.e., the period that benefits from those
costs)?
Costs to fulfill a contract are recorded as an
asset that is amortized over the contract period
when the costs are directly traceable to the
contract and are incremental (i.e., the costs
would not have been incurred if the contract
had not occurred).
If a customer never uses a gift card, what
happens to the value?
A company may recognize “Forfeited Card
Revenue” when the gift card has expired or
when, based on past experience, the company
deems that the customer has effectively
forfeited the gift card.
In most cases, when will an initial franchise fee
be recognized as revenue?
In most cases, the initial franchise fee is
recognized over the time period when the
material services and conditions are provided
by the franchisor. The fee is recorded as
unearned revenue until the franchisor meets
the conditions under the franchise agreement
and recognizes the revenue.
On January 1, 20X5, Wren Co. leased a building to Brill under an operating lease for 10 years at $50,000 per year, payable the first day of each lease year. Wren paid $15,000 to a real estate broker as a finder’s fee. The building is depreciating $12,000 per year.
For 20X5, Wren incurred insurance and property tax expenses totaling $9,000. Wren’s net rental income for 20X5 should be
$27,500.
The finder’s fee benefits the entire lease term and therefore is allocated evenly over the 10-year lease term.
The finder’s fee represents a direct, incremental cost that benefits more than one period.
The slide shows the following calculation: Net rental income = rent revenue minus expenses associated with the property, that is 50,000 minus
($15,000/10 + $12,000 +$9,000) = $27,500.
North Co. entered into a franchise agreement with South Co. for an initial fee of $50,000. North received $10,000 at the agreement’s signing. The remaining balance was to be paid at a rate of $10,000 per year, beginning the following year. North’s services per the agreement were not complete in the current year. Operating activities will commence next year.
What amount should North report as franchise revenue in the current year?
$0
Before the franchisor (North) can recognize revenue, its activities pertaining to the franchise must be substantially complete. The earliest point at which substantial completion occurs is the commencement of operations by the franchisee. Operating activities will not begin until next year; therefore, North recognizes no fee revenue in the current year.
The $10,000 received is recorded in a liability account.
A new separate contract is created when:
The additional products included in the contract modification are distinct from the products in the original contract.
The blended price of the original and additional products is appropriately reflected in the recognition of revenue after the modification.
The consideration for the additional products reflects an appropriate standalone selling price.
I and III.
For a new separate contract to be formed, the additional products must be distinct and the consideration for the additional products must reflect appropriate standalone pricing.
A company enters into a contract to sell 50 products to a customer for $30 each. After the company transfers 30 of the 50 products, the customer wants an additional 25 products. The contract is modified and the additional 25 products are priced at $15 each, a price that is not reflective of the standalone selling price. What is the price per product for the remaining 45 products (20 products from the original contract and 25 products from the modification)?
$21.67, the blended price for the products from the original contract and the modification.
To calculate the blended price, 20 remaining products at $30 each represent revenue of $600 plus 25 additional products at $15 each represent revenue of $375. Total revenue left to be recognized over the remaining 45 products is $975. $975 divided by 45 products yields a blended price of $21.67 per product.
A company incurred costs to fulfill a contract that has a four-year life. The costs are a direct result of the contract and would not have been incurred had the contract not existed. How should the costs to fulfill the contract be accounted for?
Recorded as an asset and amortized over four years
The costs to fulfill the contract are a direct result of the contract so they are considered incremental. Because the contract is for four years, the company will benefit from the costs for a period exceeding one year. The costs should be recorded as an asset and amortized over the contract period of four years.
What is the effect on net assets of billing a
customer?
There is no effect.
When is the balance in construction in progress
the same for the percentage-of-completion
method and the completed contract method?
When an overall loss is expected on the
contract
Describe revenue recognition under the
completed contract method.
No revenue is recognized until the contract is
completed.
Why are billings on construction treated as a
contra to construction in progress?
To avoid double counting of assets
What is the accounting effect when a single
period loss occurs on a contract expected to be
profitable?
Total gross profit through the period is less
than the gross profit recognized in earlier
periods and the current period profit is
negative
Describe the revenue recognized under the
percentage-of-completion method for the
second year of a contract.
Total revenue through year 2 based on the
percentage of completion through year 2, less
revenue recognized for year 1
What is the contra account to construction in
progress?
The contra account is billings on contracts.
Describe the nature of the construction in
progress account.
It is an inventory account—a current asset.
What method is used under international
standards if the percentage-of-completion
method is not appropriate?
Cost recovery (zero-profit) method.
What is the amount of loss recognized in a
period under the percentage-of-completion
method when the estimated total project cost
exceeds the contract price and gross profit was
recognized in previous years?
Total project cost less contract price, plus gross
profit recognized in previous years
What is the percentage of completion of a
project when an overall loss on the contract is
expected?
Same as usual; total cost to date divided by
total estimated project cost
List the methods of revenue recognition for
long-term contracts.
Percentage of completion
Completed contract
What is the amount of loss recognized in a
period under the completed contract method
when estimated total project cost exceeds the
contract price?
Overall loss, which is the total project cost less
the contract price
Describe revenue recognition for the
percentage-of-completion method.
Recognize profit in proportion to the degree of
completion. This method is required if
estimates of the degree of completion at
interim points can be made and reasonable
estimates of the total project cost can be made.
Mill Construction Co. uses the percentage-of-completion method of accounting. During 20X5, Mill contracts to build an apartment complex for Drew for $20mn. Mill estimates that total costs would amount to $16mn over the period of construction.
In connection with this contract, Mill incurs $2mn of construction costs during 20X5. Mill bills and collects $3mn from Drew in 20X5.
What amount should Mill recognize as gross profit for 20X5?
$500,000
The project is 12.5% complete at the end of 20X5 ($2mn/$16mn). Total gross profit through the end of 20X5 is therefore $500,000 [= .125($20mn − $16mn)].
The $500,000 amount is the proportion of completion applied to the total contract profit of $4mn. 20X5 is the first year of construction; therefore no gross profit from previous years is subtracted. The entire $500,000 gross profit is recognized in 20X5.
Frame construction company’s contract requires the construction of a bridge in three years. The expected total cost of the bridge is $2mn, and Frame will receive $2.5mn for the project. The actual costs incurred to complete the project were $500,000, $900,000, and $600,000, respectively, during each of the three years. Progress payments received by Frame were $600,000, $1.2mn, and $700,000 in each year, respectively. Assuming that the percentage-of-completion method is used, what amount of gross profit should Frame report during the last year of the project?
$150,000
The gross profit recognized for the first two years must be computed first. Then, the difference between the $500,000 final total gross profit on the project (= $2.5mn − $2mn), and the gross profit for the first two years, is the amount of gross profit recognized in the last (third) year. The percentage of completion at the end of the first two years is 70% (= $500,000 + $900,000)/$2mn). The gross profit recognized through the end of year two is $350,000 [= .70($2.5mn − $2mn)]. Therefore, gross profit for year three is $150,000 (= $500,000 total gross profit on project − $350,000).
The calculation of the income recognized in the third year of a five-year construction contract accounted for using the percentage of completion method includes the ratio of
Total costs incurred to date to total estimated costs.
The proportion of completion at the end of any year for a construction contract is the amount of work done, divided by the total amount of work required for the contract. Typically, cost is the measure of “work done.” At the end of year three, the numerator is the cost incurred for all three years. The denominator is the total estimated cost of the project, which is the sum of
(1) the cost incurred for all three years so far, plus
(2) estimated costs to complete as of the end of year three.
The percentage of completion changes each year, because both the numerator and denominator change. The gross profit to be reported for year three is the profit for all three years (using the proportion of completion just computed), less the profit already reported in the first two years.
The following information relates to a contract through its second year. The contract price is $50,000.
Year 1 Year 2 Cost incurred through end of $10,000 $34,000 Estimated cost remaining at end of 30,000 20,000
Under the completed contract method, by what amount will pretax income for the second year be affected?
Reduced $4,000
Total estimated project cost at the end of year 2 is $54,000 ($34,000 + $20,000). Note that this problem provides cumulative cost, rather than cost by year. There is an overall loss on this contract. Overall loss = $54,000 – $50,000 (contract price) = $4,000. Under the completed contract method, the overall loss is recognized immediately.
At the end of the third year of a contract, total estimated project cost exceeds the contract price. In both of the first two years, the firm recognized gross profit on the contract under percentage of completion. What is the ending balance in the construction-in-progress account at the beginning of year four on the contract under the percentage-of-completion method (PC), and under the completed-contract method (CC), had that method been used?
PC
CC
PC - Cost to date less overall loss
CC - Cost to date less overall loss
An overall loss is expected, because total estimated cost exceeds contract price. Under PC, the construction-in-progress account is increased by cost and gross profit. If the gross profit is negative (an overall loss), the loss is subtracted from construction in progress. The loss recognized in the year as overall loss becomes evident includes any previous profit. Therefore, the previously recognized gross profit is removed when the total loss is recognized. Under CC, the same idea applies, except that there is no gross profit from previous years to remove. The ending construction-in-progress balance is the same for both methods.
Falton Co. has the following first-year amounts related to its $9mn construction contract:
Actual costs incurred and paid $2mn
Estimated costs to complete $6mn
Progress billings $1.8mn
Cash collected $1.5mn
What amount should Falton recognize as a current liability at year end, using the percentage-of-completion method?
$0
The percentage of completion is ($2mn)/($2mn + $6mn) = 25%. This is the ratio of cost incurred to date, divided by the total project cost, which is the sum of cost to date and estimated remaining costs. Gross profit recognized is therefore .25($9mn − $2mn − $6mn) = $250,000. The contract price is $1mn more than the total estimated project cost. At 25% complete, the firm recognizes $250,000 of gross profit. The construction-in-progress balance is therefore $2mn + $250,000 = $2.25mn, the sum of cost to date, plus gross profit to date. With billings only $1.8mn so far, the firm reports a net asset equal to the difference between $2.25mn, the balance in construction in progress, and $1.8mn of billings. Billings are contra to construction in progress for reporting. This $450,000 difference is labeled “cost and profit in excess of billings on long-term contracts” in the balance sheet. No current liability is reported, because the asset balance (construction in progress) exceeds billings.
Choose the correct statement regarding accounting methods for revenue recognition on long-term contracts, for international and US accounting standards.
International standards require the cost recovery method when the percentage of completion method is not appropriate.
Contrary to US GAAP, international standards require a modified version of completed contract—the cost recovery method, when the percentage of completion method is not allowed.
A contractor recognized $42,000 of gross profit on a contract at the end of year one of the contract under the percentage-of-completion method. At the end of year two, total estimated project cost exceeded the contract price by $100,000. What amount of loss is to be recognized for year two alone under the percentage-of-completion method (PC), and also under the completed-contract method (CC), had that method been used?
PC
CC
PC - −$142,000
CC - −100,000
The overall loss on this contract is $100,000—the excess of total estimated cost and contract price, as given in the problem. Under PC, the previously recognized gross profit (year one) must be removed. The $142,000 loss recognized in year two yields a $100,000 combined loss for both years—the amount of the overall loss. For CC, the overall loss is recognized immediately. There is no year-one gross profit to remove, because CC recognizes no gross profit until completion of the contract.
Howard Co. had the following first-year amounts for a $7,000,000 construction contract:
Actual costs $2,000,000
Estimated costs to complete 6,000,000
Progress billings 1,800,000
Cash collected 1,500,000
What amount should Howard recognize as gross profit (loss) using the percentage-of-completion method?
($1,000,000)
With $2,000,000 actual costs incurred in year 1 and $6,000,000 of costs remaining, the firm expects to spend a total of $8,000,000 on this project. The contract price is $7,000,000. Therefore, the firm expects to lose $1,000,000 on this contract ($8,000,000 – $7,000,000). The entire loss is recognized even though the percentage of completion is only 25% ($2,000,000/($2,000,000 + $6,000,000)). With no previous years’ profit, the loss recognized in year 1 is the full $1,000,000 (negative gross profit).
Define “pension expense.”
The cost to the firm of providing the
pension benefits earned during the
year.
What fund is available for retirement
benefits?
Pension assets at market value
List the two important rates used in
pension accounting.
- Discount rate
2. Expected rate of return
List the two types of pension plans.
- Defined benefit
2. Defined contribution
List the two terms for pension plans
pertaining to whether employees
provide funds for their plan.
Plans can be contributory or
noncontributory.
How do we compute projected benefit
obligation (PBO) at the balance sheet
date using components?
Service cost to date + Interest cost to
date − Benefits paid to date + Prior
service cost +/− Net PBO gain or loss to
date
What is the pension liability balance for
a defined contribution plan?
Amount of required contribution not
paid
What is the basis of accounting for
defined benefit plans?
Accrual is the basis of accounting for
these plans.
List the outside entities that provide
services for a sponsoring firm’s defined
benefit pension plan.
Actuary
Trustee
List the three attributes of defined
benefit plan accounting.
- Delayed recognition
- Net reporting
- Offsetting
Define “projected benefit obligation
(PBO).”
Obligation for defined benefit plans;
present value of unpaid benefits as of
the balance sheet date
At what amount are plan assets
reported?
Fair value
Define “service cost” as it relates to
pension plans.
Amount of pension expense reported if
interest cost and expected return are
equal. It is the present value of benefits
earned for a period.
Define “interest cost” as it relates to
pension plans, and show the
computation.
Growth in pension obligation for a period. Interest cost is the product of the projected benefit obligation at the beginning of year and the discount rate.
List the formula for the amount of
return used in computing periodic
pension expense.
Expected return = Rate of return ×
Beginning plan assets
What accounting events affect the net
pension gain or loss at the beginning of
the year?
Recognition of gains and losses for
projected benefit obligation (PBO) and
assets; amortization of previous net
gain or loss
List the two sources of pension gains
and losses.
- Changes in projected benefit
obligation (PBO) - Difference between actual and
expected return
What is the effect of an increase in life
expectancy on a pension plan?
The projected benefit obligation (PBO)
increases (PBO loss)
Multiple components comprise Net Periodic Pension Cost. The component reported as part of compensation expense and included in the subtotal for income from operations is
Service cost
Service cost is included in compensation expense reported for the employees with whom the pension benefits are associated. Because the service cost component is included in the compensation expense line item, the subtotal for income from operations includes its effect.
