Total owners' equity question

CFA Level I FRA
#1

Hi everyone. I am having a bit of trouble understanding the rationale for one question. The question and answer are as follows:

Question) Selected data from Alpha Company’s balance sheet at the end of the year follows:

Investment in Beta Company, at fair value, $ 150,000 Deferred taxes, 86,000 Common stock, 1 par value, 550,000 Preferred stock, 100 par value, $ 175,000 Retained earnings, $893,000 Accumulated other comprehensive income, 46,000 The investment in Beta Company had an original cost of 120,000. Assuming the investment in Beta is classified as available-for-sale, Alpha’s total owners’ equity at year-end is closest to: A. 1 ,618,000. B. 1 ,664,000. c. $1,714,000. Answer) B Total stockholders’ equity consists of common stock of 550,000, preferred stock of 175,000, retained earnings of $893,000, and accumulated other comprehensive income of 46,000, for a total of 1,664,000. The $30,000 unrealized gain from the investment in Beta is already included in accumulated other comprehensive income. Now, since the stocks are listed at par value, they don’t incorporate the market value of the stocks. So, I understand why you would add retained earnings and comprehensive to the stock value. However, I simply don’t understand why the deferred taxes of 86K are not subtracted here. This is a pretty clear liability and if the accounting was consistent with the tax code, the 86K would likely have been paid from the “retained earnings”. Even though it wasn’t, it’s still a liability. Why is this not subtracted from the final value? Thanks.

#2

Rather than me answering this question – or one of the other helpful people here answering it – I’d like to see you answer it yourself . . . with a little help. You’ll learn it better that way

Let’s start with this: if, instead of (or in addition to) a deferred tax liability, they’d given you another liability, say, wages payable, would you subtract that from shareholders’ equity? Why or why not?

#3

Sure, that approach works fine with me :). Thanks for the feedback.

If it’s wages payable, as with deferred tax liability, I would substract it from the shareholders’ equity. Of course, we have to make sure there is no double counting in the next period by substracting it again when the physical payment is made. However, in the current period, this is a liability that has been incurred - even if the physical money has not changed hands.

If I have a business and I am the sole shareholder of this business, and the business had $1000 cash in assets, without anything further, my equity share would be $1000. However, if I have an assistant and I owe her $400, I would say that my equity is $600 since $400 is earmarked for someone else - even if she hasn’t been “paid” yet.

Going back to the deferred tax liability, it sounds like this is taxes payable according to the GAAP accounting rules this year, but NOT payable according to the income tax rules (which determines the actual timing of taxes). For example, there could be an income that was recognized by GAAP this year, but for some reason, not recognized by the tax code till next year - so it doesn’t need to be “paid” to the government till next year. However, this money should really be set aside for that liability since the GAAP accounting statements recognized that these particular taxes belong to this period - even if they are to be paid next year pursuant to the Tax code. We are preparing a GAAP statement here and not a tax filing. As I mentioned earlier, to prevent double counting, this tax amount should NOT be expensed again next year when the actual payment is made.

Is this approach reasonable? I guess there is something I am missing since my answer is “wrong”. Please let me know!

Thanks again for your feedback!

#4

My pleasure.

Aha!

Now we’re getting somewhere.

You’re a cash-based accountant; GAAP is accrual-based accounting.

If you owe your assistant $400, then you have $400 in wage expense this period. The fact that you haven’t paid her yet – shame on you, by the way – doesn’t matter: under accrual accounting you record the expense when it is incurred, not when it is paid. (Similarly, you record revenue when it is earned, not when it is received.)

So . . . with an accrual accounting viewpoint, if you have wages payable, do you subtract the wages payable from equity? (Go ahead with your example with your longsuffering assistant.)

You’re quite welcome.

#5

Hi S2000magician. Looks like I edited my earlier response while you posted yours! I’ll re-post the extra part I added again.

To answer your question, I would certainly substract the $400 from the equity so that my equity would be $600 - even if i haven’t paid her yet. That’s consistent with the accrual method as far as I can see. But, that’s what I don’t understand about the Schweser question - in that one, they DIDN’T substract the deferred tax payable even though it was accrued already. That’s really confusing me. The “correct” answer they say is “B” and their model response (paragraph after “Answer)”) doesn’t even talk about the deferred tax.

Also, here is the extra paragraph I added in my previous response in an edit re: the tax liability:

Going back to the deferred tax liability, it sounds like the taxes are payable according to the GAAP accounting rules this year, but NOT payable according to the income tax rules (which determines the actual timing of taxes). For example, there could be an income that was recognized by GAAP this year, but for some reason, not recognized by the tax code till next year - so it doesn’t need to be “paid” to the government till next year. However, this money should really be set aside for that liability since the GAAP accounting statements recognized that these particular taxes belong to this period - even if they are to be paid next year pursuant to the Tax code. So the tax should be deducted IMO. We are preparing a GAAP statement here and not a tax filing. As I mentioned earlier, to prevent double counting, this tax amount should NOT be expensed again next year when the actual payment is made.

