Chapter 11 Expenditure Cycle: Other Operating Items.

Chapter 11Expenditure

Cycle:Other Operating

Items

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Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Balance SheetIncome

StatementStatement of Cash Flows

Long-Term Assets:

Net Pension AssetDeferred income

tax asset

Long-Term Liabilities:

Net pension liability

Deferred income tax liability

Contingent liabilities

Employee Compensation Expense

Research and Development Expense

Advertising ExpenseLosses/Gains on

contingent ItemsIncome Tax Expense

OperatingCash paid for:

Employee Compensation

Research and Development

AdvertisingIncome Taxes

Financial Statement ItemsCovered in this Chapter

EmployeeCompensation

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The employee compensation time line illustrates that issues relating to employee compensation can extend long after the employee stops working for the company

Employee Compensation Timeline

Payroll Stock Options Pensions and and Bonuses Postretirement

Compensated Postemployment Benefits Other Absences Benefits Than Pensions

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Payrolland Payroll Taxes

Payroll:– salaries and

wages earned by employees for work done in the current period

Employee payroll taxes:

– Federal income tax– State income tax– FICA taxesEmployer payroll

taxes:– FICA taxes– Federal

unemployment taxes– State unemployment

taxes

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A company pays employees for a certain number of days when the employees do not work

– vacation leave days– sick leave days

The expense should be recognized in the period in which the days are earned, not in the period in which the actual cash payment occurs

Compensated Absences

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Bonuses

Allow employees to receive additional compensation if certain earnings objectives are met

These plans are usually restricted to top management

Potential that managers will attempt to manipulate reported earnings

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Employee Stock Options

Managers are given the option of purchasing shares of the company’s stock in the future at a price that is specified today (option price)

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Intrinsic value methodbased on the assumption that the value of an option, if any, is measured on the day it is granted (market price minus the option price)

Fair value methodbased on the assumption that the value of the option lies in the chance that the stock price will increase above the exercise price

Employee Stock OptionsAccounting for

Employee Stock Options

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Employee Stock Options: Intrinsic Value Method

Most companies set the option price above the market price at the date of grant so that no compensation expense is measured and recorded

Market

$ $Option price > market value results in no expense to issuing company

Option price < market value results in expense

to issuing company

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Employee Stock Options: Fair Value Method

The fair value is estimated by a formula that considers several factors including the expected volatility of the stock price and the length of the exercise periodThe fair value of the options is reported as compensation expense on the income statement

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Employee Stock Options: FASB’s Treatment

Companies are encouraged, but not required, to adopt the fair value method

The intrinsic value method is allowed, but if used, companies must disclose what net income would have been under the fair value method

Stay tuned for further FASB action HW #11-4

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Postemployment Benefits

Benefits that occur after an employee has ceased to work for an employer but before an employee retires

– Example: a severance pay package

The cost must be estimated and reported when the decision is made

– Example: to downsize the labor force

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Pensions

Cash compensation received by an employee after the employee has retired

Two types of pension plans:

– Defined contribution plan

– Defined benefit plan

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Pensions:Defined Contribution Plan

Requires the company to contribute a fixed amount of money to a pension fund each year on behalf of the employeeThe amount of cash contributed to the pension fund during the year is reported as pension expense

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Pensions:Defined Benefit Plan

Requires the company to pay employees a fixed monthly cash amount after they retire based on a pension formula that considers years of service and highest salary

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Estimation of the pension liability– The amount that would have to be

deposited in a bank today to accumulate enough interest to pay employees their pension benefits at retirement (actuarial present value)

– Called the projected benefit obligation (PBO)

– The PBO is offset against the plan assets fair value when reported on the balance sheet


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Three components of pension expense:

+Interest cost+Service cost– Expected return on pension fund

assets=Net pension expenseHW # E11-9


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Interest cost– The increase in the PBO due to the

passage of time (PBO × discount rate)

– The discount rate used is the settlement rate•The implicit rate of interest necessary

to purchase annuity contracts settling the pension obligation


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Service cost– The increase in the PBO from service

provided by employees during the current period

Expected return on pension fund assets

– The return that the company earns on the assets in the pension fund

– A negative (off-set) component of pension expense


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Postretirement BenefitsOther Than Pensions

Other employee benefits provided after retirement include

– Health care plans– Life insurance plans

U.S. GAAP requires that these benefits be recognized as an expense and a liability as they are incurred

Income Taxes

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Income Taxes

Income tax expense and the amount paid for income tax during a period are different for two reasons:

– Income taxes are not paid in the same year in which they are incurred

– A firm may choose one accounting method for tax purposes and another for financial reporting purposes

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Financial Income vs Taxable Income