What is the present value of all future retirement payments attributed by the pension benefit formula to employee services rendered prior to that date only?
Accumulated benefit obligation.
Accumulated benefit obligation is the present value of all unpaid future retirement benefits as of the balance sheet date based on (1) service rendered to that date, and (2) current salary levels.
Even if the pension benefit formula incorporates future salaries, accumulated benefit obligation uses current salary levels only to provide a more current measure of the pension liability.
A defined benefit plan’s projected benefit obligation totaled $20mn at the end of the current year. Plan assets at market value totaled $23mn. Choose the correct statement concerning balance sheet reporting for this plan.
$3mn pension asset.
PBO and assets are netted for balance sheet reporting purposes. The firm has an overfunded plan and reports a $3mn asset ($23mn assets − $20mn PBO).
Data for a defined benefit pension plan for the current year are as follows:
PBO, January 1, $200mn
Assets, January 1, $160mn
Pension expense, $60mn
Funding contribution, $50mn
The ending pension liability balance is
$50mn
The beginning pension liability balance was $40mn ($200mn PBO − $160mn assets). With pension expense of $60mn and funding of $50mn, the pension liability increased an additional $10mn, yielding an ending pension-liability balance of $50mn ($40mn + $10mn). There is no information about amortization of PSC or net gain or loss, or difference between expected and actual return, or gain, loss or PSC during the period.
A company has a defined benefit pension plan for its employees. On December 31, year one, the accumulated benefit obligation is $45,900, the projected benefit obligation is $68,100, and the fair value of the plan assets is $62,000. What amount, if any, related to the defined benefit plan should be recognized in the balance sheet at December 31, year one?
A liability of $6,100.
The reported pension liability for a defined benefit pension plan is the difference between projected benefit obligation ($68,100) and the fair value of plan assets ($62,000), or $6,100. The two underlying amounts are reported in the footnotes, but are not recognized in the balance sheet. Only their difference, which is also the underfunded amount, is reported in the balance sheet as a liability.
How should plan investments be reported in a defined benefit plan’s financial statements?
At fair value.
Fair value represents the most representationally faithful amount to be applied to pension obligation. Fair value is the current amount available for payment of pension benefits.
The funded status of a defined benefit pension plan for a company should be reported in
The statement of financial position.
Funded status is the difference between projected benefit obligation and plan assets at fair value. Neither of these amounts is reported in the balance sheet (they appear in the notes only), but their difference is reported in the balance sheet as the reported pension liability for defined benefit plans. It is the amount the plan is “behind” in terms of having assets available for payment of benefits.
A company sponsors two defined benefit pension plans. The following information relates to the plans at year end:
Plan A Plan B Fair value of plan assets $ 800,000 $1,000,000 Projected benefit obligation 1,000,000 700,000
What amount(s) should the company report in its balance sheet related to the plans?
Liability of $200,000; asset of $300,000.
Within the same firm, overfunded plans are not offset with underfunded plans because a plan’s funds can be used only for the benefits payable under that plan. Plan A is underfunded $200,000 because its assets are less than its PBO—resulting in a pension liability. For plan B, the opposite occurs resulting in a pension asset of $300,000 ($1,000,000 plan assets − $700,000 PBO). Both amounts are reported separately.
At December 31, 2005, the following information was provided by the Kerr Corp. pension plan administrator:
Fair value of plan assets $3.45mn
Accumulated benefit obligation $4.3mn
Projected benefit obligation $5.7mn
What is the amount of the pension liability that should be shown on Kerr’s December 31, 2005 balance sheet?
$2.25mn
This answer is the underfunded projected benefit obligation—the plan’s funded status and most critical number for the pension plan. This is the amount shown in the balance sheet. It can also be an asset, if plan assets exceed projected benefit obligation.
The following information relates to a company’s defined benefit pension plan at December 31:
Accumulated benefit obligation $1,035,000 Projected benefit obligation 1,250,000 Prior service cost 113,000 Net gain on plan assets 167,000 Plan assets (fair value) 737,000
What amount should the company report as its pension liability at December 31?
$513,000
Reported pension liability is the difference between the projected benefit obligation (PBO) ($1,250,000) and the pension plan assets at fair value ($737,000). The difference is $513,000 and reflects the amount by which the pension plan is underfunded. This is shortfall of assets accumulated to pay benefits compared with the present value of those benefits or PBO, the main measure of the pension obligation. Only $737,000 of PBO is covered as of the balance sheet date.
What is the effect of recording the first
three components of pension expense
on pension liability?
Increase by the amount of pension
expense
What is the effect of recording funding
contributions on pension liability?
Decrease by the amount of
contribution
What is the effect of payment of
retirement benefits on pension
liability?
There is no effect.
Define “formal record” as it relates to
pension plans.
The pension information maintained in
the accounts.
What is the effect of future life
expectancy exceeding previous
estimates?
The projected benefit obligation (PBO)
increases (PBO loss)
On January 1 of the current year, a firm’s defined benefit pension plan is amended to increase the benefits for service already provided by employees through that date. The resulting immediate increase in projected benefit obligation (PBO) is $500 at January 1. The average remaining service period of employees covered by the amendment is ten years. Service cost for the year is $1,500. Actual and expected return on plan assets is $178. The discount rate is 10%. PBO at January 1, including the effect of the prior service grant, is $2,800. The funding contribution for the current year is $1,800. Compute pension expense for the current year.
$1,652
Pension expense = $1,500 service cost + $280 interest cost (= $2,800 × .10) − $178 expected return + $50 amortization of PSC (= $500/10) = $1,652. When PSC is initially recorded, another comprehensive income account is debited for $500. The amortization of $50 credits that account and debits pension expense for $50.
Which of the following is not subject to delayed recognition?
PBO.
Changes to PBO are recognized immediately. SC and interest cost are recognized as increases in pension expense and pension liability in the pension-expense entry. PSC, and PBO gains and losses are recognized immediately in the pension liability and other comprehensive income. PBO, however, is not recorded directly in one account; rather, it is reported in the notes to the financial statements.
An entity sponsors a defined-benefit pension plan that is underfunded by $800,000. A $500,000 increase in the fair value of plan assets would have which of the following effects on the financial statements of the entity?
A decrease in the liabilities of the entity.
The plan is currently underfunded and remains underfunded after the asset increase. Reported pension liability is the underfunded amount, the difference between PBO and plan assets. This firm’s reported pension liability decreased from $800,000 to $300,000 ($800,000 − $500,000) owing to the asset increase.
Which of the following would not cause a change in the net gain or loss at the beginning of a period?
Retroactive increase in benefits for employee service already performed.
This answer describes prior service cost (PSC). This increase in PBO is not merged with net gain or loss, but is rather treated separately, for purposes of computing pension expense. Amortization of PSC yields component 4; amortization of net gain or loss yields component 5.
The following information pertains to Seda Co.’s pension plan:
Actuarial estimate of projected benefit obligation at January 1, 2005 $72,000
Assumed discount rate 10%
Service costs for 2005 $18,000
Pension benefits paid during 2005 $15,000
If no change in actuarial estimates occurred during 2005, Seda’s projected benefit obligation at December 31, 2005 was
$82,200
Projected benefit obligation (PBO), January 1, 2005 $72,000
Plus interest cost (growth in PBO), .10($72,000) $7,200
Plus service cost $18,000
Less benefits paid in 2005 ($15,000)
PBO, December 31, 2005 $82,200
What is the formula for ending net gain
or loss subject to amortization in the
following period?
Beginning net gain or loss − Amortization of the beginning amount \+/− Projected benefit obligation (PBO) change in the period +/− Asset gain or loss
What amount is subject to amortization
for prior service grant amendments?
The initial present value of the
increased benefits for service already
rendered
What is the effect of recording funding
contributions on pension liability?
Decrease by the amount of
contribution
What method(s) are used to compute prior service cost (PSC) amortization?
Straight-line or service method
True or False: The amortization of the
net gain or loss at the beginning of the
year is a component of pension
expense.
This is a true statement.
What is the amount subject to periodic
amortization for pension gains and
losses?
Net gain or loss at the beginning of the
period
What is the effect of an increase in life
expectancy on a pension plan?
The projected benefit obligation (PBO)
increases (PBO loss)
What is the effect of recording the first
three components of pension expense
on pension liability?
Increase by the amount of pension
expense
How do we compute projected benefit
obligation (PBO) at the balance sheet
date using components?
Service cost to date + Interest cost to
date − Benefits paid to date + Prior
service cost +/− Net PBO gain or loss to
date
Define “formal record” as it relates to
pension plans.
The pension information maintained in
the accounts.
What is the prior service cost
amortization method that recognizes
more amortization in periods when
more employees are working?
Service method.
List the two significant changes to
which defined benefit plans are subject
and which are subject to delayed
recognition in pension expense.
- Prior service cost
2. Pension gains and losses
What is the effect of payment of
retirement benefits on pension
liability?
There is no effect.
What immediate changes in projected benefit obligation (PBO) will cause a change in pension liability?
Prior service cost (PSC) and PBO gains
and losses
What is the amortization method that
can result in no amortization even if
there is a beginning net gain or loss?
Corridor (minimum) method
What accounting events affect the net
pension gain or loss at the beginning of
the year?
Recognition of gains and losses for
projected benefit obligation (PBO) and
assets; amortization of previous net
gain or loss
In what accounts are prior service cost
and pension gains/losses recognized
immediately?
They are recognized in other
comprehensive income and pension
liability
List the two sources of pension gains
and losses.
- Changes in projected benefit
obligation (PBO) - Difference between actual and
expected return
What is the effect of future life
expectancy exceeding previous
estimates?
The projected benefit obligation (PBO)
increases (PBO loss)
At year end, a company has a defined benefit pension plan with a projected benefit obligation of $350,000; a net gain of $140,000 that was not previously recognized in net periodic pension cost; and prior service cost of $210,000 that was not previously recognized in net periodic pension cost. What amount should be reported in accumulated other comprehensive income related to the company’s defined benefit pension plan at year end?
A debit balance of $70,000.
Accumulated other comprehensive income (AOCI) is impacted by unexpected gains and losses from plan assets and unamortized portions of prior service costs from pension plan amendments. The net gain of $140,000 that has not previously been recognized in pension expense is reported as part of AOCI as a credit balance. The unamortized portion of prior service cost of $210,000 is reported as part of AOCI as a debit balance. The amount reported in AOCI related to the company’s defined benefit pension plan is a net debit balance of $70,000.
2 Click to bookmark question 2 bookmark removedbookmark removedaq.pen.exp.recog.001_2017
Use V-O keys to navigate.
Jan Corp. amended its defined benefit pension plan, granting a total credit of $100,000 to four employees for services rendered prior to the plan’s adoption. The employees, A, B, C, and D, are expected to retire from the company as follows:
A will retire after three years.
B and C will retire after five years.
D will retire after seven years.
What is the amount of prior service cost amortization in the first year?
$20,000
$20,000 is correct. Prior service cost is amortized over the average remaining life of the employees. The calculation of the average remaining service life of the employees is to add the remaining service lives of A (3 years), B (5 years), C (5 years), and D (7 years) for a total of 20 years and divide by the number of employees (20 years / 4 employees = 5 years). Therefore, the amortization of the prior service cost is $100,000 divided by 5 years, or $20,000.
On July 31, Year 5, Tern Co. amended its single employee defined benefit pension plan by granting increased benefits for services provided prior to Year 5. This prior service cost will be reflected in the financial statement(s) for
Year 5, and following years only.
Year 5 only is incorrect. Prior service costs are amortized over current (year 5) and future years.
Jamestown Corp. obtains the following information from its actuary. All amounts are as of January 1, Year 6 (beginning of the year).
Projected benefit obligation $1,530,000
Related fair value of asset $1,650,000
Unrecognized net loss $235,000
Average remaining service period 5.5 years
What amount of net loss should be recognized as part of net pension cost in Year 6 using the corridor approach ?
$12,727
$12,727 is correct. The requirement is to determine the amount of net loss to be recognized as a part of net pension cost in Year 6. Under the corridor approach, only the unrecognized net gain or loss in excess of 10% of the greater of the PBO or the related fair value of the asset is amortized.
In this case, the fair value ($1,650,000) is larger than the PBO ($1,530,000). The corridor is $165,000 (10% × $1,650,000). The unrecognized net loss ($235,000) exceeds the corridor by $70,000 ($235,000 – $165,000). This excess is amortized over the average remaining service period of active employees expected to participate in the plan ($70,000 / 5.5 = $12,727).
On January 1, Year 1, an entity has a projected benefit obligation of $3 million and plan assets of $2 million. On that date, the entity amends its pension contract to make the benefits larger, and this change creates a prior service cost of $400,000. The discount or interest rate in connection with the projected benefit obligation is 6%, and the expected earnings rate on plan assets is 4%. The average remaining service life of those employees impacted by the amendment is estimated to be 10 years. The service cost for the year is $290,000. No funding occurred during the year. What is the net pension cost (the pension expense figure) to be recognized for Year 1?
$454,000
$430,000 is incorrect. A defined benefit pension plan can have up to five components that must be used to determine net pension cost each year [service cost for the period, plus interest cost on the projected benefit obligation, minus expected return on plan assets, plus prior service cost amortization, and plus (or minus) amortization of actuarial unrealized losses (or gains)].
Here, there are four of these components. (1) The service cost for the year is $290,000. (2) The projected benefit obligation is increased from $3 million to $3.4 million by the prior service cost, so the interest on the projected benefit obligation is $3.4 million multiplied by 6%, or $204,000. (3) The income on the plan assets is $2 million multiplied by 4%, or $80,000. (4) The prior service cost is amortized to the net pension cost over the average remaining service life of the employees. That amortization increases the cost by $40,000 ($400,000 / 10 years). Hence, the net pension cost is $290,000 plus $204,000 less $80,000 plus $40,000, or $454,000.
Jefferson Corp. obtains the following information from its actuary. All amounts are as of January 1, Year 3 (beginning of the year).
Projected benefit obligation $5,000,000
Fair value of plan assets $5,500,000
Unrecognized net loss $675,000
Average remaining service period 5 years
What is the amount of corridor to be used to calculate corridor amortization?
