1

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

2

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”!

3

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

4

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”

5

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

6

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).

8

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.

9

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?)

10

20X3 Correcting Entries

Bad Debt Expense (651) 8000 Allowance for Bad Debts (108) 8000To record increase in the allowance for 20x3.

Vehicles (181) 30000 Service Cost - Direct R&M (554) 30000To reclassify R&M as vehicle cost.

Depreciation expense - trucks (701) 6000 Accumulated depreciation (182) 6000To record depreciation expense related to capitalized R&M incurred on 1/1/x3.

Leased assets (191) 380000 Capital leases - liability (415) 380000To record a capital lease

Equity Securities Allowance (114) 13000 Market (Loss) Recovery Short-Term(801) 13000To mark to market the trading securities

11

20X3 Correcting Entries

Capital lease - liability (415) 41000 Shop rent (563) 34,167 S&A rent (602) 6,833To adjust accounts for capital lease payment.

Amortization of capital leases (712) 19000 Accumulated depreciation (192) 19000To record depreciation on the capital lease.

Capital lease liability (415) 6,503 Short-term debt (321) 6,503To reclassify the current lease payable.

Interest Expense - Lease (755) 20,123 Interest Payable (311) 20,123To accrue interest expense on the lease liability.

12

20X3 Correcting Entries

Long-term debt notes (401) 5,950 Short-term portion of LT debt (321) 5,950To 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.

_______________________________________________________

13

20X3 CORRECTING ENTRIES

TAX EntriesCurrent 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)

14

REVIEW OF YEAR 3

General Questions about our engagement and the client

Review of Balance Sheet Review of Correcting Entries

15

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.

16

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

17

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

18

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.

19

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.

20

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

21

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

22

SUPPLIES

What cost flow assumptions does the client use with respect to this asset?

FIRST IN, FIRST OUT (FIFO)

23

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”)

24

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

25

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.

26

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

27

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.

28

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.

29

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.

30

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).

31

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?)

32

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.

33

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!)