- Email: [email protected]
An approach to integrating accounting courses
J. of Acc. Ed. 21 (2003) 101–126 www.elsevier.com/locate/jaccedu
Teaching and educational notes
An approach to integrating accounting courses Jane N. Baldwin*, Delton L. Chesser Department of Accounting and Business Law, PO Box 98002, Hankamer School of Business, Baylor University, Waco, TX 76798-8002, USA Received 1 March 2000; accepted 1 November 2002
Abstract This paper presents an approach for actively engaging students in developing the integration skills identified by the AICPA and others as needed for success in the accounting profession. Student groups first answer a set of questions in a comparison grid and then complete a related application case. The grid and case contrast the treatment of a specific accounting issue from the perspective of different accounting courses. We illustrate our approach with the treatment of bad debts from a financial/tax perspective. An appendix provides financial/audit and managerial/tax grids and cases. Assessment results suggest that the approach helps improve students’ integration skills. # 2003 Elsevier Science Ltd. All rights reserved. Keywords: Integration
The ability to integrate knowledge from various disciplines is an important skill for accounting students to possess upon entry into the profession (AAA, 1986; AECC, 1990; AICPA, 1999). In its Core Competency Framework, the American Institute of Certified Public Accountants (1999) indicates that student competencies should include the ability to: ‘‘Link data, knowledge, and insights together for decision-making purposes’’. ‘‘Synthesize novel or original definitions of problems and solutions as circumstances dictate’’. ‘‘Transfer knowledge from one situation to another’’. Changes in the accounting curriculum may be necessary to provide students with opportunities to develop their ability to integrate technical material from different * Corresponding author. Tel.: +1-254-710-6180; fax: +1-254-710-1067. E-mail addresses: [email protected] (J.N. Baldwin), [email protected] (D.L. Chesser). 0748-5751/03/$ - see front matter # 2003 Elsevier Science Ltd. All rights reserved. doi:10.1016/S0748-5751(03)00006-X
102
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
courses. For example, Albrecht and Sack (2000, p. 52) report that accounting educators should consider ‘‘how we should approach the students’ entire education so that we can make it integrated.’’ Walker and Ainsworth (2001) contend that educators tend to concentrate on their own disciplines and assume that students can make the connections. They conclude that without a framework to fit the pieces together, students find it difficult to understand the relationships among business disciplines. This paper presents a framework that helps students develop the ability to integrate technical material between accounting courses. The integration approach described in the paper does not require a big investment of time or major modification to existing classroom structures. The approach can also be used to integrate topics beyond the financial accounting and tax example presented in the paper. Examples that integrate financial/audit and managerial/tax topics are provided in Appendices A–D, and a more technically complex financial/tax example is presented in Appendices E and F.
1. Overview of the integration approach Tools for the integration session include a comparison grid and an application case. The grid compares the treatment of the identified accounting issue from the perspective of the courses being integrated. Professors build the grid around a set of relevant questions. Presenting the questions in the form of a grid provides a format that helps students easily compare and contrast a technical issue. Students complete the grid prepared by the instructors, considering similarities and differences in concepts, terminology, and treatment of the accounting issue. A case that applies the integration concepts identified in the grid to a specific situation is then constructed. Students complete the application case after the questions presented in the grid are discussed. Together, the grid and case provide students with an opportunity to relate and apply technical knowledge learned in different courses. In building grids and cases, a balance is needed between content complexity and integration skill development. If the technical content of the case becomes overly complex, students may focus too much on technical issues and miss the opportunity to develop their integration skills. Albrecht and Sack (2000, p. 43) warn against focusing ‘‘too much on content at the expense of skill development.’’ We therefore start with a technically simple grid and application case and build to a more complex set.
2. Classroom application 2.1. Course description and time requirement To illustrate our integration approach, we use the treatment of bad debt expense from financial accounting and tax accounting perspectives as shown in the Exhibit 1 grid and Exhibit 2 case. The grid and case have been used successfully in intermediatelevel financial accounting and undergraduate tax classes. The classes are taught through both lecture and group work, so students have already been organized into groups. We
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
103
allocate a 75-min class period to the project, which gives students adequate time to complete the grid, discuss the answers to the grid, complete the application case, and discuss the answers to the case. If time is a constraint, professors can assign either the completion of the grid or the case as homework and discuss the answers in class. Exhibit 1 Instructional Grid (with suggested solutions)
Note on Question 4: Our students have not yet been introduced to the detailed calculations of deferred taxes for financial statements and so this question does not address the specifics of the calculation of Income Tax Expense.
104
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Exhibit 2 Tax and Financial Integration Application Case (with suggested solutions in bold) NEWBURN VS. MONROE—A QUESTION OF BAD DEBT Newburn, Inc. made credit sales during 20X1 in the amount of $1,000,000. Among those sales was one to Monroe Inc. for $5,000 on December 1. Newburn estimates that 1% of credit sales will never be collected. On February 1, 20X2, Newburn, after repeated unsuccessful attempts to collect the balance due, has concluded that the Monroe account should be written off. A. 1.
Prepare the following journal entries for Newburn for financial accounting purposes. The purpose of these entries is to apply the financial principles in Points 1 through 3 on your grid. Record the sales made throughout the year (make as a single, summary entry). Accounts Receivable Sales
2.
1,000,000 1,000,000
Record any appropriate entry(ies) at December 31. Bad Debt Expense (1,000,000 X 1%) Allowance for Doubtful Accounts
3.
10,000 10,000
Record any appropriate entry(ies) at February 1. Allowance for Doubtful Accounts Accounts Receivable
B.
5,000
Assume that Newburn’s Cost of Goods Sold at December 31 is $600,000, that expenses other than Bad Debt Expense and Income Tax Expense were $200,000, that Newburn is in the 25% tax bracket, and that Newburn’s Income Tax Expense is $47,500. Prepare Newburn’s income statement for 20X1. This exercise applies the financial principles in Point 4 on your grid. Sales Cost of Goods Sold Gross Profit Other Expenses Bad Debt Expense Net Income Before Taxes Income Tax Expense Net Income
C. 1.
5,000
$1,000,000 600,000 $400,000 $200,000 10,000
210,000 $190,000 47,500 $142,500
The following questions apply the tax principles in Points 1 through 3 on your grid. For tax purposes, what action would Newburn take in 20X1 regarding bad debt expense? None—have not established that a specific bad debt exists.
2.
For tax purposes, when would Newburn deduct the bad debt expense? Is this treatment different than for financial accounting purposes? The specific write-off method allows Newburn to deduct $5,000 in Year 2. As shown in Parts A and B, financial accounting treats the bad debt expense differently, deducting it in Year 1. (continued on next page)
105
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126 Exhibit 2 (continued) NEWBURN VS. MONROE—A QUESTION OF BAD DEBT 3.
For tax purposes, are you sure that Newburn would deduct the Monroe account as a bad debt? Why? The accrual method requires Newburn to include sales to Monroe in gross income for 20X1. Therefore, Newburn can deduct bad debt expense for tax purposes in 20X2 when the debt is known to be worthless.
D.
The only difference between Newburn’s accounting net income and taxable income in 20X1 was due to the difference in the treatment of Bad Debt Expense. Again assuming that Newburn is in the 25% tax bracket, calculate the tax that Newburn owes to the IRS in 20X1. This exercise is based on the financial and tax principles in Point 5 on your grid. Sales Cost of Goods Sold Gross Profit Other Expenses Bad Debt Expense Taxable Income Tax Liability (25%)
E.
$1,000,000 600,000 $400,000 200,000 0 $200,000 $50,000
For tax purposes, does the financial accounting treatment of bad debt expense cause an M-1 adjustment? If so, what is the adjustment? Refer to Point 6 on your grid. Yes, must increase taxable income by the amount of bad debt expense that Newburn deducted using the allowance method. Thus for 20X1, M-1 adjustment equals $10,000 increase. For 20X2, M-1 adjustment is a $5,000 decrease.
F.
Prepare the journal entry for financial statement purposes to record Newburn’s income taxes at December 31, 20X1. (HINT: The expense will not be for the same amount as the liability.) This entry is an application of Point 7 on your grid. Income Tax Expense [(200,00025%)+2500] Deferred Tax Asset (10,00025%) Income Taxes Payable (200,00025%)
G.
47,500 2,500 50,000
Newburn frets that their tax bill is too high and considers changing their bad debt estimate from 1% to 1 12%. Would this lower their tax liability? Why or why not? No, because the tax deduction is not affected by the financial accounting estimate. For tax purposes the specific debt must be worthless before it can be deducted.
2.2. Discussion procedures and grading process At the beginning of class, we briefly discuss our goals and then distribute the grid shown in Exhibit 1, without the suggested solutions, to the students. Students work in groups of four to complete their grids, permitting them to consider opposing points of views about the topic. Textbooks and class notes may be used, and students are allowed to ask questions while working on the grid. When possible,
106
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
instructors should respond to students’ questions with questions. As Cunningham (1999) suggests, this approach keeps students involved and probing for solutions. After giving groups about 20 minutes to complete the grid, individual students from different groups are selected to answer questions from both financial and tax perspectives. Students receive feedback and comments from the instructors after each question. Immediate feedback identifies common misconceptions, clarifies points of confusion, and reduces learning bottlenecks more quickly (Wilson, 1999). For example, students can observe that accrual basis taxpayers use the allowance method for bad debts for financial accounting purposes because the matching principle requires the bad debt expense be recorded in the same period as the related sale. In contrast, tax accounting prohibits the use of estimates, except for special cases. Consequently, bad debt can be expensed for tax purposes only after the debt has been specifically identified as worthless. This contrasting treatment provides an excellent opportunity to reinforce the purpose of Schedule M-l adjustments (reconciling taxable income to financial income) for corporate taxpayers. Because the presenting group member’s answer represents a consensus, we use this student’s response to assign a grade to all members of the group. Students are informed of the grading process at the beginning of the integration class period. After completing and discussing the grid, students are given the related case shown in Exhibit 2. Students work in their groups for about 20 minutes before students are chosen to present his or her group’s solution to the case. The discussion and grading process described for the grid is also used for the case. Because solutions to the grid and case are discussed and graded in class, no outside grading is required. We have also conducted this exercise without assigning grades and found students to be just as interested and motivated. 2.4. Assignment timing and syllabi coordination Instructors assign the project soon after the topic of bad debts has been taught in both classes, although coverage of the topic need not be coordinated between classes. Bad debts are generally discussed in financial accounting before being covered in tax accounting, so the financial accounting professor assigns textbook pages for review before the integration class session. The financial and tax professors must decide whether the integration day will occur during a financial accounting class session or a tax class session. Both course syllabi note the integration day and both the financial and tax professors are present for the discussion of the grid and the related case problem.