$550,000
Under the corridor approach, the corridor amount is calculated as 10% of the greater of the beginning-of-year PBO or the beginning-of-year fair value of plan assets. In this case, the fair value of the plan assets ($5,500,000) is larger than the PBO ($5,000,000). Therefore, corridor should be calculated using the fair value of the plan assets. The corridor is $550,000 ($5,500,000 × 10%).
Madison Corp. obtains the following information from its actuary. All amounts are as of January 1, Year 4 (beginning of the year).
Projected benefit obligation $5,525,000
Fair value of plan assets $5,750,000
Unrecognized net loss $750,000
Average remaining service period 10 years
What is the amount of corridor amortization?
$17,500
The corridor approach is applied to determine the amount of net loss to amortize (recognize) as part of pension expense. Under the corridor approach, the unrecognized net gain or loss in excess of 10% of the greater of the beginning-of-year PBO or the beginning-of-year fair value of plan assets is amortized. In this case, the fair value of the plan assets ($5,750,000) is larger than the PBO ($5,525,000). Therefore, corridor should be calculated using the fair value of the plan assets. The corridor is $575,000 ($5,750,000 × 10%). To calculate corridor amortization, the amount in excess of corridor must be amortized over the remaining service period. $175,000 is the amount in excess of corridor ($750,000 – 575,000). This amount should be divided by the remaining service period to calculate the corridor amortization of $17,500 ($175,000 ÷ 10 years).
Adams Corp. obtains the following information from its actuary. All amounts are as of January 1, Year 3 (beginning of the year).
Projected benefit obligation $3,000,000
Fair value of plan assets $3,500,000
Unrecognized net loss $435,000
Average remaining service period 4 years
What is the amount in excess of corridor to be used in the calculation of corridor amortization?
$85,000
Under the corridor approach, the corridor amount is calculated as 10% of the greater of the beginning-of-year PBO or the beginning-of-year fair value of plan assets. In this case, the fair value of the plan assets ($3,500,000) is larger than the PBO ($3,000,000). Therefore, corridor should be calculated using the fair value of the plan assets, not the PBO. The corridor is $350,000 ($3,500,000 × 10%), and the amount in excess of corridor is $85,000 ($435,000 – $350,000).
Choose the correct statement regarding the treatment of prior service cost (PSC) for defined benefit plans under international accounting.
The entire PSC amount, at present value, is recognized immediately in pension expense.
PSC is recognized immediately in pension expense and DBO.
Distinguish between the rate used to
compute rate of return under IFRS and
U.S. GAAP.
Under IFRS, the discount rate used to compute interest cost must also be used to compute expected return on plan assets. Therefore, net interest cost is the difference between interest cost and expected return on plan assets. In contrast, under U.S. standards, expected return is based on any reasonable rate of return chosen by management. As a result, the asset gain or loss for IFRS will not be the same amount as per U.S. standards.
Explain how to account for past service
cost (IFRS).
We know this is in regard to IFRS because of the terminology “past service cost” instead of “prior service costs” (U.S. GAAP). Under international standards, past service costs are expensed immediately in pension expense as part of service cost.
The entity that administers pension
plans must report the following
separately for the plans it administers:
The entity that administers pension
plans is required to separately provide
accrual-based financial statements for
the plans it administers.
Under IFRS, how is pension expense
reported?
Under international standards, pension expense is reported in separate components rather than as a single amount on the income statement. These components are: service cost (including past service cost) and net interest cost (interest cost netted against expected return).
Under IFRS, what is the terminology is
used to refer to pension gains/losses
for U.S. standards?
Pension gains/losses for U.S. standards
are called “remeasurement
gains/losses” for international
standards.
A firm is applying international accounting standards to its defined-benefit pension plan and has pension gains and losses. As a result,
The firm’s earnings will not be affected.
Pension gains and losses are recognized immediately and in full in accumulated other comprehensive income. However, they are not subsequently amortized to earnings.
A firm is applying international accounting standards to its defined-benefit pension plan. At the end of the current year, the actuary informs the firm that the plan has experienced an actuarial gain of $2mn. The average remaining service period of plan participants is ten years. Therefore,
Other comprehensive income is immediately increased.
OCI is increased through the increase in pension gains/losses—OCI.
What type of postretirement benefit
other than pensions is by far the most
costly?
Postretirement healthcare coverage
What is the primary obligation measure
for postretirement health care
coverage?
Accumulated postretirement benefit
obligation (APBO)
List the six components of
postretirement benefit expense.
- Service cost
- Interest cost
- Expected return on assets
- Amortization of prior service cost
- Amortization of net gain or loss
at January 1 - Amortization of transition
obligation
List the conditions under which the
accrual of a liability for
postemployment benefits is necessary.
When the benefits meet the four criteria of "Accounting for Compensated Absences." When the benefits do not meet those four criteria, then "Accounting for Contingencies" is followed.
When is there no amortization of
transition obligation for postretirement
benefit expense?
When firms elected to recognize immediately the entire accumulated postretirement benefit obligation (APBO) as an accounting change, decreasing income in the year of transition
What basis of accounting is used for
recognizing the expense for retirement
benefits other than pensions?
The basis is accrual.
List the steps in computing the primary
obligation for retirement benefits.
Compute EPBO (present value of benefits expected to be paid); then multiply EPBO by the fraction of the required service period represented by service to date (yields accumulated postretirement benefit obligation [APBO]).
On what date does an employee meet
the requirements to receive the levels
of benefits expected to be paid?
Full eligibility date
Beyond what date is no further service
cost recognized for an employee?
Full eligibility date
An employee covered by a post-retirement healthcare plan just completed her 18th year of service for a firm. Each year of employment to full eligibility provides credit for post-retirement healthcare benefits for this firm. She must work an additional seven years from today to be eligible for 75% healthcare coverage during retirement. She is expected to work ten more years from today. If this employee worked 15 more years from today, the firm would pay all her healthcare costs during retirement. Choose the correct statement.
Service cost will not be computed for the employee during her last three years of service to the firm.
The employee’s full eligibility date occurs seven years from today. At that time, she is fully eligible for 75% coverage. The last three years of her service do not increase the level of her benefit. There is no additional service cost beyond that date, although interest cost will continue. If she were expected to work 15 years after today, her full eligibility would not occur until 15 years from now, at which time she would be fully eligible for 100% coverage and service cost would continue through that date.
The following information relates to a post-retirement benefit plan:
APBO beginning, $300mn
Plan assets beginning, $100mn
Net post-retirement benefit gain, beginning, $20mn
Amortization of net gain or loss is based on SL method, ten-year average remaining service period
Prior-service cost, initial amount, recognized four years ago, $50mn
Amortization of prior-service cost is based on SL method, ten-year average remaining service period
Service cost, $40mn
Discount rate, 5%
Expected rate of return, 6%
Actual return, $10mn
Change in estimated life expectancy caused a gain of $16mn, year-end
Funding contribution, $20mn
What amount will be reported in the ending balance sheet for post-retirement benefit liability?
$209mn
Beginning post-retirement benefit liability equals $200mn ($300mn APBO − $100mn assets).
Post-retirement benefit expense: $40mn SC + $15mn interest cost (.05 × $300mn) − $6mn expected return (.06 × $100mn) + $5mn amortization of PSC ($50mn/ten) − $2mn amortization of net gain ($20mn/10) = $52mn.
Entry:
dr. post-retirement benefit expense 52,
dr. postretirement gain/loss-OCI 2,
cr. PSC-OCI 5,
cr. post-retirement benefit liability 49.
There is a $4mn asset gain = $10mn actual return − $6mn expected return.
Entry:
dr. postretirement benefit liability 4,
cr. postretirement gain/loss-OCI 4.
Entry for actuarial gain: dr. postretirement benefit liability 16, cr. post-retirement gain/loss-OCI 16.
Entry for funding: dr. post-retirement benefit liability 20, cr. cash 20.
From the entries: ending post-retirement benefit liability = 200 beginning + 49 − 4 - 16 − 20 = 209.
Alternatively, ending post-retirement benefit liability = $200mn beginning post-retirement benefit + $40mn SC + $15mn interest cost − $10mn actual return − $16mn actuarial gain − $20mn funding = $209mn.
An employer’s obligation for post-retirement healthcare benefits that are expected to be fully provided to or for an employee must be fully accrued by the date the
Employee is fully eligible for benefits.
Post-retirement healthcare benefits often are provided in terms of percentage of total coverage. For example, an employee may have to work 20 years to attain 50% healthcare coverage during retirement, and 30 years to attain 100% coverage.
If the employee is expected to work 25 years, then the 50% coverage is the level built into the expense and liability computations, and the accrual period is the first 20 years of service. After serving 20 years, the employee earns no more benefit.
Therefore, the full eligibility date is the date by which the employee has served the required number of years to attain the level of benefits the employee is expected to attain.
Which of the following costs is unique to post-retirement healthcare benefits?
Per capita claims
The per capital claims cost is the basis for computing the obligation reported for a post-retirement healthcare plan. These costs are estimated based on historical norms adjusted for estimated healthcare cost-trend rates and are affected by the estimated age of employees at retirement, their health, and other factors. Only post-retirement healthcare plans require this type of estimate. Pension benefits, for example, are based on variables such as age at retirement, number of years of service, and final salary. Both defined-benefit pension plans and post-retirement healthcare plans involve the other three answer alternatives. Both have service-cost and interest-cost components for their respective expenses, and both can incur prior-service cost.
An overfunded single-employer defined benefit postretirement plan should be recognized in a classified statement of financial position as a
Noncurrent asset.
The excess of plan assets over the benefit liability (accumulated postemployment benefit liability or APBO) is reported as an asset and is classified as noncurrent. The plan assets and APBO are not reported separately but rather are offset. Given the long-term nature of such plans, the asset is classified as a noncurrent asset.
Overfunded means plan assets exceed the plan’s obligation. An asset is reported, and it is classified as noncurrent.
When plan assets exceed the plan liability (an overfunded plan), the difference is reported as an asset. The asset and liability are not reported separately.
What does a stock option plan provide
an employee?
It provides an employee with the option to purchase shares of the employer firm's stock at a fixed price in the future, after a reasonable service period.
How are compensation expenses
related to stock compensation
reported?
They are reported as a component of
income from continuing operations.
How is compensation expense for a
fixed stock option plan measured?
The fair value of options granted is
estimated using an option pricing
model at the grant date.
On what date is total compensation
expense determined for a fixed stock
option plan?
Grant date
What is the total compensation
expense for a fixed stock option plan?
The fair value at grant date of options
expected to vest
What effect does the stock price at
grant date have on the fair value of one
option?
Higher prices yield higher fair values
What is the period over which
compensation expense is recognized
for a fixed stock option plan?
The service period—grant date to first
exercisable date
What is the net effect of accounting for
a fixed option plan from grant date
through exercise date (assuming the
options do not expire)?
Cash and owners' equity are increased by the cash paid in by the employees; retained earnings are reduced by the amount of compensation expense recognized.
What is the accounting effect of the
expiration of stock options?
There is no change in compensation
expense or owners’ equity.
What is the effect of expected
forfeitures on compensation expense
recognized?
Expected forfeitures reduce total
compensation expense.
How is compensation expense
determined after a change in estimated
forfeitures?
Compensation expense in a period of change is the amount resulting in total compensation expense through the period of change that equals the fraction of the service period elapsed multiplied by the new estimate of total compensation expense.
Define “graded vesting plans.”
Stock option plans that stagger the
vesting dates
List the acceptable approaches to
accounting for graded vested option
plans.
Treat as one plan or
Treat each group with different
vesting dates as separate plans.
Describe the general approach to
recognizing compensation expense for
a performance option plan.
At end of each period, recompute the total compensation expense based on the performance level expected to be achieved. Recognize the compensation expense for the period in the amount that results in total compensation through the period equaling the fraction of the service period elapsed times the new estimate of the total compensation expense.
What is the accounting effect when no
stock options are expected to vest
because the performance target is not
expected to be met?
Reverse the compensation expense
and the associated owners’ equity
account for the amount of expense
recognized in previous periods.
What is the general treatment of option
plans with vesting contingent on
meeting a stock price target?
It is the same as for fixed stock option
plans if the target is met.
What is the accounting effect when
there is an expiration of option plans
with vesting contingent on meeting a
stock price target?
There is no change in compensation
expense or owners’ equity
A company granted its employees 100,000 stock options on January 1, Year 1. The stock options had a grant date fair value of $15 per option and a three-year vesting period. On January 1, Year 2, the company estimated the fair value of the stock options to be $18 per option. Assuming that the company did not grant any additional options or modify the terms of any existing option grants during Year 2, what amount of share-based compensation expense should the company report for the year ended December 31, Year 2?
$500,000
Total share-based compensation expense is measured at the grant date by multiplying the number of options by the fair value of each option. The annual share-based compensation expense is calculated by dividing the total share-based compensation expense by the vesting or service period.
The employees were granted 100,000 options, each of which had a fair value of $15 at the grant date. Total shared-based compensation expense is $1,500,000 (100,000 options multiplied by $15). Total shared-based compensation expense of $1,500,000 divided by the three-year vesting period results in an annual share-based compensation expense of $500,000. Assuming none of the employees forfeit their options, share-based compensation expense of $500,000 will be recognized at the end of years 1, 2, and 3.
Under the fair-value method of accounting for stock option plans, total compensation recognized
Is based on the value of the option at the grant date, adjusted for forfeitures.
The fair value of the option sets the compensation expense to be recognized for each option expected to be vested. Applying the forfeiture rate ensures that only options expected to be vested will be entered into the calculation.
A stock option plan with a positive fair value at grant date caused compensation expense of $50,000 per year to be recorded over the five-year service period. During the exercise period (two years), the stock price never exceeded the option price. Therefore, none of the options was exercised.
Choose the correct statement about the accounting for these options.
The contributed capital increase from recording compensation expense is left intact.
Expiration of stock options does not cause reversal of compensation expense because, at the grant date, the firm did provide value to the employee, given that the option had a fair value at that time.
The expense recognized for stock option plans is not based on the expected value of the employee services; rather, it is based on the value of what was given by the employer to the employee.
There is no retroactive adjustment reducing previous expense. Rather, the firm reclassifies the paid-in capital account generated from the stock option grant.
