. 16
( 29)


Analyzing 7-2 (Archer Daniels Midland)
Selected financial statement information relating to inventories for ARCHER
DANIELS MIDLAND (ADM) is given below:

1999 1998

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,051,306 $14,727,670
Inventory FIFO valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,734,054 2,608,167
Inventory LIFO valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,732,694 2,562,650

ADM accounts for approximately 75% of its inventories using the FIFO method,
but accounts for some of its inventories using the LIFO method. Thus, the dif-
ferences reflected in the above table represent those inventories accounted for
using the two methods.
1. Compute ADM s number of days sales in inventory for 1999 using (a) the
FIFO valuation for inventory and (b) the LIFO valuation for inventory. Are
the differences significant enough to concern you?
2. Suppose that ADM purchases its inventory with the terms net 30 days.
That is, ADM s creditors expect payment in 30 days. Is ADM going to have
a cash flow problem?
344 f345
Inventory CEO Chapter 7

Analyzing 7-3 (La-Z-Boy and McDonald s)
The following information is taken from the 1998 financial statements of LA-Z-
BOY, INC., maker of recliners and other home furnishings, and the 1999 fi-
nancial statements of MCDONALD S, maker of the Big Mac¬ and other fast

La-Z-Boy McDonald s

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $825.3* $3,204.6
Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78.8 77.3
Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91.9 82.7

*Amounts in millions.

1. Before you do any computations, forecast which of the two companies will
have a lower number of days sales in inventory.
2. Compute each company s number of days sales in inventory. Was your
forecast in (1) correct?
3. How can these two very successful companies have number of days sales
in inventory that are so different?

Why No LIFO?
The LIFO method of accounting for inventory is primarily a U.S. invention.
Many countries around the world will not allow LIFO to be used, and other
countries discourage its use. For example, the International Accounting Stan-
dards Committee calls LIFO an undesirable but allowable method. In the
United Kingdom, LIFO is allowable under corporate law but is unacceptable
under professional accounting standards.
Why do you think other countries have such an unfavorable opinion of
LIFO? Think about these issues: In periods of rising prices, does the amount
shown on the balance sheet relating to inventory reflect current cost? If a com-
pany s inventory on the balance sheet reflected costs from years past, what
would happen to the income statement if those inventory costs were suddenly
moved to Cost of Goods Sold? Would the result reflect a firm s actual perfor-

Shipping Bricks
In 1989 the U.S. Department of Justice Criminal Division discovered a massive
inventory fraud that was being conducted by managers at MINISCRIBE COR-
PORATION. MiniScribe manufactured and sold computer disk drives. The fraud
included placing bricks in disk drive boxes, shipping those boxes to customers,
and recording a sale when the box was shipped. MiniScribe managers also
knowingly shipped defective drives and recorded sales even though they knew
those drives would be returned.
What would be the effect on the income statement and the balance sheet
of shipping bricks and recording those shipments as sales? (HINT: Think about
the journal entry that would have been made by MiniScribe accountants when
a box of bricks was shipped to customers who were expecting disk drives.)
f346 Inventory
Part 2 CEO Operating Activities

Would company officials be able to fool financial statement users for a long
time using this type of deception? What could financial statement users have
looked for to detect this type of fraud?

Estimating Inventory
Jon Johnson, an accountant with a local CPA firm, has just completed an in-
ventory count for Mom & Pop s Groceries. Mom and Pop provide audited fi-
nancial statements to their bank annually, and part of that audit requires an in-
ventory count. Don Squire, a partner with the CPA firm, has also conducted an
analysis to estimate this period s ending inventory. Don used the gross mar-
gin method, a method whereby the prior period s gross margin percentage is
used to infer this period s percentage, to estimate ending inventory. In addi-
tion, the store is equipped with cash registers that scan each product as it is
sold and, as a result, provide a perpetual inventory record.
These three inventory analysis methods have resulted in three very differ-
ent answers, which are summarized in the following table:

Method Inventory Value

Inventory count . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 98,500
Gross margin analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119,750
Point-of-sale scanners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111,500

In evaluating the results, Jon and Don are curious as to why the three meth-
ods result in such large differences. Since the inventory count reports actual
inventory on hand, they begin to wonder if Mom and Pop have an inventory
theft problem. Write a short memo explaining why the other two methods,
gross margin analysis and point-of-sale scanners, can result in significantly dif-
ferent answers without there being a theft problem.

One Method for All
As you know, we have periodic and perpetual inventory methods, along with
LIFO, FIFO, and average cost variations of each. How can we compare the fi-
nancial statements of different companies if they are using different inventory
methods? This debate focuses on the question of whether financial statement
users would be better able to compare information if all companies used the
same inventory method.
Divide your group into two teams and prepare a five-minute presentation
defending the following positions:
One team represents What s Good for One Is Good for All. To make fi-
nancial statements comparable, all companies should be required to use
the same inventory method. Which one? Rather than fight over the pros
and cons of LIFO and FIFO, a compromise position would be to require all
firms to use perpetual average cost. With the availability of computers, the
computational problems associated with this method no longer exist. The
resulting information would then allow more comparability across firms.
The other team represents It s OK to Be Different. Firms are different.
One size does not fit all, and one inventory method is not appropriate for
346 f347
Inventory CEO Chapter 7

all firms. Firms should be allowed to use the inventory method(s) that are
best suited for their unique operations.

This spreadsheet assignment is a continuation of the spreadsheet assignments
given in earlier chapters. If you completed those spreadsheets, you have a head
start on this one. If needed, review the spreadsheet assignment for Chapter 4
to refresh your memory on how to construct forecasted financial statements.

1. Handyman wishes to prepare a forecasted balance sheet and income state-
ment for 2004. Use the original financial statement numbers for 2003 [given
in part (1) of the Cumulative Spreadsheet Project assignment in Chapter 2]
as the basis for the forecast, along with the following additional information:
a. Sales in 2004 are expected to increase by 40% over 2003 sales of $700.
b. Cash will increase at the same rate as sales.
c. The forecasted amount of accounts receivable in 2004 is determined
using the forecasted value for the average collection period. For sim-
plicity, do the computations using the end-of-period accounts receiv-
able balance instead of the average balance. The average collection pe-
riod for 2004 is expected to be 14.08 days.
d. In 2004, Handyman expects to acquire new property, plant, and equip-
ment costing $80.
e. The $160 in operating expenses reported in 2003 breaks down as fol-
lows: $5 depreciation expense, $155 other operating expenses.
f. No new long-term debt will be acquired in 2004.
g. No cash dividends will be paid in 2004.
h. New short-term loans payable will be acquired in an amount sufficient
to make Handyman s current ratio in 2004 exactly equal to 2.0.
Note: These statements were constructed as part of the spreadsheet as-
signment in Chapter 6; you can use that spreadsheet as a starting point if
you have completed that assignment. Clearly state any additional as-
sumptions that you make.
For this exercise, add the following additional assumptions:
i. The forecasted amount of inventory in 2004 is determined using the
forecasted value for the number of days sales in inventory (computed
using the end-of-period inventory balance). The number of days sales
in inventory for 2004 is expected to be 107.6 days.
ii. The forecasted amount of accounts payable in 2004 is determined us-
ing the forecasted value for the number of days purchases in accounts
payable (computed using the end-of-period accounts payable balance).
The number of days purchases in accounts payable for 2004 is ex-
pected to be 48.34 days.
2. Repeat (1), with the following changes in assumptions:
a. Number of days sales in inventory is expected to be 66.2 days.
b. Number of days sales in inventory is expected to be 150.0 days.
3. Comment on the differences in the forecasted values of cash from operat-
ing activities in 2004 under each of the following assumptions about the
number of days sales in inventory: 107.6 days, 66.2 days, and 150.0 days.
4. Is there any impact on the forecasted level of accounts payable when the
number of days sales in inventory is changed? Why or why not?
5. What happens to the forecasted level of short-term loans payable when the
number of days sales in inventory is reduced to 66.2 days? Explain.
f348 Inventory
Part 2 CEO Operating Activities

