FAR 2 Exam 2

Taxable Income for Corporations

Corporations are assessed taxes equal to 21% of their

taxable income.

how do

corporations determine taxable income?

PTBI and book tax differences

Why cant individuals determine taxable income this way?

they dont have GAAp starting numbers

“Unfavorable”

Increases taxable income in a given year.

“Favorable”

Decreases taxable income in a given year.

Permanent

Represents an absolute difference between book and

tax; difference will never reverse

Temporary

Represents a timing difference between book and tax;

difference will reverse in the future

Permanent differences result from either

• Items included in PTBI, but never included in taxable income

• Items included in taxable income, but never in PTBI

Nontaxable Income (Perm diff)

interest income from municipal bonds,

proceeds from life insurance on key officers

Nondeductible Expenses

Expenses related to tax exempt

income (e.g., premiums paid on life insurance), fines, penalties

Additional Deductions Provided by Tax Law

Dividends

received deduction (DRD)

Deferred tax assets

Represent future tax savings as the result of deductible temporary differences existing at the end of the current year

Deferred tax liabilities

Represent future taxes payable as a result of taxable temporary differences existing at the end of the end of the year

What happens when a company has a negative amount

of taxable income in a given year?

• Company generates a net operating loss (NOL).

• Company pays no income taxes for the year in which

the NOL is generated.

• The NOL can be carried forward to future years to

reduce taxes in future years

NOLs essentially are a form of a temporary difference

because

• For book purposes, if a loss occurs, the Company

simply reports a loss.

• For tax purposes, if a loss occurs, the loss is limited

to zero on the current provision (companies do not

get a refund today for the loss) and the benefits of the

loss are instead delayed to the future.

Do NOLs produce DTAs or DTLs?

DTA

If more likely than not that the future benefits of the DTA

will not be fully realized

a valuation allowance must be created

Valuation allowance extreme scenario

a valuation allowance may be

recorded against all of the DTAs (“full VA position”) if the

company is not projected to generate any taxable income

in the future

The ETR is usually different than the federal statutory tax rate

for various reasons, including

• Permanent differences – Question: Why not temporary?

• Change in valuation allowance

• Different statutory rates for different jurisdictions

• Change in tax rates applied to deferred balances

pension plan

is an arrangement whereby an employer

provides benefits (payments) to retired employees for

services they provided in their working years

Contributory

Employees voluntarily make

payments to increase their

benefits.

Noncontributory

Employees do not contribute;

employers bear the entire cost

Qualified

Offers tax benefits; employer’s

contributions are deductible and

earnings from pension assets

are tax free.

To account for defined contribution plans:

• The amount of pension expense is the employer’s

annual required contribution to the pension.

• The employer has no liability to the pension other than

to make the required contribution.

vested benefit obligation

• benefits only for vested employees at their current salaries

accumulated benefit obligation

benefits for vested and nonvested at current salaries

projected benefit obligation

benefits for vested and nonvested at future salaries

Overfunded

Plan Assets > Projected Benefit Obligation

Underfunded:

Plan Assets < Projected Benefit Obligation

The five primary components of pension expense under

the defined benefit plans are as follows:

1. Service cost (current period)

2. Interest on the liability

3. Return on plan assets (expected)

4. Amortization of prior year service cost

5. Amortization of gains/losses (using corridor approach)

Service Costs

represent the actuarial present value of

the benefits (attributed by the pension benefit formula) to

employee services provided during the period.

Interest on the Liability

Interest during the period on the projected benefit

obligation outstanding during the period. Discount rate

used is referred to the settlement rate

Return on Plan Assets

represents residual change in

plan assets from activity other than contributions and

benefits paid (i.e., from interest, dividends, and fair value

changes).

• expected

Prior Service Costs

represent benefit obligations granted

to employees for prior service rendered before the

initiation or amendment of a defined benefit plan.