3. Assessment To evaluate the success of our integration approach, we administered the pre- and post-tests shown in Exhibit 3. We wanted to assess whether the approach helps students link the conceptual and technical aspects of financial and tax accounting as it relates to bad debts and to obtain students’ opinions of the usefulness of the integration
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
107
Exhibit 3 Pre-test/post-test questions These questions are designed to evaluate the value to you of a day of integration of tax accounting and financial accounting. Please answer them as accurately as possible. The following information relates to Tyler Company for the year ended December 31, 20X1: Sales revenue Cost of goods sold Expenses other than bad debt expense
$1,000 250 400
Assume that $30 of bad debts were actually written off during 20X1 and that Tyler estimates 2% of sales revenue will never be collected. 1. How much is financial net income before tax? 2. How much is taxable income? 3. Explain why the timing of the recognition of bad debt expense is different for financial accounting purposes than for tax purposes. Include in your explanation a brief reference to the difference in the goals of financial and tax accounting. 4. How well do you feel that you understand the similarities and differences between financial accounting and tax accounting in general? a. Very well b. Somewhat well c. Somewhat poorly d. Very poorly 5. How well do you feel that you understand the similarities and differences between accounting for bad debts for financial accounting purposes and for tax accounting purposes? a. Very well b. Somewhat well c. Somewhat poorly d. Very poorly 6. Evaluate today’s class session as to its effectiveness in helping you to integrate your knowledge of financial and tax accounting.
approach. Sixty junior-level financial and tax accounting students completed the tests. The pre-test was given in the class immediately before the integration exercise was used and the post-test was administered at the end of the integration class session. Question 6 asks students to evaluate the integration class session and is therefore asked only on the post-test. The results of the test, shown in Exhibit 4, indicate positive results for both student understanding and opinion about the integration approach. In the first two questions regarding the calculation of financial income versus taxable income, 31% more students calculated financial income correctly and 5% more calculated taxable income correctly after the integration class session. Thirty-six percent more students
108
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Exhibit 4 Summary of responses to pre-test/post-test questions Out of 60
Change in Percentage
Pre-test
Post-test
Questions 1–3: Correct Responses Question 1 Question 2 Question 3
27 (45%) 43 (72%) 16 (27%)
46 (76%) 46 (77%) 38 (63%)
+31 +5 +36
Question 4 Very well Somewhat well Somewhat poorly Very poorly
2 41 16 1
(3%) (68%) (27%) (2%)
13 44 3 0
(22%) (73%) (5%) (0%)
+19 +5 22 2
Question 5 Very well Somewhat well Somewhat poorly Very poorly
2 23 32 3
(3%) (39%) (53%) (5%)
35 25 0 0
(58%) (42%) (0%) (0%)
+55 +3 53 5
provided an adequate explanation of the reason for the difference in the timing of the recognition of expense for financial accounting and tax accounting in Question 3. There was a 19% increase in students reporting that they understood very well the similarities and differences in financial and tax accounting in general (Question 4) and a 55% increase in those who felt they understood very well those similarities and differences as they relate to accounting for bad debts (Question 5). Most rewarding were the students’ written comments regarding the integration class session. All student comments were positive, and a few are quoted later. I enjoyed the class very much and feel the topic was emphasized very clearly and effectively. I think it was helpful to see financial and tax side by side so that you can see the differences, similarities, and reinforce your understanding of both. This was fun and a good way of seeing the differences. Since we have separate classes, you sometimes forget they are all intertwined. The class session helped to clear up questions and having two teachers, one for each field of study, was very helpful in understanding the topic as well. I enjoyed it. I hope we do more because until today, we had no reason to even compare financial with tax reporting - never was needed in class.
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
109
The worksheet helped a lot. I hope there will be more class integration days in the future. I wish I learned this much everyday. It would be cool to have more days like this. 4. Conclusion Several position papers indicate that accounting students need integration skills to function effectively in the accounting profession, but that the accounting curriculum often fails to offer adequate instruction in integration. Our paper presents an approach to providing accounting students with integration instruction and application that can be used within an existing classroom structure. We have used this integration approach for several semesters. During that time, we have observed that most students at the intermediate level have not yet considered the need to integrate information from various accounting courses and, consequently, have made little progress in integrating on their own. Instructors must teach students how to connect information from different courses instead of assuming that students already possess this skill. The assessment results suggest that our approach helps develop the linking, synthesis, and knowledge transfer skills needed in the accounting profession. We have also found that faculty involved in the design and implementation of the grids and cases benefit from the integration exercise. The design process itself brings colleagues together to create integration avenues that they might not otherwise have considered.
110
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Appendix A. Instructional grid (with suggested solutions) AUDIT AND FINANCIAL TREATMENT OF BAD DEBTS
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
111
Appendix B. Audit and financial integration application case (with suggested solutions in bold) SHAKEY CUSTOMERS—RECORDING AND AUDITING BAD DEBTS Newburn, Inc. manufactures and sells luggage to its distributors. Because the tourism industry has been negatively affected by recent world events, sales of luggage this year have sharply declined. The following summarizes Newburn’s accounts receivable and allowance for doubtful accounts before year-end adjustment. Accounts receivable Allowance for doubtful accounts Net accounts receivable
$350,000 5,000 $345,000
Newburn, Inc. has chosen to age its accounts receivable to estimate the bad debts. The aging schedule for December 31, 20X1 is presented below. Customer
Current
30–60 Days
60–90 Days
Over 90 Days
Total Balance
Evelyn Imports Fern, Inc. Iwana Co. Victor, Inc. William and Sons
$140,000
$20,000 60,000
$40,000
$80,000
27,000 $67,000
$10,000 15,000 7,000 6,000 $38,000
$160,000 110,000 15,000 7,000 33,000 $325,000
$140,000
Newburn has the following information about the customers with outstanding balances at December 31. Evelyn Imports: Evelyn has an excellent credit history, usually paying within 45 days. Fern, Inc.: Fern has been one of Newburn’s best customers for 10 years without incident. The over 90-day balance is related to a dispute over goods severely damaged in shipment. Fern refuses to pay for the damaged goods although Newburn’s lawyers believe that Fern is legally responsible. Iwana Co.: Iwana has been Newburn’s customer since beginning operations one year ago. Because Iwana is a high-volume purchaser of Newburn’s luggage, Newburn has been generous in allowing Iwana to make late payments. Iwana has eventually paid all bills in full. Victor, Inc.: Victor is a new customer located in Kansas. Newburn has learned that the shopping mall in which Victor’s business is located was destroyed in a tornado. Efforts to contact Victor have been unsuccessful. Williams and Sons: Williams and Sons has been Newburn’s customer for 25 years. The senior Mr. Williams is recently deceased and Newburn’s telephone messages have not been returned.
112
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
A. Answer the following questions as if you are a member of Newburn’s management. This exercise is an application of Points 7 and 8 on your grid. 1. Which accounts (if any) should be considered potential bad debts? Justify your conclusion. Various answers 2. Which accounts (if any) should be written off? Justify your conclusion. Various answers B. Regardless of your answer in part A, assume that Newburn’s management concludes that the bad debt estimate should consist of the following accounts. Customer
Newburn’s Estimate
Fern, Inc. Victor, Inc. Total
$10,000 7,000 $17,000
Prepare the entry to record the bad debt estimate at December 31, 20X1. Bad Debt Expense Allowance for Doubtful Accounts (17,0005,000)
12,000 12,000
C. Newburn is experiencing a difficult year in 20X1. The following questions are an application of Point 2 on your grid. 1. Specifically, how might management be tempted to use the bad debt estimate in part B to improve net income? Omit the Fern or Victor account from the estimate. 2. How would net income change if management decides that one of the accounts listed in part B might be collectible after all? Net income would increase by that amount net of tax. 3. Would you consider your answer in 1 to be income management or income manipulation? Why? Various answers D. Answer the following questions as if you are Newburn’s auditors. This exercise is an application of Points 7–10 on your grid. 1. What is Newburn asserting about the bad debt estimate in part B? 1. The estimate is reasonable in amount. (valuation) 2. The estimate is presented and disclosed in conformity to GAAP. (presentation/disclosure) 2. With what specific financial accounting principle(s) should the bad debt estimate comply in order to be in conformity with GAAP? The matching principle. The bad debt expense should be matched into the same accounting period as the related revenue.
113
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
3. Name at least two errors that management could make that would result in a bad debt estimate that did not comply with GAAP. 1. Math error. 2. Failure to properly identify potentially uncollectible accounts that are related to current-year sales, i.e., failure to match. The error could be due to mistake, poor judgment, or deliberate misrepresentation. E. Design an audit program for Newburn’s allowance for doubtful accounts that would test Newburn’s assertions and help detect the errors that you identified in part D. This exercise is an application of Point 9 on your grid. Obtain or prepare an aged accounts receivable trial balance. Test the aged trial balance for clerical accuracy. Have the client post subsequent cash collections to the aging schedule. Test the client’s subsequent collections on major account balances by examining deposit slips. 5. If uncollected accounts are significant, test the aging of the remaining accounts, preferably using original sales documents to test the propriety of aging. 6. For each material past due account, inspect credit files, review customer correspondence, or discuss the status of collection with client. Identify potentially doubtful accounts. 7. Perform analytical procedures, computing the accounts receivable turnover and day’s sales to collection, comparing the statistics with the prior year for this company and with the industry, investigating material fluctuations. 1. 2. 3. 4.
F. Assume that based on the audit results, Newburn’s auditor has concluded that more of the accounts should be included in the bad debt estimate than Newburn’s management is willing to accept. The comparison is below. Customer
Auditor’s Estimate
Newburn’s Estimate
Fern, Inc. Iwana Co. Victor, Inc. Total
$10,000 15,000 7,000 $32,000
$10,000 0 7,000 $17,000
1. From the auditor’s point of view, discuss the pros and cons of agreeing with Newburn’s management. What is your decision? This exercise is an application of Points 4 and 5 on your grid. Pro—Client stays satisfied. Con—Iwana does not pay and Newburn’s financial statements are misleading; stockholders hold auditors responsible. 2. Is there a way that the auditor might legitimately come to agree with Newburn’s estimate before the audit is completed? The subsequent collection of the balance owed by Iwana.
114
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Appendix C. Instructional grid (with suggested solutions) MANAGERIAL AND TAX CAPITAL BUDGETING DECISIONS MANAGERIAL
TAX The effect on gross income, deductible expenses (both current and future) and consequently, taxable income.
1.
What are the primary considerations regarding costs associated with the acquisition and use of new equipment?
The effect of revenues and costs on cash flows.
2.
Are these considerations interrelated? How?
Yes. Cash flows will be affected by the taxes paid on revenues produced by the new equipment and by tax savings from depreciation and other expenses.
3.
Does the financial accounting method of calculating depreciation (e.g., straight line or double declining balance) impact any asset acquisition decision? Why?
No, doesn’t affect cash flow.
No, doesn’t affect taxable income.
4.
Does the tax accounting method of calculating depreciation (e.g., straight line or MACRS) impact any asset acquisition decision? Why?
Yes, affects cash flows through size of tax savings from depreciation and repairs expense.
Yes, affects taxable income.
5.
Would selling Asset X and buying Asset Y be viewed differently than exchanging Asset X for Asset Y if the initial net cash outflows were the same either way? Why?
No, except for any cash flow effects from tax differences.
Yes, gains are deferred in like-kind exchanges.