We began this chapter with a discussion of SEARS ROEBUCK & COMPANY.
Access its Web site at http://www.sears.com. Sometimes Web addresses
change, so if this address doesn t work, access the Web site for this textbook
(http://albrecht.swcollege.com) for an updated link.
Once you have located the company s Web site, answer the following ques-
1. Locate the portion of the Web site dedicated to Sears history. Can you find
information about Sears beginnings (similar to the narrative at the begin-
ning of this chapter)? In what year did Sears issue its first large general
2. Locate Sears balance sheet. Have inventories, as a percentage of total as-
sets, increased or decreased over the time period presented?
3. Compute Sears number of days sales in inventory. Is it increasing or de-
creasing over the time period presented?
4. Locate Sears note information relating to inventory. Which inventory meth-
ods does Sears employ?
Completing the
Operating Cycle


learning objectives After studying this chapter, you should be able to:

1 Account for the various 3 Distinguish between 4 Understand when an 5 Prepare an income
components of employee contingent items that should expenditure should be statement summarizing
compensation expense. be recognized in the recorded as an asset and operating activities as well
financial statements and when it should be recorded as other revenues and
2 Compute income tax those that should be merely as an expense. expenses, extraordinary
expense, including
disclosed in the financial items, and earnings per
appropriate consideration of
statement notes. share.
deferred tax items.
350 chapter f8
Completing The Operating Cycle

Before 1850, the primary use for petroleum out to him by convincing them that he had
was as a medicine. Known variously as arranged such a favorable deal with the
Seneca oil, American oil, and rock oil, a railroads that competing head-to-head
mixture of water and petroleum was re- with him would be impossible.
portedly good for rheumatism, chronic Rockefeller was eager to expand the
cough, ague, toothache, corns, neuralgia, business interests of his STANDARD OIL
urinary disorders, indigestion, and liver ail- COMPANY OF OHIO into other areas, but
ments. The oil was collected by wringing the incorporation laws in existence at the
out woolen blankets that had been thrown time made it difficult for corporations to
onto the surfaces of ponds that had been merge. Therefore, Rockefeller created a
fouled by seeping oil. Oil was also a nui- “trust,” which was basically a corporation
sance by-product of drilling wells in search of corporations. The stockholders of each
of underground salt brine deposits. corporation transferred their shares to the
Gradually, additional properties of oil care of the nine trustees of the STANDARD
were discov- OIL TRUST; in exchange, the stockholders
fyi ered. It was received trust certificates.
found that oil Thereafter, the nine trustees
The oil boom did not hit Texas
could serve as ran the businesses and the
John D. Rockefeller used some
until 1901 when a well on a lubricant for stockholders received the
of his Standard Oil profits to
Spindletop Hill, south of Beau- the machinery dividends. When the Ohio
that was be- Supreme Court ruled this found the University of Chicago
mont, Texas, began to gush
coming more trust illegal in 1892, lawyers in 1891.
100,000 barrels of oil a day.
common as for Standard Oil sought an-
the Industrial other business structure
Revolution progressed. In addition, dis- that would preserve the essence of the
tilled oil was found to burn well in the trust. They found the answer in the incor-
household lamps that had traditionally poration laws of the state of New Jersey,
burned vegetable oil or sperm whale oil. which allowed the formation of a holding
As the demand for petroleum increased, company that would own shares of vari-
the search for oil began in earnest. A group ous corporations, duplicating the function
setting the stage
of investors hired Edwin L. Drake to drill of the central trust. In 1899, legal owner-
for oil in northwestern Pennsylvania, ship of the companies controlled by Rock-
where oil had long been found in springs efeller was transferred to a holding com-
and wells. In late August 1859, Drake pany called the STANDARD OIL
struck oil at a depth of 691/2 feet, creating COMPANY OF NEW JERSEY.
In the early 1890s, the spirit of reform
an oil well that yielded 25 barrels per day.
spread over the United States. Many peo-
This discovery touched off an oil rush in
ple felt that Big Business was too powerful
western Pennsylvania, and the opportuni-
and must be reined in by the federal gov-
ties to get rich were soon fanned by the
ernment. President Theodore
increased demand for lubricating oil asso-
Roosevelt set the tone by
ciated with the North™s war production
proclaiming himself a “trust-
during the Civil War.
The federal antitrust case
buster,” and his administra-
In those early days, Cleveland, Ohio,
against MICROSOFT has been
tion vigorously pursued an
was the center of oil refining, and one of
antitrust case against Stan-
the earliest players in the refining business compared to the Standard Oil
dard Oil. In 1911, the U.S.
was John D. Rockefeller. Rockefeller had case of 1911, with Bill Gates
Supreme Court mandated
started his business career in Cleveland as playing the role of a modern-
the breakup of the Standard
a bookkeeper(!) in 1855. By saving his
day Rockefeller.
Oil Company into 34 smaller
earnings, he acquired some investment
companies. Many of those
capital, and, with a partner, he put up
companies are still very well known, as ev-
$4,000 to begin a refinery in Cleveland in
idenced by the partial list contained in Ex-
1862. Rockefeller™s aggressive business
hibit 8-1.
tactics aroused controversy almost from
The largest piece of the dismembered
the beginning. In particular, Rockefeller
Standard Oil Trust was the Standard Oil
was accused of negotiating favorable
Company of New Jersey, which changed
freight rates with the railroads hauling his
its named to EXXON in 1972. Exxon now
oil whereas his competitors were required
operates in over 100 countries, exploring
to pay the stated rates. In 1872, Rockefeller
for oil, producing petrochemical products,
was able to persuade a large number of
and transporting oil and natural gas. In
his Cleveland refining competitors to sell
f352 Part 2 Completing The Operating Cycle
Operating Activities

Companies Descended from the Original Standard Oil
exhibit 8-1

Total Revenue
for 1999
(in millions)

Amoco (subsidiary of BP Amoco) $ 33,000*
Ashland 20,293
Atlantic Richfield (merger with BP Amoco pending) 13,055
Chevron 36,586
Conoco 27,309
ExxonMobil 185,527
Pennzoil“Quaker State 2,989
Total $318,759

By contrast, the #1 company in the Fortune 500 revenue listing in 1999 was
General Motors with revenues of $189,058 million.
Source: The Wall Street Journal, December 2, 1998, p. B1, updated.

many places, the company is known as of New Jersey) announced an agreement
ESSO, representing the initials “SO” for to merge with MOBIL (the former STAN-
Standard Oil. To illustrate the size of DARD OIL COMPANY OF NEW YORK),
Exxon™s operations, the company had thus reuniting these two pieces of the vast
worldwide proved oil reserves of 11.3 bil- empire built by John D. Rockefeller. The
lion barrels and proved natural gas re- formal joining of the two companies was
serves of 56.8 trillion cubic feet as of De- completed on November 30, 1999, creat-
cember 31, 1999. On December 1, 1998,
Exxon (the former Standard Oil Company