On which of the following dates is a public entity required to measure the cost of employee services in exchange for an award of equity interests, based on the fair market value of the award?
Date of grant.
The fair value on the grant date is used for measuring compensation expense, because, on that date, the employer has given a resource of value to the employee.
The vesting date is the date on which the award or option is no longer contingent on continued employment. The employee received value at the grant date.
The exercise date is the last date on which the employee has any involvement with the option or award. The value is measured at grant date, the date the employer conveyed value to the employee.
On January 1, year 1, the board of directors of a corporation granted 10,000 stock options to the CEO. Each option permits the purchase of one share of stock at $25 per share, the current market price of the stock. The options are exercisable on December 31, year 4, as long as the CEO is still employed. The options expire on December 31, year 5. The grant date fair value of each option is $5. The corporation must recognize
$12,500 of compensation expense per year for four years.
Total compensation expense is the product of the fair value of one option at the grant date ($5) and the number of options granted (10,000). The result is $50,000 of total compensation expense. This total is allocated equally to each year in the service period. The service period is the period from grant date to vesting date (first exercisable date), or 4 years. Annual compensation expense is $50,000/4 = $12,500.
What total amount of compensation
expense is associated with a stock
award plan?
The number of shares awarded times
the market price of the stock at grant
date
What account is credited when the net
method is used to record
compensation expense for a stock
award?
Paid-in capital from stock award.
Define “stock award plans.”
Plans awarded for continuing employment, but the employee cannot sell the stock (the main restriction) until the award is vested, and the employee may not receive the shares until the award is vested.
List the two methods of recording
compensation expense for stock
awards.
- Gross method
2. Net method
What account is credited when the
gross method is used to record
compensation expense for a stock
award?
Deferred compensation expense.
Describe the accounting treatment of
unexpected forfeitures of stock awards.
Reversal of previously recognized
compensation expense
What is the classification of the
deferred compensation expense
account?
The classification is Contra owners’
equity.
A restricted stock award was granted at the beginning of 2005 calling for 3,000 shares of stock to be awarded to executives at the beginning of 2009. The fair value of one option was $20 at grant date. During 2007, 100 shares were forfeited because an executive left the firm.
What amount of compensation expense is recognized for 2007?
$13,500
Total compensation expense at grant date is $60,000 (3,000 × $20). The service period is four years (20x5 − 20x8). Annual expense recognized is $15,000 ($60,000/4).
Through 20x6, a total of $30,000 of compensation expense is recognized. After the forfeit, only 2,900 shares remain to be awarded.
Annual compensation expense for the remaining two years before considering forfeited shares is therefore $14,500 [(2,900 × $20)/4].
The expense for the two years associated with the 100 shares forfeited is $1,000 [(100 × $20)/2].
For 20x7, subtracting the reversal of the $1,000 yields $13,500 as the final amount of expense to be recognized.
Another way to calculate the $14,500 is: ($60,000 original total compensation expense − $30,000 expense for x5 and x6 − $1,000 expense for x7 and x8 on forfeited shares)/2.
On January 1, year 1, a company issued its employees 10,000 shares of restricted stock. On January 1, year 2, the company issued to its employees an additional 20,000 shares of restricted stock. Additional information about the company’s stock is as follows:
Date Fair value of stock (per share)
January 1, year 1 $20
December 31, year 1 22
January 1, year 2 25
December 31, year 2 30
The shares vest at the end of a four-year period. There are no forfeitures. What amount should be recorded as compensation expense for the 12-month period ended December 31, year 2?
$175,000
Total compensation expense is computed as the fair value of the stock awarded, and is allocated evenly over the vesting period. The fair value at award date is the fair value used for this computation. The two awards are treated as separate awards, each with four year amortization periods. The total expense for year 2 is the sum of the compensation expense to be recognized for each plan for year 2 and is computed as 10,000($20)/4 + 20,000($25)/4 = $175,000. Total fair value is not updated after the award date.
What type of account is credited when
periodic compensation expense is
recognized for an stock appreciation
right (SAR) payable in cash?
The account credited is Liability.
Describe the features of a stock appreciation right (SAR).
Employee receives the difference between the stock price at grant date and the stock price at the exercise date. The employee pays nothing. The employee specifies the benefit in either cash or stock.
What is the total compensation
expense for stock appreciation rights
(SARs) payable in cash?
Number of rights times the difference
between the stock price at date of
exercise and the stock price at grant
date
What is the fair value of a stock
appreciation right (SAR) at the exercise
date?
The difference between grant date
price and the price at exercise date
When can compensation expense be
negative for a period?
When the stock price falls to a level causing the total compensation expense through the end of the period to be less than the compensation expense recognized in previous periods
Select the correct statement about executive compensation plans involving stock.
The total amount of compensation expense for a restricted stock award plan is recognized when the stock is issued.
The total amount of compensation expense for a restricted stock award plan is determined at the grant date.
For stock-appreciation rights plans payable in cash, compensation expense is recognized only during the service period.
For stock-appreciation rights plans payable in cash, compensation expense recognized in any given reporting period cannot be negative.
The total amount of compensation expense for a restricted stock award plan is determined at the grant date.
Total compensation expense is the product of the number of shares in the award and the market price of stock at the grant date. This amount is recognized over the service period required for the employee to receive or keep the shares.
Compensation expense is recognized over the service period required for the employee to keep the stock. No stock-based plan recognizes the total amount of compensation expense in one transaction.
For stock-appreciation rights plans payable in cash, compensation continues until the exercise date, at which time the fair value of the right is known. The amount paid to the employee is the difference between the market price at exercise date and the stock price at grant date.
Compensation recognized in a given reporting period can be negative (credited) if the total fair value of the plan declines to the point that compensation to be recognized through the current year is less than the compensation expense recognized in previous periods.
Define “deferred income tax.”
The amount of income tax expense that
is not currently due
Define “deferred income tax provision.”
The amount of income tax
expense that is not currently due.
It equals the net sum of the
change in the deferred tax
accounts.
Define “income tax liability.”
The amount of income tax the firm
must pay on taxable income for a year.
Define “taxable income.”
Income before tax for tax purposes
Define “pretax accounting income.”
Income before income tax for financial
accounting purposes determined by
applying generally accepted
accounting principles
Define “current income tax provision.”
The amount of income taxes due for the year (same as income tax liability)
Define “interperiod tax allocation.”
The process of measuring and
recognizing the total income tax
consequences of transactions in the
year
Define “income tax expense.”
The account reported in the income statement that measures the income tax cost for the year's transactions affecting income from continuing operations. It is the net sum of the income tax liability and the net change in the deferred tax accounts.
Which of the following statements is a primary objective of accounting for income taxes?
To recognize the amount of deferred tax liabilities and deferred tax assets reported for future tax consequences.
From a financial reporting perspective, a primary objective of accounting for income taxes is to recognize and measure the deferred tax consequences (e.g. deferred tax assets and deferred tax liabilities) of temporary differences between pretax financial income and taxable income.
A company has two temporary differences resulting in deferred tax consequences. One difference results in a deferred tax asset; the other difference results in a deferred tax liability. The deferred tax asset is greater than the deferred tax liability. How should the company report the deferred tax consequences of the temporary differences on the balance sheet?
Report a net noncurrent deferred tax asset in the noncurrent assets section of the balance sheet.
The company should report a net noncurrent amount on the balance sheet. Because the deferred tax asset is greater than the deferred tax liability, the two netted together result in an overall net noncurrent deferred tax asset amount.
According to FASB 109, for the year ended 20X5, Nala should report deferred income tax expense or benefit equal to the
Sum of the net changes in deferred tax assets and deferred tax liabilities.
Total income tax expense is the sum of the current and deferred portions.
The current portion is the income tax liability for the year.
The deferred portion is the net sum of the changes in the deferred tax accounts.
Consider the tax-accrual entry for a year, assuming no estimated tax payments have been made: Dr. Income tax expense 20 Dr. Deferred tax asset 3 Cr. Deferred tax liability 5 Cr. Income tax payable 18
Total income tax expense = 20
= current tax expense + deferred tax expense
= $18 + $2
The $2 deferred tax expense equals the increase in the deferred tax liability of $5, less the increase in the deferred tax asset of $3.
According to FASB Statement No. 109, Accounting for Income Taxes, justification for the method of determining periodic deferred tax expense is based on the concept of
Recognition of assets and liabilities.
FAS 109 adopted the asset/liability approach. The deferred tax expense is the net change in the deferred tax accounts for the year. Deferred tax accounts are measured at the enacted tax rate for the period in which the future temporary differences reverse.
Rather than base income tax expense on accounting income adjusted for permanent differences, as was the case before 109, income tax expense is now the sum of current income tax expense (the income tax liability for the year) and the net change in deferred tax accounts. The expense is a residual amount, based on the changes in assets and liabilities. Matching is no longer the conceptual basis for measurement.
Rein Inc. reported deferred tax assets and deferred tax liabilities at the end of 20X3 and at the end of 20X4.
According to FASB Statements No. 109 Accounting for Income Taxes, for the year ended 20X4, Rein should report deferred income tax expense or benefit equal to the
Sum of the net changes in deferred tax assets and deferred tax liabilities.
The net amount of deferred tax expense or benefit is that amount that is not recognized in current period income.
A simple equation describes the total tax effects for a period: income tax expense or benefit + deferred income tax expense or benefit = current tax liability. The deferred income tax expense or benefit can further be described as the net change in both types of deferred tax accounts.
Are current-year or future permanent
differences used in the current-year tax
accrual entry?
Current-year differences are used.
What is the effect of a nontaxable
revenue on income tax expense?
Income tax expense is not increased.
List some common permanent
differences.
Tax-free interest income
Life insurance expense premiums
on key employee
Proceeds from life insurance on
key employee
Dividends received deduction
Fines and penalties
What is the effect of a nontaxable
revenue on income tax liability?
Income tax liability is not increased.
What is the effect of a nondeductible
expense on income tax expense?
Income tax expense is not reduced.
If book depletion is $4,000 and tax
depletion is $12,000, what is the
amount of the permanent difference?
The amount is $8,000.
What general effect does a permanent
difference have on income tax
expense?
The effect of a permanent difference on
income tax expense is the same as its
effect on the income tax liability for the
period.
Define “permanent difference.”
An amount that appears in the tax
return or income statement but never
both
On June 30, 20X4, Ank Corp. pre-paid a $19,000 premium on an annual insurance policy.
The premium payment was a tax-deductible expense in Ank’s 20X4 cash-basis tax return. The accrual-basis income statement will report a $9,500 insurance expense in 20X4 and 20X5.
Ank elected early application of FASB Statement No. 109, Accounting for Income Taxes.
Ank’s income tax rate is 30% in 20X4 and 25% thereafter.
In Ank’s December 31, 20X4 balance sheet, what amount related to the insurance should be reported as a deferred income tax liability?
$2,375
The future temporary difference at December 31, 20X4 is $9,500, the amount of insurance expense to be recognized for financial-reporting purposes.
The entire $19,000 deduction was taken for tax purposes in 20X4. Therefore, no further deduction will be taken beyond 20X4. The difference is taxable, because future taxable income exceeds future pre-tax accounting income from transactions through 20X4.
The deferred tax liability uses the future tax rate, because that is the rate at which the deferred taxes will be paid. The ending deferred tax liability for 20X4 = $2,375 = .25($9,500).
Lake Corp., a newly organized company, reported pre-tax financial income of $100,000 for Year 1.
Among the items reported in Lake’s Year 1 income statement are the following:
Premium on officer’s life insurance with Lake as owner
and beneficiary $15,000
Interest received on municipal bonds 20,000
The enacted tax rate for Year 1 is 30% and 25% thereafter. In its December 31, Year 1 balance sheet, Lake should report a deferred income tax liability of
$0
Both listed items are permanent differences. These are differences that never reverse and are not used in the determination of deferred tax accounts. Both income tax expense and income tax liability are affected the same way by these items.
A deferred income tax liability is based on future taxable differences at the end of the reporting year.
There are no such differences. Therefore, there is no deferred tax liability.
What temporary difference causes
future taxable income to exceed future
book income?
A taxable temporary difference
Define “temporary difference.”
An item of revenue or expense that,
over the total life of the item, will affect
pretax accounting income and taxable
income in the same total amount but
will be recognized in different amounts
in any given year for financial reporting
and tax purposes
List the two categories of temporary
differences.
- Taxable temporary differences
2. Deductible temporary differences
What type of deferred tax accounts do
deductible temporary differences
cause?
They cause deferred tax assets.
True or False. Future taxable temporary
differences are differences that cause
deferred tax liabilities.
True.
Define “taxable temporary
differences.”
Differences that initially cause a
postponement in the payment of taxes.
Define “deductible temporary
differences.”
Differences that initially cause a
prepayment of taxes.
What type of difference is caused by the
liability for a warranty?
Deductible difference.
Are originating or future reversing
temporary differences used in
determining the ending balance in
deferred tax accounts?
Future reversing temporary differences
are used.
Define “deferred tax asset.”
The future tax effect of a future
deductible difference
Define “deductible difference.”
A temporary difference that causes
future taxable income to be less than
future book income
What type of temporary difference is
caused by depreciation?
Taxable difference
For the year ended December 31, 20X4, Mont Co.’s books showed income of $600,000 before provision for income tax expense. To compute taxable income for federal income tax purposes, the following items should be noted:
Income from exempt municipal bonds $60,000
Depreciation deducted for tax purposes in excess of depreciation recorded on the books $120,000
Proceeds received from life insurance on death of officer $100,000
Estimated tax payments 0
Enacted corporate tax rate 30%
Ignoring the alternative minimum tax provisions, what amount should Mont report at December 31, 20X4 as its current federal income tax liability?
$96,000
The tax liability is the tax rate times taxable income = .30($600,000 − $60,000 − $120,000 − $100,000) = $96,000.
The municipal- bond interest is tax exempt, but included in pre-tax accounting income of $600,000 and therefore is subtracted when computing taxable income.
The excess depreciation is also subtracted, because pre-tax accounting income reflects only depreciation recorded for financial accounting purposes.
The proceeds on life insurance are included in pre-tax accounting income, but are not taxable and are therefore subtracted in computing taxable income.