Thanks very much!!

#6

Oh, they didn’t, did they? What makes you think that?

Going back to the wages: accrual accounting does subtract the $400 this year’s from shareholders’ equity, as you say. I’d like you to tell me – explicitly – how that is subtracted. (Forget about the taxes thing for a bit; once we get through the wages, you’ll be able to do the taxes.)

One problem you need to overcome is getting the language correct: “taxes payable” comes from the tax return, whereas “tax expense” comes from the income statement; they’re different ideas. (This causes problems even for business majors, so don’t fret it; however, you do have to get it correct to understand what’s happening.)

But, enough about taxes: tell me about wages.

My pleasure, as always.

#7

I am getting confused :(. I guess what you are saying is that somehow they substracted it already - but I am not sure I see it. The only way I can think of is that the deferred tax is ALREADY taken into account when the “Retained earnings” are stated?

In the question, the two relevant lines are:

Deferred taxes, $86,000 Retained earnings, $893,000

So, are you saying that if the deferred taxes was $76K (i.e. 10K less), then the retained earnings would be $903K?

With my very limited knowledge of accounting, I am presuming they will earmark that money to pay the assistant as a negative amount. This $400 should show up in the liabilities column as it is an accrued liability. The assets = 1000, liabilities = 400, and the equity = 1000 - 400 = 600. As above with the deferred tax, I am presuming the “retained earnings” would “already” take this ($400) into account when it’s stated?

My thanks as always! :).

#8

As I said, let’s set the taxes aside for a moment.

Are you conversant with the double-entry approach to accounting: debits and credits? That’s where we need to start.

#9

I am familiar with the general concept. For example, if you borrow 100K to buy some equipment, your assets would increase by 100K (for the equipment) and your liabilities would also increase by 100K (for the debt). In effect, since you haven’t really done anything to increase the wealth (other than change its form), this balances out the equity to the same amount as before.

In our example, the work done by the assistant accrues an expense of $400, which needs to be paid. This also increases a liability of $400 (liability account). I am presuming, this would also in turn reduce the equity by $400 to $600 as well (equity account). When the amount is paid (lets say next year), the liability would decrease to $0 and the cash on hand (asset account) would decrease from $1000 to $600 - equity would remain at $600.

Is this accurate? However, I still don’t see how this is related to the Scheweser tax example and how the deferred tax is already captured in another account. I guess what I am asking is, which other account is it? (from the listed ones in the question)

Thanks S2000magician!

#10

Accurate? Yes. Complete? Not quite.

You’re correct: when we credit wages payable (a liability account) $400, we debit wage expense (an expense account) $400. You say that that reduces equity by $400, which is also correct. But you missed a step or two:

  • How does the $400 expense reduce equity by $400?
  • On what financial statement do we find that $400 expense?
  • Which equity account (e.g., preferred stock, common stock, additional paid-in capital, retained earnings) is affected by that $400 expense, and how does it get there?

By taking this a step at a time – and making sure that all of the steps are covered – you’re going to have a solid understanding of what affects what in accounting, and why.

Once again, let’s exhaust the wages payable first; we’ll get to the taxes payable, I promise.

Save your thanks till we’re done and you have a thorough understanding of this stuff.

#11

Well, the basic formula is asset - liabilities = equity. The assets haven’t changed here and remain at $1000. The liabilities are $400, so the equity must be $600. In terms of which financial statement, I’ve seen “retained earnings” appear in both the balance sheet (under stockholders’ equity) and statement of owner’s equity. Given the list of the 4 equity accounts that you listed, I would say it belongs in retained earnings. With due consideration to double counting, I would imagine one could also argue that it can also be reflected the market value of any common/preferred stocks - i.e. a new accrued expense would be reflected in the market price. However, without the market price, it should be reflected in the retained earnings - thus in turn effecting the shareholder equity… Is that better? :slight_smile:

Still - thank you :).

#12

You skipped a question:

  • On what financial statement do we find that $400 expense?

(By the way: isn’t this fun?)

#13

Always! :). The $400 wages expense should be on the income statement as an expense and on the balance sheet as a liability. It’s not on the cashflow statement (nothing paid yet), and not “directly” on the owner’s equity statement - I suppose indirectly through the retained earnings.

Thanks!

#14

And on the balance sheet also through Retained Earnings.

So now we have the income statement involved as well.

The $400 expense reduces Net Income on the income statement, and that Net Income gets added to Retained Earnings on the balance sheet (and the statement of owner’s equity, though we don’t really care about that one at the moment), so _ the balance that we show in Retained Earnings is reduced by $400 _ (compared to what it would have been without that expense).

No!

The liability “Wages Payable” is on the balance sheet as a liability, but the expense “Wage Expense” is not on the balance sheet as a liability; it’s not a liability account (which would have a credit balance); it’s an expense account (which has a debit balance).