In Chapters 6 and 7, we discussed the accounting for sales and the cost of inventory sold. For firms
that sell a product, the cost of the inventory sold typically represents the largest expense. For example,
cost of goods sold was the largest expense category for EXXONMOBIL in 1999, totaling 42% of
sales. For WAL-MART, cost of goods sold was 79% of sales in 1999. Although cost of goods sold rep-
resents a significant expense for those companies such as ExxonMobil and Wal-Mart that manufac-
ture and/or sell a product, it is certainly not the only expense. And for those companies that sell a ser-
vice, other expenses such as employee compensation or advertising can be far more significant than
cost of goods sold.
In this chapter, we discuss a number of these other significant operating issues. We will begin
with a discussion of two significant operating expenses that are incurred by almost every firm: em-
ployee compensation and income taxes. We also discuss the accounting for the costs associated with
contingencies, which are items that are not fully resolved at the time the financial statements are
prepared. Two common examples of contingencies are lawsuits and environmental cleanup obliga-
tions. Also in this chapter we discuss how one determines whether a cost should be recorded as an
asset (capitalized) or recorded as an expense. The expense versus capitalize issue has arisen many

1 Information for this description was obtained from Daniel J. Boorstin, The Americans: The Democratic Expe-
rience (New York: Random House, 1973) and Ida M. Tarbell, The History of the Standard Oil Company (New
York: MacMillan Company, 1904).
352 f353
Completing The Operating Cycle Chapter 8
Completing the Operating Cycle

times over the years as accountants have wrestled with how to account for advertising costs, research
costs, and others.
The financial statement items covered in this chapter are illustrated in Exhibit 8-2. Various op-
erating items affecting the income statement are covered in the chapter. The two most significant are
employee compensation and income taxes. The balance sheet items discussed are pension liabilities,
deferred income tax liabilities, and contingent liabilities. The accounting aspects of these balance sheet
items are intriguing in that both the pension and deferred tax items are sometimes reported as assets
rather than liabilities. In addition, contingent liabilities are frequently not reported on the balance
sheet at all. The details of all these topics, and more, are discussed in this chapter.

Account for the various
Often, one of the largest operating expenses of a business is the salaries and wages of its em-
components of employee
compensation expense. ployees. But the cost of employees is not simply the expense associated with the current period™s
wages. As the following time line illustrates, issues associated with employee compensation can
extend long after the employee has retired.

Employee Compensation Event Line

Pensions and
Bonuses and Postemployment Postretirement
Stock Options Benefits Benefits Other
than Pensions


Financial Statement Items Covered in This Chapter
exhibit 8-2

Statement of
Balance Sheet
Cash Flows
Long-Term Assets:
Net pension assets
Cash Paid for:
Deferred income tax asset
Employee Compensation
Research and Development
Long-Term Liabilities:
Net pension liability
Income Taxes
Deferred income tax liability
Contingent liabilities

Income Statement
Employee Compensation Expense
Research and Development
Advertising Expense

Losses/Gains on Contingent Items

Income Tax Expense
f354 Part 2 Completing The Operating Cycle
Operating Activities

Payroll relates to the salaries and wages earned by employees for work done in the current
period. Wages are paid anywhere from weekly to monthly, depending on the company. Com-
pensated absences exist when an employer agrees to pay workers for sick days or vacation days.
These obligations must be estimated and accrued in the period that the employee earns those
days off. Many employees are paid bonuses based on some measure of performance (such as in-
come or sales volume). Those bonuses are often paid quarterly or annually. One way to provide
bonuses to employees is through the granting of stock options. In some cases, employees may
earn what are termed “postemployment benefits,” which kick in if an employee is laid off or ter-
minated. Finally, firms offer benefits to their employees upon retirement. We will discuss each
of these items in further detail in the sections that follow.

In its simplest form, accounting for payroll involves debiting Salaries Expense and crediting
Salaries Payable when employees work and then debiting Salaries Payable and crediting Cash
when wages are paid. However, accounting for salaries and related payroll taxes is never quite
that simple and can, in fact, be quite complex. This is primarily because every business is legally
required to withhold certain taxes from employees™ salaries and wages.
Very few people receive their full salary as take-home pay. For example, an employee who
earns $30,000 a year probably takes home between $20,000 and $25,000. The remainder is
withheld by the employer to pay the employee™s federal and state income taxes, Social Security
Social Security (FICA) taxes
(FICA) taxes,2 and any voluntary or contractual withholdings that the employee has authorized
Federal Insurance Distribu-
tions Act taxes imposed on (such as union dues, medical insurance premiums, and charitable contributions). Thus, the ac-
the employee and the em-
counting entry to record the expense for an employee™s monthly salary (computed as 1/12 of
ployer; used mainly to pro-
$30,000) might be:
vide retirement benefits.

Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500
FICA Taxes Payable, Employees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
Federal Withholding Taxes Payable . ......................... 400
State Withholding Taxes Payable . . . ......................... 200
Salaries Payable . . . . . . . . . . . . . . . . ......................... 1,709
To record Mary Perrico™s salary for July.

All the credit amounts (which are arbitrary in this example) are liabilities that must be paid
by the employer to the federal and state governments and to the employee. It should be noted
that these withholdings do not represent an additional expense to the employer because the em-
ployee actually pays them. The employer merely serves as an agent for the governments for col-
lecting and paying these withheld amounts.
In addition to remitting employees™ income and FICA taxes, companies must also pay cer-
tain payroll-related taxes, such as the employer™s portion of the FICA tax (an amount equal to
the employee™s portion) and state and federal unemployment taxes. The payroll-related taxes
paid by employers are expenses to the company and are included in operating expenses on the
income statement. An entry to record the company™s share of payroll taxes relating to Mary Per-
rico™s employment (again using arbitrary amounts) would be:

Payroll Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
FICA Taxes Payable, Employer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
Federal Unemployment Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
State Unemployment Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
To record employer payroll tax liabilities associated with
Mary Perrico™s salary for July.

2 Congress has split FICA taxes into two parts”Social Security and Medicare. For the purposes of this chapter,
we will combine the two.
354 f355
Completing The Operating Cycle Chapter 8
Completing the Operating Cycle

The different liabilities recorded in the preceding two entries for payroll would be elimi-
nated as payments are made. The entries to account for the payments are:

FICA Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
Federal Withholding Taxes Payable. . . . . . . . . . ................... 400
Federal Unemployment Taxes Payable . . . . . . . ................... 18
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................... 800
Paid July withholdings and payroll taxes to federal government.
State Withholding Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
State Unemployment Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
Paid July withholdings and payroll taxes to state government.
Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,709
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,709
Paid July salary to Mary Perrico.

As these entries show, three checks are written for payroll-related expenses: one to the fed-
eral government, one to the state, and one to the employee.
One further point about salaries and wages needs to be made. The period of time covered
by the payroll may not coincide with the last day of the year for financial reporting. Thus, if
the reporting year ends on Wednesday, December 31, and the salaries and wages for that week
will be paid Monday, January 5 of the following year, then the company must show the salaries
and wages earned from Monday through Wednesday (December 29, 30, and 31) as a liability
on the December 31 balance sheet. To accomplish this, the company would record an end-of-
year adjusting entry to record the salaries and wages earned for those three days.

Compensated Absences
Suppose that you work for a business that provides each employee one day of sick leave for each
full month of employment. When should that sick day (or compensated absence) be accounted
for? When it is taken by the employee? When it is earned by the employee? And how much of
an accrual should be associated with the compensated absences?
The matching principle requires that the expense associated with the compensated absence
be accounted for in the period in which it is earned by the employee. Some of the conceptual
issues associated with accounting for compensated absences are similar to those addressed in ac-
counting for bad debts. In the case of bad debts, if we waited until we were sure a customer
wasn™t going to pay, then we could be certain about our bad debt expense. But we may not find
out that we are not going to be paid until several periods later, and as a result, the bad debt ex-
pense would be reflected in the wrong accounting period. So instead of waiting until accounts
are dishonored, we estimate the expense for each period. The same is true with compensated
absences. Although we could wait until those sick days are taken and then know exactly what
they will cost, it may be years before we know. Rather than wait, we estimate instead. For ex-
ample, if you earn both $100 a day and one sick day per month, then it makes sense for your
employer to recognize an expense (and accrue a liability) of $100 per month related to your sick
pay. This would be done with the following journal entry:

Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Sick Days Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
To recognize accrued sick pay.