Orleans Co., a cash-basis taxpayer, prepares accrual-basis financial statements. Since Year 1, Orleans has applied FASB ASC 740 - Income Taxes. In its Year 3 balance sheet, Orleans’ deferred income- tax liabilities increased compared to Year 2.
Which of the following changes would cause this increase in deferred income tax liabilities?
I. An increase in pre-paid insurance.
II. An increase in rent receivable.
III. An increase in warranty obligations.
I and II.
Deferred tax liabilities are the future tax effects of future taxable temporary differences. Such differences cause future taxable income to exceed future pre-tax accounting income.
I. An increase in pre-paid insurance implies that future accounting insurance expense will exceed future tax insurance expense. Therefore, future taxable income will increase relative to future pre-tax accounting income. This increases the deferred tax liability.
II. An increase in rent receivable implies that future tax-rent revenue will exceed future accounting-rent revenue. A rent receivable is recorded when accounting-rent revenue is recognized before cash is received. Cash will be received in the future, which will be recognized as rent revenue for tax, but no revenue will be recognized for accounting. Therefore, again, future taxable income will increase relative to future pre-tax accounting income.
III. An increase in warranty obligations implies that future tax-warranty expense will exceed future accounting-warranty expense. Accounting has recognized the warranty expense in the year of sale, whereas tax-warranty expense is recognized in the year the repairs are made. This time, future taxable income will decrease relative to future pre-tax accounting income. This increases the deferred tax asset, rather than the deferred tax liability.
Therefore, only I and II increase the deferred tax liability.
At the end of year one, Cody Co. reported a profit on a partially completed construction contract by applying the percentage-of-completion method.
By the end of year two, the total estimated profit on the contract at completion in year three had been drastically reduced from the amount estimated at the end of year one.
Consequently, in year two, a loss equal to one-half of the year-one profit was recognized. Cody used the completed-contract method for income tax purposes and had no other contracts.
According to FASB Statement No. 109, Accounting for Income Taxes, the year-two balance sheet should include a deferred tax
Asset
Liability
Asset - No
Liability - YES
More profit will be recognized under completed contract in year three for tax purposes than will be recognized under percentage-of-completion in year three for accounting purposes. The entire profit will be recognized under completed contract (tax purposes) in year three. But a portion of income has already been recognized for accounting purposes before year three. Therefore, less income will be recognized in year three for accounting purposes.
Consequently, at the end of year two, there is a future taxable difference because future taxable income will exceed future pre-tax accounting income. Taxable differences give rise to deferred tax liabilities.
Dunn Co.’s 20X5 income statement reported $90,000 income before provision for income taxes.
To compute the provision for federal income taxes, the following 20X5 data are provided:
Rent received in advance $16,000
Income from exempt municipal bonds 20,000
Depreciation deducted for income tax purposes in excess of depreciation reported for financial-statement purposes 10,000
Enacted corporate income tax rate 30%
If the alternative minimum tax provisions are ignored, what amount of current federal income tax liability should be reported in Dunn’s December 31, 20X5 balance sheet?
$22,800
The tax liability is 30% of taxable income.
Pre-tax accounting income $90,000
Plus advance rent $16,000
(taxable, but not included in
pre-tax accounting income)
Less municipal bond income ($20,000)
(this is included in pre-tax
accounting income,
but is not taxable)
Less depreciation for (10,000)
tax in excess of
depreciation for the books
Equals taxable income $76,000
Times tax rate x .30
Equals income tax liability $22,800
When accounting for income taxes, a temporary difference occurs in which of the following scenarios?
An item is included in the calculation of net income in one year and in taxable income in a different year.
This answer describes one category of temporary difference. In general, a temporary difference is one for which the item’s recognition takes place at a different rate or time for financial reporting and the tax return. However, the total impact of the item is the same over its life, for both systems of reporting.
List the formula for computing the
effect of a permanent difference on the
effective tax rate.
Product of permanent difference and
stated rate divided by pretax
accounting income
What tax rate should be used when
computing the change in the deferred
tax accounts?
Enacted future tax rates (which would
be the same as the current tax rate if
rates have not been changed)
How do permanent differences affect
the tax accrual entry?
Taxable income excludes them; this
exclusion is reflected in income tax
expense—a plug figure.
What book versus tax differences does
the computation of income tax liability
consider?
It considers current-period temporary
and permanent differences.
How is income tax expense for a period
computed?
It is a derived amount or plug figure,
the net change caused by the changes
in deferred tax accounts and the
income tax liability
Stone Co. begins operations in 20X4 and reports $225,000 in income before income tax for the year. Stone’s 20X4 tax depreciation exceeds its book depreciation by $25,000. Stone also has non-deductible book expenses of $10,000 related to permanent differences.
Stone’s tax rate for 20X4 is 40%, and the enacted rate for years after 20X4 is 35%. Stone elects early adoption of FASB Statement No. 109, Accounting for Income Taxes.
In its December 31, 20X4 balance sheet, what amount of deferred income tax liability should Stone report?
$8,750
The deferred tax liability is based solely on the depreciation temporary difference.
Permanent differences do not enter into the determination of deferred tax accounts. This is the first year of operations. Therefore, the depreciation difference in this year must equal the net future temporary difference.
The deferred tax liability balance at the end of the year is therefore $8,750 ($25,000 × .35). Future enacted tax rates are used because they are the rates that will be in effect when the future tax consequences will be realized.
The permanent difference should not be included in the computation. Deferred tax accounts reflect the anticipated effect of future temporary differences only. Depreciation is the only difference to be considered in this question.
Tara Corp. uses the equity method of accounting for its 40% investment in Flax, Inc.’s common stock. During 20X5, Flax reports earnings of $750,000 and pays dividends of $250,000.
Assume that:
All the undistributed earnings of Flax will be distributed as dividends in future periods.
The dividends received from Flax are eligible for the 80% dividends-received deduction.
There are no other temporary differences.
Tara’s 20X5 income tax rate is 30%.
Enacted income tax rates after 20X5 are 25%.
Tara elected early application of FASB Statement No. 109, Accounting for Income Taxes. In its December 31, 20X5 balance sheet, the increase in the deferred income tax liability from the above transactions would be
$10,000
The deferred tax liability ending balance in this problem equals the change in the deferred tax liability for the period, because the firm adopted SFAS No. 109 in this period.
The change in the deferred tax liability is the future tax effect of the amount of income from the investment that is expected to be taxable in the future, using enacted tax rates. That amount is $10,000 = .25(.20)(.40)($750,000 − $250,000).
The ($750,000 − $250,000) amount represents the total future earnings difference between tax and book accounting. The .20 represents the proportion of income that will ultimately be taxed, and the .25 is the future enacted tax rate. The .40 is the proportion ownership. The final result, $10,000, is the anticipated future tax liability, based on current transactions.
Bart, Inc., a newly organized corporation, uses the equity method of accounting for its 30% investment in Rex Co.’s common stock. During 20X5, Rex paid dividends of $300,000 and reported earnings of $900,000. In addition:
The dividends received from Rex are eligible for the
80% dividends-received deduction.
All the undistributed earnings of Rex will be distributed in future years.
There are no other temporary differences.
Bart’s 20X5 income tax rate is 30%.
The enacted income tax rate after 20X5 is 25%.
In Bart’s December 31, 20X5 balance sheet, the deferred income tax liability should be
$9,000
The deferred tax liability is the future enacted tax rate, multiplied by the future taxable temporary difference.
The future temporary difference is the amount of income from the investment, based on Rex’s earnings through 20X5 only, that is expected to be taxable in the future, using enacted tax rates. No additional income for financial-accounting purposes will be recognized on Rex’s 20X5 income, because the equity method has recognized Bart’s entire share in 20X5. The future temporary difference is (.20)(.30)($900,000 − $300,000).
Rex has paid $300,000 dividends so far and will pay the remaining $600,000 in the future. Bart’s share is 30%, and only 20% will be taxed, owing to the dividends-received deduction. Multiplying that future temporary difference by the future tax rate of .25 yields the ending deferred tax liability of $9,000 = .25(.20)(.30)($900,000 − $300,000). The future tax rate is used, because that is the rate applicable when the difference reverses.
In its 20X5 income statement, Tow, Inc. reports proceeds from an officer’s life-insurance policy of $90,000 and depreciation of $250,000. Tow was the owner and beneficiary of the life insurance on its officer.
Tow deducted depreciation of $370,000 in its 20X5 income tax return when the tax rate was 30%. Data related to the reversal of the excess tax deduction for depreciation follow:
Year Reversal of excess tax deduction Enacted tax
rates
20X6 $50,000 35%
20X7 $40,000 35%
20X8 $20,000 25%
20X9 $10,000 25%
There are no other temporary differences. In its December 31, 20X5 balance sheet, what amount should Tow report as a deferred income tax liability?
$39,000
The life-insurance proceeds represent a permanent difference and therefore do not contribute to the deferred tax liability. Only temporary differences affect deferred tax accounts. The future temporary differences for depreciation are multiplied by the enacted tax rates in effect in the reversing period.
The $39,000 ending deferred tax liability for 20X5 is the sum of the tax effects of these differences: [$50,000(.35) + $40,000(.35) + $20,000(.25) + $10,000(.25)] = $39,000. The future enacted rates are used because those are the rates in effect when the differences reverse.
Fern Co. has net income, before taxes, of $200,000, including $20,000 interest revenue from municipal bonds and $10,000 paid for officers’ life insurance premiums where the company is the beneficiary. The tax rate for the current year is 30%. What is Fern’s effective tax rate?
28.5%
The effective tax rate is the ratio of income tax expense to pre-tax accounting income. income tax expense equals income tax liability in this case, because there are no temporary differences. Both the interest revenue and life-insurance premiums are permanent differences. The income tax liability is the product of the income tax rate and taxable income. Taxable income is $190,000 ($200,000 − $20,000 non-taxable interest included in the $200,000 + $10,000 non-deductible insurance premiums subtracted from $200,000). The income tax liability (and income tax expense) equal $57,000 (.30 × $190,000). The effective tax rate is .285 ($57,000/$200,000).
In its 20X5 income statement, Cere Co. reported income before income taxes of $300,000.
Cere estimated that, because of permanent differences, taxable income for 20X5 would be $280,000. During 20X5, Cere made estimated tax payments of $50,000, which were debited to income tax expense. Cere is subject to a 30% tax rate.
What amount should Cere report as income tax expense?
$84,000
income tax expense reflects the tax effects of permanent differences as measured by the tax code.
Because there are no temporary differences, income tax expense equals the income tax liability for the period or: $.30($280,000) = $84,000.
This reflects the tax ultimately payable on 20X5 transactions.
Therefore, income tax expense should also reflect that amount, in the absence of temporary differences.
According to FASB Statement No. 109, Accounting for Income Taxes, which of the following items should affect current income tax expense for 20X5?
Change in income tax rate for 20X5.
Current income tax expense is the income tax liability for the year. A change in 20X5’s tax rate changes the tax on taxable income and therefore current income tax expense. A change in the 20X6 tax rate, even if enacted in 20X5, would not change current income tax expense. It would change deferred income tax, however.
The other two answer alternatives are amounts that must be paid in 20X5, but are not recognized as current income tax. These amounts are separately payable to the taxing authority and are not computed as part of taxable income for 20X5. Therefore, current income tax for 20X5, which is income tax liability for 20X5, is unaffected by these items.
In Year 1, Lobo Corp. reported for financial-statement purposes the following revenue and expenses that were not included in taxable income:
Premiums on officers’ life insurance under which the corporation is the beneficiary $5,000
Interest revenue on qualified-state or municipal bonds $10,000
Estimated future warranty costs to be paid in Year 2 and Year 3 $60,000
Lobo’s enacted tax rate for the current and future years is 30%. Lobo has paid income taxes of $170,000 for the three-year period ended December 31, Year 1. There were no temporary differences in prior years.
The deferred tax benefit to be applied against current income tax expense is
$18,000
The only difference between taxable income and accounting income that results in a future tax benefit is the estimated warranty costs.
The future tax benefit is $18,000, which is computed as .30($60,000). In the future, $60,000 of warranty costs will be deductible, yet these costs have reduced accounting earnings as of December 31, Year 1. Therefore, future taxable income will be reduced by $60,000 as a result of transactions through December 31, Year 1.
That benefit is recorded as a deferred tax asset. The $18,000 amount reduces Year 1 income tax expense relative to income tax payable, because the payable does not reflect the warranty deduction in Year 1. It is not deductible until later years.
The insurance premiums and municipal-bond interest are permanent differences and do not result in future tax benefits.
Leer Corp.’s pre-tax income in 20X5 is $100,000. The temporary differences between amounts reported in the financial statements and the tax return are as follows:
Depreciation in the financial statements is $8,000 more than tax depreciation.
The equity method of accounting resulted in financial statement income of $35,000. A $25,000 dividend is received during the year, which is eligible for the 80% dividends received deduction.
Leer’s effective income tax rate was 30% in 20X5. In its 20X5 income statement, Leer should report a current provision for income taxes of
$23,400
The current provision for income taxes is the tax liability for the year: taxable income times the tax rate. Taxable income = $100,000 + $8,000 − $35,000 + .20($25,000) = $78,000. Therefore, current income tax expense (also the firm’s tax liability) is $23,400 ($78,000 × .30).
The $8,000 is added to pre-tax accounting income, because the latter income amount reflects $8,000 more depreciation than should be reflected in taxable income. The $35,000 is subtracted, because it is included in pre-tax accounting income, but is not included in taxable income. Only 20% of the dividends received is taxable owing to the 80% dividends-received deduction. The equity in income of the investee is not taxable income.
What effect does a reversing taxable
difference have on the tax accrual
entry?
It decreases the required ending
deferred tax liability balance.
What is the general formula for
computing income tax expense?
Income tax liability +/− Change in the
deferred tax accounts
How is the change in the deferred tax
liability account for a period
computed?
Required ending deferred tax liability
balance – Beginning deferred tax
liability balance
If future enacted tax rates are not the same as the current rate and future temporary differences originated in the current period, which rate(s) do(es) income tax expense reflect?
Both current and future enacted tax
rates are reflected.
How is the required ending deferred tax
liability balance expressed?
It is the product of the sum of future
taxable differences and the future
enacted tax rate.
If more than one tax bracket and tax
rate apply, what rate is used to
determine the change in deferred tax
accounts?
