ACC302 EXAM 2

CH 16,17,18

Why is pretax financial income often different from taxable income?

Because financial accounting (GAAP) and tax regulations have different objectives, leading to differences in timing and recognition of revenues and expenses

What is the main objective of accounting for income taxes?

To recognize deferred tax assets (DTAs) and deferred tax liabilities (DTLs) for future tax consequences of events already recognized in financial statements

What is the key issue underlying differences between book income and taxable income?

Not whether amounts are taxable or deductible, but when they are recognized

What are temporary differences?

Differences between book and tax income that arise because items are recognized in different periods and will reverse in the future

What do temporary differences result in?

Deferred tax assets (DTAs) or deferred tax liabilities (DTLs)

How do temporary differences relate to future taxable amounts?

If they create future taxable income, they result in a deferred tax liability (DTL)

How do temporary differences relate to future deductible amounts?

If they create future deductions (reduce taxable income), they result in a deferred tax asset (DTA)

What is a future taxable amount?

A situation where taxable income will increase in the future relative to accounting income

What is a future deductible amount?

A situation where taxable income will decrease in the future relative to accounting income

How are DTLs calculated?

Temporary book-tax differences × applicable tax rate

How are DTAs calculated?

Future deductible amounts × applicable tax rate

What does it mean when a temporary difference “reverses”?

The difference between book and tax income eliminates in a future period, affecting taxable income

How is income tax expense computed?

Income tax payable ± change in deferred tax assets and liabilities

What is income tax payable?

The amount of taxes owed for the current year based on the tax return

Why is income tax expense considered a “plug”?

Because it is determined after accounting for tax payable and changes in deferred tax accounts

What is the journal entry for income taxes?

DEBIT: Income tax expense

CREDIT: Income tax payable

How is income tax expense presented on the income statement?

As a single line item that includes both current tax payable and deferred tax effects

What are permanent differences?

Differences between book and income tax that will never reverse and never affect taxable income in the future

Do permanent differences create DTAs and DTLs?

No because they do not result in future taxable or deductible amounts

How do permanent differences affect the relationship between pretax income and taxable income?

They cause a permanent gap between the two, without future reversal

How do permanent differences affect the effective tax rate?

They change the ratio of tax expense to pretax accounting income

Example of a permanent difference

Interest income from municipal bonds that is tax-exempt and never included in taxable income

What are the two primary components of shareholders’ equity?

Paid-in capital and retained earnings

What does paid-in capital represent?

Amounts invested by shareholders when they purchase shares from the corporation

What does retained earnings represent?

Accumulated, undistributed income

What does a debit balance in retained earnings indicate?

A deficit

What 4 categories make up accumulated other comprehensive income (ACOI)?

1. Investments holding gains/losses

2. Post retirement plan adjustments

3. Deferred derivative gains/losses

4. Foreign currency translation adjustments

What major advantage of the corporate form protects owners from business debts?

Limited liability

What voting-related right do common shareholders’ possess?

The right to vote on matters such as electing corporate directors

What is the preemptive right of common shareholders?

The right to maintain their percentage ownership when new shares are issued

What dividends preference do preferred shareholders typically have?

They receive designated dividends before common shareholders

How are shares issued for non-cash consideration measured?

At the fair value of the assets or services received

Why do companies repurchase their own shares?

To distribute profits without dividends, support share price, or offset shares issued in compensation plans

How is treasury stock treated under the cost method?

As a temporary reduction of shareholders’ equity at the cost of the shares

When is a liability for cash dividends recorded?

When the board of directors declares the dividend

What determines which shareholders receive a declared dividend?

Shareholders of record on the date of record

How are property dividends measured?

At the fair value of assets to be distributed

What is the effect of a stock dividend on shareholder ownership percentages?

Proportional ownership remains unchanged

What distinguishes a large stock dividend of a small one?

A large stock dividend is 25% or more of outstanding shares

How is a 2-for-1 stock split accounted for?

No journal entry is made; par value per share is reduced by half

What does earnings per share (EPS) summarize?

The performance of a business enterprise in a single number

How is basic EPS calculated?

Earnings available to common shareholders/ weighted‑average number of common shares outstanding

What reduces earnings available to common shareholders before calculating EPS?

Dividends to preferred shareholders

Why must the weighted‑average number of shares be used in EPS?

Because the number of shares can be changed during the reporting period

How does issuing new shares affect EPS?

It increases the number of shares and dilutes existing shareholders’ interest in earnings

How do stock dividends and stock splits affect EPS?

They increase the number of shares without changing assets, requiring EPS to be adjusted for the larger share count

How are reacquired shares treated in the EPS calculation?

They reduce the weighted-average number of shares for the portion of the year they were not outstanding

How are cumulative preferred dividends treated in EPS?

They are subtracted from earnings even if not declared, because they are presumed to be paid eventually

What is a complex capital structure?

A structure that includes potential common shares such as options or convertible securities

What is the purpose of diluted EPS?

To incorporate the dilutive effect of all potential common shares

What method is used to account for stock options in diluted EPS?

The treasury stock method

Under the treasury stock method, how is the number of incremental shares determined?

New shares from option exercise minus the number of shares that could be repurchased with the exercise proceeds

How do convertible bonds affect diluted EPS?

The numerator increases by after‑tax interest savings, and the denominator increases by the shares that would be issued upon conversion

How does convertible preferred stock affect diluted EPS?

Preferred dividends are not subtracted, and the denominator increases by the shares issued upon conversion

When are potential common shares excluded from diluted EPS?

When they are antidilutive (i.e., they increase EPS instead of decreasing it)