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Chapter 4: Problem 27

During \(2010,\) Liselotte Company earned income of \(\$ 1,500,000\) before income taxes and realized a gain of \(\$ 450,000\) on a government-forced condemnation sale of a division plant facility. The income is subject to income taxation at the rate of \(34 \%\). The gain on the sale of the plant is taxed at \(30 \% .\) Proper accounting suggests that the unusual gain be reported as an extraordinary item. Illustrate an appropriate presentation of these items in the income statement.

Short Answer

Expert verified
Net income for 2010 is \(\$1,305,000\).

Step by step solution

01

Identify the components

First, identify the different components of income that need to be accounted for in the income statement. In this case, we have the income before taxes amounting to \(\\(1,500,000\), and a gain from an extraordinary item (the condemnation sale) of \(\\)450,000\).
02

Calculate income tax on ordinary income

Since the ordinary income is subject to a tax rate of \(34\%\), calculate the income tax on \(\\(1,500,000\). This is given by: \(Income\ Tax = 1,500,000 \times 0.34 = \\)510,000\).
03

Calculate income tax on extraordinary gain

The extraordinary gain of \(\\(450,000\) is subject to a different tax rate of \(30\%\). Calculate this tax: \(Gain\ Tax = 450,000 \times 0.30 = \\)135,000\).
04

Calculate net income

Calculate the net income by subtracting the applicable taxes from the total income and gains. First, calculate the net ordinary income: \(Net\ Ordinary\ Income = 1,500,000 - 510,000 = \\(990,000\). Then calculate the net extraordinary item: \(Net\ Extraordinary\ Gain = 450,000 - 135,000 = \\)315,000\). Add these to get total net income: \(Net\ Income = 990,000 + 315,000 = \$1,305,000\).
05

Prepare the income statement

The income statement should separate the ordinary income from the extraordinary item. Present it as follows:**Income Statement for the Year 2010**- **Ordinary Income before Income Taxes**: \(\\(1,500,000\)- **Less: Income Tax Expense**: \(\\)510,000\)- **Net Ordinary Income**: \(\\(990,000\)- **Extraordinary Gain (Condemnation Sale)**: \(\\)450,000\)- **Less: Income Tax on Gain**: \(\\(135,000\)- **Net Extraordinary Gain**: \(\\)315,000\)- **Net Income**: \(\$1,305,000\)

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Income Statement
An income statement is a financial document that summarizes a company's revenues, costs, and expenses during a specific period. It showcases the company's profitability by outlining various components like gross profit, operating income, and net income.
In the case of Liselotte Company, the income statement also includes an extraordinary item: a gain from the government-forced condemnation sale. This adds a special twist to the typical income statement structure.
Typically, the income statement begins with ordinary income, so:
  • List revenue or sales first.
  • Subtract cost of goods sold (COGS) to find gross profit.
  • Account for operating expenses to determine operating income.
  • Depict non-operating items and taxes to reach net income.
Highlighting extraordinary items separately helps stakeholders comprehend unusual gains or losses without confusing them with ongoing operations.
Taxation
Taxation plays a crucial role in accounting as it directly affects a company's net income. Taxes are mandatory financial charges imposed by the government to fund public services and infrastructure. For businesses, taxes impact profitability and cash flow.
In Liselotte's scenario, different tax rates apply:
  • The ordinary income of $1,500,000 is taxed at 34%, a common corporate rate.
  • The extraordinary gain of $450,000 is taxed at a separate 30% rate.
Understanding which tax rate applies to ordinary versus extraordinary items is vital for accurate financial reporting.
This separation ensures that each type of income reflects its true tax burden, helping businesses manage their finances effectively and forecast future tax liabilities.
Ordinary Income
Ordinary income refers to earnings derived from the usual business operations. These are the core activities that define the company's primary purpose.
For Liselotte, the ordinary income was $1,500,000 before taxes. Calculating the net ordinary income involves subtracting taxes, providing a clearer view of operational profitability.
The focus on ordinary income helps:
  • Assess the company's traditional business performance.
  • Separate routine results from irregular outcomes.
  • Provide insights for managerial decision-making focused on the company's usual activities.
This separation helps investors and managers assess the firm鈥檚 core business performance without the influence of one-time gains or losses.
Intermediate Accounting
Intermediate accounting is a level of accounting study that dives deeper into complexities and special topics like extraordinary items, detailed income statements, and tax implications.
It's often viewed as a bridge between fundamental accounting concepts and advanced accounting practices.
This course of accounting covers areas such as:
  • Revenue recognition and measurement.
  • Accounting for income taxes and extraordinary items.
  • Understanding the broader financial statements.
In our example with Liselotte Company, intermediate accounting principles guide the presentation of extraordinary items separately from ordinary income, ensuring clarity and adherence to accounting standards.

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Most popular questions from this chapter

Identify at least two situations in which application of different accounting methods or accounting estimates results in difficulties in comparing companies.

What kinds of questions about future cash flows do investors and creditors attempt to answer with information in the income statement?

Cooper Investments reported an unusual gain from the sale of certain assets in its 2010 income statement. How does intraperiod tax allocation affect the reporting of this unusual gain?

Discuss the appropriate treatment in the financial statements of each of the following. (a) An amount of 113,000 dollars realized in excess of the cash surrender value of an insurance policy on the life of one of the founders of the company who died during the year. (b) A profit-sharing bonus to employees computed as a percentage of net income.(c) Additional depreciation on factory machinery because of an error in computing depreciation for the previous year. (d) Rent received from subletting a portion of the office space. (e) A patent infringement suit, brought 2 years ago against the company by another company, was settled this year by a cash payment of \(\$ 725,000\) (f) A reduction in the Allowance for Doubtful Accounts balance, because the account appears to be considerably in excess of the probable loss from uncollectible receivables.

Why should caution be exercised in the use of the net income figure derived in an income statement? What are the objectives of generally accepted accounting principles in their application to the income statement?
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