6.
Assume that if a company does not replace old, leaky equipment, the government will impose a fine for pollution. Does the fine have a managerial accounting implication? A tax implication? Why?
Yes, reduces cash flows when it is paid.
No, taxable income is not affected because the fine is not deductible.
(continued on next page)
115
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126 Appendix C. (continued) MANAGERIAL
TAX
7.
In an otherwise profitable year, is an unanticipated loss on the disposal of equipment favorable or unfavorable? Why?
Unfavorable, because it reduces anticipated cash flows.
Favorable, because it reduces taxable income.
8.
Assume that the accountant’s qualitative analysis indicates that a product line should be dropped. Are there non-qualitative aspects of dropping the product line that the accountant should consider?
It is more often the managerial accountant’s job to consider the impact of a decision on its employees—e.g. lost jobs, or lower morale.
No, the tax accountant considers primarily the impact on taxable income.
Appendix D. Managerial and tax integration application case (with suggested solutions in bold) SHOW ME THE MONEY—MANAGERIAL AND TAX CONSIDERATIONS IN CAPITAL BUDGETING Show Me the Money (SMTM), Inc. provides duplicating services and is considering the purchase of a new duplicating machine to replace its old one. The new machine would cost $135,000 and have an estimated salvage value of $9,000 at the end of its 7-year life. The machine would be in the 5-year property class for MACRS depreciation. Its estimated annual operating costs are $55,000. The old machine was purchased two years ago at a cost of $100,000 and with an expected life of 9 years. Today, it has an adjusted basis of $48,000 [(100,000(20,000+32,000)], a remaining life of 7 years, and an expected salvage value of $7,000. The old machine could be sold now for $60,000. It is in the 5-year property class for MACRS depreciation. The annual operating costs are $71,500. The tax rate is 30% for ordinary income. SMTM desires an after tax return of 10% on investments in equipment. The revenue produced by both the new and old machine is expected to be the same. A. List the cash flows that would occur if SMTM, Inc. decides to buy the new equipment. This is an application of Point 1 on your grid. 1. 2. 3. 4. 5. 6.
Cost of new equipment Cash operating costs on new equipment Tax savings from depreciation deduction Cash from sale of old equipment Tax expense on gain on sale of old equipment Salvage on new equipment
116
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
B. List the cash flows that would occur if SMTM, Inc. decides to keep the old equipment. This is an application of Point 1 on your grid. 1. Cash operating costs on old equipment 2. Tax savings from depreciation deduction 3. Salvage on old equipment C. Calculate the amount of the gain on the sale of the old machine. What is the tax treatment for this gain? This is an application of Point 5 on your grid. Sales price Adjusted basis Gain
$60,000 48,000 $12,000
The gain is recaptured as ordinary income under x1245 and taxed at ordinary tax rates. D. Complete the analysis to determine whether SMTM, Inc. should buy the new machine or keep the old one. This is an application of Points 1– on your grid. Alternative 1: Buy the new duplicating machine Descriptions
Years Amount Tax After-tax 10%present Present effect cash flows value factor value of cash flows
.Cost of new machine Now $135,000 – ($135,000) .Annual cash operating costs 1–7 55,000 1–0.30 (38,500) .Depreciation deductions Year Cost MACRS% Depr. Amount
1.000 ($135,000) 4.868 (187,418)
1 $135,000 20.0% $27,000 1 2 135,000 32.0% 43,200 2 3 135,000 19.2% 25,920 3 4 135,000 11.5% 15,525 4 5 135,000 11.5% 15,525 5 6 135,000 5.8% 7,830 6 Cash received from sale of old machine Now Tax expense from gain on sale of old machine: Sales price $60,000 Adjusted basis 48,000 $12,000 1 Gain on sale
0.909 0.826 0.751 0.683 0.621 0.564 1.000
7,363 10,705 5,840 3,181 2,893 1,325 60,000
Cash received from sale of new machine Tax expense from gain on sale of new machine: Sales price $9,000 Adjusted basis 0 Gain on sale $9,000 Present value of cash flows from Alternative 1
27,000 43,200 25,920 15,525 15,525 7,830 60,000
0.30 0.30 0.30 0.30 0.30 0.30 –
8,100 12,960 7,776 4,658 4,658 2,349 60,000
12,000
0.30
(3,600)
0.909
(3,272)
9,000
0.513
4,617
(2,700)
0.513
(1,385) $(231,151)
7
9,000
–
7
9,000
0.30
117
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Alternative 2: Keep the old duplicating machine Descriptions
.Annual cash operating costs .Depreciation deductions: Year Cost MACRS% Depr. Amount 1 100,000 19.2% 19,200 2 100,000 11.5% 11,500 3 100,000 11.5% 11,500 4 100,000 5.8% 5,800 .Cash received from sale of old machine .Tax expense from gain on sale of old machine: Sales price $7,000 Adjusted basis 0 $7,000 Gain on sale Present value of cash flows from Alternative 2
Years Amount
Tax After-tax 10% present effect cash flows value factor
1–7 $71,500 1–0.30 ($50,050)
Present value of cash flows
4.868 ($243,643)
1 2 3 4 7
19,200 11,500 11,500 5,800 7,000
0.30 0.30 0.30 0.30 –
5,760 3,450 3,450 1,740 7,000
0.909 0.826 0.751 0.683 0.513
5,236 2,850 2,591 1,188 3,591
7
7,000
0.30
(2,100)
0.513
(1,077) $(229,264)
Summary of results: Present value of Alternative 1 (buy new) Present value of Alternative 2 (keep old) Net present value in favor of Alternative 2 (keep old)
$(231,151) (229,264) $1,887
E. 1. What cash flow item would be different if SMTM exchanged the new machine for the old machine in a like-kind exchange? This is an application of Point 5 on your grid. The tax on the gain on the sale would be eliminated. 2. Would your decision in part D be different if there was an exchange rather than a purchase and sale? This is an application of Point 5 on your grid. Yes, without the tax on the gain, the net present value would favor the new machine by $1,385 [229,264(231,1513,272)]. F. Assume that SMTM, Inc.’s present value analysis shows the corporation should purchase the new duplicating machine. The new machine would perform a job that was previously done by poor old Fred. Fred is 64 years old and just adopted a puppy. What are some possible options regarding SMTM’s machine decision and Fred’s fate? Which option would you choose? This is an application of Point 8 on your grid.
118
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
1. 2. 3. 4.
Purchase the new machine and fire Fred. Keep the old machine until Fred retires next year. Purchase the new machine and let Fred take early retirement. Other possibilities.
Appendix E. Instructional grid (with suggested solutions) FINANCIAL AND TAX TREATMENT OF PROPERTY, PLANT, AND EQUIPMENT Note on Appendices E and F: Because the property, plant, and equipment issues addressed in this grid and case are more complex than those in the bad debt expense example, we allocate two class days to the project. On the first day, students complete the grid below. We use the same class format and grading scheme for this grid exercise as described earlier. At the end of the class in which the grid is completed, we distribute the application case presented in Appendix F. We overview the case and assign the five requirements at the end of the case for the next class. To ensure that the students will be prepared to discuss their solutions, we require them to have typewritten answers ready at the beginning of the next class period and instruct students to work alone on their answers. On the next class day, we discuss the case. A student can earn an individual participation grade by either raising issues or offering reasonable alternative answers. They submit their typewritten solutions at the end of the class for a written grade. FINANCIAL
TAX
1. What costs are capitalized as the acquisition cost when property, plant, and equipment is purchased?
All costs that are ordinary, reasonable, and necessary to get the asset ready for its intended use.
Same, except where the taxpayer elects immediate expensing under Sec. 179.
2. What amount is capitalized as the acquisition cost when owners contribute assets to a corporation?
The fair market value of the assets at the time they are contributed.
If the transaction is nontaxable (Sec. 351), the capitalized cost is equal to the owners’ tax basis. If the transaction is taxable, the capitalized cost is equal to the fair market value of the assets.
3. What are the names of the methods that are considered appropriate for allocating the cost of acquisition across the periods benefited?
Straight-line, sum-of-the-years’ ACRS, MACRS, digits, declining balance, straight-line, ADS. units-of-production.
4. What is the name given to the results of the following calculation? CostAccumulated depreciation=
Book value.
Adjusted basis. (continued on next page)
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
119
Appendix E. (continued) FINANCIAL
TAX
5. What is the appropriate treatment of costs incurred subsequent to acquisition?
Capitalize additions, Same, except where the improvements, rearrangements taxpayer elects immediate and reinstallations by debiting expensing under Sec. 179. the asset account. Capitalize replacements by debiting accumulated depreciation. Expense repairs and maintenance.
6. Describe the process for recording the sale of an asset.
When appropriate, record depreciation to the date of disposal. The gain/loss is the difference between the cash received and the book value.
Determine gain or loss as: Amount realized Adjusted basis Real/Recog G/L
7. What is the name given to an exchange of assets that carry on the same function?
Similar asset exchange.
Like-kind exchange.
8. What is the name given to an exchange of assets that do not carry on the same function?
Dissimilar asset exchange.
Taxable exchange.
9. In a dissimilar/taxable asset exchange, is the gain or loss on the disposal of the old asset recognized?
Loss—yes. Gain—yes.
Same.
10. In a dissimilar/taxable asset exchange, how is the gain or loss on the disposal of the old asset calculated?
FMV of asset surrendered Book value of asset surrendered.
Amount realized Adjusted basis Real/Recog G/L
11. In a dissimilar/taxable asset exchange, how is the cost of the new asset calculated?
FMV of asset surrendered+ FMV of new asset. Boot paid OR - Boot received.
12. In a similar/like-kind asset exchange in which no cash is received (therefore, the company could not have traded down), is a gain or loss on the disposal of the old asset recognized?
Loss—yes. Gain—no.
No, unless boot other than cash or equivalent is given. Gain is recognized on boot given by the taxpayer.
13. In a similar/like-kind asset exchange FMV of asset surrendered in which no cash is received, how is Book value of asset a loss on the disposal of the old asset surrendered. calculated?
No loss is recognized on the like-kind property. Loss is recognized on boot given by taxpayer.
14. In a similar/like-kind asset exchange in which no cash is received, how is the cost/adjusted basis of the new asset calculated?
New asset assumes the old asset’s adjusted basis. Consideration must be made for any boot given or liability assumed.
Lower of book value or FMV of asset surrendered+ Boot paid.
(continued on next page)
120
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Appendix E. (continued) FINANCIAL
TAX
15. In a similar/like-kind asset exchange Loss—yes. in which cash is received, is a gain or Gain—partially. loss on the disposal of the old asset recognized?
Loss—no. Gain—yes, if gain is realized.
16. In a similar/like-kind asset exchange in which cash is received, how is a gain or loss on the disposal of the old asset calculated?
Loss—is not recognized. Gain—the lesser of the gain realized or the cash received. The recognized gain must be characterized as ordinary (Sec. 1245, 1250, 291), capital, or Sec. 1231.
LossFMV of asset surrenderedBook value of asset surrendered. Gain
17. In a similar/like-kind asset exchange in which cash is received, how is the cost/adjusted basis of the new asset calculated?