When you take that sick day (and let™s not forget that the government will take its share of
your sick pay also), the journal entry would be:
f356 Part 2 Completing The Operating Cycle
Operating Activities

Sick Days Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Various Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
To record payment of sick day net of FICA, federal, and state taxes.

Now suppose that you don™t take your sick day until next year. Assume also that you re-
ceived a $10 raise per day. This makes our estimate of $100 incorrect, so we will fix that esti-
mate in the period in which you take the sick day. The journal entry in this instance would be:

Sick Days Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Various Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
To record payment of sick day net of FICA, federal, and state taxes.

The same procedures would apply when accounting for accrued vacation pay or other types
of compensated absences.

Many companies offer employee bonus plans that allow employees to receive additional com-
bonus Additional compen-
sation, beyond the regular pensation should certain objectives be achieved. These bonus plans sometimes apply to all em-
compensation, that is paid ployees although more often they are restricted to members of top management. In many in-
to employees if certain ob-
stances, the terms of the bonus plan are defined using financial statement numbers. For example,
jectives are achieved.
in its 1999 proxy statement filed with the Securities and Exchange Commission (SEC), EXXON-
MOBIL disclosed that it has a management bonus plan targeted at 1,000 of its managers. The
plan grants a certain number of award units to the managers; a manager is entitled to receive
cash equal to the company™s reported earnings per share for each award unit held. For example,
ExxonMobil™s chief executive officer (CEO), Lee R. Raymond, received 301,140 of these award
units in 1999. With ExxonMobil™s earnings per share in 1999 being $2.25, these award units
added $677,565 (301,140 award units $2.25) to Raymond™s base salary of $2,110,417.
The purpose of an earnings-based bonus plan is to encourage managers to work harder and
smarter to improve the performance of the company. However, such a plan also increases the
incentive of managers to manipulate reported earnings. In fact, one of the factors looked at by
auditors in evaluating the risk of financial statement fraud in a company is whether the com-
pany has an earnings-based management bonus plan.

Stock Options
Employee stock options have become an increasingly popular way to compensate top execu-
employee stock options
Rights given to employees tives. Under a stock option plan, managers are given the option of purchasing shares of the com-
to purchase shares of stock pany™s stock in the future at a price that is specified today. For example, in 1999, Lee Raymond,
of a company at a predeter-
CEO of ExxonMobil, was granted 425,000 options, each allowing him to buy one share of
mined price.
ExxonMobil stock in the future for $83.56, which was the market value of ExxonMobil shares
on the date the options were granted. Raymond will make money from these options if he is
able to improve the performance of ExxonMobil and increase its stock price. If, for example,
the company™s stock price were to increase to $100.00 per share, these 425,000 options, allow-
ing Raymond to buy ExxonMobil shares at the fixed price of $83.56, would be worth $6,987,000
[425,000 ($100.00 $83.56)]. Stock options are an attractive way to compensate top man-
agement because the options pay off only if the managers are able to increase the value of the
company, which is exactly what the owners of the company (the stockholders) desire.
There has been significant debate in the United States about how to compute the com-
pensation expense associated with employee stock options. The debate centers around the issue
356 f357
Completing The Operating Cycle Chapter 8
Completing the Operating Cycle

of what the value of an option is. Two methods for valuing employee options for accounting
purposes are described below.

The “intrinsic value” of an option is the value it has if it
must be exercised immediately. For example, if a company™s stock price is $50 and it issues an
option allowing an employee to buy a share of stock for $50, the option has no “intrinsic value”
because the employee would be just as well off purchasing the company™s stock in the market
for $50, just as anyone not holding an option could do.

The “fair value” of an option stems from the possibility that the
employee may want to exercise the option in the future if the company™s stock price goes up.
For example, even if an option exercise price of $50 is equal to the stock price on the date the
option is granted to an employee, there is a chance that the stock price may increase during the
life of the option. This means that an option with no “intrinsic value” can still have substantial
economic value because the employee holding the option may be able to buy the stock at less
than its market value some time in the future. Exact computation of the fair value of options
involves complex formulas derived using stochastic calculus, but commercially available software
packages make option valuation no more difficult than using a spreadsheet.
The fair value method, with its theoretically correct emphasis on estimating the actual
value of the options granted to employees, is backed by the FASB. Nevertheless, the vast ma-
jority of U.S. corporations opposed the FASB™s attempt in 1994 to require recognition of a
stock option compensation expense. The reason for this opposition was simple: recognition of
a stock option compensation expense would reduce reported earnings. The surprising vigor of
the opposition to the fair value method caused the FASB to reluctantly approve the following
accounting treatment:

• Companies are allowed to use the intrinsic value method. For most stock option plans, this
means that no expense is recognized.
• Companies are encouraged, but not required, to adopt the fair value method for employee
stock options. The fair value method results in compensation expense being recognized for
almost all stock option plans.
• Those companies choosing to use the intrinsic value method must disclose what their net
income would have been if they had used the fair value method.
Like most U.S. companies, ExxonMobil uses the intrinsic value method. In 1999,
fyi ExxonMobil granted over 22 million employee stock options, all with intrinsic values of
$0 as of the grant date. Thus, ExxonMobil reported no compensation expense in relation
MICROSOFT reports that if it
to these 22 million options. In the notes to its financial statements, ExxonMobil discloses
had used the fair value method
that these 22 million options had a total fair value of $149 million. This amount would
instead of the intrinsic value
have been recognized as compensation expense (spread over the number of years employ-
method in 1999, its reported
ees are required to stay with the company to earn the options) if ExxonMobil had used
compensation expense would the fair value method.
have been increased by $1.1
Postemployment Benefits

Postemployment benefits are perhaps the least common of the topics covered in this sec-
tion on employee compensation. Postemployment benefits are those benefits that are incurred
postemployment benefits
Benefits paid to employees after an employee has ceased to work for an employer but before that employee retires. A com-
who have been laid off or mon example is a company-provided severance package for employees who have been laid off.
This severance package might include salary for a certain time period, retraining costs, educa-
tion costs, and the like. Although the company may not know the exact postemployment cost,
accounting standards require that the amount be estimated and accrued in the period in which
the decision is made to cut back the labor force. For example, suppose a company decides to
close a segment of its operations, thereby laying off a certain percentage of its labor force. The
company must estimate the costs associated with the benefits offered to those laid-off employ-
ees and would record the following journal entry:
f358 Part 2 Completing The Operating Cycle
Operating Activities

business environment essay

What Goes into Pensions? A pension is be a percentage, commonly 2%, of your average an-
an agreement between an employer nual salary over the last five years of your employment
and the employees that the employees multiplied by the number of years of employment.
will receive a certain sum of money What factors need to be considered in determining the
upon retirement. That money may be employer™s future liability?
paid in a single sum or over several As you can imagine, estimating these various fac-
years. In addition, employers often of- tors involves some enormous assumptions. Plus, once
fer other postretirement benefits such the estimates have been made, the fact that those ex-
as medical and life insurance. Consider penditures will not be made for 40 years (assuming
how difficult it can be to account for you retire when you turn 65) must be factored in.
these items. As if that isn™t enough, the employer must do this
Let™s assume that you are 25 years old when you computation for every employee. In the case of large
start working for your current employer. Your em- companies, such as EXXONMOBIL with 106,000 em-
ployer™s pension plan states that upon retirement you ployees, the computations are staggering. Fortu-
will receive medical and life insurance benefits in ad- nately, businesses have help in the form of actuaries.
dition to a monthly pension check. The pension will Actuaries make their living predicting the future. They

