FAR 7

Question 1

How many of the following four aspects of accounting for pension gains and losses contribute to the reduction in volatility of reported pension expense: (1) use of corridor amortization as an acceptable method, (2) gains and losses cancel, (3) spreading the amount subject to amortization over the average remaining service period of plan participants, (4) the use of expected return for component 3 of pension expense?

Answer 1

How many of the following four aspects of accounting for pension gains and losses contribute to the reduction in volatility of reported pension expense: (1) use of corridor amortization as an acceptable method, (2) gains and losses cancel, (3) spreading the amount subject to amortization over the average remaining service period of plan participants, (4) the use of expected return for component 3 of pension expense?

Question 2

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

Answer 2

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

Question 3

A firm is applying international accounting standards to its defined-benefit pension plan. Owing to an amendment to the plan at the end of the current year, prior service cost (PSC) of $1mn is recognized (60% of which is vested). The appropriate period for amortization is ten years. As a result of the amendment, by what amount is pension expense for the following year increased?

Answer 3

The vested portion of PSC is recognized immediately. The remainder (40% or $400,000) is gradually amortized to pension expense over ten years, or $40,000 per year.

Question 4

Under certain circumstances, a firm provides severance pay and tuition assistance to employees who are laid-off. The beginning balance in the associated liability for the current year is $112,000. During the year, employees earned $48,000 of additional benefits, 60% of which are expected to be used by terminated employees, based on past experience. During the year, the firm paid $38,000 to reimburse previous employees for benefits taken. Compute the ending balance of the benefit liability.

Answer 4

Only 60% of the benefits earned are expected to be taken by the covered employees. The amount recognized as expense is limited to this amount, because the criteria for recognition require that payments be probable in order for accrual to take place. The following equation (or T-account) provides the solution: $112,000 + (.60)($48,000) - $38,000 = $102,800.

Question 5

Which of the following is not a criterion that must be met in order for nonretirement postemployment benefits to be accrued, rather than be treated as a cash expense upon payment.

Answer 5

This answer is a description of vested benefits. Benefits need not vest for accrual to be mandatory.

Question 6

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?

Answer 6

Beginning post-retirement benefit liability equals $200mn ($300mn APBO - $100mn assets). Post-retirement benefit expense: $40mn SC + $15mn interest cost (.05 x $300mn) - $6mn expected return (.06 x $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.

Question 7

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.

Answer 7

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

Question 8

On January 1, 2003, Gel Inc. granted a maximum of 900 stock options to selected employees. The options are exercisable beginning in 2007. The fair value of one option is estimated to be $2. The options vest based on the extent to which Gel’s sales increases from its 2002 base level:
500 shares vest if sales in 2006 increased 15% over 2002 sales
750 shares vest if sales in 2006 increased 25% over 2002 sales
900 shares vest if sales in 2006 increased 40% over 2002 sales
At December 31, 2003, Gel’s management anticipates: (1) no forfeitures, and (2) based on 2003 results, the firm will meet the 15% performance target.

At December 31, 2004, Gel’s management anticipates: (1) 5% total forfeitures, regardless of the performance target reached, and (2) based on 2004 results, the firm will meet the 25% performance target. Compute compensation expense for 2004.

Answer 8

Service period is four years (2003-06).
Total estimated compensation expense at December 31, 2003: 500($2) = $1,000.

Compensation expense for 2003: ($1,000/4) = $250.

Total estimated compensation expense at December 31, 2004: 750(1 - .05)($2) = $1,425.

Compensation expense for 2004: $1,425(2/4) - $250 = $462.50.

Question 9

The stockholders of Meadow Corp. approved a stock-option plan that grants the company’s top three executives options to purchase a maximum of 1,000 shares each of Meadow’s $2 par common stock for $19 per share. The options were granted on January 1 when the fair value of the stock was $20 per share. Meadow determined that the fair value of the compensation is $300,000 and the vesting period is three years. What amount of compensation expense from the options should Meadow record in the year the options were granted?

