CMA 0687 3.12 and CMA 0687 3.11

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  • #214729

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    This forum is restricted to members of the associated course(s).

    Rebecca Wetzel
    Participant

    Good afternoon,

    Re: CMA 0687 3.12: Can you explain how the net income would be reported on Boggs, Inc.?

    Re: CMA 0687 3.11 Can you explain why we are not deducting the dividend portion ($30,000) although the company is using the equity method?

    Finally, is there any way to ‘flag’ the questions we have doubts on so we can review just those in the future?

    Thank you kindly,
    Rebecca

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  • #214731

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    Lynn Roden
    HOCK international

    Hi Rebecca,

    CMA 0687 3.12: Because Boggs does not exercise significant influence over Mattly Corporation, Boggs accounts for the investment in Mattly the same as it would account for an ownership of less than 20%: at fair value. That means the fair value of the stock on Boggs’ balance sheet is adjusted at each reporting date and the amount of the increase or decrease in fair value is an unrealized gain or loss on Boggs’ income statement. In addition, Boggs recognizes dividend revenue for the dividends it receives, which according to the information given would be $30,000 on July 1. But no information is given about the amount of change in the fair value of the stock, so we cannot draw any conclusions about the unrealized gain or loss for the period.

    CMA 0687 3.11: In this question, Boggs does exercise significant influence over Mattly and accounts for the investment using the equity method. Boggs reports 30% of Mattly’s net income as investment income and increases the value of the investment on its balance sheet by the same amount. The debit is to the investment account and the credit is to investment income.

    The dividend received decreases the value of the investment on Boggs’ balance sheet, but it does not affect the amount of income reported by Boggs. The dividend is recorded as a debit to cash and a credit to the investment account, so that does not affect Boggs’ income.

    I will ask Kevin Hock to contact you about your question about “flagging” questions.

    Lynn

    #214736

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    Kevin Hock
    Participant

    Hi Rebecca,

    The flagging feature is available before answering a question, and the flag status will show on the session summary, but there’s no way to “do” anything with the flagged questions later in terms of creating a session with them or something like that. But, you can certain flag and then look at them when reviewing a session later.

    Kevin

    #214783

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    Rebecca Wetzel
    Participant

    Thank you very much. I understand better now. I will see about the flagging when I do another MCQ session; I did not see a flag button at the bottom where the previous, next, see answer, and end session buttons are. I will text again if I cannot locate how to flag. Thanks again.

    Regards,
    Rebecca

    #214784

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    Kevin Hock
    Participant

    Rebecca,

    The flag icon is next to the question number.

    Kevin

    #214787

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    Rebecca Wetzel
    Participant

    Good morning, Lynn,

    I have attached a spreadsheet with both questions and explanations. I wanted to get a clearer picture and used the T tables, for each company. Below the T tables, I have questions. I understand your explanations perfectly. Now I’m just trying to see it in the books for each company. For example, with the equity method that Boggs uses in one of the questions, Boggs is reporting $90k of investment income, as well as Mattly reporting $300k of net income. This seems to be double taxation as a result of this. Maybe this is how it works for real. If you could please shed some light on my questions below the T tables, I would greatly appreciate it. Thank you very much!

    #214791

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    Lynn Roden
    HOCK international

    Hi Rebecca,

    If the Mattly stock that Boggs purchased was stock that was newly issued by Mattly, then you would see the 700,000 that Mattly received from the sale on Matty’s balance sheet as an increase to cash (a debit) and an increase to common stock and additional paid-in capital (debits). But we do not know for sure that the stock that Boggs purchased was newly-issued stock. Boggs could have bought the stock from some other shareholder, and if that occurred, there would be no effect of the $700,000 purchase on Mattly’s balance sheet—it would be only on Boggs’ balance sheet. Also, assuming the stock was newly-issued, the $700,000 in Mattly’s Cash account should be a debit (on the left side), not a credit (on the right side), so those are turned around on your spreadsheet.

    You also have the $100,000 in dividends paid by Mattly recorded backwards on Mattly’s Cash and Retained Earnings T-Accounts. And Mattly’s $300,000 of net income should be on the credit side of its Retained Earnings account, not the debit side.

    We can add a Common Stock and Additional Paid-In Capital T-Account for Mattly to your spreadsheet and, assuming the stock Boggs’ bought was newly-issued, show a $700,000 credit on the right side of that T-Account representing the purchase. (We do not know what the par value of Mattly’s common stock is, so we cannot split the cash received up between Common Stock and Additional Paid-in Capital). I have made those changes on your spreadsheet and attached it.

    But that of course does not answer your question about double taxation. It is true to an extent that double taxation occurs, but that occurs (to a greater or lesser extent, depending on the circumstances) with any equity investment because dividends paid are not deductible on the payer’s tax return. But when a corporation owns stock in another corporation, in the U.S. it can deduct from its taxable income a certain portion of the dividends it receives that it would otherwise report as taxable income and have to pay taxes on. That is called the “dividends-received deduction.” In the U.S., when a company owns between 20% and 80% of a qualifying company, 65% of the dividends received are not taxable to the investor.

    Furthermore, when consolidation or the equity method is used to account for a long-term investment in another company, the investor does not report its portion of the investee’s earnings on its income tax return (and thus does not pay taxes on them) until the earnings are actually transferred to the investor as cash dividends or the investor sells the investment and recognizes a capital gain on its tax return. Until then, the tax on the earnings is accounted for in the investor’s financial income by means of deferred taxes. As the investor recognizes the earnings of the investee in its financial income over the period the investor holds the stock, the investor does include an estimate of the related income tax expense on its income statement. But the investor does not include those earnings on its income tax return. Instead of reporting the earnings on its tax return and paying the taxes in the same year it recognizes the earnings in its financial income, the investor recognizes a deferred tax liability on its balance sheet. When the earnings are transferred to the investor in the form of cash, then the investor includes the earnings transferred on its tax return, pays the tax on the taxable portion, and reduces the deferred tax liability on its balance sheet.

    So in this situation, Boggs would report the portion of the earnings received as a cash dividend ($30,000) on its tax return. Boggs would be able to deduct 65% of that $30,000 dividend and pay tax on only $10,500 of it in the year it was received because Boggs could take the dividends-received deduction. So Boggs would not owe tax at all on $19,500 of the $30,000 dividend.

    Boggs would owe income tax on 35% of the rest of its share of Mattly’s earnings for the year because 65% would be deductible, but the tax on the remaining 35% would be deferred until Boggs received it in a dividend. The rest of its share of Mattly’s earnings would be $60,000 ($90,000 minus the $30,000 dividend). So Mattly would account for income tax on $21,000 (35% of $60,000) of income from Mattly as a deferred tax liability.

    An overview of deferred taxes is covered in your CMA Part 1, Vol. 1 book in the topic “Accounting for Income Taxes.”

    Lynn

    • This reply was modified 1 year, 5 months ago by Lynn Roden.
    #214795

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    Rebecca Wetzel
    Participant

    Awesome!! Thank you so much, Lynn. You’re great. I couldn’t sleep well thinking about this problem! I’ve learned a lot. I will go through it very carefully to get a better understanding and see my mistakes. Again, thank you for the detailed explanation. Have a great day!

    #214796

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    Rebecca Wetzel
    Participant

    Thank you, Kevin.

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