Differences in financial income and taxable income are

– Permanent– Temporary

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Permanent Differences

• Used to determine financial income, but never taxable income

• Reflect statutory differences between GAAP and the Internal Revenue Code– Example: interest on state and local

bonds is included in financial income, but not in taxable income

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Temporary Differences

Some transactions affect taxable income in a different period from financial accounting income

– Depreciation methods– Rent received in advance

Reported on the balance sheet as– Deferred tax assets– Deferred tax liabilities HW # E-10

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Tax Liabilities

Income taxes payable– Based on taxable income on the

tax return– An existing (current) legal liability

Deferred tax liability– Requires a payment in the future– Is the expected income tax on

income earned but not yet taxed– Not an existing legal liability HW # E-11-14

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Deferred Tax Liability

A typical entry for recording income taxes with a Deferred Tax Liability would be

• Income Tax Expense is reported on the income statement

• Income Taxes Payable and Deferred Tax Liability are reported on the balance sheet

Income Tax Expense 12,000Income Taxes Payable 4,000Deferred Tax Liability 8,000

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• The expected benefit of a future tax deduction for an expense item that has already been incurred but is not yet deductible for tax purposes

• Can only be recognized if it is“more likely than not” that future income will be realized against which the deduction can be offset

Deferred Tax Asset

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A typical entry for recording income taxes with a Deferred Tax Asset would be

• Income Tax Expense is reported on the income statement

• Income Taxes Payable and Deferred Tax Asset are reported on the balance sheet

Income Tax Expense 20,000Deferred Tax Asset 4,000

Income Taxes Payable 24,000

Deferred Tax Asset

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Income Tax Disclosure

Provide details about– Current and deferred federal taxes– Current and deferred state taxes– Taxes owed to foreign

governments– Taxes attributable to foreign

operations

Capitalize vs Expense

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Expense/Asset Continuum

• An expenditure that is expected to benefit future periods is capitalized as an asset

• All other expenditures are treated as expenses

Supplies Used Repairs

Research and

Develop-ment

Software

Develop-ment

Oil and Gas

Explora-tion

Land and

Buildings

Expense Asset

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ResearchThose activities undertaken to discover new knowledge that will be useful in developing new products, services, or processes or that will result in significant improvement of existing products or processes

Development Applies the research findings to develop a plan or design for new or improved products and processes

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Research and development costs are expensed in the period incurred due to the uncertainty surrounding the future economic benefits of R&D activities


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Point of technological feasibility

Research & Development:Software

Expense

Treat as R&D(future benefit uncertain)

Capitalize

Uncertainty of futurebenefit is decreased

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Oil and Gas Exploration Costs

Two methods of accounting for the cost of “dry holes”

– Full cost method•All exploratory costs are capitalized

and allocated to the cost of successful wells

– Successful efforts method•Exploratory costs for dry holes are

expensed, and only exploratory costs for successful wells are capitalized

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General treatment:– expensed due to the uncertainty of their

future economic benefits

Exception:– Capitalize if– Future benefits are more certain

•Target customers who have purchased before•Able to estimate degree of favorable

responseHW # E11-16

Advertising Costs

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Contingencies

An uncertain circumstance involving a potential gain or loss that will not be resolved until some future event occursHW # E11-17

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Three important definitions:– Probable

•Likely to occur

– Remote•Not likely to occur

– Reasonably possible•More than remote but less than

likely

Contingencies

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Accounting for Contingencies

Losses GainsProbable

Recognize a probable liability if the amount can be reasonably estimated.

May be disclosed in the financial statements by note, but should not be reflected in income, because doing so may result in recognizing revenue prior to its realization. Care should be exercised in disclosing gain contingencies to avoid misleading implications

Possible Disclose a possible liability in a note.

Remote No recognition or disclosure unless contingency represents a guarantee. Then, note disclosure is required

No recognition or disclosure

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Accounting for Contingencies:

LawsuitsIf the facts of the case indicate that a loss is probable and the amount of the loss can be estimated, a loss should be reported on the income statement and a liability should be reported on the balance sheet

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Accounting for Contingencies:

Environmental LiabilitiesMost companies do not reflect these loss contingencies as liabilities on the balance sheet

– The future cost of the cleanup is very difficult to estimate

– Accounting standards do not provide disclosure guidance

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In Summary ...

• In addition to payroll, compensation takes the form of bonuses, stock options, pensions, and other benefits

• Taxable income and financial income are normally different amounts; deferred taxes are recorded as non-current assets and/or liabilities

• Capitalized expenses have future benefit and are recorded as assets

• Contingencies are described as probable, possible, and remote; accounting treatment depends on likelihood and ability to estimate an amount

Chapter 11 Expenditure Cycle: Other Operating Items.

Documents

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pensionsfinancial accounting

stock price

option pricefair value

market price

additional compensation

companys stock

thomsonintrinsic value