Selected Topics first
I want to cover some of the more difficult topics
first
If don‘t get to all the slides—the entire
―lecture‖ will be posted to the course web site
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EQUIPMENT
What depreciation methods does the Company use for
these assets? What estimated useful lives have been
used for these assets in the past? Are depreciation
methods the same for book and tax?
For book purposes, a straight-line basis over 5 years for equipment
and over 6 years for crew trucks is used. For tax purposes, the client
records depreciation using MACRS for the trucks.
The Net Book Value of the trucks exceeds the tax basis at the end of
Year 20X3--resulting in a Deferred Tax Liability (long-term) that will
soon start ―reversing‖!
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LEASED ASSETS
Why has the lease been recorded (capitalized) as an
asset of $380,000 and a liability of $380,000?
―GAAP Rule = The lease has been recorded as an asset because SFAS
No. 13 requires that leases with terms that exceed 75% of the
estimated economic life receive such treatment.
(Lease life and building life are both 20 years)
Conceptually = this is ―like an installment loan to purchase the assets‖
with ‗rewards and risks‘ of ownership passing to Hydromaint—the
leasee
What type of asset is being leased?
Shop and office building
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LEASED ASSETS
Is the asset being depreciated (amortized)? If so, how and
over what period of time? Is the depreciation the same for
book and tax? How are deferred taxes impacted?
Yes, the capital lease asset is depreciated on a straight line basis at
$19,000 per year over the 20 years.
For tax purposes the leases are operating, so no depreciation is
allowed.
Deferred tax ASSET (long-term) created by the temporary difference
related to the lease:
» the net book value of the capitalized lease (net book value of lease
asset less both principal balance on lease obligation and less
Accrued Interest Payable) is less than the tax basis (Prepaid
Rent) of the lease at the end of 20X3 OR
» Depreciation Expense + Interest Expense deductions on Books is
GREATER than Rent Expense on Tax Return in Early years of
Lease—thus the Government ―Owes‖ Hydromaint some future
tax deductions.
This is similar to ―Bad Debt Expense‖
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ACCRUED PENSION LIABILITY
Is this the Projected Benefit Obligation (PBO)?
NO, the PBO (and the plan assets) only appears in the note
disclosure
How is this ―Accrued Pension Liability calculated?
Normally = Cumulative Pension Expense that has been recorded
over the years vs. Cumulative Employer Cash Contributions to
Plan Trustee
However in Year 3 needed to Increase the recorded ―Accrued
Pension Liability‖ amount to get the liability up to the
‗Minimum Pension Liability‘ (excess of ABO over plan assets).
ABO (Accumulated Benefit Obligation – using existing salary
rates – is only used to compute the Minimum Pension Liability
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DEFERRED PENSION COSTS
How does the client get the amount to record this asset?
This amount is the difference between the Accrued Pension Liability
that exists from the ―regular‖ pension entry and the minimum
pension liability that must be reported (excess of ABO vs. Fair market
value of pension fund assets)
What exactly is this asset? Is it a tangible asset?
This is an intangible asset that represents the future benefit that
Hydromaint expects to receive from its employees for the work that
they will perform in the future. The increase in the intangible asset
(other side of entry to increase Accrued Pension Liability
up to amount needed to meet ―Minimum Liability Requirement‖) is
‗supposedly‘ due to not yet funding all the Prior Service Cost. The
prior service retirement benefits given to existing employees for their
past work is ‗suppose to‘ make them ‗happy employees‘ and
supposedly do ‗good‘ work in the future (i.e., = intangible asset).
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DEFERRED TAXES
How is the Deferred Tax Liability or Asset journal entry for the
year calculated?
This amount represents the change in the difference between book
and tax basis between years multiplied by the tax rate.
OR
Temporary differences between current year’s tax return revenue and
expenses VS. current year’s Income Statement revenue and expenses
multiplied by the tax rate
Has the client had any problems recording this liability in the
past?
Yes, the client has had problems with tax entries in every year of the
engagement.
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DEFERRED TAXES
What permanent and temporary differences
has Hydromaint encountered in the past?
Temporary differences:
» accounts receivable (why?)
» truck depreciation (why?)
» Building lease (why?)
» trading securities (why?)
Permanent differences:
» dividends received deduction (why?)
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20X3 Correcting Entries
Bad Debt Expense (651) 8000 Vehicles (181) 30000
Allowance for Bad Debts (108) 8000 Service Cost - Direct R&M (554) 30000
To record increase in the allowance for 20x3. To reclassify R&M as vehicle cost.
Equity Securities Allowance (114) 13000
Market (Loss) Recovery Short-Term(801) 13000
To mark to market the trading securities
Depreciation expense - trucks (701) 6000
Accumulated depreciation (182) 6000
To record depreciation expense related to capitalized R&M incurred on 1/1/x3.
Leased assets (191) 380000
Capital leases - liability (415) 380000
To record a capital lease
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20X3 Correcting Entries
Capital lease - liability (415) 41000
Shop rent (563) 34,167
S&A rent (602) 6,833
To adjust accounts for capital lease payment.
