Chapter 10

Other Items That

Affect Net Income
and Owners’
Equity

McGraw-Hill/Irwin Copyright © 2011. The McGraw-Hill Companies. All Rights Reserved.

 Components of Stockholders’
Equity
• Common stock.
• Preferred stock.
• Retained earnings.
• Direct debits/credits.

10-2
 Topics in Chapter
• Nonowner transactions affecting owners’
equity (and disclosure requirements).
• Extraordinary items.
• Discontinued operations.
• Accounting changes.
• Accounting errors.
• Foreign currency translation adjustments.
• Derivatives.
10-3
 Reporting Requirement
• Total nonowners changes in owners’ equity.
– Considerable leeway in reporting format.
– Net income plus other nonowner changes in
owners equity.
• Unrealized gains and losses on available-for-sale
securities (Chapter 5).
• Net investment foreign currency translation
adjustments.
• Gains and losses on certain derivatives.
• Other items (beyond scope of this book).

10-4
 Extraordinary Items
• Unusual and infrequent.
– Unusual (i.e., highly abnormal and unrelated to
ordinary activities of entity).
– Infrequent (i.e., not reasonably expected to recur in
foreseeable future).
• FASB: report on income statement after “income
from continuing operations” (net of income tax
effect ).
• IASB: no such distinction, no separate reporting.
10-5
 Not Extraordinary items
• Write-downs or write-offs of accounts
receivable, inventory, or intangible assets.
• Gains or losses from exchange rate changes.
• Gains or losses on disposal of segment of a
business.
• Gains or losses from disposal of fixed assets.
• Effects of a strike.

10-6
 Discontinued Operations

• Discontinuance of a division or other

identifiable segment of a business.
• Must involve a whole business unit, not
one asset or a product line.
• May be abandoning segment and selling
off assets (usually at a loss), or
• Selling off the segment (for a gain or a
loss).
10-7
 Accounting for
Discontinued Operations
• If loss is expected:
– Record in period in which decision is made.
– Involves:
• Estimating revenues and expenses until disposition.
• Estimating proceeds of assets sale.
• Determining book value of assets disposed of.
• If gain is expected, do not recognize until
realized (i.e., disposal date).
10-8
 Discontinued Operations
Income Statement Presentation

• Reported net of tax in two amounts:

– Net income or loss attributable to
operations of segment until it is sold.
– Estimation of gain or loss on disposal arising
from all aspects of sale.

10-9
 Change in Accounting
Principles
• Consistency concept requires using same
accounting principle year after year.
• But, new pronouncement from FASB/IASB
may require a change.
• Can also change if there is a sound reason.
• Accounted for retrospectively.
– Prior periods restated as if new policy has always
been used (unless impractical to do so).

10-10
 Errors

• Mathematical mistakes.
• Mistakes in the application of accounting
principles.
• Oversight or misuse of facts that existed
at time financial statements were
prepared.
• Also accounted for retrospectively.

10-11
 Personnel Costs
• Wages and salaries earned by employees
and other costs related to their services.
• Employee deductions (not a cost to
employer):
• FICA contributions for Social Security and
Medicare.
• Withholding for federal and state income
taxes.
• Deductions for charitable contributions,
savings plans, union dues, etc. 10-12
 Personnel Costs

• Employer costs:
• Matching FICA contributions.
• Unemployment insurance.
• Fringe benefits (e.g., pensions, life insurance,
health care, vacation).

10-13
 Pensions

• Payments received by employees after

they retire.
• Typically 5%-10% of payroll.
• Regulated under Employee Retirement
Income Security Act (ERISA).
– In most cases pensions must be at least
partially funded.

10-14
 Types of Pension Plans
• Defined contribution plan:
– Employer contributes an agreed amount.
– No promise as to how much benefits will
be.
– Employer’s expense is amount
contributed to plan each year.
• Defined benefit plan:
– Employer agrees to contribute an
amount so that employees will receive a
specified amount of benefits.
10-15
 Pension Cost
• Defined benefit plan determinations are
complicated.
• Based on present value concepts.
• Must estimate:
– How many years employees will work.
– Employee turnover.
– Average employee earnings.
– How many years employees live after retirement.
– Inflation.
– Earnings on invested pension funds.
– Other factors.
10-16
 Components of Pension Cost
• Service cost (+).
– Present value of future benefits employees earned
during year.
• Interest cost (+).
– Amount by which plan’s beginning of year obligations
has increased.
• Return on plan assets (-).
– Based on an long-run expected rate of return.
• Prior service cost (+).
– Adjustment for employees service prior to initiation
(or change) of plan.
10-17
 Pension Disclosures

• Period’s net pension cost.

• Unfunded plan position for each defined
benefit plan.
• Four components of net pension cost.
• Assumptions of calculations of a plan’s
funding position.