Boot Gain Boot þ FMV of Asset Acquired
Lower of book value or FMV of asset surrendered+Boot paid OR Boot received+ Gain recognized (if any).
The new asset assumes the old asset’s tax basis adjusted for the gain recognized and the amount of the cash (boot) received.
Appendix F. Integration application case HEALTHY, INC. In 2000 John and Bob decided to open a chicken processing plant in Flower Grove, Texas. The chicken market had increased dramatically since 1987 due to changing diets in the United States as well as Europe. Chicken futures were sound investments and generally ranked as one of the best commodities for trading. John had been in the chicken ranching business for a number of years and owned two ranches near Flower Grove, which he contributed to Healthy, Inc. for 51% of the common stock. Bob had been a partner in a cattle ranch in Pineville, Louisiana for about ten years. Because of consumers’ decision to reduce their consumption of beef, the market for cattle declined. Consequently, Bob decided to sell his partnership interest in the cattle ranch. Bob was able to sell his partnership interest in 1999 for $1 million, which he contributed to Healthy, Inc. for a 49% interest. Thus, Healthy, Inc. began on June 30, 2000 with $1 million cash and two chicken ranches. The chicken ranches contained the following assets.
Tax Basis Chicken house #1 Chicken house #2 Land for chicken house #1 Land for chicken house #2 John Deere Tractor Massey Ferguson Tractor Ford truck
$174,000 230,000 40,000 60,000 15,000 32,000 12,000
FMV $275,000 270,000 100,000 70,000 10,000 26,000 11,000 (continued on next page)
121
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126 Appendix F. (continued) Tax Basis Chevrolet truck 10,000 chickens (house #1) 15,000 chickens (house #2) Chicken feed Miscellaneous chicken supplies
15,000 50,000 60,000 46,000 35,000
FMV 17,000 70,000 105,000 53,000 33,800
John and Bob had previously developed plans for a state-of-the-art chicken processing plant that would be almost completely automated. This meant that processing equipment, although very expensive, could limit the amount of unskilled labor required to operate the plant. During the last six months of 2000, Healthy, Inc. incurred various expenditures relating to the construction of the processing plant. Cost Land (50 acres) Land survey Land title search fee Building permit Temporary quarters for construction crew Razing an old building Special assessment tax for street project Damages for injuries sustained in construction (no insurance coverage) Cost of construction Cost of paving a parking lot Cost of shrubs, trees, and landscaping
$300,000 1,500 350 500 10,750 25,000 2,000 4,200 750,000 25,000 5,000
The processing plant was completed and put into service on January 1, 2001. In addition, on January 1, 2001, Healthy, Inc. purchased robotic chicken processing equipment and other assets. Cost Deluxe 327 processor Arden 289 automatic deboner Conveyers Arch 312 dryer Iceman 356 freezer Miscellaneous small equipment
$115,000 112,000 58,000 72,000 46,000 5,000
Healthy, Inc. also traded in the Ford truck on June 30, 2001, for a new Dodge truck priced at $25,000. The dealer allowed $10,000 on the trade. In 2002, John and Bob decided that Healthy should convert chicken house #1 to egg production instead of raising chickens. Thus, the chickens that normally would
122
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
be processed at the six-month time period were kept to generate eggs. These hens could produce eggs for about two years before being sold. In addition, Healthy, Inc. decided it would be better to purchase chickens from a third party rather than maintaining chicken house #2. Thus, Healthy, Inc. sold the land and chicken house #2 to ‘‘Chickens R Us’’ on December 31, 2002, for $350,000 ($55,000 allocated to the land). As a result of this sale, the Massey Ferguson tractor and Chevrolet truck were not needed. However, the company did need a heavy duty fork lift. On December 31, 2002, Healthy, Inc. sold the tractor for $26,000 cash and traded the Chevrolet truck for a Hyster fork lift. Healthy, Inc. traded the Chevrolet truck to H&K Heavy Equipment and received a forklift valued at $15,000 and $2,000 cash. Finally, on December 31, 2002, the state requisitioned 5 acres of land that was purchased at the time the processing plant was built. The state plans to build an interstate highway. The state paid Healthy, Inc. $10,000 per acre for the land. Requirements: 1. Financial Prepare a schedule showing the allocation to appropriate financial statement categories (Land, Buildings, etc.) of the expenditures incurred for the construction of the processing plant.
Land Land Survey Land Title Search Building Permit Construction Crew Quarters Razing Building Street Assessment Tax Uninsured Injuries Construction Cost Parking Lot Pavement Landscaping Totals
Land 300,000 1,500 350
Building
Land Improvements
Expenses
500 10,750 25,000 2,000 4,200 750,000 25,000 5,000 333,850
761,250
25,000
4,200
2. Financial and Tax Show the calculations of the book and tax depreciation expense for Healthy, Inc. for the processing plant building for 2001 and 2002. Disregard your answer in Question 1 regarding the cost allocated to the building and assume that for both book and tax depreciation the acquisition cost/tax basis is $2,000,000. For both book and tax, assume a 39-year life and no salvage value. For book purposes, use whole-months depreciation computed using 1) straight-line, and 2) double-declining balance.
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
123
Tax: Processing Plant—MACRS Straight line 39 years; placed in service January 1, 2001. 2001 Depreciation
2002 Depreciation
2,000,000 0.2461 49,220
2,000,000 0.02564 51,280
Financial: 2001 Depreciation
2002 Depreciation
Straight-line 2,000,000/39=51,282
Same
Double Declining Balance Rate=(100%/39)2=5.13% (2,000,0000)5.13%=102,600
(2,000,000102,600)5.13%=97,337
3. Financial List all the factors Healthy, Inc. should consider in choosing a depreciation method for its depreciable assets for financial statement purposes. Explain why those factors should be considered. 1. Higher net income—impress investors and creditors. Straight line 2. Lower net income—double declining balance or sum of years digits 3. Smooth net income—impress investors & creditors with stability—match ever increasing maintenance with ever decreasing depreciation expense. DDB or SYD 4. Easy—straight line 5. Industry standard 4. Financial Based on the factors considered in Question 3, which depreciation method would you recommend that Healthy, Inc. use for financial statements to depreciate Buildings? Equipment? Land Improvements? Defend your answers. Various answers. 5. Financial and Tax For each transaction in 2001 and 2002 involving an exchange or sale, show 1) the acquisition cost (i.e., cost of new asset) and tax basis of the property acquired, and 2) the gain or loss (if any) on the sale or exchange of the old asset using the grid below. For both book and tax, assume a seven-year life for personal property, a 39-year life for real property, and no salvage value.
124
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
For financial statement purposes, assume straight-line, whole-months depreciation is used for all depreciable assets. Show only your final answers on the schedule below, but be prepared to show how you calculated these amounts in the class presentation. For tax purposes, report the tax basis of new assets, where applicable. Additionally, indicate the amount of any gain/loss recognized by Healthy, Inc. Also characterize the gain/loss as x1231, x1245, etc. Transaction 1. Ford truck trade Acquisition cost/tax basis of Dodge Gain/loss on disposal of Ford Gain/loss recognized for tax purposes Character of gain/loss 2. Chicken house #2 land sale Gain/loss on disposal of land Gain/loss recognized for tax purposes Character of gain/loss
Financial Statements
Tax Return
$XX
$XX
$XX
$XX
$XX
$XX
3. Etc.
Financial suggested solutions Ford truck trade for Dodge (similar exchange) Accumulated Depreciation=11,000/71=1,571 Book Value=11,0001,571=9,429 Cost of new Dodge=Lower of FMV or BV+Boot paid =9,429+(25,00010,000) =24,429 Gain on Ford=FMVBV =10,0009,429 =571 All is deferred because no boot is received Land sale from chicken house Loss=Cash receivedBV =55,00070,000 =15,000 Chicken house sale Accumulated Depreciation=270,000/392 12=17,308 Book Value=270,00017,308=252,692 Gain=Cash receivedBV =(350,00055,000)252,692 =42,308
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Tractor sale Accumulated Depreciation=26,000/72 12=9,286 Book Value=26,0009,286=16,714 Gain=Cash receivedBV =26,00016,714 =9,286 Chevy truck for forklift (dissimilar) Accumulated Depreciation=17,000/72 12=6,071 Book Value=17,0006,071=10,929 Cost of new forklift=FMVBoot received =(15,000+2,000)2,000 =15,000 Gain on Chevy=FMVBV =17,00010,929 =6,071 All is recognized because assets are dissimilar Forced land sale Cost=333,850/505 acres=33,385 Gain=Cash receivedBV =(10,0005)33,385 =16,615
Tax suggested solutions Ford truck trade for Dodge No gain recognized because transaction qualified as a like kind exchange and no boot was received. New Dodge adjusted basis: Adjusted basis of old Boot given Adjusted basis of new
8,816 15,000 23,816
Land sale from chicken house Amount realized Adjusted basis Realized/recognized x1231 loss
55,000 60,000 (5,000)
Chicken house sale Amount realized Adjusted basis Realized/recognized gain
295,000 215,252 79,748
125
126
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Gain recognized as: Section 291 gain 0.2(14,7480)=2,950 Section 1231 gain (79,7482,950)=76,798 Tractor sale Depreciation taken: 15,208=32,0000.47525 Amount realized Adjusted basis Realized/recognized x1245 Gain Chevy truck for forklift Depreciation taken: 7,129=15,0000.47525
26,000 16,792 9,208
Amount realized 17,000 Adjusted basis 7,871 Realized/recognized gain 9,129 All of gain recognized because transaction does not qualify as a like kind exchange. Gain recognized as: Section 1245 gain - 7,129 (equal to all of depreciation) Section 1231 gain - 2,000 (equal to amount of gain over depreciation) Forced land sale Cost per acre=333,850/50 acres=6,677/acre Amount realized Adjusted basis Realized/recognized x1231 gain
50,000 (5 acres10,000) 33,385 (5 acres6,677) 16,615
References Accounting Education Change Commission (AECC). (1990). Objectives of education for accountants: position statement number one. Issues in Accounting Education, 5(2), 307–312. Albrecht, W. S., & Sack, R. J. (2000). Accounting education: charting the course through a perilous future. Accounting Education Series: 16. Sarasota, FL: American Accounting Association. American Accounting Association (AAA). (1986). Committee on the Future Structure, Content, and Scope of Accounting Education (The Bedford Committee). Future accounting education: preparing for the expanding profession. Issues in Accounting Education, 1(1), 168–195. American Institute of Certified Public Accountants (AICPA). (1999). AICPA core competency framework for entry into the accounting profession. Available: http://www.aicpa.org/edu/corecomp.htm. Cunningham, B. M. (1999). Energizing your teaching: a view from deep in the trenches. Issues in Accounting Education, 14(2), 307–321. Walker, K. B., & Ainsworth, P. L. (2001). Developing a process approach in the business core curriculum. Issues in Accounting Education, 16(1), 41–66. Wilson, G. P. (1999). Teaching and learning can be energizing. Issues in Accounting Education, 14(2), 337– 368.