• Amortized into pension expense over the remaining service

life of the related employees, rather than included

immediately into pension expense

Amortization of PSC

represents the transfer of the prior

service costs from OCI to pension expense over the

remaining service life of the related employees.

• FASB prefers the years-of-service method (similar to

activity method depreciation).

• However, companies may use straight-line amortization

over average remaining service life of employees.

Gains and Losses on Plan Assets

• Gain: Actual Return > Expected Return

• Loss: Actual Return < Expected Return

Gains and Losses on PBO

arise from changes in the

actuarial assumptions used to measure the obligation

(e.g., discount rate, mortality, turnover).

• Gain: Assumption changes decrease the PBO.

• Loss: Assumption changes increase PBO.

Amortization of Gains (Losses)

Gains and losses will typically offset one another through

time, but if the AOCI balance becomes too large, then

the gains and losses will be amortized out of OCI and

into pension expense

Corridor Approach

determines the required minimum

amortization if the AOCI balance becomes too large.

• “Too large”: Beginning AOCI > 10% of the greater of

beginning PBO or plan assets.

• If not too large, then there is no amortization.

• If too large, any excess over the threshold is amortized into

pension expense over the average service life of existing

employees.

 Average Service Life = Total Service Years/# of Employees

Key Point: This analysis is done at the BEGINNING of each period!

when is corridor approach done?

BEGINNING OF YEAR

Financial Statement Reporting: Defined Benefit Plans

• Recognize on a noncurrent asset or liability on the

balance sheet based on overfunded or underfunded

status of the pension.

Financial Statement Reporting: Defined Benefit Plans

Pension expense must be shown by component on the

income statement:

 Current year service cost: Operating Expense

 Other components: Other Expenses and Losses

Financial Statement Reporting: Defined Benefit Plans

Note disclosures, such as components of pension

expense, change in actuarial assumptions, rates assumed,

allocation of plan assets, and expected future payouts.

Why lease property? (Lessees)

100% financing at fixed rates, protection against obsolescence, flexibility

Why lease property? (Lessors)

Profitable interest margins, stimulate sales,

tax benefits, can provide a high residual value.

Sales-Type (Lessor)

If the lease transfers control

of the underlying asset to the

lessee, with no involvement

of third parties

Direct Financing

If a lease transfers control of

the underlying asset to the

lessee, with a third party

guaranteeing the residual

value

Included in “payments” for 90% test:

• Fixed payments

• Variable payments that can be determined

• Guaranteed residual value

• Payments related to purchase or termination options that

the lessee is reasonably certain to exercise

Operating Leases with ASC 842 (Prior)

No asset and liability recorded at lease

inception (off-balance sheet financing). Lessees recognized

rent expense straight-line over life of lease.

Operating Leases with ASC 842 (Now)

Lessees always record a ROU asset and

lease liability at lease inception. Lease expense remains

straight-line, but is now a function of the underlying asset

and liability:

 Interest component: Based on liability carrying value.

 Asset amortization component: Plugged to keep total lease

expense equal each period

Gains/Losses: Lease Liability

Special Issues: Residual Values

The lessee may record a gain or loss on the lease

liability related to a guaranteed residual value if the

required payment differs from the expected payment as

of the inception of the lease:

• Gain: Actual “shortfall” < expected “shortfall”

• Loss: Actual “shortfall” > expected “shortfall”

If the residual value is unguaranteed, the lessee will not

record any gain or loss as the lessee does not bear any

risk for the residual value in that circumstance.

Gains/Losses: Lease Receivable

Special Issues: Residual Values

The lessor may record a gain or loss on the lease

receivable if the residual value is higher or lower than

the expected residual value as of the inception of the

lease:

• Gain: Actual residual value > expected residual value

• Loss: Actual residual value < expected residual value

If the residual value is guaranteed, the lessor will not record

any loss as the lessee will be required to pay the lessor for

any “shortfall” in the expected value. Lessor could still have

gain if worth more than expected though

Other items that affect ROU asset, but not lease liability

Prepayments (Increase): Any amount paid by lessee to

lessor before lease begins (i.e., prepaid rent).