Amortization of capital leases (712) 19000
Accumulated depreciation (192) 19000
To record depreciation on the capital lease.
Capital lease liability (415) 6,503
Short-term debt (321) 6,503
To reclassify the current lease payable.
Interest Expense - Lease (755) 20,123
Interest Payable (311) 20,123
To accrue interest expense on the lease liability.
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20X3 Correcting Entries
Long-term debt notes (401) 5,950
Short-term portion of LT debt (321) 5,950
To reclassify long-term debt to short-term debt.
Accrued Pension Liability (411) 110,000
Pension Expense (604) 110,000
Correct Jerry‘s entry for employer‘s cash contribution.
_______________________________________________________
Pension Expense (604) 127,575
Accrued Pension Liability (411) 127,575
Record pension expense for year 3.
_______________________________________________________
Deferred Pension Cost (216) 80,499
Accrued Pension Liability (411) 80,499
Increase Accrued Pension Liability up to need ―Minimum
Required Liability‖ balance of $98,074.
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_______________________________________________________
20X3 CORRECTING ENTRIES
TAX Entries
Current Taxes Payable (312) 23,047
Income Tax Expense (821) 23,047
Reverse client‘s tax entry
Income Tax Expense (821) 26,646
Current Taxes Payable (312) 12,983
Deferred Income Taxes L-T (421) 12,103
Deferred Income Taxes S-T (141) 1,560
(See Year Three‘s Work Papers OR Correcting Journal Entries for Year 3 for
supporting detail of Tax Entries)
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REVIEW OF YEAR 3
General Questions about our engagement and
the client
Review of Balance Sheet
Review of Correcting Entries
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Questions about Client & CPA Firm
Who are the two principal owners of Hydromaint?
Nick Riley (mechanical engineer)
Ray Ballard (former manager of City Water District)
Other relatives provided ―angel capital‖
What service does Hydromaint perform?
Provide hydraulic maintenance services on a contract basis to water districts, oil
pipe line companies, chemical plants, refineries
Who is the controller?
Jerry Loos (we recommended him—independence issue!)
What is the name of the CPA firm we work for?
Coe & Lane (C&L) St. Louis office of Regional CPA firm.
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Questions about Client & CPA Firm
Who is the partner on the Hydromaint engagement? How did he
‗get‘ this client?
Tom Lockhart (play tennis & racquetball with Nick Riley, and ‗estate‘ work)
Who is the ―tax‖ person from our firm who is assigned to
Hydromaint?
Linda Dirkee
What level of service are we providing for Hydromaint? Why
does client require it?
―REVIEW‖ through Year 3 (Starting in Year 4 it will be an AUDIT; Why?)
Bank Loan Agreement (to get financing for trucks) requires it
Bank Loan Officer that Hydromaint deals with =
» Roger Sontag
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Questions about Client & CPA Firm
What two procedures does a REVIEW entail?
Inquiries
Analytical Procedures
What are ―analytical procedures‖? What is an
example of an analytical procedure for
Hydromaint?
Analytical Procedures = ratio and trend analysis
Compare over time the percentage of Allowance to Total A. R.
What does a REVIEW report look like?
Link to ―Boilerplate‖ Report from SSARS #1
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Questions about Client & CPA Firm
How would you determine the amount we
charged Hydromaint for last year‘s Review?
Look in general ledger account #609 SELLING & ADMIN –
PROFESSIONAL FEES and find our invoice
Why else might we look at every invoice (even
if not ‗material‘ in amount in that particular
account)?
Find invoices from attorneys the client engaged. We want to be
aware of them and what cases they were working on.
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ACCOUNTS RECEIVABLE
Where do the Company‘s receivables come from?
The receivables represent unpaid amounts owed to Hydromaint, Inc.
for the rendering of maintenance services. These usually are related
to the month-to-month operating agreements.
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ACCOUNTS RECEIVABLE
What is the correct method of ―valuing‖ Accounts Receivable (i.e.,
what should the Balance Sheet ‗show‘ for Accounts Receivable)?
Net Realizable Value (NRV)
Therefore, which ―related‖ account have we been dealing with
because of the VALUATION issue for Hydromaint‘s Accounts
Receivable?
Adequacy of the allowance for uncollectible accounts
Is there a tax issue related to the Receivables?
YES, Hydromaint uses ―Allowance‖ method of estimating bad debt expense on
the ‗books‘ but uses the ―Direct write-off‖ method for tax purpose.
Thus, deferred tax asset (current asset) exists because Hydromaint is ―entitled
to ‖ future tax deductions
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INVENTORY
What does the client include in this asset classification?
Shop supplies held for use in providing maintenance services.
Pumps and Valves for SALE starting in Year 4
Has the client previously had any problems accounting
for this asset in the past?
Yes, in Year 1 the client did not inventory these at year-end and
expensed all items purchased.
What is the proper method for ―VALUATION‖ of
Inventories?