Teaching and educational notes
An approach to integrating accounting courses Jane N. Baldwin*, Delton L. Chesser Department of Accounting and Business Law, PO Box 98002, Hankamer School of Business, Baylor University, Waco, TX 76798-8002, USA Received 1 March 2000; accepted 1 November 2002
Abstract This paper presents an approach for actively engaging students in developing the integration skills identified by the AICPA and others as needed for success in the accounting profession. Student groups first answer a set of questions in a comparison grid and then complete a related application case. The grid and case contrast the treatment of a specific accounting issue from the perspective of different accounting courses. We illustrate our approach with the treatment of bad debts from a financial/tax perspective. An appendix provides financial/audit and managerial/tax grids and cases. Assessment results suggest that the approach helps improve students’ integration skills. # 2003 Elsevier Science Ltd. All rights reserved. Keywords: Integration
The ability to integrate knowledge from various disciplines is an important skill for accounting students to possess upon entry into the profession (AAA, 1986; AECC, 1990; AICPA, 1999). In its Core Competency Framework, the American Institute of Certified Public Accountants (1999) indicates that student competencies should include the ability to: ‘‘Link data, knowledge, and insights together for decision-making purposes’’. ‘‘Synthesize novel or original definitions of problems and solutions as circumstances dictate’’. ‘‘Transfer knowledge from one situation to another’’. Changes in the accounting curriculum may be necessary to provide students with opportunities to develop their ability to integrate technical material from different * Corresponding author. Tel.: +1-254-710-6180; fax: +1-254-710-1067. E-mail addresses: [email protected] (J.N. Baldwin), [email protected] (D.L. Chesser). 0748-5751/03/$ - see front matter # 2003 Elsevier Science Ltd. All rights reserved. doi:10.1016/S0748-5751(03)00006-X
102
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
courses. For example, Albrecht and Sack (2000, p. 52) report that accounting educators should consider ‘‘how we should approach the students’ entire education so that we can make it integrated.’’ Walker and Ainsworth (2001) contend that educators tend to concentrate on their own disciplines and assume that students can make the connections. They conclude that without a framework to fit the pieces together, students find it difficult to understand the relationships among business disciplines. This paper presents a framework that helps students develop the ability to integrate technical material between accounting courses. The integration approach described in the paper does not require a big investment of time or major modification to existing classroom structures. The approach can also be used to integrate topics beyond the financial accounting and tax example presented in the paper. Examples that integrate financial/audit and managerial/tax topics are provided in Appendices A–D, and a more technically complex financial/tax example is presented in Appendices E and F.
1. Overview of the integration approach Tools for the integration session include a comparison grid and an application case. The grid compares the treatment of the identified accounting issue from the perspective of the courses being integrated. Professors build the grid around a set of relevant questions. Presenting the questions in the form of a grid provides a format that helps students easily compare and contrast a technical issue. Students complete the grid prepared by the instructors, considering similarities and differences in concepts, terminology, and treatment of the accounting issue. A case that applies the integration concepts identified in the grid to a specific situation is then constructed. Students complete the application case after the questions presented in the grid are discussed. Together, the grid and case provide students with an opportunity to relate and apply technical knowledge learned in different courses. In building grids and cases, a balance is needed between content complexity and integration skill development. If the technical content of the case becomes overly complex, students may focus too much on technical issues and miss the opportunity to develop their integration skills. Albrecht and Sack (2000, p. 43) warn against focusing ‘‘too much on content at the expense of skill development.’’ We therefore start with a technically simple grid and application case and build to a more complex set.
2. Classroom application 2.1. Course description and time requirement To illustrate our integration approach, we use the treatment of bad debt expense from financial accounting and tax accounting perspectives as shown in the Exhibit 1 grid and Exhibit 2 case. The grid and case have been used successfully in intermediatelevel financial accounting and undergraduate tax classes. The classes are taught through both lecture and group work, so students have already been organized into groups. We
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
103
allocate a 75-min class period to the project, which gives students adequate time to complete the grid, discuss the answers to the grid, complete the application case, and discuss the answers to the case. If time is a constraint, professors can assign either the completion of the grid or the case as homework and discuss the answers in class. Exhibit 1 Instructional Grid (with suggested solutions)
Note on Question 4: Our students have not yet been introduced to the detailed calculations of deferred taxes for financial statements and so this question does not address the specifics of the calculation of Income Tax Expense.
104
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Exhibit 2 Tax and Financial Integration Application Case (with suggested solutions in bold) NEWBURN VS. MONROE—A QUESTION OF BAD DEBT Newburn, Inc. made credit sales during 20X1 in the amount of $1,000,000. Among those sales was one to Monroe Inc. for $5,000 on December 1. Newburn estimates that 1% of credit sales will never be collected. On February 1, 20X2, Newburn, after repeated unsuccessful attempts to collect the balance due, has concluded that the Monroe account should be written off. A. 1.
Prepare the following journal entries for Newburn for financial accounting purposes. The purpose of these entries is to apply the financial principles in Points 1 through 3 on your grid. Record the sales made throughout the year (make as a single, summary entry). Accounts Receivable Sales
2.
1,000,000 1,000,000
Record any appropriate entry(ies) at December 31. Bad Debt Expense (1,000,000 X 1%) Allowance for Doubtful Accounts
3.
10,000 10,000
Record any appropriate entry(ies) at February 1. Allowance for Doubtful Accounts Accounts Receivable
B.
5,000
Assume that Newburn’s Cost of Goods Sold at December 31 is $600,000, that expenses other than Bad Debt Expense and Income Tax Expense were $200,000, that Newburn is in the 25% tax bracket, and that Newburn’s Income Tax Expense is $47,500. Prepare Newburn’s income statement for 20X1. This exercise applies the financial principles in Point 4 on your grid. Sales Cost of Goods Sold Gross Profit Other Expenses Bad Debt Expense Net Income Before Taxes Income Tax Expense Net Income
C. 1.
5,000
$1,000,000 600,000 $400,000 $200,000 10,000
210,000 $190,000 47,500 $142,500
The following questions apply the tax principles in Points 1 through 3 on your grid. For tax purposes, what action would Newburn take in 20X1 regarding bad debt expense? None—have not established that a specific bad debt exists.
2.
For tax purposes, when would Newburn deduct the bad debt expense? Is this treatment different than for financial accounting purposes? The specific write-off method allows Newburn to deduct $5,000 in Year 2. As shown in Parts A and B, financial accounting treats the bad debt expense differently, deducting it in Year 1. (continued on next page)
105
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126 Exhibit 2 (continued) NEWBURN VS. MONROE—A QUESTION OF BAD DEBT 3.
For tax purposes, are you sure that Newburn would deduct the Monroe account as a bad debt? Why? The accrual method requires Newburn to include sales to Monroe in gross income for 20X1. Therefore, Newburn can deduct bad debt expense for tax purposes in 20X2 when the debt is known to be worthless.
D.
The only difference between Newburn’s accounting net income and taxable income in 20X1 was due to the difference in the treatment of Bad Debt Expense. Again assuming that Newburn is in the 25% tax bracket, calculate the tax that Newburn owes to the IRS in 20X1. This exercise is based on the financial and tax principles in Point 5 on your grid. Sales Cost of Goods Sold Gross Profit Other Expenses Bad Debt Expense Taxable Income Tax Liability (25%)
E.
$1,000,000 600,000 $400,000 200,000 0 $200,000 $50,000
For tax purposes, does the financial accounting treatment of bad debt expense cause an M-1 adjustment? If so, what is the adjustment? Refer to Point 6 on your grid. Yes, must increase taxable income by the amount of bad debt expense that Newburn deducted using the allowance method. Thus for 20X1, M-1 adjustment equals $10,000 increase. For 20X2, M-1 adjustment is a $5,000 decrease.
F.
Prepare the journal entry for financial statement purposes to record Newburn’s income taxes at December 31, 20X1. (HINT: The expense will not be for the same amount as the liability.) This entry is an application of Point 7 on your grid. Income Tax Expense [(200,00025%)+2500] Deferred Tax Asset (10,00025%) Income Taxes Payable (200,00025%)
G.
47,500 2,500 50,000
Newburn frets that their tax bill is too high and considers changing their bad debt estimate from 1% to 1 12%. Would this lower their tax liability? Why or why not? No, because the tax deduction is not affected by the financial accounting estimate. For tax purposes the specific debt must be worthless before it can be deducted.
2.2. Discussion procedures and grading process At the beginning of class, we briefly discuss our goals and then distribute the grid shown in Exhibit 1, without the suggested solutions, to the students. Students work in groups of four to complete their grids, permitting them to consider opposing points of views about the topic. Textbooks and class notes may be used, and students are allowed to ask questions while working on the grid. When possible,
106
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
instructors should respond to students’ questions with questions. As Cunningham (1999) suggests, this approach keeps students involved and probing for solutions. After giving groups about 20 minutes to complete the grid, individual students from different groups are selected to answer questions from both financial and tax perspectives. Students receive feedback and comments from the instructors after each question. Immediate feedback identifies common misconceptions, clarifies points of confusion, and reduces learning bottlenecks more quickly (Wilson, 1999). For example, students can observe that accrual basis taxpayers use the allowance method for bad debts for financial accounting purposes because the matching principle requires the bad debt expense be recorded in the same period as the related sale. In contrast, tax accounting prohibits the use of estimates, except for special cases. Consequently, bad debt can be expensed for tax purposes only after the debt has been specifically identified as worthless. This contrasting treatment provides an excellent opportunity to reinforce the purpose of Schedule M-l adjustments (reconciling taxable income to financial income) for corporate taxpayers. Because the presenting group member’s answer represents a consensus, we use this student’s response to assign a grade to all members of the group. Students are informed of the grading process at the beginning of the integration class period. After completing and discussing the grid, students are given the related case shown in Exhibit 2. Students work in their groups for about 20 minutes before students are chosen to present his or her group’s solution to the case. The discussion and grading process described for the grid is also used for the case. Because solutions to the grid and case are discussed and graded in class, no outside grading is required. We have also conducted this exercise without assigning grades and found students to be just as interested and motivated. 2.4. Assignment timing and syllabi coordination Instructors assign the project soon after the topic of bad debts has been taught in both classes, although coverage of the topic need not be coordinated between classes. Bad debts are generally discussed in financial accounting before being covered in tax accounting, so the financial accounting professor assigns textbook pages for review before the integration class session. The financial and tax professors must decide whether the integration day will occur during a financial accounting class session or a tax class session. Both course syllabi note the integration day and both the financial and tax professors are present for the discussion of the grid and the related case problem.