pension An agreement be-
Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxx
tween an employer and
employees that provides for Benefits Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxx
benefits upon retirement. To record postemployment benefits for laid-off employees.
defined contribution plan A
pension plan under which
When the benefits are paid, a journal entry would be made to reduce the payable and to
the employer contributes a
record the cash outflow.
defined amount to the pen-
sion fund; after retirement,
the employees receive the
amount contributed plus
A pension is cash compensation received by an employee after that employee has retired. Two
whatever it has earned.
primary types of pension plans exist. A defined contribution plan requires the company to
defined benefit plan A pen-
place a certain amount of money into a pension fund each year on behalf of the employees.
sion plan under which the
Then, after the employees retire, they receive the money contributed to the pension fund plus
employer defines the
the earnings on those contributions. With a defined benefit plan, on the other hand, the
amount that retiring em-
company promises the employees a certain monthly cash amount after they retire, based on
ployees will receive and
contributes enough to the factors such as number of years worked by the employee, employee™s highest salary, and so
pension fund to pay that
The accounting for a defined contribution plan is quite simple”a company merely reports
pension expense equal to the amount of cash it is required to contribute to its employees™ pen-
sion fund during the year. Normally, no balance sheet liability is reported in connection with a
defined contribution plan because, once the company has made the required contribution to the
pension fund, it has no remaining obligation to the employees.
The accounting issues associated with defined benefit plans are much more
Who bears the risks asso-
ciated with a defined contribution plan”the complex because the ultimate amount that a company will have to pay into its
employees™ pension fund depends on how long the employees work before re-
employer or the employee? Which party
tiring, what their highest salaries are, how long the employees live after they re-
bears the risks associated with a defined
tire, and how well the investments in the pension fund perform. The account-
benefit plan? ing concept underlying this complexity, however, is still the same basic idea of
matching: the income statement this year should contain all expenses related
to generating revenue this year, whether those expenses are paid in cash this year (like cash wages)
or are not expected to be paid for many years (like pension benefits).
358 f359
Completing The Operating Cycle Chapter 8
Completing the Operating Cycle

estimate birth and death rates, trends in inflation, So, if you start thinking that accounting is difficult
health-care costs, salaries, and other relevant infor- and you become uncomfortable with all the assump-
mation. There are about 14,000 actuaries in the United tions and estimates, remember that it could be worse:
States, compared to over 1 million accountants. you could be studying to be an actuary!

Postretirement Benefit Factors to Consider

Medical insurance What will health-care costs be in the future?
How long will you live to enjoy those health insurance benefits?
(The longer you live, the greater the cost.)
Life insurance What will insurance premiums be for the remainder of your employment?
Pension check How long will you work?
What will your average annual salary be in your last five years of employment?
How long will you or your spouse live after you retire?

Each of the major bal-
ance sheet and income statement items related to pension accounting is briefly introduced below.

• Pension fund. When a company has a defined benefit pension plan, it is required by U.S.
federal law to establish a separate pension fund to ensure that employees receive the defined
benefits promised under the plan. The pension fund is basically a large investment fund of
stocks and bonds. The company still owns these pension fund assets, but it cannot use them
for any purpose except to pay pension benefits to employees.
• Pension obligation. The promise to make defined benefit pension payments to employees
represents a liability to the company making the promise. The amount of this liability is
quite difficult to estimate because it depends on future salary increases, employee turnover,
employee life span, and so forth. The estimation of the liability is done by professionals
called actuaries. These are the same individuals who provide the computations that life in-
surance companies use in setting premiums.
• Net pension asset or liability. One possible way to present the pension information on a bal-
ance sheet is to list the pension plan assets among the long-term assets and the pension li-
ability as a long-term liability. However, the accounting standards stipulate that these two
items be offset against one another and a single net amount be shown as either a net pen-
sion asset or a net pension liability.
• Pension-related interest cost. The estimated pension obligation represents an amount owed
by a company to its employees. Accordingly, a pension-related interest cost is recognized
each year; the amount of this interest cost is the increase in the pension obligation result-
ing from interest on the unpaid pension obligation.
• Service cost. The amount of a company™s pension obligation increases each year as employ-
ees work and earn more pension benefits. This increase in the pension obligation is an ex-
pense associated with work done during the year and is called the pension service cost.
• Return on pension fund assets. The cost of a company™s pension plan is partially offset by the
return that the company earns on the assets in its pension fund.
• Pension expense. Just as pension liabilities and assets are offset against one another to arrive
at a single net liability or asset to be reported on the balance sheet, the three components
of pension expense (interest cost, service cost, and return on pension fund assets) are net-
ted against one another to yield a single number that is reported on the income statement.
f360 Part 2 Completing The Operating Cycle
Operating Activities

In the notes to
its 1999 financial statements, ExxonMobil discloses the following about its pension benefit oblig-
ation and its pension fund. All numbers are in millions of dollars.

U.S. Plans Non-U.S. Plans Total

Pension benefit obligation $8,032 $11,628 $19,660
Pension fund assets 7,965 8,689 16,654
Net pension liability $ 67 $ 2,939 $ 3,006

Note that ExxonMobil has separated its pension plans into those covering employees in the
United States and those covering employees located outside the United States. This is a useful
separation because the laws governing the maintenance of pension plans vary from country to
country; U.S. laws are generally viewed as giving more protection to the rights of the employ-
ees covered by pension plans than foreign laws do. Also note that ExxonMobil™s pension plans
are “underfunded,” meaning that the market value of the assets in the pension funds is less than
the estimated pension liability. ExxonMobil also provides the following information about its
pension expense in 1999. Again, all of the numbers are in millions.

U.S. Plans Non-U.S. Plans Total

Service cost $ 249 $ 312 $ 561
Interest cost 555 608 1,163
Less: Expected return on fund assets (601) (599) (1,200)
Other miscellaneous items (35) 217 182
Net pension expense $ 168 $ 538 $ 706

Note the significant reduction in reported pension expense caused by the expected return
on pension fund assets; without the return on the pension fund, ExxonMobil™s pension
The expected, not the actual,
expense would be more than twice as high.
return on the pension fund as-
sets is subtracted in computing Postretirement Benefits Other Than Pensions
pension expense. The account-
In addition to pension benefits, employers often offer employees other benefits after their
ing for the difference between
retirement. For example, ExxonMobil promises its employees that it will continue to cover
expected and actual return in-
them with health-care and life insurance plans after retirement. These types of plans are
volves deferring gains and
typically less formal than pension plans and often are not backed by assets accumulated in
losses, corridor amounts, and
a separate fund. For example, ExxonMobil has only a $600 million separate fund set up to
other complexities best left for cover its estimated $2.6 billion obligation to cover the health-care needs of employees.
an intermediate accounting The accounting rules require companies to currently recognize the expense and long-
term liability associated with the postretirement benefits that are earned in the current
year, in keeping with the normal practice of matching expenses to the period in which
they are initially incurred. The actual accounting is complex but similar to that required for pen-
sions. The potential liabilities for these future payments can be quite significant for many firms.
GENERAL MOTORS has the largest postretirement benefit plan in the United States, with a
nonpension postretirement obligation totaling $44.683 billion as of December 31, 1999. Inter-
estingly, General Motors clearly indicates that although it is reporting a liability for these postre-
tirement benefits, it does not recognize these benefits as a legal obligation. In the notes to the
1999 financial statements, GM™s management states:

GM has disclosed in the consolidated financial statements certain
amounts associated with estimated future postretirement benefits other
than pensions and characterized such amounts as “accumulated postre-
tirement benefit obligations,” “liabilities,” or “obligations.” Notwith-
standing the recording of such amounts and the use of these terms, GM
360 f361
Completing The Operating Cycle Chapter 8
Completing the Operating Cycle

does not admit or otherwise acknowledge that such amounts or exist-
ing postretirement benefit plans of GM (other than pensions) represent
legally enforceable liabilities of GM.