The average future enacted tax rate is
used to determine the change in
deferred tax accounts.
Kent, Inc.’s reconciliation between financial statement and taxable income for 20X5 is as follows:
Pre-tax financial income $150,000
Permanent difference ($12,000)
$138,000
Temporary difference - depreciation ($9,000)
Taxable income $129,000
========
Additional information:
At
___________________
Dec 31, 20X4 Dec 31, 20X5
Cumulative
temporary differences
(future taxable amounts) $11,000 $20,000
The enacted tax rate was 34% for 20X4, and 40% for 20X5 and years thereafter.
In its December 31, 20X5 balance sheet, what amount should Kent report as deferred income tax liability?
$8,000
The total future taxable difference at the end of 20X5 is $20,000.
Therefore, the balance in the deferred tax liability account is .40($20,000) = $8,000. Taxes payable in the future (after 20X5) will increase $8,000 as a result of transactions in 20X5 and earlier.
Mill, which began operations on January 1, 20X3, recognizes income from long-term construction contracts under the percentage-of-completion method in its financial statements and under the completed-contract method for income tax reporting.
Income under each method follows:
Year Completed-contract Percentage-of-completion
20X3 $ - $300,000
20X4 $400,000 $600,000
20X5 $700,000 $850,000
The income tax rate was 30% for 20X3 through 20X5. For years after 20X5, the enacted tax rate is 25%. There are no other temporary differences. Mill should report in its December 31, 20X5 balance sheet, a deferred income tax liability of
$162,500
Total income for the three years under the two methods is:
Percentage-of-completion:
$1.75mn ($300,000 + $600,000 + $850,000)
Completed-contract:
$1,100,000 ($400,000 + $700,000)
Difference $650,000
This difference is also the future difference in earnings to be recognized under the two methods, because both methods ultimately recognize the same total amount of income. Completed contract (for tax purposes) will recognize $650,000 more income than percentage of completion (for book purposes) after 20X5. Therefore, the difference is taxable and gives rise to a deferred tax liability of $162,500 ($650,000 × .25). The future enacted tax rate is applied, because that is the rate at which the deferred tax liability will be paid.
On January 2, 20X4, Ross Co. purchases a machine for $70,000. This machine has a five-year useful life, a residual value of $10,000, and is depreciated using the straight-line method for financial-statement purposes.
For tax purposes, depreciation expense was $25,000 for 20X4 and $20,000 for 20X5. Ross’ 20X5 income, before income tax and depreciation expense, was $100,000 and its tax rate was 30%.
If Ross had made no estimated tax payments during 20X5, what amount of current income tax liability would Ross report in its December 31, 20X5 balance sheet?
$24,000
The $24,000 current tax liability is the current tax rate times taxable income: $24,000 = .30($100,000 − $20,000).
Taxable income $450,000
Ram Corp. prepared the following reconciliation of income per books with income per tax return for the year ended December 31, 20X5:
Book income before income taxes $750,000
Add temporary difference construction contract revenue, which will reverse in 20X9 $100,000
Deduct temporary difference depreciation expense, which will reverse in equal amounts in each of the next four years ($400,000)
Ram’s effective income tax rate is 34% for 20X5. What amount should Ram report in its 20X5 income statement as the current provision for income tax?
$153,000
The current provision for income tax, also called the tax liability for the year, is the current tax rate multiplied by taxable income: .34 × $450,000 = $153,000.
Miro Co. began business on January 2, 20X0. Miro uses the double-declining balance method of depreciation for financial statement purposes for its building, and the straight-line method for income taxes.
On January 16, 20X2 Miro elected to switch to the straight-line method for both financial statement and tax purposes. The building cost $240,000 in 20X0, which has an estimated useful life of 15 years and no salvage value.
Data related to the building are as follows:
Year DD depreciation Straight-line depreciation
20X0 $30,000 $16,000
20X1 $20,000 $16,000
Miro’s tax rate is 40%
There should be no reduction in Miro’s deferred tax liabilities or deferred tax assets in 2002.
A change in method of depreciation is treated as an estimate change. The remaining book value is allocated over the remaining useful life of the asset. Therefore, the total future difference between book and tax depreciation as of the beginning of 20X2 remains unchanged. That difference is $18,000, the difference between book and tax depreciation through the end of 20X1. The pattern of reversal of this difference in the future has changed owing the change in method, but the total difference remains unchanged. Therefore, there is no reduction in the deferred tax asset at the beginning of 20X2.
Kent, Inc.’s reconciliation between financial statement and taxable income for 20X5 is as follows:
Pre-tax financial income $150,000
Permanent difference ($12,000)
$138,000
Temporary difference - depreciation ($9,000)
Taxable income $129,000
========
Additional information:
At
___________________
Dec 31, 20X4 Dec 31, 20X5
Cumulative
temporary differences
(future taxable amounts) $11,000 $20,000
The enacted tax rate was 34% for 20X4, and 40% for 20X5 and years thereafter.
In its 20X5 income statement, what amount should Kent report as current portion of income tax expense?
$51,600
The current portion of income tax expense is the tax liability for the year. The tax rate for the current year is applied to taxable income to compute this amount: .40($129,000) = $51,600.
A company reported the following financial information:
Taxable income for current year $120,000
Deferred income tax liability, beginning of year 50,000
Deferred income tax liability, end of year 55,000
Deferred income tax asset, beginning of year 10,000
Deferred income tax asset, end of year 16,000
Current and future years’ tax rate 35%
The current-year’s income tax expense is what amount?
$41,000
Income tax expense for the year is a derived amount and is the net sum of the income tax liability and the changes in the deferred tax accounts for the year. The income tax liability is the product of taxable income and the current-year tax rate, or $120,000(.35) = $42,000. The changes in the deferred tax accounts are the differences between the beginning and ending balances of those accounts.
From the data, the deferred tax liability increased $5,000 for the year and the deferred tax asset increased $6,000. With the two liabilities increasing a total of $47,000 and the deferred tax asset increasing $6,000, income tax expense is the difference, or $41,000.
The tax accrual journal entry is: dr. Income tax expense 41,000; dr. Deferred tax asset 6,000; cr. Deferred tax liability 5,000; cr. Income tax payable 42,000.
The increase in the deferred tax asset represents a future reduction in income tax recognized in income tax expense for the current year. The increase in the deferred tax liability represents a future increase in income tax recognized in income tax expense for the current year.
List the evidence suggesting the need
of a valuation allowance.
1. History of unused net operating losses 2. History of operating losses 3. Losses expected in future years 4. Very unfavorable contingencies 5. Very brief carryback or carryforward period
What is the classification of the
valuation allowance for deferred tax
assets?
The classification is contra deferred tax
asset.
List the sources for realizing a deferred
tax asset.
Expectation of future taxable
income
Taxable income in prior years
within the carryback period
Future taxable differences
Tax planning strategies
How is the amount of a valuation
allowance determined?
Enough to reduce deferred tax asset to
amount that has a better than 50%
chance of being realized.
When is a valuation allowance created
for a deferred tax asset?
When there is a 50% or less chance of
the deferred tax asset being fully
realized
What minimum percentage is used for
determining realization of a deferred
tax asset?
50%
Compute the ending valuation allowance if the total future deductible difference is $4,000, the tax rate is 30%, and only $1,000 of future taxable income is assured.
$900 (deferred tax asset balance is
$1,200, but only $300 is expected to be
realized)
What does a history of unused net
operating losses suggest?
It suggests that the deferred tax asset
will not be realized.
On its December 31, 20X5 balance sheet, Shin Co. has income tax payable of $13,000 and a current deferred tax asset of $20,000, before determining the need for a valuation account.
Shin had reported a deferred tax asset of $15,000 at December 31, 20X4. No estimated tax payments are made during 20X5. At December 31, 20X5, Shin determines that it is more likely than not that 10% of the deferred tax asset would not be realized.
In its 20X5 income statement, what amount should Shin report as total income tax expense?
$10,000
Income tax expense is the net sum of the income tax liability for the year, the changes in the deferred tax accounts, and the change in the valuation account for deferred tax assets.
Tax liability (current portion of income tax expense): $13,000
Less increase in deferred tax asset: $20,000 − $15,000 ($5,000)
Plus increase in valuation account: .10($20,000) $2,000
Equals income tax expense $10,000
The increase in the deferred tax asset causes income tax expense to decrease relative to the tax liability, because, as a result of transactions through the end of the current year, future taxable income will be reduced. This reduction is not realized in the current year as a reduction in the tax liability. Therefore, the anticipated future reduction is treated as an asset at the end of the current period. When realized, the asset is reduced in a future year.
The increase in the valuation allowance, which is contra to the deferred tax asset, reduces the deferred-tax-asset effect, because it is an amount of the deferred tax asset not likely to be realized.
Describe the accounting effect when the probability of sustaining an uncertain tax position is equal to or greater than the minimum for reducing income tax expense.
Recognize a reduction in income tax expense for the largest amount for which the cumulative probability of realization exceeds 50%, and recognize an additional liability for the unrecognized portion.
Describe the accounting effect when
the actual tax benefit is greater than
expected in a later year.
Reduce the income tax expense for the
difference between the benefit
recognized in the previous year and the
actual benefit.
Define “uncertain tax position.”
A position taken on the firm’s tax return
that reduces income tax but that may
be challenged by the taxing authorities
Describe the accounting effect when
the actual tax benefit is greater than
expected in a later year.
Reduce the income tax expense for the
difference between the benefit
recognized in the previous year and the
actual benefit.
Describe the account effect when the
probability of sustaining an uncertain
tax position is less than the minimum
for reducing income tax expense.
Report a liability for the uncertain tax
position in addition to the income tax
liability.
What is the minimum probability of
sustaining an uncertain tax position
required to reduce income tax expense
for an uncertain tax position?
Greater than 50%
Two years ago, Aggre Inc. recognized the tax benefit of an uncertain tax position. income tax expense in that year was reduced by $20,000 as a result. In addition, Aggre recorded a $5,000 tax liability for unrecognized benefits for the same tax position. During the current year, the uncertainty is resolved and a benefit of $22,000 is upheld. By what amount is current-year income tax expense affected by the resolution of the prior uncertainty?
$2,000 decrease.
Income tax expense was reduced two years ago by $20,000, but the final benefit upon resolution is $22,000. The $2,000 increase in benefit is recognized in the year of resolution.
The resolved benefit exceeds the $20,000 benefit taken previously. The firm has been awarded a $2,000 tax reduction, not yet recognized. This amount is recognized in the current year.
$20,000 of the benefit was recognized two years ago. Only the additional $2,000 is recognized in the current year as a change in estimate.
At the end of the current year, Swen Inc. prepares its tax return, which reflects an uncertain amount, reducing the firm’s tax liability by $40,000. Swen estimates that, upon audit by the IRS, there is a 20% chance that the full $40,000 benefit will be upheld, and a 40% chance that the benefit will be only $25,000. As a result of the required recognition and measurement principles for uncertain tax positions, current-year income tax expense is reduced by what amount?
$25,000
This is the largest amount, which has at least a 50% probability of occurring. The cumulative probability through this amount is 60%. A liability is recognized for the $15,000 of the total $40,000, which has less than a 50% chance of occurring.
The purpose of the cumulative probability approach is to identify the largest amount, which has at least a 50% probability of occurring. In this case, the amount is $25,000. There is a 60% chance of at least that much benefit occurring.
How should deferred tax accounts
under international accounting
standards be classified?
The classification is all noncurrent.
Increase in deferred tax asset is a feature of which option for net operating losses (NOLs)?
Both the carryback-carryforward
option and the carryforward-only
option.
What effect do future taxable differences have on the ending deferred tax asset for a firm with an unused net operating loss carryforward?
They have no effect; taxable differences
yield deferred tax liabilities.
What is the required ending balance of a deferred tax asset when there are future deductible differences and an unused net operating loss (NOL) carryforward?
It is the product of the future enacted
tax rate and the sum of future
deductible differences plus unused
NOL carryforward.
What period of years can a net
operating loss (NOL) be carried back
and forward?
Two years back, 20 years forward
What is the journal entry for recording a
net operating loss carryforward?
DR: Deferred Tax Asset
CR: Income Tax Benefit
What is the general expression for the change in deferred tax asset for a period for a net operating loss (NOL) carryforward that is not fully used up in the period?
End-of-period sum of future deductible
differences plus unused NOL
carryforward, times future enacted tax
rate, less beginning deferred tax asset
What is the journal entry for recording a
net operating loss carryback?
DR: Refund Receivable
CR: Income Tax Benefit
What effect does income tax benefit
have on income for financial reporting?
It increases net income.
What effect does a change in tax status
from nontaxable to taxable have on
deferred tax accounts?
Apply interperiod tax allocation as
usual; there are no beginning deferred
tax balances to use.
What is the ending balance of a
deferred tax asset for a net operating
loss (NOL) carryforward?
It is the product of the enacted future
tax rate and NOL remaining to
carryforward.
What is the main reason for choosing
the carryforward-only option?
An expectation of higher future tax
rates
What is the effective length of the
taxing period for the carrybackcarryforward
option?
The effective length of the taxing
period is 23 years.
Refund of taxes paid in the past is a
feature of which option for net
operating losses?
The carryback-carryforward option
What tax rate is used in computing a
refund from carryback of net operating
losses?
The tax rate paid on taxable income for
the previous two years.
List the net operating loss options a
taxpayer has.
Carryback carryforward option
Carryforward-only option
True or False: The total of all deferred
tax assets and deferred tax liabilities is
not required to be disclosed.
False. The total of all deferred tax
assets and deferred tax liabilities must
be disclosed.
Describe the general effect of a net
operating loss (NOL) on the ending
deferred tax asset balance for the
carryforward-only option.
Include in the ending DTA the full NOL
multiplied by the future enacted tax
rate.
How is a carryforward valued?
It is the product of enacted future tax
rate and the net operating loss (NOL)
remaining to carryforward.
Describe the general effect of a net
operating loss (NOL) on the ending
deferred tax asset balance for the
carryback-carryforward option.
Include in the ending DTA for the
portion of NOL remaining after being
used in the carryback multiplied by the
future enacted tax rate.
What effect does a change in tax status
from taxable to nontaxable have on
deferred tax accounts?