3. Assessment To evaluate the success of our integration approach, we administered the pre- and post-tests shown in Exhibit 3. We wanted to assess whether the approach helps students link the conceptual and technical aspects of financial and tax accounting as it relates to bad debts and to obtain students’ opinions of the usefulness of the integration
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
107
Exhibit 3 Pre-test/post-test questions These questions are designed to evaluate the value to you of a day of integration of tax accounting and financial accounting. Please answer them as accurately as possible. The following information relates to Tyler Company for the year ended December 31, 20X1: Sales revenue Cost of goods sold Expenses other than bad debt expense
$1,000 250 400
Assume that $30 of bad debts were actually written off during 20X1 and that Tyler estimates 2% of sales revenue will never be collected. 1. How much is financial net income before tax? 2. How much is taxable income? 3. Explain why the timing of the recognition of bad debt expense is different for financial accounting purposes than for tax purposes. Include in your explanation a brief reference to the difference in the goals of financial and tax accounting. 4. How well do you feel that you understand the similarities and differences between financial accounting and tax accounting in general? a. Very well b. Somewhat well c. Somewhat poorly d. Very poorly 5. How well do you feel that you understand the similarities and differences between accounting for bad debts for financial accounting purposes and for tax accounting purposes? a. Very well b. Somewhat well c. Somewhat poorly d. Very poorly 6. Evaluate today’s class session as to its effectiveness in helping you to integrate your knowledge of financial and tax accounting.
approach. Sixty junior-level financial and tax accounting students completed the tests. The pre-test was given in the class immediately before the integration exercise was used and the post-test was administered at the end of the integration class session. Question 6 asks students to evaluate the integration class session and is therefore asked only on the post-test. The results of the test, shown in Exhibit 4, indicate positive results for both student understanding and opinion about the integration approach. In the first two questions regarding the calculation of financial income versus taxable income, 31% more students calculated financial income correctly and 5% more calculated taxable income correctly after the integration class session. Thirty-six percent more students
108
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Exhibit 4 Summary of responses to pre-test/post-test questions Out of 60
Change in Percentage
Pre-test
Post-test
Questions 1–3: Correct Responses Question 1 Question 2 Question 3
27 (45%) 43 (72%) 16 (27%)
46 (76%) 46 (77%) 38 (63%)
+31 +5 +36
Question 4 Very well Somewhat well Somewhat poorly Very poorly
2 41 16 1
(3%) (68%) (27%) (2%)
13 44 3 0
(22%) (73%) (5%) (0%)
+19 +5 22 2
Question 5 Very well Somewhat well Somewhat poorly Very poorly
2 23 32 3
(3%) (39%) (53%) (5%)
35 25 0 0
(58%) (42%) (0%) (0%)
+55 +3 53 5
provided an adequate explanation of the reason for the difference in the timing of the recognition of expense for financial accounting and tax accounting in Question 3. There was a 19% increase in students reporting that they understood very well the similarities and differences in financial and tax accounting in general (Question 4) and a 55% increase in those who felt they understood very well those similarities and differences as they relate to accounting for bad debts (Question 5). Most rewarding were the students’ written comments regarding the integration class session. All student comments were positive, and a few are quoted later. I enjoyed the class very much and feel the topic was emphasized very clearly and effectively. I think it was helpful to see financial and tax side by side so that you can see the differences, similarities, and reinforce your understanding of both. This was fun and a good way of seeing the differences. Since we have separate classes, you sometimes forget they are all intertwined. The class session helped to clear up questions and having two teachers, one for each field of study, was very helpful in understanding the topic as well. I enjoyed it. I hope we do more because until today, we had no reason to even compare financial with tax reporting - never was needed in class.
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
109
The worksheet helped a lot. I hope there will be more class integration days in the future. I wish I learned this much everyday. It would be cool to have more days like this. 4. Conclusion Several position papers indicate that accounting students need integration skills to function effectively in the accounting profession, but that the accounting curriculum often fails to offer adequate instruction in integration. Our paper presents an approach to providing accounting students with integration instruction and application that can be used within an existing classroom structure. We have used this integration approach for several semesters. During that time, we have observed that most students at the intermediate level have not yet considered the need to integrate information from various accounting courses and, consequently, have made little progress in integrating on their own. Instructors must teach students how to connect information from different courses instead of assuming that students already possess this skill. The assessment results suggest that our approach helps develop the linking, synthesis, and knowledge transfer skills needed in the accounting profession. We have also found that faculty involved in the design and implementation of the grids and cases benefit from the integration exercise. The design process itself brings colleagues together to create integration avenues that they might not otherwise have considered.
110
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Appendix A. Instructional grid (with suggested solutions) AUDIT AND FINANCIAL TREATMENT OF BAD DEBTS
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
111
Appendix B. Audit and financial integration application case (with suggested solutions in bold) SHAKEY CUSTOMERS—RECORDING AND AUDITING BAD DEBTS Newburn, Inc. manufactures and sells luggage to its distributors. Because the tourism industry has been negatively affected by recent world events, sales of luggage this year have sharply declined. The following summarizes Newburn’s accounts receivable and allowance for doubtful accounts before year-end adjustment. Accounts receivable Allowance for doubtful accounts Net accounts receivable
$350,000 5,000 $345,000
Newburn, Inc. has chosen to age its accounts receivable to estimate the bad debts. The aging schedule for December 31, 20X1 is presented below. Customer
Current
30–60 Days
60–90 Days
Over 90 Days
Total Balance
Evelyn Imports Fern, Inc. Iwana Co. Victor, Inc. William and Sons
$140,000
$20,000 60,000
$40,000
$80,000
27,000 $67,000
$10,000 15,000 7,000 6,000 $38,000
$160,000 110,000 15,000 7,000 33,000 $325,000
$140,000
Newburn has the following information about the customers with outstanding balances at December 31. Evelyn Imports: Evelyn has an excellent credit history, usually paying within 45 days. Fern, Inc.: Fern has been one of Newburn’s best customers for 10 years without incident. The over 90-day balance is related to a dispute over goods severely damaged in shipment. Fern refuses to pay for the damaged goods although Newburn’s lawyers believe that Fern is legally responsible. Iwana Co.: Iwana has been Newburn’s customer since beginning operations one year ago. Because Iwana is a high-volume purchaser of Newburn’s luggage, Newburn has been generous in allowing Iwana to make late payments. Iwana has eventually paid all bills in full. Victor, Inc.: Victor is a new customer located in Kansas. Newburn has learned that the shopping mall in which Victor’s business is located was destroyed in a tornado. Efforts to contact Victor have been unsuccessful. Williams and Sons: Williams and Sons has been Newburn’s customer for 25 years. The senior Mr. Williams is recently deceased and Newburn’s telephone messages have not been returned.
112
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
A. Answer the following questions as if you are a member of Newburn’s management. This exercise is an application of Points 7 and 8 on your grid. 1. Which accounts (if any) should be considered potential bad debts? Justify your conclusion. Various answers 2. Which accounts (if any) should be written off? Justify your conclusion. Various answers B. Regardless of your answer in part A, assume that Newburn’s management concludes that the bad debt estimate should consist of the following accounts. Customer
Newburn’s Estimate
Fern, Inc. Victor, Inc. Total
$10,000 7,000 $17,000
Prepare the entry to record the bad debt estimate at December 31, 20X1. Bad Debt Expense Allowance for Doubtful Accounts (17,0005,000)
12,000 12,000
C. Newburn is experiencing a difficult year in 20X1. The following questions are an application of Point 2 on your grid. 1. Specifically, how might management be tempted to use the bad debt estimate in part B to improve net income? Omit the Fern or Victor account from the estimate. 2. How would net income change if management decides that one of the accounts listed in part B might be collectible after all? Net income would increase by that amount net of tax. 3. Would you consider your answer in 1 to be income management or income manipulation? Why? Various answers D. Answer the following questions as if you are Newburn’s auditors. This exercise is an application of Points 7–10 on your grid. 1. What is Newburn asserting about the bad debt estimate in part B? 1. The estimate is reasonable in amount. (valuation) 2. The estimate is presented and disclosed in conformity to GAAP. (presentation/disclosure) 2. With what specific financial accounting principle(s) should the bad debt estimate comply in order to be in conformity with GAAP? The matching principle. The bad debt expense should be matched into the same accounting period as the related revenue.
113
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
3. Name at least two errors that management could make that would result in a bad debt estimate that did not comply with GAAP. 1. Math error. 2. Failure to properly identify potentially uncollectible accounts that are related to current-year sales, i.e., failure to match. The error could be due to mistake, poor judgment, or deliberate misrepresentation. E. Design an audit program for Newburn’s allowance for doubtful accounts that would test Newburn’s assertions and help detect the errors that you identified in part D. This exercise is an application of Point 9 on your grid. Obtain or prepare an aged accounts receivable trial balance. Test the aged trial balance for clerical accuracy. Have the client post subsequent cash collections to the aging schedule. Test the client’s subsequent collections on major account balances by examining deposit slips. 5. If uncollected accounts are significant, test the aging of the remaining accounts, preferably using original sales documents to test the propriety of aging. 6. For each material past due account, inspect credit files, review customer correspondence, or discuss the status of collection with client. Identify potentially doubtful accounts. 7. Perform analytical procedures, computing the accounts receivable turnover and day’s sales to collection, comparing the statistics with the prior year for this company and with the industry, investigating material fluctuations. 1. 2. 3. 4.
F. Assume that based on the audit results, Newburn’s auditor has concluded that more of the accounts should be included in the bad debt estimate than Newburn’s management is willing to accept. The comparison is below. Customer
Auditor’s Estimate
Newburn’s Estimate
Fern, Inc. Iwana Co. Victor, Inc. Total
$10,000 15,000 7,000 $32,000
$10,000 0 7,000 $17,000
1. From the auditor’s point of view, discuss the pros and cons of agreeing with Newburn’s management. What is your decision? This exercise is an application of Points 4 and 5 on your grid. Pro—Client stays satisfied. Con—Iwana does not pay and Newburn’s financial statements are misleading; stockholders hold auditors responsible. 2. Is there a way that the auditor might legitimately come to agree with Newburn’s estimate before the audit is completed? The subsequent collection of the balance owed by Iwana.
114
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Appendix C. Instructional grid (with suggested solutions) MANAGERIAL AND TAX CAPITAL BUDGETING DECISIONS MANAGERIAL
TAX The effect on gross income, deductible expenses (both current and future) and consequently, taxable income.
1.
What are the primary considerations regarding costs associated with the acquisition and use of new equipment?
The effect of revenues and costs on cash flows.
2.
Are these considerations interrelated? How?
Yes. Cash flows will be affected by the taxes paid on revenues produced by the new equipment and by tax savings from depreciation and other expenses.
3.
Does the financial accounting method of calculating depreciation (e.g., straight line or double declining balance) impact any asset acquisition decision? Why?
No, doesn’t affect cash flow.
No, doesn’t affect taxable income.
4.
Does the tax accounting method of calculating depreciation (e.g., straight line or MACRS) impact any asset acquisition decision? Why?
Yes, affects cash flows through size of tax savings from depreciation and repairs expense.
Yes, affects taxable income.
5.
Would selling Asset X and buying Asset Y be viewed differently than exchanging Asset X for Asset Y if the initial net cash outflows were the same either way? Why?
No, except for any cash flow effects from tax differences.
Yes, gains are deferred in like-kind exchanges.
6.
Assume that if a company does not replace old, leaky equipment, the government will impose a fine for pollution. Does the fine have a managerial accounting implication? A tax implication? Why?
