CHAPTER 10 PAYROLL TAXES BONUSES EXPENDITURE CYCLE: OTHER OPERATING ITEMS

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1 CHAPTER 10 EXPENDITURE CYCLE: OTHER OPERATING ITEMS 1 PAYROLL TAXES Employee payroll taxes: Federal income tax State income tax FICA taxes Employer payroll taxes: FICA taxes Federal unemployment taxes State unemployment taxes 2 BONUSES Bonus plans allow employees to receive additional compensation if certain earnings objectives are met These plans are usually restricted to top management One possible danger is that managers will attempt to manipulate reported earnings 3 1

2 INCOME TAXES Income tax expense and the amount paid for income tax are different for two reasons: Income taxes are not totally paid in the same year in which they are incurred One accounting method may be used for tax purposes and another for financial reporting purposes 4 INCOME TAXES Differences in financial statement income and taxable income are due to two types of differences Differences can be Permanent or Temporary 5 PERMANENT DIFFERENCES Enter into accounting income, but never into taxable income These are differences between GAAP and the Internal Revenue Code For example, interest on state and local bonds is included in financial income, but not in taxable income 6 2

3 TIMING DIFFERENCES Temporary differences Some transactions affect taxable income in a different period from financial accounting income Depreciation methods Rent received in advance The affects of these differences are recorded as deferred tax assets or liabilities and shown on the balance sheet 7 DEFERRED TAXES Deferred Tax Liability Requires a payment in the future Is the expected income tax on income earned but not yet taxed Income Taxes Payable Tax due within the next 12 months 8 DEFERRED TAXES Entry for recording income taxes with a Deferred Tax Liability would be Income Tax Expense 12,000 Income Taxes Payable 4,000 Deferred Tax Liability 8,000 Income Tax Expense is an expense on the income statement Income Taxes Payable and Deferred Tax Liability are reported on the balance sheet 9 3

4 DEFERRED TAXES Deferred Tax Asset The expected benefit of a future tax deduction for an expense that has already been incurred but is not yet deductible for tax purposes It can only be recognized if it is more likely than not that future income will be realized against which the deduction can be offset 10 DEFERRED TAXES A typical entry for recording income taxes with a Deferred Tax Asset would be Income Tax Expense 20,000 Deferred Tax Asset 4,000 Income Taxes Payable 24,000 Income Tax Expense is an expense on the income statement Income Taxes Payable and Deferred Tax Asset are reported on the balance sheet 11 CAPITALIZE VERSUS EXPENSE An expenditure that is expected to benefit future periods is capitalized as an asset All other expenditures are treated as expenses 12 4

5 CAPITALIZE VERSUS EXPENSE Research and development costs Research is defined as Those 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 13 improved products and processes CAPITALIZE VERSUS EXPENSE Research and development costs are expensed in the period incurred due to the uncertainty surrounding the future economic benefits of R&D activities 14 CAPITALIZE VERSUS EXPENSE Software development requires special treatment All costs incurred up to the point where technological feasibility is established are to be expensed as research and development After technological feasibility is established, costs incurred are capitalized Determining technological feasibility is a matter of judgement 15 5

6 CAPITALIZE VERSUS EXPENSE Advertising costs Generally, advertising costs are expensed due to the uncertainty of their future economic benefits In selected cases where the future benefits are more certain, advertising costs should be capitalized 16 CONTINGENCIES A contingency is an uncertain circumstance involving a potential gain or loss that will not be resolved until some future event occurs 17 CONTINGENCIES Three important definitions: Probable Likely to occur Remote Not likely to occur Reasonably possible More than remote but less than likely 18 6

7 CONTINGENT LOSSES Likelihood Probable Accounting Action Recognize a probable liability if the amount can be reasonably estimated. Reasonably possible Disclose a possible liability in a note. Remote No recognition or disclosure unless contingency represents a guarantee. Then, note disclosure is required. 19 CONTINGENT GAINS Likelihood Probable Reasonably possible Remote Accounting Action Recognize a probable asset if the amount can be reasonably estimated. If not estimable, disclose facts in a note. Disclose a possible asset in a note, but be careful to avoid misleading implications. In practice, possible contingent gains are often not disclosed. No recognition or disclosure. 20 ACCOUNTING FOR LAWSUITS If 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 21 7