Close the accounts against income tax
expense (e.g., closing a deferred tax
asset increases income tax expense).
Which years of taxable income are
absorbed by a net operating loss (NOL)
carryback?
The taxable income two years before
the year of the NOL is used first, then
one year before the NOL
Define “net operating loss.”
Negative taxable income (strictly a tax
term)
Venus Corp.’s worksheet for calculating current and deferred income taxes for 20X4 is as follows:
20X4 20X5 20X6 Pre-tax income $1,400 Temporary differences: Depreciation ($800) ($1,200) $2,000 Warranty costs $400 ($100) ($300)
\_\_\_\_\_\_ \_\_\_\_\_\_ \_\_\_\_\_\_ Taxable income $1,000 ($1,300) $1,700 Loss carry-back (1,000) $1,000 Loss carry-forward $300 ($300)
\_\_\_\_\_\_ \_\_\_\_\_\_ \_\_\_\_\_\_
$0 $0 $1,400
===== ===== ===== Enacted rate 30% 30% 25% Deferred tax liability (asset):
Current ($300)
=====
Non-current $350
==== Venus had no prior deferred tax balances. In its 20X4 income statement, what amount should Venus report as:
Deferred income tax expense?
Deferred income tax expense is the net change in deferred tax accounts for the year. Because the firm began the year without any deferred tax accounts, that change equals the net sum of the ending deferred tax accounts for 20X4. Enacted tax rates are used to compute the change in deferred tax accounts.
Ending deferred tax liability (from depreciation temporary differences): $2,000(.25) − $1,200(.30) $140
Less ending deferred tax asset (from warranty temporary difference): $300(.25) + $100(.30) ($105)
Equals net change in deferred tax accounts, and deferred income tax expense $35
The 20X5 temporary difference for depreciation is subtracted from the 20X6 difference, because the 20X5 difference is an originating difference, whereas the 20X6 difference is the reversing difference.
No deferred tax asset was recognized in the Year 1 financial statements by the Chaise Company when a loss from discontinued segments was carried forward for tax purposes. Chaise had no temporary differences. The tax benefit of the loss carried forward reduced current taxes payable on Year 2 continuing operations.
The Year 2 financial statements would include the tax benefit from the loss brought forward in
Income from continuing operations.
The tax benefit of the carry-forward reduced taxes on Year 2 income from continuing operations, as indicated in the question. Therefore, the benefit is included in income from continuing operations.
At the end of the previous year, a firm reported a $6,000 deferred tax asset from a net-operating-loss carry-forward that can be carried forward several years into the future. The tax rate is 30%. For the current year, the firm records estimated warranty expense of $30,000 for the year and incurred $10,000 of warranty-claims costs. Taxable income for the current year is $12,000. Compute income tax expense (benefit) for the current year.
($2,400)
The unused net operating loss (NOL) at the beginning of the year is $20,000 (= $6,000/.3). The firm pays no tax for the current year, because $12,000 of the NOL is used to absorb the $12,000 of taxable income. $8,000 of the NOL remains to carry forward to the next year. Also, there is a future temporary difference of $20,000 from the future warranty deduction ($30,000 − $10,000 current-year claims). In total, then, the basis for the ending deferred tax asset is $28,000 (= $8,000 + $20,000). The ending deferred tax asset balance is $8,400 (= $28,000 × .3). The beginning deferred tax asset balance is $6,000. Therefore, the deferred tax asset is increased by $2,400 and income tax benefit of that amount also is recorded (credited) in the tax-accrual entry.
Which of the following should be disclosed in a company’s financial statements related to deferred taxes?
I. The types and amounts of existing temporary differences.
II. The types and amounts of existing permanent differences.
III. The nature and amount of each type of operating loss and tax credit carry-forward.
I and III only.
Deferred income tax accounts are not affected by permanent differences, because their effect on income tax is the same as their effect on income tax liability.
But temporary differences and operating loss and tax-credit carry-forwards produce deferred tax accounts. Temporary differences cause both deferred tax liabilities and assets to be recognized. Operating loss and tax credit carry-forwards generate only deferred tax assets.
To fully understand the nature of deferred tax accounts, the types and amounts of I and III are reported in a detailed footnote. For example, depreciation differences are major causes of deferred tax liabilities.
List the two accounting approaches for
recording accounting changes.
- Retrospective
2. Prospective
What accounting approach is applied
to error corrections?
Retrospective (restatement)
What accounting approach is applied
to principle changes?
Retrospective
What concept is displayed when there
is restatement of prior-year financial
statements?
Comparability
What is a change in accounting
principle?
A change from one generally accepted accounting principle to another when there are at least two acceptable principles or when the current principle used is no longer generally accepted.
What accounting approach is applied
to estimate changes?
Prospective
List the three types of accounting
changes.
- Change in accounting principle
- Change in accounting estimate
- Change in reporting entity
What type of changes and events are
comparative financial statements of
prior periods changed for?
Accounting principle changes
Error corrections
What accounting approach is used for a
change in reporting entity?
Retrospective method
What is the date of application used by
firms for accounting changes?
First day of the year of change
How is a change in method that is
indistinguishable from a change in
estimate accounted for?
Change in estimate
On January 1, Year 3, a company changed its inventory costing method from LIFO to FIFO. The company’s Year 3 financial statements contain comparative information for Year 2. How should the company present the Year 1 effect of the change in accounting principle in its Year 3 comparative financial statements?
As an adjustment to the beginning Year 2 inventory balance with an offsetting adjustment to beginning Year 2 retained earnings
Changes in accounting principles are applied retrospectively. Therefore, the beginning inventory of the earliest year presented is adjusted as if FIFO had always been applied. The earliest year presented is Year 2. Therefore, the beginning inventory and beginning retained earnings of Year 2 would be adjusted for the cumulative effect of the principle change.
How should a company report its decision to change from a cash-basis to an accrual-basis of accounting?
As a Prior period adjustment (net of tax), by adjusting the beginning balance of retained earnings.
The accrual basis of accounting is required by GAAP. A change from an inappropriate method to the correct method is treated as an error correction. The procedure requires retrospective application, resulting in an after-tax cumulative adjustment to prior years’ earnings (called a Prior period adjustment) to the beginning balance in retained earnings.
The effect of a change in accounting principle that is inseparable from the effect of a change in accounting estimate should be reported
As a component of income from continuing operations, in the period of change and future periods if the change affects both.
When an accounting principle change cannot be distinguished from an estimate change, it is accounted for as an estimate change. Changes in accounting estimate are accounted for currently and prospectively and are reported in income from continuing operations. The relevant accounts affected by the change are adjusted for the current and future years. The change is not retroactively applied.
The cumulative effect of a change in accounting principle should be recorded as an adjustment to retained earnings, when the change is:
Completed-contract method of accounting for long-term construction-type contracts to the percentage-of-completion method.
Accounting-principle changes such as this one are recorded by retroactively restating prior-year financial statements. The entry to record the change results in an adjustment to the beginning balance of retained earnings in the year of the change.
Changes in depreciation method are treated as estimate changes. There is no catch-up adjustment.
Longer useful life of equipment to shorter useful life is an estimate change and is handled currently and prospectively. Retained earnings are not adjusted and no catch-up adjustment is recorded.
Cash basis of accounting for vacation pay to the accrual basis would be accounted for as a correction of an error. The accrual basis is the required method of accounting for vacation pay. The change from an erroneous accounting principle to the correct one is an error correction and would require restatement of Prior period financial statements and Prior period adjustment if prior years’ earnings were affected. The accounting treatment for error corrections and principle changes is similar, however.
Foy Corp. failed to accrue warranty costs of $50,000 in its December 31, 2003 financial statements. In addition, a change from straight-line to accelerated-depreciation made at the beginning of 2004 resulted in a $30,000 decrease in income for the year. Both the $50,000 and the $30,000 are net of related income taxes.
What amount should Foy report as Prior period adjustments in 2004?
$50,000
The failure to accrue warranty expense is an accounting error. It gives rise to a Prior period adjustment in the year of discovery (2004).
Prior period adjustments are limited to corrections of errors affecting prior-year net income. They adjust the beginning balance of retained earnings in the year of correction. The change in depreciation method is an estimate change, which is reported in earnings. It is not a Prior period adjustment.
Lore Co. changed from the cash basis to the accrual basis of accounting during 2005. The cumulative effect of this change should be reported in Lore’s 2005 financial statements as a
Prior period adjustment resulting from the correction of an error.
The cash basis of accounting is not acceptable under GAAP. Therefore, the change to the accrual basis is a change from an unacceptable method or basis of accounting to an acceptable method or basis. Such a change is treated as an error correction, which is reported as a Prior period adjustment. This adjustment is to the beginning balance in retained earnings for the current year.
Prior period adjustments do not result from changes in accounting principle.
Although retained earnings is adjusted, the adjustment is a Prior period adjustment, rather than a cumulative effect of accounting principle change.
The correction does not affect current-year income at all. Rather, it is treated as a Prior period adjustment, which is an adjustment to the beginning balance of current-year retained earnings. The FASB has eliminated the category for extraordinary gains and losses, therefore extraordinary items no longer exist.
What account records the effect of
principle change on prior years?
Retained earnings
What account is debited when an
accounting principle change causes
income in prior years to decrease?
Retained earnings (cumulative effect of change)
What is the pretax amount of the
cumulative effect of a change in
inventory method?
The difference in inventory balance for
the new and old methods, at the
beginning of the year of change
What is the amount recorded for the
change in deferred taxes for a change
in accounting principle?
The pretax cumulative effect multiplied
by the tax rate
What is the amount of the cumulative
effect reported in the earliest reported
year of the retained earnings
statement?
The effect of the change on years
before the earliest year reported
What accounting change is often
impracticable to compute a cumulative
effect?
Change to last in first out (LIFO)
The following schedule shows year-end inventory balances under the FIFO and weighted-average methods:
Year FIFO Weighted-average
2002 $45,000 $54,000
2003 $78,000 $71,000
2004 $83,000 $78,000
What amount, before income taxes, should be reported in the 2005 financial statements as the cumulative effect of the change in accounting principle?
$5,000 decrease.
The cumulative effect is computed as of the beginning of the year of change (2005), because the new method (WA) is used in 2005 to compute cost of goods sold and ending inventory. The pre-tax effect of the change on the previous three years is the difference between ending 2004 inventory under the two methods. The only income account affected by the method change is cost of goods sold. The cumulative effect adjusts the beginning of 2005 retained earnings balance.
At the beginning of operations in 2002, there was no beginning inventory. Purchases are the same under either method. Therefore, the difference in cost of goods sold and therefore pre-tax income for the three years between the two methods is $5,000 = ($83,000 − $78,000). WA recognizes more cost of goods sold. Therefore, the cumulative effect reduces 2005 pre-tax income by $5,000.
During 2005, Orca Corp. decided to change from the FIFO method of inventory valuation to the weighted-average method. Inventory balances under each method were as follows:
FIFO Weighted-average January 1, 2005 $71,000 $77,000 December 31, 2005 $79,000 $83,000
Orca’s income tax rate is 30%.
In its 2005 financial statements, what amount should Orca report as the cumulative effect of this accounting change?
$4,200
$6,000 is the cumulative pre-tax income difference between the two methods as of January 1, 2005.
The after-tax difference is .70($6,000) or $4,200. Accounting changes are measured as of the beginning of the year of change. The $6,000 represents the total difference in cost of goods sold between the two methods for the entire life of the firm, because under weighted-average, the firm has $6,000 more in inventory than under FIFO at January 1, 2005. This is the “ending” inventory for that firm, as of that date, for the firm’s entire existence.
The $6,000 difference completely explains the pre-tax difference in income under the two methods for years up to January 1, 2005; the $4,200 is the after-tax difference.
Cumulative effects are reported net of tax as an adjustment to the beginning balance of retained earnings in the year of the change.
During 2006, Orca Corp. decides to change from the FIFO method of inventory valuation to the weighted-average method. Inventory balances under each method were as follows:
FIFO Weighted-average January 1, 2006 $71,000 $77,000 December 31, 2006 $79,000 $83,000
Orca’s income tax rate is 30%.
Orca should report the cumulative effect of this accounting change as a(an)
Adjustment to retained earnings.
Accounting-principle changes are reported as an adjustment to retained earnings at the beginning of the year of change. Prior financial statements are retrospectively adjusted.
Accounting-principle changes are not classified as Prior period adjustments (adjustments to the beginning retained earnings balance).
Only corrections of errors in prior-year income are classified as Prior period adjustments.
What accounting approach is applied
to changes in depreciation method?
Prospective
What is the most frequent type of
accounting change?
Estimate change
What is the amount of cumulative
effect recorded for change in
depreciation method?
None (The prospective approach is
applied.)
What is the rationale for applying the
prospective method to estimate
changes?
The new information triggering the
change is not applicable to prior years.
How is a change in depletion method
accounted for?
Prospective approach (same as estimate change)
What is the first computation in
accounting for an estimate change
involving a depletable resource?
Compute book value at the beginning
of the year of change.
What disclosures are required for
estimate changes?
Effect of the change on income from
continuing operations and net income
for the year of change
During 2005, Krey Co. increased the estimated quantity of copper recoverable from its mine. Krey uses the units-of-production-depletion method.
Which of the following statements correctly describes the appropriate accounting for this change?
The change in estimate is applied as of the beginning of 2005 for current and future periods.
This is an accounting-estimate change. These accounting changes are handled currently and prospectively by applying the new estimate to the current and future periods, if affected. The effect of the change on prior years’ earnings is not computed, because the new information causing the estimate change was not known at that time.
Cumulative effects are reported for accounting principle changes, not estimate changes, because the effect of the change on prior years is computed and reported for accounting principle changes only.
On January 1, 2002, Flax Co. purchased a machine for $528,000 and depreciated it by the straight-line method using an estimated useful life of eight years with no salvage value.
On January 1, 2005, Flax determines that the machine had a useful life of six years from the date of acquisition and will have a salvage value of $48,000. An accounting change is made in 2005 to reflect these additional data.
The accumulated depreciation for this machine should have a balance at December 31, 2005 of
$292,000
This is a change in estimate. The new estimated useful life and salvage value are applied to the book value at the beginning of the year of the estimate change.