Yes, reduces cash flows when it is paid.
No, taxable income is not affected because the fine is not deductible.
(continued on next page)
115
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126 Appendix C. (continued) MANAGERIAL
TAX
7.
In an otherwise profitable year, is an unanticipated loss on the disposal of equipment favorable or unfavorable? Why?
Unfavorable, because it reduces anticipated cash flows.
Favorable, because it reduces taxable income.
8.
Assume that the accountant’s qualitative analysis indicates that a product line should be dropped. Are there non-qualitative aspects of dropping the product line that the accountant should consider?
It is more often the managerial accountant’s job to consider the impact of a decision on its employees—e.g. lost jobs, or lower morale.
No, the tax accountant considers primarily the impact on taxable income.
Appendix D. Managerial and tax integration application case (with suggested solutions in bold) SHOW ME THE MONEY—MANAGERIAL AND TAX CONSIDERATIONS IN CAPITAL BUDGETING Show Me the Money (SMTM), Inc. provides duplicating services and is considering the purchase of a new duplicating machine to replace its old one. The new machine would cost $135,000 and have an estimated salvage value of $9,000 at the end of its 7-year life. The machine would be in the 5-year property class for MACRS depreciation. Its estimated annual operating costs are $55,000. The old machine was purchased two years ago at a cost of $100,000 and with an expected life of 9 years. Today, it has an adjusted basis of $48,000 [(100,000(20,000+32,000)], a remaining life of 7 years, and an expected salvage value of $7,000. The old machine could be sold now for $60,000. It is in the 5-year property class for MACRS depreciation. The annual operating costs are $71,500. The tax rate is 30% for ordinary income. SMTM desires an after tax return of 10% on investments in equipment. The revenue produced by both the new and old machine is expected to be the same. A. List the cash flows that would occur if SMTM, Inc. decides to buy the new equipment. This is an application of Point 1 on your grid. 1. 2. 3. 4. 5. 6.
Cost of new equipment Cash operating costs on new equipment Tax savings from depreciation deduction Cash from sale of old equipment Tax expense on gain on sale of old equipment Salvage on new equipment
116
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
B. List the cash flows that would occur if SMTM, Inc. decides to keep the old equipment. This is an application of Point 1 on your grid. 1. Cash operating costs on old equipment 2. Tax savings from depreciation deduction 3. Salvage on old equipment C. Calculate the amount of the gain on the sale of the old machine. What is the tax treatment for this gain? This is an application of Point 5 on your grid. Sales price Adjusted basis Gain
$60,000 48,000 $12,000
The gain is recaptured as ordinary income under x1245 and taxed at ordinary tax rates. D. Complete the analysis to determine whether SMTM, Inc. should buy the new machine or keep the old one. This is an application of Points 1– on your grid. Alternative 1: Buy the new duplicating machine Descriptions
Years Amount Tax After-tax 10%present Present effect cash flows value factor value of cash flows
.Cost of new machine Now $135,000 – ($135,000) .Annual cash operating costs 1–7 55,000 1–0.30 (38,500) .Depreciation deductions Year Cost MACRS% Depr. Amount
1.000 ($135,000) 4.868 (187,418)
1 $135,000 20.0% $27,000 1 2 135,000 32.0% 43,200 2 3 135,000 19.2% 25,920 3 4 135,000 11.5% 15,525 4 5 135,000 11.5% 15,525 5 6 135,000 5.8% 7,830 6 Cash received from sale of old machine Now Tax expense from gain on sale of old machine: Sales price $60,000 Adjusted basis 48,000 $12,000 1 Gain on sale
0.909 0.826 0.751 0.683 0.621 0.564 1.000
7,363 10,705 5,840 3,181 2,893 1,325 60,000
Cash received from sale of new machine Tax expense from gain on sale of new machine: Sales price $9,000 Adjusted basis 0 Gain on sale $9,000 Present value of cash flows from Alternative 1
27,000 43,200 25,920 15,525 15,525 7,830 60,000
0.30 0.30 0.30 0.30 0.30 0.30 –
8,100 12,960 7,776 4,658 4,658 2,349 60,000
12,000
0.30
(3,600)
0.909
(3,272)
9,000
0.513
4,617
(2,700)
0.513
(1,385) $(231,151)
7
9,000
–
7
9,000
0.30
117
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Alternative 2: Keep the old duplicating machine Descriptions
.Annual cash operating costs .Depreciation deductions: Year Cost MACRS% Depr. Amount 1 100,000 19.2% 19,200 2 100,000 11.5% 11,500 3 100,000 11.5% 11,500 4 100,000 5.8% 5,800 .Cash received from sale of old machine .Tax expense from gain on sale of old machine: Sales price $7,000 Adjusted basis 0 $7,000 Gain on sale Present value of cash flows from Alternative 2
Years Amount
Tax After-tax 10% present effect cash flows value factor
1–7 $71,500 1–0.30 ($50,050)
Present value of cash flows
4.868 ($243,643)
1 2 3 4 7
19,200 11,500 11,500 5,800 7,000
0.30 0.30 0.30 0.30 –
5,760 3,450 3,450 1,740 7,000
0.909 0.826 0.751 0.683 0.513
5,236 2,850 2,591 1,188 3,591
7
7,000
0.30
(2,100)
0.513
(1,077) $(229,264)
Summary of results: Present value of Alternative 1 (buy new) Present value of Alternative 2 (keep old) Net present value in favor of Alternative 2 (keep old)
$(231,151) (229,264) $1,887
E. 1. What cash flow item would be different if SMTM exchanged the new machine for the old machine in a like-kind exchange? This is an application of Point 5 on your grid. The tax on the gain on the sale would be eliminated. 2. Would your decision in part D be different if there was an exchange rather than a purchase and sale? This is an application of Point 5 on your grid. Yes, without the tax on the gain, the net present value would favor the new machine by $1,385 [229,264(231,1513,272)]. F. Assume that SMTM, Inc.’s present value analysis shows the corporation should purchase the new duplicating machine. The new machine would perform a job that was previously done by poor old Fred. Fred is 64 years old and just adopted a puppy. What are some possible options regarding SMTM’s machine decision and Fred’s fate? Which option would you choose? This is an application of Point 8 on your grid.
118
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
1. 2. 3. 4.
Purchase the new machine and fire Fred. Keep the old machine until Fred retires next year. Purchase the new machine and let Fred take early retirement. Other possibilities.
Appendix E. Instructional grid (with suggested solutions) FINANCIAL AND TAX TREATMENT OF PROPERTY, PLANT, AND EQUIPMENT Note on Appendices E and F: Because the property, plant, and equipment issues addressed in this grid and case are more complex than those in the bad debt expense example, we allocate two class days to the project. On the first day, students complete the grid below. We use the same class format and grading scheme for this grid exercise as described earlier. At the end of the class in which the grid is completed, we distribute the application case presented in Appendix F. We overview the case and assign the five requirements at the end of the case for the next class. To ensure that the students will be prepared to discuss their solutions, we require them to have typewritten answers ready at the beginning of the next class period and instruct students to work alone on their answers. On the next class day, we discuss the case. A student can earn an individual participation grade by either raising issues or offering reasonable alternative answers. They submit their typewritten solutions at the end of the class for a written grade. FINANCIAL
TAX
1. What costs are capitalized as the acquisition cost when property, plant, and equipment is purchased?
All costs that are ordinary, reasonable, and necessary to get the asset ready for its intended use.
Same, except where the taxpayer elects immediate expensing under Sec. 179.
2. What amount is capitalized as the acquisition cost when owners contribute assets to a corporation?
The fair market value of the assets at the time they are contributed.
If the transaction is nontaxable (Sec. 351), the capitalized cost is equal to the owners’ tax basis. If the transaction is taxable, the capitalized cost is equal to the fair market value of the assets.
3. What are the names of the methods that are considered appropriate for allocating the cost of acquisition across the periods benefited?
Straight-line, sum-of-the-years’ ACRS, MACRS, digits, declining balance, straight-line, ADS. units-of-production.
4. What is the name given to the results of the following calculation? CostAccumulated depreciation=
Book value.
Adjusted basis. (continued on next page)
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
119
Appendix E. (continued) FINANCIAL
TAX
5. What is the appropriate treatment of costs incurred subsequent to acquisition?
Capitalize additions, Same, except where the improvements, rearrangements taxpayer elects immediate and reinstallations by debiting expensing under Sec. 179. the asset account. Capitalize replacements by debiting accumulated depreciation. Expense repairs and maintenance.
6. Describe the process for recording the sale of an asset.
When appropriate, record depreciation to the date of disposal. The gain/loss is the difference between the cash received and the book value.
Determine gain or loss as: Amount realized Adjusted basis Real/Recog G/L
7. What is the name given to an exchange of assets that carry on the same function?
Similar asset exchange.
Like-kind exchange.
8. What is the name given to an exchange of assets that do not carry on the same function?
Dissimilar asset exchange.
Taxable exchange.
9. In a dissimilar/taxable asset exchange, is the gain or loss on the disposal of the old asset recognized?
Loss—yes. Gain—yes.
Same.
10. In a dissimilar/taxable asset exchange, how is the gain or loss on the disposal of the old asset calculated?
FMV of asset surrendered Book value of asset surrendered.
Amount realized Adjusted basis Real/Recog G/L
11. In a dissimilar/taxable asset exchange, how is the cost of the new asset calculated?
FMV of asset surrendered+ FMV of new asset. Boot paid OR - Boot received.
12. In a similar/like-kind asset exchange in which no cash is received (therefore, the company could not have traded down), is a gain or loss on the disposal of the old asset recognized?
Loss—yes. Gain—no.
No, unless boot other than cash or equivalent is given. Gain is recognized on boot given by the taxpayer.
13. In a similar/like-kind asset exchange FMV of asset surrendered in which no cash is received, how is Book value of asset a loss on the disposal of the old asset surrendered. calculated?
No loss is recognized on the like-kind property. Loss is recognized on boot given by taxpayer.
14. In a similar/like-kind asset exchange in which no cash is received, how is the cost/adjusted basis of the new asset calculated?
New asset assumes the old asset’s adjusted basis. Consideration must be made for any boot given or liability assumed.
Lower of book value or FMV of asset surrendered+ Boot paid.
(continued on next page)
120
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Appendix E. (continued) FINANCIAL
TAX
15. In a similar/like-kind asset exchange Loss—yes. in which cash is received, is a gain or Gain—partially. loss on the disposal of the old asset recognized?
Loss—no. Gain—yes, if gain is realized.
16. In a similar/like-kind asset exchange in which cash is received, how is a gain or loss on the disposal of the old asset calculated?
Loss—is not recognized. Gain—the lesser of the gain realized or the cash received. The recognized gain must be characterized as ordinary (Sec. 1245, 1250, 291), capital, or Sec. 1231.
LossFMV of asset surrenderedBook value of asset surrendered. Gain
17. In a similar/like-kind asset exchange in which cash is received, how is the cost/adjusted basis of the new asset calculated?