LCM
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SUPPLIES
What cost flow assumptions does the client use
with respect to this asset?
FIRST IN, FIRST OUT (FIFO)
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TRADING SECURITIES
At what ―VALUE‖ are these securities reported?
Market value under SFAS No. 115 since Hydromaint considers them
to be ―trading securities‖.
Actually they do NOT really appear to meet the requirements for
Trading Securities classification. More likely they really belong in the
―Available for Sale‖ classification.
What are the similarities and differences between the
accounting for the Trading Securities vs. the Available for
Sale Securities?
Both have asset value “marked to market”
Trading Securities = unrealized gain/loss through Income Statement
Available for Sale Securities:
» Unrealized gain/loss NOT included on Income Statement
» Unrealized gain/loss directly to Stockholders‘ Equity on Balance
Sheet (and also considered part of ―Comprehensive Income‖)
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EQUIPMENT
What types of equipment has the Company recorded
on its books?
Shop Equipment, Trucks and related improvements
What problem has the client had in the past with
recording the proper amounts in this asset category?
Hydromaint has previously incorrectly expensed as Repair and
Maintenance Expense costs of $30,000 that should have been
capitalized as an asset.
World Com did just the opposite
Auditors frequently test large amounts in both Asset & R&M
Expense accounts looking for improper capitalization of costs
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LICENSING COSTS
What is this asset?
Licensing fees incurred in 20X1 to obtain certain equipment usage rights.
Is this asset depreciated? If so over what period of
time?
The asset is amortized over 5 years on a straight line basis.
Are there any book/tax differences related to this asset?
No, the treatment is the same for both book and tax.
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ACCOUNTS PAYABLE
What types of liabilities does the client include
in this liability class?
Principally, payables incurred for the acquisition of
maintenance supplies inventory.
Remember for the Direct Method of Calculating Cash from
Operations: The Cash Paid to Vendors = Cost of Services
Expense +/- Change in Inventory +/- Change in Accounts
Payable
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UNEARNED CONTRACT REVENUE
What comprises this financial statement liability?
The amount represents cash collected in advance on
maintenance agreements for which future services must be
rendered.
Why is the amount constant between 20X2 and 20X3?
The amount is the same because all contracts with advance
payments remained the same between the two years.
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INCOME TAX PAYABLE
What does this $6,041 liability actually represent? Is it
the total tax liability due this year?
It is the current tax liability due and unpaid in the current
year.
It is the beginning balance of $1,210 plus the $12,983 increase
for the year (per our tax entry) minus the $8,152 cash payment
made during the year.
Has the firm had any problems properly recording the
income tax payable in the past?
Yes. The client has needed assistance every year in recording
tax expense and the related assets and liabilities correctly.
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SHORT-TERM PORTION
OF LONG TERM DEBT
What liabilities does this category include?
Principal payments for the bank note and the capital lease that are
due in the next 12 months. The current amount is $55,534 ($87,384 -
$31,850 interest) for the bank note and $6,503 ($41,000 - $34,497
interest) for the capital lease.
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INTEREST PAYABLE
Why is this classification necessary?
This account is necessary to record the amount of interest that is due
but unpaid at the end of the fiscal year. Recording accruals reflects
the application of the matching principle.
What liabilities does the category include?
The bank note ($29,196 for 11 months) and the capital lease ($20,123
for 7 months).
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NOTE PAYABLE
To whom does the Company owe this money and why?
Midwest National Bank – loan to purchase Trucks
What are the terms and covenants of the loan agreement?
Five Annual payment of $87,384 beginning Feb. 1, 20X3 (ordinary
annuity)
Annual financial statements must be reviewed by a CPA.
Dividends may not be distributed unless earnings exceed five times
interest.
Loans may not be made to either Mr. Ballard or Mr. Riley.
Salary increases for either Mr. Ballard or Mr. Riley must be
approved by the bank.
(WHY the last three loan covenants?)
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CAPITAL LEASE LIABILITY
To whom does the Company owe this money?
The property lessor.
What are the terms and covenants?
There are no covenants, but the lease calls for annual payments of
$41,000 for 20 years beginning on 6/1/X3 (annuity due)
Are there any tax issues related to this debt?
Yes. As previously noted, the lease is capitalized for book
purposes, but not for tax purposes. This results in a temporary
difference.
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OTHER QUESTIONS
What were the major accounting issues confronted by you
during Hydromaint‘s first three years?
Accounting for Contingencies (Bad Debts)
Trading securities
Accounting for investments
Lease Capitalization
Interest capitalization
Temporary differences for PP&E and lease capitalization
Bank debt and related covenants
Pensions
Contract revenue recognition
(ALL OF THESE TOPICS YOU ―LEARNED‖ BY ENCOUNTERING
THEM IN A REAL-WORLD CONTEXT—NOT THE
TRADITIONAL ‗LECTURE‘.
THE LEARNING PROCESS SHOULD SERVE YOU WELL IN THE
FUTURE!)
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