On the balance sheet we have a liability (Wages Payable), and, in Retained Earnings, the effect (through the income statement) of the expense (Wage Expense): liabilities are higher by $400, equity (Retained Earnings) is lower by $400.

So . . . do we use Retained Earnings at $893,000, or do we reduce it by the $400 liability – Wages Payable – and use $892,600?

#15

Thanks S2000magician. That was very helpful.

No we shouldn’t reduce it further as it is already part of the retained earnings. If we do, that would in effect be double counting!

#16

Ta da!

OK . . . enough of this stupid Wages Payable stuff! Let’s talk taxes!

When you created that deferred tax account, you credited Deferred Tax Liability. What did you debit?

#17

ok look at it this way…equity=assets-liablity…so liablities have already been subtracted while calculating equity(which are already given in the question) so if u deduct them again it would lead to double subtraction…lets say you were given all the assets and liablities of a firm and than you had to find out the owners equity than it would be a tenable approach to deduct the liablities from assets to arrive at the net worth…however if you are given directly the equity u dnt have to subtract anything from it…

#18

I would say you debited the cash account - since you are not paying as much tax as you would have if the taxable profits was the same as accounting profits. To clarify, I am not saying to actually have an entry to “add more” money to the cash account - just that there is “less money” taken out of the cash account to pay taxes for the curent year. Instead of paying 100K in taxes, in this case, you would pay 80K in taxes and add 20K to the deferred tax account. So that’s what I meant by a “debit” to the cash account. Perhaps that’s the incorrect terminology, but all I meant was that the increase in the tax deferred account (a liability) is balanced by “less money being taken out of the cash account to pay taxes”.

To further clarify, in this case, the taxable profits is LESS than accounting profits - so you pay “less taxes” now. However, when the taxable profits catch up (and surpass) the accounting profits in later years, you will pay “more” taxes - thus the deferral. So, if you are crediting a deferred tax liability account, you should get a “lower credit” (debit?) on the cash account for less taxes paid in the current year. Both are asset accounts and the net effect is $0. So, the owner’s equity should not be affected.

Am I on the right track? Thanks :).

Thanks Meeee20!

#19

Nope.

If you debit cash, then you received cash. Here, you haven’t.

There’s an analogy here:

  • When you owed wages to an employee but didn’t pay them you credited Wages Payable (a liability) and debited Wage Expense (an expense)
  • When you owe taxes but don’t pay them you debit Deferred Tax Liability (a liability) and credit . . . what?
#20

“Tax Expense” or “Provision for taxes” in the Income statement? For example, lets say the Tax Expense in the Income statement is $20K. If the company has paid 14K of this already this year, WILL pay another 1K in the current operating cycle, and has DEFERRED another 5K, the entries will be as follows: - Income Statement will show a 20K “tax expense” - Balance sheet will show a 1K “taxes payable” - Balance sheet will show a 5K "deferred taxes’ - The cash account will be reduced (credited) by 14K - but it’s not shown on the balance sheet as a separate entry. This is however shown on the Cash Flow statement as “cash taxes”. Furthermore, please let me know if the points below are accurate as it reflects my current understanding: - the difference in net equity (assets - liabilities) that is reflected between year 1 and year 2 of the Balance Sheet is completely explained by the Income Statement. The net income from the Income Statement should completely account for any differences in total equity between the two years on the Balance Sheet. - The Cash Flow statement obviously explains the actual cash flow of the company. Related to the other statements, it ignores all the deferred payments, differed receivables, depreciations, and other non-cash adjustments and completely explains the “cash difference” between year 1 and year 2 of the Balance Sheet. While we are on topic about these statements, I have another question which is confusing me a bit related to Free Cash Flow: One of the formulas provided is: FCFF = CFO + [Interest x (1 - tax rate)] - FCInv CFO = cash flow from operations, Interest = interest expense, FCInv = fixed capital investment Now in this FCFF formula, we don’t substract any “working capital investment” (WCI). Substantially, this makes sense. [WCI = current assets - current liabilities]. In calculating CFO from net income (indirect method), we add liabilities (e.g. wages payable) and subtract non cash assets (e.g. accounts receivable). Therefore, many components of WCI is already subtracted from net income to get CFO - subtracting WCI again will be double counting for many items. However, what about the “cash” aspect of working capital investment? Lets say that current assets is largely “cash” due to the company expecting some unforeseen circumstances. Therefore, WCI is largely made up of this stockpile of cash. This cash asset will NOT be subtracted from net income in calculating CFO (unlike accounts receivable) - since it’s cash. However, we want to retain this amount in the company without distributing it out based on the FCFF calculation. e.g. the management feels that it is absolutely necessary to keep $1M on hand for something crazy that might happen, but in calculating CFO from net income using the indirect method, this cash is not subtracted. However, it needs to be subtracted before calculating FCFF since we DON’T want to distribute it and want to retain it. How can this be accomodated in the above FCFF formula? As always, many thanks!