Boot Gain Boot þ FMV of Asset Acquired
Lower of book value or FMV of asset surrendered+Boot paid OR Boot received+ Gain recognized (if any).
The new asset assumes the old asset’s tax basis adjusted for the gain recognized and the amount of the cash (boot) received.
Appendix F. Integration application case HEALTHY, INC. In 2000 John and Bob decided to open a chicken processing plant in Flower Grove, Texas. The chicken market had increased dramatically since 1987 due to changing diets in the United States as well as Europe. Chicken futures were sound investments and generally ranked as one of the best commodities for trading. John had been in the chicken ranching business for a number of years and owned two ranches near Flower Grove, which he contributed to Healthy, Inc. for 51% of the common stock. Bob had been a partner in a cattle ranch in Pineville, Louisiana for about ten years. Because of consumers’ decision to reduce their consumption of beef, the market for cattle declined. Consequently, Bob decided to sell his partnership interest in the cattle ranch. Bob was able to sell his partnership interest in 1999 for $1 million, which he contributed to Healthy, Inc. for a 49% interest. Thus, Healthy, Inc. began on June 30, 2000 with $1 million cash and two chicken ranches. The chicken ranches contained the following assets.
Tax Basis Chicken house #1 Chicken house #2 Land for chicken house #1 Land for chicken house #2 John Deere Tractor Massey Ferguson Tractor Ford truck
$174,000 230,000 40,000 60,000 15,000 32,000 12,000
FMV $275,000 270,000 100,000 70,000 10,000 26,000 11,000 (continued on next page)
121
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126 Appendix F. (continued) Tax Basis Chevrolet truck 10,000 chickens (house #1) 15,000 chickens (house #2) Chicken feed Miscellaneous chicken supplies
15,000 50,000 60,000 46,000 35,000
FMV 17,000 70,000 105,000 53,000 33,800
John and Bob had previously developed plans for a state-of-the-art chicken processing plant that would be almost completely automated. This meant that processing equipment, although very expensive, could limit the amount of unskilled labor required to operate the plant. During the last six months of 2000, Healthy, Inc. incurred various expenditures relating to the construction of the processing plant. Cost Land (50 acres) Land survey Land title search fee Building permit Temporary quarters for construction crew Razing an old building Special assessment tax for street project Damages for injuries sustained in construction (no insurance coverage) Cost of construction Cost of paving a parking lot Cost of shrubs, trees, and landscaping
$300,000 1,500 350 500 10,750 25,000 2,000 4,200 750,000 25,000 5,000
The processing plant was completed and put into service on January 1, 2001. In addition, on January 1, 2001, Healthy, Inc. purchased robotic chicken processing equipment and other assets. Cost Deluxe 327 processor Arden 289 automatic deboner Conveyers Arch 312 dryer Iceman 356 freezer Miscellaneous small equipment
$115,000 112,000 58,000 72,000 46,000 5,000
Healthy, Inc. also traded in the Ford truck on June 30, 2001, for a new Dodge truck priced at $25,000. The dealer allowed $10,000 on the trade. In 2002, John and Bob decided that Healthy should convert chicken house #1 to egg production instead of raising chickens. Thus, the chickens that normally would
122
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
be processed at the six-month time period were kept to generate eggs. These hens could produce eggs for about two years before being sold. In addition, Healthy, Inc. decided it would be better to purchase chickens from a third party rather than maintaining chicken house #2. Thus, Healthy, Inc. sold the land and chicken house #2 to ‘‘Chickens R Us’’ on December 31, 2002, for $350,000 ($55,000 allocated to the land). As a result of this sale, the Massey Ferguson tractor and Chevrolet truck were not needed. However, the company did need a heavy duty fork lift. On December 31, 2002, Healthy, Inc. sold the tractor for $26,000 cash and traded the Chevrolet truck for a Hyster fork lift. Healthy, Inc. traded the Chevrolet truck to H&K Heavy Equipment and received a forklift valued at $15,000 and $2,000 cash. Finally, on December 31, 2002, the state requisitioned 5 acres of land that was purchased at the time the processing plant was built. The state plans to build an interstate highway. The state paid Healthy, Inc. $10,000 per acre for the land. Requirements: 1. Financial Prepare a schedule showing the allocation to appropriate financial statement categories (Land, Buildings, etc.) of the expenditures incurred for the construction of the processing plant.
Land Land Survey Land Title Search Building Permit Construction Crew Quarters Razing Building Street Assessment Tax Uninsured Injuries Construction Cost Parking Lot Pavement Landscaping Totals
Land 300,000 1,500 350
Building
Land Improvements
Expenses
500 10,750 25,000 2,000 4,200 750,000 25,000 5,000 333,850
761,250
25,000
4,200
2. Financial and Tax Show the calculations of the book and tax depreciation expense for Healthy, Inc. for the processing plant building for 2001 and 2002. Disregard your answer in Question 1 regarding the cost allocated to the building and assume that for both book and tax depreciation the acquisition cost/tax basis is $2,000,000. For both book and tax, assume a 39-year life and no salvage value. For book purposes, use whole-months depreciation computed using 1) straight-line, and 2) double-declining balance.
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
123
Tax: Processing Plant—MACRS Straight line 39 years; placed in service January 1, 2001. 2001 Depreciation
2002 Depreciation
2,000,000 0.2461 49,220
2,000,000 0.02564 51,280
Financial: 2001 Depreciation
2002 Depreciation
Straight-line 2,000,000/39=51,282
Same
Double Declining Balance Rate=(100%/39)2=5.13% (2,000,0000)5.13%=102,600
(2,000,000102,600)5.13%=97,337
3. Financial List all the factors Healthy, Inc. should consider in choosing a depreciation method for its depreciable assets for financial statement purposes. Explain why those factors should be considered. 1. Higher net income—impress investors and creditors. Straight line 2. Lower net income—double declining balance or sum of years digits 3. Smooth net income—impress investors & creditors with stability—match ever increasing maintenance with ever decreasing depreciation expense. DDB or SYD 4. Easy—straight line 5. Industry standard 4. Financial Based on the factors considered in Question 3, which depreciation method would you recommend that Healthy, Inc. use for financial statements to depreciate Buildings? Equipment? Land Improvements? Defend your answers. Various answers. 5. Financial and Tax For each transaction in 2001 and 2002 involving an exchange or sale, show 1) the acquisition cost (i.e., cost of new asset) and tax basis of the property acquired, and 2) the gain or loss (if any) on the sale or exchange of the old asset using the grid below. For both book and tax, assume a seven-year life for personal property, a 39-year life for real property, and no salvage value.
124
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
For financial statement purposes, assume straight-line, whole-months depreciation is used for all depreciable assets. Show only your final answers on the schedule below, but be prepared to show how you calculated these amounts in the class presentation. For tax purposes, report the tax basis of new assets, where applicable. Additionally, indicate the amount of any gain/loss recognized by Healthy, Inc. Also characterize the gain/loss as x1231, x1245, etc. Transaction 1. Ford truck trade Acquisition cost/tax basis of Dodge Gain/loss on disposal of Ford Gain/loss recognized for tax purposes Character of gain/loss 2. Chicken house #2 land sale Gain/loss on disposal of land Gain/loss recognized for tax purposes Character of gain/loss
Financial Statements
Tax Return
$XX
$XX
$XX
$XX
$XX
$XX
3. Etc.
Financial suggested solutions Ford truck trade for Dodge (similar exchange) Accumulated Depreciation=11,000/71=1,571 Book Value=11,0001,571=9,429 Cost of new Dodge=Lower of FMV or BV+Boot paid =9,429+(25,00010,000) =24,429 Gain on Ford=FMVBV =10,0009,429 =571 All is deferred because no boot is received Land sale from chicken house Loss=Cash receivedBV =55,00070,000 =15,000 Chicken house sale Accumulated Depreciation=270,000/392 12=17,308 Book Value=270,00017,308=252,692 Gain=Cash receivedBV =(350,00055,000)252,692 =42,308
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Tractor sale Accumulated Depreciation=26,000/72 12=9,286 Book Value=26,0009,286=16,714 Gain=Cash receivedBV =26,00016,714 =9,286 Chevy truck for forklift (dissimilar) Accumulated Depreciation=17,000/72 12=6,071 Book Value=17,0006,071=10,929 Cost of new forklift=FMVBoot received =(15,000+2,000)2,000 =15,000 Gain on Chevy=FMVBV =17,00010,929 =6,071 All is recognized because assets are dissimilar Forced land sale Cost=333,850/505 acres=33,385 Gain=Cash receivedBV =(10,0005)33,385 =16,615
Tax suggested solutions Ford truck trade for Dodge No gain recognized because transaction qualified as a like kind exchange and no boot was received. New Dodge adjusted basis: Adjusted basis of old Boot given Adjusted basis of new
8,816 15,000 23,816
Land sale from chicken house Amount realized Adjusted basis Realized/recognized x1231 loss
55,000 60,000 (5,000)
Chicken house sale Amount realized Adjusted basis Realized/recognized gain
295,000 215,252 79,748
125
126
J.N. Baldwin, D.L. Chesser / J. of Acc. Ed. 21 (2003) 101–126
Gain recognized as: Section 291 gain 0.2(14,7480)=2,950 Section 1231 gain (79,7482,950)=76,798 Tractor sale Depreciation taken: 15,208=32,0000.47525 Amount realized Adjusted basis Realized/recognized x1245 Gain Chevy truck for forklift Depreciation taken: 7,129=15,0000.47525
26,000 16,792 9,208
Amount realized 17,000 Adjusted basis 7,871 Realized/recognized gain 9,129 All of gain recognized because transaction does not qualify as a like kind exchange. Gain recognized as: Section 1245 gain - 7,129 (equal to all of depreciation) Section 1231 gain - 2,000 (equal to amount of gain over depreciation) Forced land sale Cost per acre=333,850/50 acres=6,677/acre Amount realized Adjusted basis Realized/recognized x1231 gain
50,000 (5 acres10,000) 33,385 (5 acres6,677) 16,615
References Accounting Education Change Commission (AECC). (1990). Objectives of education for accountants: position statement number one. Issues in Accounting Education, 5(2), 307–312. Albrecht, W. S., & Sack, R. J. (2000). Accounting education: charting the course through a perilous future. Accounting Education Series: 16. Sarasota, FL: American Accounting Association. American Accounting Association (AAA). (1986). Committee on the Future Structure, Content, and Scope of Accounting Education (The Bedford Committee). Future accounting education: preparing for the expanding profession. Issues in Accounting Education, 1(1), 168–195. American Institute of Certified Public Accountants (AICPA). (1999). AICPA core competency framework for entry into the accounting profession. Available: http://www.aicpa.org/edu/corecomp.htm. Cunningham, B. M. (1999). Energizing your teaching: a view from deep in the trenches. Issues in Accounting Education, 14(2), 307–321. Walker, K. B., & Ainsworth, P. L. (2001). Developing a process approach in the business core curriculum. Issues in Accounting Education, 16(1), 41–66. Wilson, G. P. (1999). Teaching and learning can be energizing. Issues in Accounting Education, 14(2), 337– 368.