Accumulated depreciation,
January 1, 2005 = $528,000(3/8) = $198,000
Book value,
January 1, 2005 = $528,000 − $198,000 = $330,000
Depreciation,
2005 = ($330,000 − $48,000)/(6 − 3) = $94,000
Accumulated depreciation,
31 December 2005 $292,000
The denominator of the 2005 depreciation calculation (6 − 3) is the new total useful life of six years, less the three years for which the asset has been used as of January 1, 2005.
On January 2, year 3, to better reflect the variable use of its only machine, Holly, Inc. elects to change its method of depreciation from the straight-line method to the units-of-production method. The original cost of the machine on January 2, year 1, is $50,000, and its estimated life is ten years. Holly estimates that the machine’s total life is 50,000 machine hours.
Machine-hour usage was 8,500 during year 2 and 3,500 during year 1. Machine-hour usage for year 3 is 3,800.
Holly’s income tax rate is 30%. Holly should report the accounting change in its year 3 financial statements as a(an)
Estimate change recognizing $4,000 of depreciation in year 3.
A change in depreciation method is accounted for as an estimate change. The remaining book value at the beginning of the year of change is allocated over the remaining useful life using the new method.
Book value January 1, year 3
= $50,000 - ($50,000/10)2 = $40,000.
Estimated remaining machine hours at January 1, year 3 = $50,000 − $8,500 − $3,500 = $38,000.
Depreciation expense for 2005 = 3,800($40,000/38,000) = $4,000.
Mellow Co. depreciates a $12,000 asset over five years, using the straight-line method with no salvage value. At the beginning of the fifth year, it is determined that the asset will last another four years.
What amount should Mellow report as depreciation expense for year five?
$600
The book value at the beginning of the year of the change in estimated useful life is used as the base for subsequent depreciation. After four years, the book value remaining is one-fifth of its original cost, because there is no salvage value and the firm uses SL depreciation.
That remaining book value is spread equally over four more years, yielding $600 of depreciation in each of those years. Book value at the beginning of year five = $12,000 − 4($12,000/5) = $2,400. Depreciation expense for year five = $2,400/4 = $600. The four years remaining include year five.
When a company changes the expected service life of an asset because additional information has been obtained, which of the following should be reported?
Cumulative effect of accounting principle change
Deferred income tax adjustment
Cumulative effect of accounting principle change - NO
Deferred income tax adjustment - NO
The change in expected service life is an accounting-estimate change. These are handled currently and prospectively. No attempt is made to compute the effect of the change on prior years’ income, because the new information was not available at that time.
With no catch-up adjustment, there is no change in deferred taxes, because future differences between book and tax depreciation have not been changed.
Which of the following statements is correct as it relates to changes in accounting estimates?
Whenever it is impossible to determine whether a change in accounting estimate or a change in accounting principle has occurred, the change should be considered a change in estimate.
When it is impossible to determine whether the change is an estimate or a change in accounting principle, the change should be considered a change in estimate and accounted for prospectively.
On January 1, 2004, Taft Co. purchases a patent for $714,000. The patent is being amortized over its remaining legal life of 15 years, expiring on January 1, 2019.
During 2007, Taft determined that the economic benefits of the patent would not last longer than ten years from the date of acquisition.
What amount should be reported in the balance sheet for the patent, net of accumulated amortization, at December 31, 2007?
$489,600
This is a change in accounting estimate. The beginning 2007 patent balance is $714,000(12/15) = $571,200, because three years of amortization would have been recorded as of that date, based on 15 years. Amortization in 2007, therefore, is $571,200(1/7) = $81,600.
As of the beginning of 2007, only seven years remain in the useful life, because the total useful life as of that date was changed to ten years, and the patent had been used for three years as of that date.
Therefore, the ending net balance in the patent is $571,200 − $81,600 = $489,600.
Belle Co. determined after four years that the estimated useful life of its labeling machine should be ten, rather than 12 years. The machine originally cost $46,000 and had an estimated salvage value of $1,000. Belle uses straight-line depreciation. What amount should Belle report as depreciation expense for the current year?
$5,000
The asset has a depreciable base of $46,000-$1,000=$45,000. The depreciation expense for years one through four is $45,000/12=$3,750.
Accumulated depreciation after four years is $3,750 × 4 =$15,000.
The carrying value after four years is $46,000-$15,000=$31,000.
Depreciation based on the new estimated useful life is $31,000-$1,000 = $30,000 for the depreciable base. The remaining useful life is 10-4=6 years.
Depreciation for the current year is $30,000/6 = $5,000.
Matt Co. included a foreign subsidiary in its 2008 consolidated financial statements.
The subsidiary was acquired in 2002 and was excluded from previous consolidations. The change was caused by the elimination of foreign-exchange controls.
Including the subsidiary in the 2008 consolidated financial statements results in an accounting change that should be reported
By restating the financial statements of all prior periods presented.
The elimination of foreign-currency controls would legitimately change the status of the foreign sub from non-consolidated to consolidated.
This causes a change in the reporting entity, since both companies must now be reported together. A change in reporting entity utilizes the retrospective method.
What accounting approach is applied
to corrections of errors affecting prioryear
net income?
Retrospective
How many years should be considered
when computing the adjustment to the
earliest year in the retained earnings
statement?
All years before the earliest year in the
statement affected by the error
Define “prior-period adjustment.”
Change in retained earnings for error
corrections
How many years should be considered
in the journal entry to correct retained
earnings?
All years affected by the error through
the beginning of the year of change
What is the change in retained earnings
for an error correction called?
Prior-period adjustment
How should the effect of a change in accounting estimate be accounted for?
In the period of change and future periods if the change affects both.
Accounting-estimate changes are treated currently and prospectively (in the future).
If the change affects only the current period, then only current-period earnings is affected. More frequently, though, the change affects future periods as well. Then, current and future earnings are affected.
An estimate change is never treated retroactively. Prior-year earnings are never adjusted for a change in estimate, because the information giving rise to the change could not have been known in prior periods.
Conn Co. reports a retained-earnings balance of $400,000 at December 31, 2004.
In August 2005, Conn determines that insurance premiums of $60,000 for the three-year period beginning January 1, 2004 had been paid and fully expensed in 2004. Conn has a 30% income tax rate.
What amount should Conn report as adjusted beginning retained earnings in its 2005 statement of retained earnings?
$428,000
The 2005 statement of retained earnings must disclose a Prior period adjustment to the beginning retained-earnings balance for the amount required to correct prior-year net income.
2004 insurance expense actually recognized (in error) $60,000
Less 2004 correct insurance expense - the amount that should have been recognized ($60,000/3 - a three-year policy) (20,000)
Equals the error in pre-tax income before 2005(income understated) $40,000
Times (1 - tax rate) to determine after-tax error x .70
Equals the error correction, the amount by which retained earnings at January 1, 2005 must be increased(the Prior period adjustment) $28,000
Plus unadjusted retained earnings at January 1, 2005 $400,000
Equals adjusted retained earnings at January 1, 2005 $428,000
On January 1, year one, Newport Corp. purchases a machine for $100,000. The machine is depreciated using the straight-line method over a ten-year period with no residual value. Because of a bookkeeping error, no depreciation was recognized in Newport’s year-one financial statements, resulting in a $10,000 overstatement of the book value of the machine on December 31, year one. The oversight was discovered during the preparation of Newport’s year-two financial statements. What amount should Newport report for depreciation expense on the machine in the year-two financial statements?
$10,000
The year-one error has no bearing on the amount of depreciation to be recognized in subsequent years. Annual depreciation is $10,000 (= $100,000/10). In year two, a Prior period adjustment will be recorded, correcting beginning retained earnings and accumulated depreciation. Year-one statements reported comparatively with year two’s statements will be shown correctly. Year two will report $10,000 of depreciation expense.
Miller Co. discovers that in the prior year, it failed to report $40,000 of depreciation related to a newly constructed building. The depreciation was computed correctly for tax purposes. The tax rate for the current year is 40%.
What was the impact of the error on Miller’s financial statements for the prior year?
Understatement of accumulated depreciation of $40,000.
Accumulated depreciation is a pre-tax amount. The journal entry omitted in the past is:
dr. Depreciation expense, $40,000;
cr. Accumulated depreciation, $40,000.
The beginning balance of accumulated depreciation in the year the error was discovered is understated by $40,000 because that amount was not recorded in a prior year.
The senior accountant for Carlton Co., a public company with a complex capital structure, has just finished preparing Carlton’s income statement for the current fiscal year. While reviewing the income statement, Carlton’s finance director noticed that the earnings-per-share data have been omitted. What changes will have to be made to Carlton’s income statement as a result of the omission of the earnings-per-share data?
Carlton’s income statement will have to be revised to include the earnings-per-share data.
All publicly traded companies are required to report EPS information. However, only the current year is affected. Restatement of prior-year statements is not required.
In single period statements, which of the following should be reflected as an adjustment to the opening balance of retained earnings?
Effect of a failure to provide for uncollectible accounts in the previous period.
This is an error correction. The correction of an error affecting the income of prior periods is accounted for as a Prior period adjustment. This adjustment corrects the beginning retained earnings balance in the period the error was discovered, thereby correcting the retained earnings carried forward from earlier periods.
On January 2, 2005, Air, Inc. agrees to pay its former president $300,000 under a deferred-compensation arrangement.
Air should have recorded this expense in 2004, but did not do so. Air’s reported income tax expense would have been $70,000 lower in 2004 had it properly accrued this deferred compensation.
In its December 31, 2005 financial statements, Air should adjust the beginning balance of its retained earnings by a
$230,000 debit.
The after-tax amount of the overstatement of 2004 earnings is $230,000 ($300,000 − $70,000 tax effect).
2004 income is overstated by this amount, because the expense and tax effect were not recorded. Ending 2004 retained earnings is overstated by $230,000. Therefore, beginning 2005 retained earnings must be decreased (debited) $230,000. This is accomplished by adjusting the beginning 2005 retained earnings balance with a Prior period adjustment of $230,000 (debit).
Cuthbert Industrials, Inc. prepares three-year comparative financial statements. In year 3, Cuthbert discovered an error in the previously issued financial statements for year 1. The error affects the financial statements that were issued in years 1 and 2. How should the company report the error?
The financial statements for years 1 and 2 should be restated; the cumulative effect of the error on years 1 and 2 should be reflected in the carrying amounts of assets and liabilities as of the beginning of year 3.
When there is an error in prior period financial statements and those statements are presented with the current year, the error should be corrected in years 1 and 2 so they are comparative to year 3. The effect of the error should be reflected in the year 3 beginning balances of the appropriate assets and liabilities.
During 2005, Dale Corp. made the following accounting changes:
Method used in 2004 Sum-of-the-years' digits depreciation After-tax Method used in 2005 Straight-line depreciation effect $30,000
Method used in 2004
Weighted-average for inventory valuation
After-tax Method used in 2005
First-in, first-out for inventory valuation
effect $98,000
What amounts should be classified in 2005 as Prior period adjustments?
What amounts should be classified in 2005 as Prior period adjustments?
$0
Neither of the changes listed are Prior period adjustments (PPA). A PPA is an adjustment to the beginning retained earnings balance that corrects the effect on retained earnings of errors in reporting prior-year income. A PPA is not a voluntary accounting change.
The change in inventory method is an accounting principle change, which requires the recording of a cumulative effect of accounting change as an adjustment to retained earnings. This account measures the effect of the change on prior-year net income. The change in depreciation method is treated as an estimate change. The remaining book value at the beginning of the year of change is allocated to the remaining useful life using the new depreciation method.
At the end of 2003, Ritzcar Co. fails to accrue sales commissions earned during 2003, but paid in 2004. The error is not repeated in 2004.
What was the effect of this error on 2003 ending working capital and on the 2004 ending retained earnings balance?
2003 ending working capital
20x4 ending retained earnings
2003 ending working capital - Overstated
20x4 ending retained earnings -No Effect
The entry that should have been accrued at the end of 2003 is:
dr. Commission expense xxx
cr. Commission payable xxx
Working capital (current assets, less current liabilities) is overstated, because current liabilities (via unrecorded commission payable) are understated. By the end of 2004, the error has counterbalanced. The commission expense attributable to 2003 (in the above entry) would have been recognized as expense upon payment in 2004. Although earnings of both years are in error, the ending retained earnings balance for 2004 is correct.
In which of the following situations should a company report a Prior period adjustment?
The correction of a mathematical error in the calculation of prior years’ depreciation.
A Prior period adjustment is defined as the correction of an error affecting prior-year income. The adjustment reverses the error by correcting beginning retained earnings in the year of discovery. If depreciation in a prior year is misstated, then income in that year is also incorrect, as well as the balance in retained earnings. The Prior period adjustment corrects retained earnings and accumulated depreciation.
A change in depreciation method is treated as an estimate change. The book value at the beginning of the year of change is allocated to the remaining years of useful life. Prior periods are unaffected by estimate changes. A Prior period adjustment corrects an error in the reported income of prior years.
Disposal of assets before the end of their estimated useful lives is a common occurrence. The asset and accumulated depreciation are removed from the accounts and a gain or loss is recognized. There is no effect on prior periods.
Estimate changes are treated currently and prospectively - the change is applied to current years and future years, if affected. The book value at the beginning of the year of change is allocated to the remaining years of useful life using the new estimated remaining useful life.
In which of the following situations should a company report a Prior period adjustment?
The correction of a mathematical error in the calculation of prior years’ depreciation.
A Prior period adjustment is defined as the correction of an error affecting prior-year income. The adjustment reverses the error by correcting beginning retained earnings in the year of discovery. If depreciation in a prior year is misstated, then income in that year is also incorrect, as well as the balance in retained earnings. The Prior period adjustment corrects retained earnings and accumulated depreciation.
A change in depreciation method is treated as an estimate change. The book value at the beginning of the year of change is allocated to the remaining years of useful life. Prior periods are unaffected by estimate changes. A Prior period adjustment corrects an error in the reported income of prior years.
Disposal of assets before the end of their estimated useful lives is a common occurrence. The asset and accumulated depreciation are removed from the accounts and a gain or loss is recognized. There is no effect on prior periods.
Estimate changes are treated currently and prospectively - the change is applied to current years and future years, if affected. The book value at the beginning of the year of change is allocated to the remaining years of useful life using the new estimated remaining useful life.