10-18
 Other Fringe Benefits
• Other postretirement benefits.
– E.g., healthcare, life insurance.
– Accounting similar to pensions.
• Compensated absences.
– Occurs when unearned sick and/or vacation days
can be carried forward.
– Expense in period earned; credit liability account.
– Reduce liability account when employee is
compensated.
10-19
 Income Tax Expense
• Current year’s tax expense is:
– Current income tax expense (this year’s tax bill),
– Adjusted for deferred income tax expense items.
• Pretax accounting income (i.e., prescribed by
GAAP) is not always the same as taxable
income (i.e., prescribed by tax authorities).
• Arises because some items handled
differently under tax accounting vs. book
accounting (GAAP).
10-20
 Why Do Book and Taxable
Income Differ?
• Objective of tax accounting:
– Raise taxes and encourage certain
economic behavior (e.g., accelerated
depreciation to encourage investment).
• Objective of financial reporting:
– Provide information useful to creditors,
investors, etc.

10-21
 Permanent Differences
Between Book and Tax
• Do not reverse in future years.
• Expenses under GAAP that are not
deductible (e.g., fines).
• Revenues excluded from taxable income
(e.g., revenue on municipal bonds).
• Does not create accounting issues.

10-22
 Temporary Difference
Between Book and Tax
• Differences that reverse in a later period.
– Revenues or expenses that are permitted
(or required) to be reported in a different
period (e.g. depreciation).
• Creates accounting complexities in order
to match income tax expense to period
in which revenue or expense item is
recognized.
10-23
 Deferred Tax Liabilities
• Caused by a temporary difference that initially
creates taxable income that is lower than
book income (i.e., less expense or more
revenue on books).
• Common example: Accelerated depreciation
on tax return.
• However, effect reverses in future years.
– “Permanent deferrals” effect created as a
company grows.
10-24
 Deferred Tax Assets
• Caused by a temporary difference that initially
creates taxable income that is higher than
book income (i.e., more expense or less
revenue on books).
• Examples:
– Warranty expense recorded when revenue
recognized for book, when actually paid for tax.
– Subscription receipts recognized when received
for tax, when earned for book.
– Tax loss carryforwards.
10-25
 Tax Rate Changes and
Disclosures
• Deferrals recorded based on rates currently in
tax law (adjust as needed if rates change).
• Disclosures:
– Deferred tax asset and liability amounts shown
separately.
– Must be classified appropriately as current or
noncurrent.
– However, IFRS does not permit classifying
deferred tax assets/liabilities as current.
10-26
 Gain/Losses on Foreign
Currency Transactions
• Occurs when:
• Firm buys or sells goods from foreign entity.
• Transaction denominated in foreign currency.
• Currency exchange rate has fluctuated.
• At balance sheet date, recorded balances are
adjusted to current (i.e. spot) exchange rate.
• Gains/losses are included in net income in
period incurred.

10-27
 Foreign Currency
Translation Adjustments
• Occurs when foreign subsidiary records
are kept in local (foreign) currency.
• To consolidate with other operations,
must be translated into reporting
currency.
• Dependent on functional currency.

10-28
 Foreign Currency
Translation Adjustments
• Functional currency.
• Determines which translation method is
used.
• Currency of the primary economic
environment in which company operates.
• Net investment (current rate) method.
– Used when functional currency is local currency.
• Remeasurement (temporal) method.
– Used when functional currency is US dollar.
10-29
 Foreign Currency
Translation Adjustments
• Net investment (current rate) method.
• All assets and liabilities translated at current
exchange rate (at balance sheet date).
• All revenue and expense items translated at
average exchange rate for period.
• Translation gains/losses do not appear on income
statement.
• Shown as component of other nonowner changes
in owners equity (e.g., “Cumulative foreign
currency translation adjustment”).
10-30
 Foreign Currency
Translation Adjustments
• Remeasurement (temporal) method.
• Objective is to report foreign subsidiary’s
financial activities as if were carried out as
integral part of parent’s operations.
• Most items are translated at same rate as
current rate method.
• Rate at date acquired (i.e., historical rate) used
for long-lived assets and inventory, along with
expenses related to these assets (i.e.,
depreciation and cost of goods sold).
• Gains/losses arising from remeasurement are
included in income. 10-31
 Accounting for Derivatives
• Financial instrument that changes value based
on value of one or more variables (e.g., share
price, price index, interest rate).
• Recognized as assets or liabilities and
measured at fair value.
• Gains/losses included in net income (except
when designated as and qualifying as a type of
hedge).
• Hedge derivatives shown under nonowner
changes in owners equity.
10-32
 Pro Forma Earnings

• Excludes certain items included in

computing net income (e.g., merger
related charges, non-recurring items,
goodwill impairment write-offs).
• Shown at discretion of management.
• Not covered by GAAP.
• Cannot be misleading.
10-33
 Net Income

• Also called net earnings.

• Bottom line of Income Statement.
• Never appears as label on any other line.
• Net addition to Retained Earnings.

10-34