• Incentives (Decrease): Any benefit the lessor provides to

the lessee to encourage entering the lease (e.g., one moth

free rent, cash incentives).

Bargain Purchase Option Economic Life

increases to whole economic life for lessee

Short Term Lease

• has a lease term of 12 months or

less, as of the commencement date.

• Lessees may elect to expense lease payments as

incurred for short-term leases, rather than recording a

ROU asset and lease liability.

• Renewal or termination options that are reasonably certain

to be exercised by the lessee should be considered as

part of the lease term

Change in Accounting Principle

represents change from

one generally accepted accounting principle to another

When does change in accounting principle occur

• An entity makes a decision to adopt a different principle

that is preferable (e.g., changing from FIFO to average cost

for inventory).

• Newly issued guidance requires the adoption of a new

principle.

Changes in accounting principle generally follow a

restrospective approach

Retrospective accounting principle

1. An entry is recorded for the cumulative effect (net of

tax) of adopting the new principle, as of the

beginning of the current year.

2. Amounts presented in the comparative financial

statements are adjusted to be reported under the

new principle for comparability

Reporting a Change in Principle

Major disclosure requirements are as follows:

1. Nature of the change in accounting principle.

2. The method of applying the change, and:

a. A description of the prior period information that has been

retrospectively adjusted, if any.

b. The effect of the change on income from continuing operations,

net income (or other appropriate captions of changes in net

assets or performance indicators), any other affected line item.

c. The cumulative effect of the change on retained earnings or

other components of equity in the statement of financial position

as of the beginning of the earliest period presented

How do companies handle the “domino effect” of

the retrospective approach

Companies should only retrospectively apply the direct

effects of a change in accounting principle.

 Example: If company changes from LIFO to FIFO, need to

consider impacts on LCNRV or LCM rules.

• Companies do not change prior period amounts for

indirect effects of a change in accounting principle.

 Example: If net income increases after switching to FIFO,

and this would in theory affect the company’s profit-sharing

plan – this would be indirect and disregarded

Impracticability

Change in Accounting Principle

Companies should not use retrospective application if

one of the following conditions exists:

1. Company cannot determine the effects of the

retrospective application.

2. Retrospective application requires assumptions about

management’s intent in a prior period.

3. Retrospective application requires significant estimates

that the company cannot develop.

If any of the above conditions exists, the company applies the

new accounting principle prospectively

Change in Accounting Estimate

relate to changes due to

additional information, such as acquiring more experience

or new events.

Changes in accounting estimates are reported

prospectively (past periods don’t matter)

Examples of Estimate Changes

• Useful lives and salvage values of assets

• Change in depreciation methods

• Uncollectible receivables

• Inventory obsolescence

• Periods benefited by deferred costs

• Liabilities for warranty costs and income taxes

• Recoverable mineral reserves

In certain situations, it can be difficult to differentiate

between a change in estimate and a change in

accounting principle

• If it is impossible to determine whether a change in

principle or a change in estimate has occurred, then

consider the change as a change in estimate.

• Referred to as a “change in estimate effected by a

change in accounting principle”.

• Common example: Change in depreciation method.

Steps for Calculating Revised Depreciation Expense:

1. Calculate the book value through the date of the

change of estimate using the original method and

inputs.

2. Calculate the amount of the depreciation expense in

the year of change:

 Use the current book value as the cost basis.

 Use the remaining useful life as the useful life.

 Consider the latest salvage value (where applicable).

 Apply the new method (if changed).

Books are Open

Temporary accounts have NOT been

closed to Retained Earnings yet (i.e., closing process has

not yet occurred). Any errors in the temporary accounts can

be directly corrected in the temporary accounts.

Books are Closed

Temporary accounts have been closed

to Retained Earnings (i.e., closing process has occurred).

Any errors in the temporary accounts must be corrected in

Retained Earnings