As illustrated in this section, compensation expense includes much more than just wages
and salaries. Companies presumably have calculated that the value of the services provided by
employees justifies the additional compensation cost beyond salaries and wages. The fact that
net work employees earn benefits in one year that they do not receive until later, sometimes many years
later, necessitates careful accounting to ensure that compensation expense is reported in the year
in which it is earned.
site, http://www.
northernlifetsa.com, fea-
tures a set of retirement
and investment calculators
to help in financial plan-
to summarize
ning. How much money do
you need to save per
Employee compensation is not limited to just the current period™s payroll. The
month in order to accumu-
late $1 million by the time cost of employees also includes compensated absences, bonuses, stock op-
you are 65?
tions, postemployment benefits, pensions, and other postretirement benefits.
Most companies account for employee stock options using the intrinsic value
method, meaning that, typically, no compensation expense is recognized. A
pension obligation is reported on the balance sheet as the difference between
the obligation and the amount in an associated pension fund. Pension expense
is the sum of interest cost and service cost, less the expected return on the
pension fund assets.

Compute income tax
In addition to the payroll taxes described in the previous section, companies are responsible for
expense, including
appropriate consideration paying several other taxes to federal, state, and/or local governments, including sales taxes, prop-
of deferred tax items.
erty taxes, and income taxes. The accounting for these taxes is described next.

Sales Taxes
Most states and some cities charge a sales tax on retail transactions. These taxes are paid by cus-
tomers to the seller, who in turn forwards them to the state or city. Sales taxes collected from
customers represent a current liability until remitted to the appropriate governmental agency.
For example, assume that a sporting goods store in Denver prices a pair of skis at $200 and that
the combination of state and city sales tax is 6.5%. When the store sells the skis, it collects $213
and records the transaction as follows:

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ......... 213
Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ......... 200
Sales Tax Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ......... 13
Sold a pair of skis for $200. Collected $213, including 6.5% sales tax.

The sales revenue is properly recorded at $200, and the $13 is recorded as Sales Tax Payable,
sales tax payable Money
collected from customers a liability. Then, on a regular basis, a sales tax return is completed and filed with the state or
for sales taxes that must be
city tax commission, and sales taxes collected are paid to those agencies. Note that the collec-
remitted to local govern-
tion of the sales tax from customers creates a liability to the state but does not result in the recog-
ments and other taxing au-
nition of revenue when collected or an expense when paid to the state. The company acts as an
agent of the state in collecting the sales tax and recognizes a liability only until the collected
amount is remitted to the state.
f362 Part 2 Completing The Operating Cycle
Operating Activities

Property Taxes
Property taxes are usually assessed by county or city governments on land, buildings, and other
company assets. The period covered by the assessment of property taxes is often from July 1 of
one year to June 30 of the next year. If a property taxpayer is on a calendar-year financial re-
porting basis (or on a fiscal-year basis ending on a day other than June 30), the property tax as-
sessment year and the company™s financial reporting year will not coincide. Therefore, when the
company prepares its financial statements at calendar-year end, it must report a prepaid tax as-
set (if taxes are paid at the beginning of the tax year) or a property tax liability (if taxes are paid
at the end of the tax year) for the taxes associated with the first portion of the assessment year.
To illustrate, assume that Yokum Company pays its property taxes of $3,600 on June 30, 2002,
for the period July 1, 2002, to June 30, 2003. If the company is on a calender-year basis and
records the prepayment as an asset, then the adjusting entry at December 31, 2002, would be:

Property Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800
Prepaid Property Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800
To record property tax expense for 6 months.

The prepaid property taxes account balance of $1,800 would be shown on Yokum™s bal-
ance sheet at December 31, 2002, as a current asset. On June 30, 2003, property tax expense
would be recognized for the period January 1, 2003, through June 30, 2003, with the follow-
ing entry:

Property Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800
Prepaid Property Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800
To record property tax expense for the property assessment period
January 1“June 30, 2003.

Income Taxes
Corporations pay income taxes just as individuals do. This corporate income tax is usually re-
ported as the final expense on the income statement. For example, in 1999, the final three lines
in EXXONMOBIL™s income statement were as follows, with all numbers in millions:

1999 1998 1997

Income before income taxes $11,150 $12,083 $19,337
Income taxes 3,240 3,939 7,605
Net income $ 7,910 $ 8,144 $11,732

The $3.240 billion in income tax expense reported by ExxonMobil in 1999 is not neces-
sarily equal to the amount of cash paid for income taxes during the year. In fact, ExxonMobil
paid $3.805 billion for income taxes in 1999. Reported income tax expense may differ from the
actual amount of cash paid for taxes for two reasons. First, like many other expenses, income
taxes are not necessarily paid in cash in the year in which they are incurred. The important point
to remember is that reported income tax expense reflects the amount of income taxes attribut-
able to income earned during the year, whether the tax was actually paid in cash during the year
or not.
The second reason reported income tax expense may differ from the actual amount of cash
paid for taxes is that income tax expense is based on reported financial accounting income,
whereas the amount of cash paid for income taxes is dictated by the applicable government tax
law. The $3.240 billion income tax expense reported by ExxonMobil in 1999 reflects the total
estimated amount of income tax the company expects will eventually be paid based on the in-
362 f363
Completing The Operating Cycle Chapter 8
Completing the Operating Cycle

come reported in the current year™s income statement. However, because the income computed
using the tax rules is almost always different from the income computed using financial ac-
counting standards, some of this tax may not have to be paid for several years. In addition, tax
rules may require income tax to be paid on income before the financial accounting standards
consider that income to be “earned.” These differences in tax law income and financial ac-
counting income give rise to deferred income tax items, which are discussed in this section.
Corporations in the United States compute two different income numbers”financial in-
come for reporting to stockholders and taxable income for reporting to the Internal Revenue
Service (IRS). The existence of these two “sets of books” seems unethical to some, illegal to oth-
ers. However, the difference between the stockholders™ need for information and the govern-
ment™s need for efficient revenue collection makes the computation of the two different income
numbers essential. The different purposes of these reporting systems were summarized by the
U.S. Supreme Court in the Thor Power Tool case (1979):
The primary goal of financial accounting is to provide useful informa-
tion to management, shareholders, creditors, and others properly inter-
ested; the major responsibility of the accountant is to protect these par-
ties from being misled. The primary goal of the income tax system, in
contrast, is the equitable collection of revenue.
In summary, U.S. corporations compute income in two different ways, and rightly so. Never-
theless, the existence of these two different numbers that can each be called “income before taxes”
makes it surprisingly difficult to define what is meant by “income tax expense.”

