Exam 6: Analyzing Operating Activities

Companies can capitalize software development costs when the product is "technologically feasible". Some companies never capitalize their software costs - for example, Microsoft. Viderics, a software development company capitalizes those software costs allowed under GAAP. The following information is taken from its financial statements. X1 X2 X3 X4 Capitalized software costs (in millions): Unamortized balance \ 40 \ 50 \ 63 \ 96 Amortized balance \ 10 \ 15 \ 17 \ 27 a. If Viderics had not capitalized its software costs but expensed them instead what would they have reported as software expense each year, assuming unamortized balance of software costs was $35 in year X0? b. What is the likely effect upon net income variability of expensing rather than capitalizing software development costs? c. How might income be manipulated under either of these two methods (expensing and capitalizing)?

A deferred tax liability imposes an obligation on the business to pay taxes.

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Below are selected portions from Quaker Oats' tax footnote in its X6 annual report. Provisions for income taxes on income before cumulative effect of accounting change were as follows: Dollars in Millions X6 X5 X4 Currently payable Federal \ 99.4 \ 339.1 \ 129.8 Foreign 10.2 131.7 15.0 State 26.6 54.9 40.2 Total currently payable 136.2 525.7 185.0 Deferred-net Federal 15.9 (19.8) (42.2) Foreign 10.4 (7.3) (3.1) State 5.2 (2.1) (12.4) Total deferred-net 31.5 (29.2) (57.7) Provision for income \ 167.7 \ 496.5 \ 127.3 taxes The sources of pretax income before cumulative effect of accounting change were as follows: Dollars in Millions X6 X5 X4 U.S. sources \ 362.8 \ 925.4 \ 302.2 Foreign sources 52.8 295.1 18.2 Income before income taxes and cumulative effect of accounting change \4 15.6 \1 ,220.5 \3 20.4 The components of the deferred income tax provision (benefit) were as follows: $\begin{array}{lcccc}\text { Dollars in Millions } & {\text { X6 }} & \text { X5 } & \text { X4 } \\\text { Accelerated tax depreciation } & \$ 3.7 & \$(23.8) & \$ 8.8 \\\text { Postretirement benefits } & 0.6 & (6.5) & (6.0)\\\text { Accrued expenses including }\\ \text { restructuring charges } & 40.6 & 12.6 & (30.8) \\\text { Loss carryforwards } & (7.1) & 3.5 & (6.1) \\\text { Foreign gain deferral } & 9.8 & - & - \\\text { Other } & (16.1) & (15.0) & (23.6)\\\text {Provision (benefit) for deferred}\\ \text {income taxes}&\$31.5&\$(29.2)&\$(57.7)\\\end{array}$ Deferred tax assets and deferred tax liabilities were as follows: Dollars in Millions X6 X5 Assets Liabilities Assets Liabilities Depreciation and amortization \ 56.9 \ 400.1 \ 58.8 \ 405.6 Postretirement benefits 100.3 - 100.9 - Other benefit plans 60.8 9.2 59.8 20.2 Accrued expenses including restructuring charges 80.3 7.9 147.9 10.4 Loss carryforwards 14.5 - 13.5 - Other 13.3 33.2 15.9 22.8 Subtotal 326.1 450.4 396.8 459.0 Valuation allowance (14.2) - (20.0) - Total \ 311.9 \ 450.4 \ 376.8 \ 459.0 Required: 1a. What was the effective tax rate on all income for fiscal X6? 1b. What was the effective tax rate on foreign income for fiscal X6? 2a. How much did Quaker Oats record in deferred taxes for fiscal X6? Was this an asset or liability? 2b. What was the major item contributing to the deferred tax for X6? Explain fully how this arose.

Which of the following is true with respect to extraordinary items? I. Extraordinary items are recorded net of tax in income statement. II. Extraordinary items, by definition, are probable and unusual in nature. III. By definition, gains and losses from strikes are always extraordinary. IV. By definition, gains and losses from sale of property, plant and equipment are never extraordinary.

If a company, operating in an inflationary environment, uses FIFO for tax purposes and weighted-average for financial reporting purposes, this will result in a deferred tax asset.

XYZ Company issued 10,000 options to its CEO on January 1, 2006, at the prevailing market price of $5 per share. The options were expected to vest over a 2-year period. The Black-Scholes value of the option was valued at $2 per share. On December 31, 2007, the CEO exercised all options. Market price on that day was $9 per share. Assume a 35% tax rate. 1. What will be the cumulative effect on the balance sheet as of December 31, 2007 before the exercise of option? 2. What will be the cumulative effect on the balance sheet as of December 31, 2007 after the exercise of option?

Which of the following measures of accounting income is typically reported in an income statement?

Which of the following items is not included in the calculation of net income but is included in the calculation of comprehensive income?

Many companies have significant deferred taxes. Deferred taxes are not always long-term liabilities. For the categories below, state whether deferred taxes can arise in this category and provide an example. i. Current liabilities ii. Long-term liabilities iii. Stockholders' equity iv. Current assets v. Long-term assets

Which of the following combinations of accounting practices will lead to the highest reported earnings in an inflationary environment? $\text { Depreciation Method} \quad\quad \text {Inventory Method }$ A. $\text { Straight-line } \quad \quad\quad\quad\quad\quad\text { LIFO }$ B. $\text { Double-declining balance } \quad \text { LIFO }$ C. $\text { Straight-line} \quad\quad\quad\quad\quad\quad\quad\text { FIFO}$ D. $\text { Double-declining balance } \quad \text { FIFO }$

Comprehensive income reflects nearly all changes to equity, other than those from owner activities (such as dividends and share issuances)

Exoil recorded an expense and corresponding liability to recognize potential losses relating to an oil spill in 2006 of $10 million. Its net income for the year was $200 million. It was not able to take a deduction for tax purposes until later years when it actually paid cash out in relation to this event. In 2006, with respect to this, Exoil would have:

Revenue from sales where the buyer has the right of return can only be recognized after the return period has expired.

If a company estimates that its expected return on pension plan assets will increase to 9.5% from 9.0%, this would be considered:

The capitalization of interest costs during construction increases future net income.

Which of the following will cause the reported effective tax rate to differ from the federal statutory tax rate? I. Foreign tax rates that are lower than federal statutory tax rate II. Tax-exempt income III. Different depreciation methods for tax and financial reporting purposes IV. Foreign tax rates that are higher than federal statutory tax rate

For each of these nonrecurring items give an example and indicate (match with) the appropriate accounting treatment. 1. Extraordinary item 2. Prior period adjustment 3. Change in accounting estimate 4. Change in accounting principle 5. Discontinued operation 6. Special items 7. Comprehensive income items 8. Change in reporting entity 9. SEC Enforcement Releases A. Shown net as a separate line item between net income and comprehensive income, no restatement. B. Income statement line items adjusted as appropriate, gross or net, prior years restated. C. Gross amount is part of its regular income or expense line item in income from continuing operations, prior years restated. D. Gross amount is part of its regular income or expense line item in income from continuing operations, no restatement. E. Shown gross as a separate line item in income from continuing operations, no restatement.F. Shown net as a separate line item between income from continuing operations and net income, prior years restated.G. Shown cumulative net as a separate line item between income from continuing operations and net income, no restatement.H. Shown net as a separate line item between income from continuing operations and net income, no restatement.I. Not in income statement, opening retained earnings is changed by net amount, no restatement.

Revenues are earned inflows that arise from a company's ongoing business activities.

Extraordinary items are defined as those that are both unusual in nature and infrequent in occurrence. These items are disclosed, net of tax in the income statement.