Answer 9

Compensation expense per year is the total $300,000 compensation expense divided by 3 years, or $100,000 per year.

Question 10

Compensation expense for year two causes total recognized compensation expense through year two to be half of total compensation expense using the new estimate.

Answer 10

The new estimate is used to compute compensation expense on prior years and the year of change. The resulting total amount of expense through the year of change, less the expense already recognized, is the amount of expense recognized in the year of change.
The new estimate continues to be applied in later years.

Question 11

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?

Answer 11

Total compensation expense at grant date is $60,000 (3,000 x $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 x $20)/4].

The expense for the two years associated with the 100 shares forfeited is $1,000 [(100 x $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.

Question 12

On January 2, 2005, Morey Corp. granted Dean, its president, 20,000 stock appreciation rights for past services. Those rights are exercisable immediately and expire on January 1, 2008.
On exercise, Dean is entitled to receive cash for the excess of the stock’s market price on the exercise date over the market price on the grant date. Dean did not exercise any of the rights during 2005. The market price of Morey’s stock was $30 on January 2, 2005 and $45 on December 31, 2005.

As a result of the stock appreciation rights, Morey should recognize compensation expense for 2005 of

Answer 12

The 2005 compensation expense for these stock-appreciation rights equals: (number of shares) x (ending market price - grant-date market price) = 20,000($45 - $30) = $300,000.
The rights are immediately vested, because they can be exercised immediately. Therefore, the entire $300,000 amount is recognized as expense in 2005. Changes in market price in future years, before the rights are exercised, are recognized on a current and prospective basis (change in estimate).

Question 13

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

Answer 13

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.

Question 14

Lake Corp., a newly organized company, reported pre-tax financial income of $100,000 for 2005.
Among the items reported in Lake’s 2005 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
Lake elected early application of FASB Statement No. 109, Accounting for Income Taxes. The enacted tax rate for 2005 is 30% and 25% thereafter. In its December 31, 2005 balance sheet, Lake should report a deferred income tax liability of

Answer 14

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.

Question 15

On June 31, 2004, Ank Corp. pre-paid a $19,000 premium on an annual insurance policy.
The premium payment was a tax-deductible expense in Ank’s 2004 cash-basis tax return. The accrual-basis income statement will report a $9,500 insurance expense in 2004 and 2005.
Ank elected early application of FASB Statement No. 109, Accounting for Income Taxes.
Ank’s income tax rate is 30% in 2004 and 25% thereafter. In Ank’s December 31, 2004 balance sheet, what amount related to the insurance should be reported as a deferred income tax liability?

Answer 15

The future temporary difference at December 31, 2004 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 2004. Therefore, no further deduction will be taken beyond 2004. The difference is taxable, because future taxable income exceeds future pre-tax accounting income from transactions through 2004.

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 2004 = $2,375 = .25($9,500).

Question 16

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, 2004 as its current federal income tax liability?

Answer 16

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.

Question 17

Orleans Co., a cash-basis taxpayer, prepares accrual-basis financial statements. Since 2002, Orleans has applied FASB Statement No. 109, Accounting for Income Taxes. In its 2005 balance sheet, Orleans’ deferred income- tax liabilities increased compared to 2004.

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.

Answer 17

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.

Question 18

When accounting for income taxes, a temporary difference occurs in which of the following scenarios?

Answer 18

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.

Question 19

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?

Answer 19

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 x $190,000). The effective tax rate is .285 ($57,000/$200,000).

Question 20

Tara Corp. uses the equity method of accounting for its 40% investment in Flax, Inc.’s common stock. During 2005, 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 2005 income tax rate is 30%.
Enacted income tax rates after 2005 are 25%.
Tara elected early application of FASB Statement No. 109, Accounting for Income Taxes. In its December 31, 2005 balance sheet, the increase in the deferred income tax liability from the above transactions would be

Answer 20

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.