Deferred Tax Example
Assume that you invest $1,000 by buying shares in a mutual fund on January 1. Also assume
that the income tax rate is 40%. According to the tax law, any economic gain you experience
through an increase in the value of your mutual fund shares is not taxed until you actually sell
your shares. The rationale behind this tax rule is that until you sell your shares, you don™t have
the cash to pay any tax. Now, assume further that the economy does well and that the value of
your mutual fund shares increases to $1,600 by December 31. You decide to prepare partial fi-
nancial statements to summarize your holdings and the performance of your shares during the
year. These financial statements are as follows:

Balance Sheet Income Statement

Assets: Revenues:
Mutual Fund Shares $1,600 Gain on Mutual Fund Investment $600

A moment™s consideration reveals that this balance sheet and income statement are mis-
leading. Yes, it is true that your shares are now worth $1,600, but if and when you liquidate
the shares, you will have to pay income tax of $240 [($1,600 $1,000) .40]. Thus, you are
overstating your economic position by only reporting the $1,600 in mutual fund shares; you
should also report that a liability of $240 exists in relation to these shares. Similarly, it is mis-
leading to report the $600 gain on your income statement without also reporting that, at some
future time, you will have to pay $240 in income tax on that gain. A more accurate set of fi-
nancial statements would appear as follows:

Balance Sheet Income Statement

Assets: Revenues:
Mutual Fund Shares $1,600 Gain on Mutual Fund Investment $600

Liabilities: Expenses:
Deferred Income Tax Liability $ 240 Income Tax Expense $240
f364 Part 2 Completing The Operating Cycle
Operating Activities

The appropriate journal entry to recognize income tax expense in this case is as follows:

Income Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
Deferred Income Tax Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240

Note that the deferred income tax liability is not a legal liability because, as far as the IRS
is concerned, you do not currently owe any tax on the increase in the value of your mutual fund.
Nevertheless, the deferred tax liability is an economic liability that should be reported now be-
cause it reflects an obligation that will have to be paid in the future as a result of an event (the
increase in the value of the mutual fund shares) that occurred this year.
Now, what if the mutual fund shares had decreased in value from $1,000 to $400? Con-
sider whether the following set of financial statements would accurately reflect your economic
position and performance:

Balance Sheet Income Statement
Assets: Expenses:
Mutual Fund Shares $400 Loss on Mutual Fund Investment $600

Again, these financial statements are somewhat misleading because they ignore the future tax
implications of the change in the value of the mutual fund shares. In this case, when the shares
are sold, you will realize a taxable loss of $600. If you have other investment income, that loss
can be used to reduce your total taxable income by $600, which will save you $240 ($600
.40 in income taxes. Thus, in a real sense, this loss on the mutual funds is not all bad because
it will provide you with a $240 reduction in income taxes in the year in which you sell the
shares. This reduction in taxes is an asset, a deferred income tax asset, because it represents a
probable future economic benefit that has arisen from an event (the drop in the value of the
mutual fund shares) that occurred this year. Similarly, the income statement effect of this fu-
ture savings in taxes is to soften the blow of the reported $600 loss. The loss that occurred this
year will result in an income tax benefit in the future, so the benefit is reported on this year™s
income statement, as follows:

Balance Sheet Income Statement

Assets: Expenses:
Mutual Fund Shares $400 Loss on Mutual Fund Investment $ 600
Less: Income Tax Benefit (240)
Deferred Income Tax Asset $240
Net Loss $ 360

The journal entry to recognize the income tax “expense” is as follows:

Deferred Income Tax Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
Income Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240

Notice that Income Tax Expense is credited, or reduced, in this entry. If there are other income
taxes for the year, this credit will result in a reduction in reported income tax expense. If there
are no other income taxes, then the credit amount will be reported on the income statement as
an addition to income under the title “income tax benefit.”
As this simple mutual fund example illustrates, the amount of income tax expense reported
on a company™s income statement is not necessarily the same as the amount of income tax the
company must pay on taxable income generated during the year. There are literally hundreds
364 f365
Completing The Operating Cycle Chapter 8
Completing the Operating Cycle

of accounting areas in which income is taxed by the taxing authorities in a different year
than the year in which the income is reported to the financial statement users in the in-
The value of the deferred tax as- come statement. The details of deferred income tax accounting are among the most com-
set depends on your having plicated issues covered in intermediate accounting courses.
other investment income in the
future against which the loss on
the mutual fund shares can be
to summarize
offset. Thus, accounting for de-
ferred tax assets is complicated
The amount of sales tax collected is reported as a liability until the funds
by the fact that one must make
are forwarded to the appropriate government agency. When property
an assumption about the likeli-
taxes are paid in advance, the amount is reported as a prepaid asset un-
hood that a company will have til the time period covered by the property tax has expired. Reported in-
enough taxable income in the come tax expense is not merely the amount of income tax that a com-
pany legally owes for a given year. Because of differences between
future to be able to take advan-
financial accounting rules and income tax rules, revenues and expense
tage of the deferred tax benefit.
can enter into the computation of income in different years for financial
accounting purposes and for income tax purposes. Proper accounting for de-
ferred income taxes ensures that reported income tax expense for a year rep-
resents all of the income tax consequences arising from transactions under-
taken during the year.

Distinguish between
By its very nature, business is full of uncertainty. As discussed in relation to employee compen-
contingent items that
should be recognized in the sation and taxes, proper recording of an expense in the current period frequently requires mak-
financial statements and
ing estimates about what will occur in future periods. Sometimes the very existence of an asset
those that should be merely
or liability depends on the occurrence, or nonoccurrence, of a future event. For example, whether
disclosed in the financial
statement notes. a company will have to make a payment as a result of a lawsuit arising from events occurring this
year depends on a judge or jury ruling that may not be known for several years. In accounting
terms, a contingency is an uncertain circumstance involving a potential gain or loss that will not
contingency Circumstances
involving potential losses be resolved until some future event occurs. In this section, we discuss the conceptual issues asso-
or gains that will not be re-
ciated with contingencies and the accounting for events for which the outcome is uncertain.
solved until some future
If you were a financial statement user, would you want to be informed of events known to
event occurs.
management that might have an adverse effect on the company™s future? Consider as an exam-
ple a lawsuit filed against a company. Because litigation can take years, how should that com-
pany account for the possibility of a loss? Would you want the company to wait until the law-
suit is resolved before informing financial statement users of the litigation? Of course not. You
would want to know about the lawsuit if the outcome could potentially materially affect the op-
erations of the company. But would you want to know about every lawsuit filed against the
company? Probably not.
Accounting standard-setters have addressed this issue and determined that the proper dis-
closure for a contingency depends upon the assessed outcome. The first thing to note is that ac-
counting standard-setters determined that accounting for contingent gains is, in most cases, in-
appropriate. Contingent gains are typically not accounted for until the future event relating to
the contingent gain resolves itself. Contingent liabilities are to be accounted for differently de-
pending on an assessment of the likely outcome of the contingency. Exhibit 8-3 contains the
relevant terms, definitions, and proper accounting for contingent liabilities.
If you think about it, this probability spectrum makes a great deal of sense. For example,
if it is likely that your company will lose a lawsuit in which it is the defendant, then it would
be appropriate to account for that outcome now by recognizing a loss and establishing a payable.
If the likelihood of your company losing the case is slight, then it makes sense to do nothing.
And if you are unsure of the outcome, then disclosure in the notes seems appropriate.
f366 Part 2 Completing The Operating Cycle
Operating Activities

Accounting for Contingent Liabilities
exhibit 8-3

Term Definition Accounting

Probable The future event is likely to occur. Estimate the amount of the contingency
and make the appropriate journal entry;
provide detailed disclosure in the notes.
Reasonably possible The chance of the future event occurring Provide detailed disclosure of the possible
is more than remote but less than likely. liability in the notes.
Remote The chance of the future event occurring No disclosure required.
is slight.

The problem in implementing these terms relates to assessing the likelihood of an outcome.
Who is to say if your company will lose a lawsuit? The company must obtain
objective assessments as to the possible outcome of future events. In the case
Why might a company
hesitate to assess the likelihood of losing an of litigation, the company would ask its attorneys about the possible outcome.
The firm auditing the company might use its own attorneys to assess the pos-
ongoing lawsuit as being probable? If you
sible outcome. In any case, companies are required to make objective assess-
were the attorney for the plaintiff, how
ments as to the likely outcome of contingent events and then account for those
could you use the resulting information events based on that assessment.
from the financial statements? MICROSOFT™s 1999 annual report (see Appendix A) contains the com-
pany™s disclosure relating to contingencies. At the time, the company was be-
ing investigated by the Justice Department for potential monopolistic practices. Note that the
disclosure relating to the antitrust contingency is minimal, consisting of just two paragraphs.
Contrast Microsoft™s disclosure with the 1999 disclosure provided by PHILIP MORRIS, the
tobacco company, relating to its involvement in ongoing tobacco litigation. The company pro-
vides over seven pages of disclosure relating to its potential liability.

