Difficulty: Intermediate to Advanced | Prerequisites: Topics 1-5 (income statement structure, revenue recognition, cash flows)
Topics 6 through 9 move into the right side of the balance sheet and the more complex areas of financial reporting. You will learn how differences between book and tax accounting create deferred tax assets and liabilities, how to account for bonds issued at a premium or discount, how equity transactions and stock compensation affect the financial statements, and how to compute basic and diluted EPS. These topics are more computational than Topics 1 to 5 and reward careful practice with journal entries.
Date: Weeks 6-7 | Source: Ch. 14, pgs. 14.1-14.54 | Exercises: E 1, 2, 7-9; P 1, 2, 5
Tags: deferred tax asset, DTA, deferred tax liability, DTL, temporary difference, permanent difference, valuation allowance, tax rate change, income tax expense, current tax expense, book-tax difference, ASC 740
Companies keep two sets of books: one for financial reporting (GAAP) and one for tax purposes (IRC). The rules often differ on when revenues and expenses are recognised, creating timing differences. Deferred tax accounting bridges this gap, ensuring the income statement reflects the tax consequences of transactions in the period they occur for financial reporting purposes, regardless of when they hit the tax return. This is one of the most heavily tested topics in intermediate accounting because it requires both conceptual understanding and computational precision.
Temporary Difference
A difference between the tax basis of an asset or liability and its carrying amount in the financial statements that will reverse in future periods. These create deferred tax assets or deferred tax liabilities.
In simple terms, a temporary difference is a timing gap. The same revenue or expense will be recognised for both book and tax purposes, just in different periods.
Permanent Difference
A difference between book and tax treatment that will never reverse. Examples: municipal bond interest (tax-exempt, so recognised in book income but never taxed), fines and penalties (expensed in books but never deductible for tax), life insurance premiums on officers.
Permanent differences affect the effective tax rate but do not create deferred taxes.
Deferred Tax Liability (DTL)
Arises when taxable income will be higher than book income in future periods because of a temporary difference. The company has deferred paying tax, and the DTL represents the future tax obligation.
Common source: accelerated depreciation for tax, straight-line for books. In early years, tax depreciation exceeds book depreciation, so taxable income is lower than book income. This reverses in later years.
Deferred Tax Asset (DTA)
Arises when taxable income will be lower than book income in future periods. The company has, in effect, prepaid tax or has a future deductible amount.
Common sources: warranty liabilities (accrued for books but deductible for tax only when paid), bad debt expense (estimated for books under the allowance method but deductible for tax only when written off), net operating loss carryforwards.
Valuation Allowance
A contra-account to the DTA. Recorded when it is more likely than not (greater than 50% probability) that some or all of the DTA will not be realised. The DTA is reported net of the valuation allowance.
Think of it as management's admission that the company may not earn enough taxable income in the future to use its deferred tax benefits.
Income Tax Expense (Total)
The sum of current tax expense (the amount owed on the current year's tax return) and deferred tax expense (the net change in deferred tax assets and liabilities during the period).
The Asset-Liability Approach
Compare the book carrying amount and the tax basis of every asset and liability.
If carrying amount > tax basis for an asset: future taxable amount, creates a DTL.
If carrying amount < tax basis for an asset: future deductible amount, creates a DTA.
For liabilities, the logic reverses: carrying amount > tax basis creates a DTA (the liability will produce a future deduction).
Multiply each temporary difference by the enacted tax rate expected to apply when the difference reverses.
Journal Entries
To record income tax expense when DTL increases: Debit Income Tax Expense (total) Credit Income Tax Payable (current) Credit Deferred Tax Liability (the increase)
When DTA increases: Debit Income Tax Expense (total, a smaller amount or a benefit) Debit Deferred Tax Asset (the increase) Credit Income Tax Payable (current)
Recording or adjusting a valuation allowance: Debit Income Tax Expense Credit Valuation Allowance (contra to DTA)
Tax Rate Changes
When enacted tax rates change, all existing DTAs and DTLs must be remeasured at the new rate.
The adjustment is recognised in income tax expense in the period the rate change is enacted.
A rate decrease reduces both DTLs and DTAs. A rate increase does the opposite.
Presentation
All deferred tax assets and liabilities are classified as non-current on the balance sheet.
DTAs and DTLs from the same tax jurisdiction are netted.
Income Tax Expense = Current Tax Expense + Deferred Tax Expense
Current Tax Expense = Taxable Income x Current Tax Rate
Deferred Tax Expense = Change in DTL - Change in DTA (before valuation allowance effects)
DTL or DTA = Temporary Difference x Enacted Future Tax Rate
The 2017 Tax Cuts and Jobs Act reduced the U.S. corporate tax rate from 35% to 21%. Companies with large DTLs saw significant one-time benefits (their future tax obligations shrank), while companies with large DTAs saw one-time charges (their future deductions became less valuable). This made deferred tax accounting front-page news for every major corporation.
Date: Weeks 7-8 | Source: Ch. 12, pgs. 12.1-12.25 | Exercises: E 1-6, 9; P 2
Tags: bonds payable, bond premium, bond discount, effective interest method, straight-line method, amortisation, carrying amount, face value, stated rate, market rate, debt issuance costs, early extinguishment, gain or loss on extinguishment
Debt is how most companies fund their operations beyond what equity provides. This topic covers the accounting for bonds from issuance through maturity or early retirement. The key insight is that when a bond's stated interest rate differs from the market rate at issuance, the bond sells at a premium or discount, and that difference is amortised over the life of the bond using the effective interest method. Understanding this topic is essential for later work on leases (Topic 11), which uses the same present-value mechanics.