Environmental Liabilities
Environmental liabilities have gained increasing attention of late because of their potential mag-
nitude. Environmental liabilities are obligations incurred because of damage done by compa-
environmental liabilities
Obligations incurred be- nies to the environment. Common environmental liabilities include cleanup costs associated with
cause of damage done to
oil spills, toxic waste dumps, or air pollution. These liabilities are usually brought to the com-
the environment.
pany™s attention as a result of fines or penalties imposed by the federal government or when dam-
age that is caused by the company is recognized. Although the accounting and disclosures asso-
ciated with environmental liabilities fall under the guidelines for contingencies discussed in the
previous section, environmental liabilities present a unique problem.
In the case of a lawsuit, one can typically make a reasonable estimate as to the upper bound
of the potential settlement. For example, if your company is being sued for $4 million, it is un-
likely that any potential settlement will be higher than that amount. In the case of environ-
mental liabilities, it is often very difficult to estimate the cost of environmental cleanup. Thus,
while the company may deem it probable that a liability exists, estimating that liability can be
difficult. Recall that the contingency standard requires a liability to be recorded on the com-
pany™s books if it is probable and estimable. If a potential liability is possible and estimable, the
standards require note disclosure.
What about the situation where a potential liability is probable but cannot be estimated
with much accuracy, as is often the case with environmental liabilities? Obviously, if a company
cannot estimate a probable obligation, it makes sense to provide extensive note disclosure. Most
companies will estimate a least a minimum amount and provide note disclosure as to the pos-
sibility of additional costs. As an illustration, EXXONMOBIL disclosed the information in Ex-
hibit 8-4 in its 1991 and 1999 annual reports in connection with lawsuits filed as a result of the
Exxon Valdez oil spill. Note that in 1991, the company sounds quite optimistic that it has set-
366 f367
Completing The Operating Cycle Chapter 8
Completing the Operating Cycle

ExxonMobil”1991 and 1999 Disclosures Concerning Exxon Valdez Oil Spill
exhibit 8-4

Disclosure in 1991
On March 24, 1989, the Exxon Valdez, a tanker owned by Exxon Shipping Company, a
subsidiary of Exxon Corporation, ran aground on Bligh Reef in Prince William Sound off
the port of Valdez, Alaska, and released approximately 260,000 barrels of crude oil. More
than 315 lawsuits, including class actions, have been brought in various courts against
Exxon Corporation and certain of its subsidiaries.
On October 8, 1991, the United States District Court for the District of Alaska approved a
civil agreement and consent decree. . . . These agreements provided for guilty pleas to
certain misdemeanors, the dismissal of all felony charges and the remaining
misdemeanor charges by the United States, and the release of all civil claims against
Exxon . . . by the United States and the state of Alaska. The agreements also released all
claims related to or arising from the oil spill by Exxon. . . .
Payments under the plea agreement totaled $125 million”$25 million in fines and $100
million in payments to the United States and Alaska for restoration projects in Alaska.
Payments under the civil agreement and consent decree will total $900 million over a ten-
year period. The civil agreement also provides for the possible payment, between
September 1, 2002, and September 1, 2006, of up to $100 million for substantial loss or
decline in populations, habitats, or species in areas affected by the oil spill which could
not have been reasonably anticipated on September 25, 1991.
The remaining cost to the corporation from the Valdez accident is difficult to predict and
cannot be determined at this time. It is believed the final outcome, net of reserves already
provided, will not have a materially adverse effect upon the corporation™s operations or
financial condition.

Disclosure in 1999
On September 24, 1996, the United States District Court for the District of Alaska entered
a judgment in the amount of $5.058 billion in the Exxon Valdez civil trial that began in
May 1994. The District Court awarded approximately $19.6 million in compensatory
damages to fisher plaintiffs, $38 million in prejudgment interest on the compensatory
damages and $5 billion in punitive damages to a class composed of all persons and
entities who asserted claims for punitive damages from the corporation as a result of the
Exxon Valdez grounding. The District Court also ordered that these awards shall bear
interest from and after entry of the judgment. The District Court stayed execution on the
judgment pending appeal based on a $6.75 billion letter of credit posted by the
corporation. The corporation has appealed the judgment. The corporation has also
appealed the District Court™s denial of its renewed motion for a new trial. The United
States Court of Appeals for the Ninth Circuit heard oral arguments on the appeals on May
3, 1999. The corporation continues to believe that the punitive damages in this case are
unwarranted and that the judgment should be set aside or substantially reduced by the
appellate courts.
The ultimate cost to ExxonMobil from the lawsuits arising from the Exxon Valdez
grounding is not possible to predict and may not be resolved for a number of years.

tled the bulk of the claims related to the oil spill and that any further claims “will not have a
materially adverse effect” upon the company. This optimistic disclosure is particularly interest-
ing in light of the $5 billion adverse judgment discussed in the 1999 disclosure.

to summarize
Contingent liabilities depend on some future event to determine if a liability
actually exists. Companies are required to assess the likelihood of certain fu-
ture events occurring and then, based on that assessment, provide appropri-
ate disclosure. If the company deems the future event to be likely, the journal
f368 Part 2 Completing The Operating Cycle
Operating Activities

entries are made and the liability is accrued. If the future event is deemed rea-
sonably possible, note disclosure is required. For those events considered re-
mote, no disclosure is required. Environmental liabilities represent a case where
a liability exists but measurement is difficult. A minimum liability is typically
established along with extensive note disclosure.

Understand when an
To this point in the text, we have assumed that the decision of expensing a cost to the income
expenditure should be
recorded as an asset and statement or capitalizing an expenditure and placing it on the balance sheet as an asset is an easy
when it should be recorded
one. In reality, that decision is often difficult and one that makes accounting judgment critical.
as an expense.
For example, should a building that cost $1 million and is expected to benefit 20 future peri-
ods be capitalized and placed on the balance sheet? The answer is pretty clear”of course. What
about office supplies that are used this period? Will they benefit future periods? No, and as a
result, the costs of those supplies should be expensed. What about research and development
costs? Should they be capitalized as an asset or expensed to the income statement? Now you see
the problem. Sometimes it is difficult to determine whether an expenditure will benefit the fu-
ture. Exhibit 8-5 provides an expense/asset continuum that demonstrates the difficulty of the
decision to capitalize or expense a cost.
The endpoints of the continuum are easy. The decision starts to get fuzzy, though, once
you leave the endpoints. Do repairs and maintenance benefit future periods (and therefore need
to be capitalized), or are they necessary expenditures just to keep a machine running (and should
be expensed)? To illustrate the issues involved in deciding whether an expenditure should be
capitalized or expensed, two specific areas will be discussed”research and development (R&D)
and advertising.

Research and Development
Research is an activity undertaken to discover new knowledge that will be useful in developing
new products, services, or processes. Development involves the application of research findings
to develop a plan or design for new or improved products and processes. EXXONMOBIL re-
ports that, from 1997 through 1999, it spent an average of $715 million per
year on R&D activities.
Would you expect that a
Because of the uncertainty surrounding the future economic benefit of
rule requiring all firms to expense R&D out- R&D activities, the FASB decided in 1974 that research and development ex-


. 16
( 29)