Face Value (Par Value)
The amount the issuer promises to pay the bondholder at maturity. Also the basis for calculating the periodic cash interest payment.
Stated (Coupon) Rate
The interest rate printed on the bond. Multiplied by face value to determine the cash interest payment each period.
Market (Effective) Rate
The rate of return investors demand given the bond's risk. This is the rate used to discount the bond's cash flows and determine its issue price.
Bond Premium
Arises when the stated rate exceeds the market rate. Investors pay more than face value because the bond offers above-market interest. The premium is amortised over the bond's life, reducing interest expense below the cash interest paid each period.
Bond Discount
Arises when the market rate exceeds the stated rate. Investors pay less than face value. The discount is amortised over the bond's life, increasing interest expense above the cash interest paid each period.
Effective Interest Method
The required GAAP method for amortising premiums and discounts. Interest expense each period = Carrying amount at the start of the period x Market rate. The difference between interest expense and cash interest paid is the amortisation of the premium or discount.
In simple terms, each period you apply the market rate to what the bond is currently worth on the books, and the gap between that and the cash coupon payment is your amortisation.
Debt Issuance Costs
Costs incurred to issue the debt (legal fees, underwriting fees, printing costs). Reported as a direct deduction from the carrying amount of the debt and amortised over the life of the bond using the effective interest method.
Bond Issuance at a Discount
Issue price < Face value.
Journal entry at issuance: Debit Cash (issue price), Debit Discount on Bonds Payable (difference), Credit Bonds Payable (face value).
Each period: Debit Interest Expense (carrying amount x market rate), Credit Discount on Bonds Payable (the amortisation), Credit Cash (face value x stated rate).
Carrying amount increases each period toward face value.
Bond Issuance at a Premium
Issue price > Face value.
Journal entry at issuance: Debit Cash (issue price), Credit Premium on Bonds Payable (difference), Credit Bonds Payable (face value).
Each period: Debit Interest Expense (carrying amount x market rate), Debit Premium on Bonds Payable (the amortisation), Credit Cash (face value x stated rate).
Carrying amount decreases each period toward face value.
Early Extinguishment of Debt
When a company retires bonds before maturity, it compares the reacquisition price (what it pays to buy back the bonds) to the carrying amount.
If reacquisition price > carrying amount: loss on extinguishment.
If reacquisition price < carrying amount: gain on extinguishment.
Gains and losses on extinguishment are reported in income from continuing operations.
Bond issue price = PV of face value (at market rate) + PV of annuity of interest payments (at market rate)
Interest expense (effective interest method) = Carrying amount x Market rate
Amortisation of discount = Interest expense - Cash interest paid
Amortisation of premium = Cash interest paid - Interest expense
Gain/Loss on extinguishment = Carrying amount - Reacquisition price
When interest rates dropped significantly in the early 2020s, many companies refinanced their debt, retiring high-coupon bonds early and issuing new bonds at lower rates. Each early retirement generated a gain or loss on extinguishment. Analysts need to understand that these are non-recurring items and should be excluded when forecasting future earnings.
Date: Weeks 8-9 | Source: Ch. 16, pgs. 16.1-16.8; 16.14-16.15; 16.38-16.44 | Exercises: E 2, 3, 8, 10, 13, 14
Tags: common stock, preferred stock, par value, additional paid-in capital, APIC, treasury stock, cost method, retained earnings, dividends, stock dividends, stock splits, basic EPS, diluted EPS, weighted average shares, dilutive securities, convertible bonds, stock options, if-converted method, treasury stock method
Equity is the residual interest in a company's assets after deducting liabilities. This topic covers how equity transactions (issuing stock, repurchasing shares, paying dividends) are recorded, and then moves into one of the most important metrics in financial analysis: earnings per share. EPS is the one number most commonly cited in earnings announcements and analyst reports. Computing it correctly, especially diluted EPS, requires careful attention to the effect of potentially dilutive securities like stock options and convertible debt.
Par Value
A nominal value assigned to each share in the corporate charter. It has little economic significance but determines the credit to the Common Stock account when shares are issued. Any amount received above par goes to Additional Paid-In Capital.
Additional Paid-In Capital (APIC)
The excess of the issue price over par value. Also called "paid-in capital in excess of par."
Treasury Stock
A company's own shares that it has repurchased and not retired. Reported as a contra-equity account. Under the cost method (most common), treasury stock is recorded at the repurchase cost.
Cash Dividends
Distributions of cash to shareholders. The key dates: declaration date (liability is recorded), record date (determines who receives the dividend, no entry), payment date (cash is paid, liability is removed).
Stock Dividends
Distributions of additional shares to existing shareholders. A small stock dividend (less than 20-25% of outstanding shares) is recorded at fair market value. A large stock dividend (over 20-25%) is recorded at par value.
Stock Split
Increases the number of shares outstanding and proportionally reduces the par value per share. No journal entry is required, only a memo entry. Total equity is unchanged.
Basic EPS
Net income available to common shareholders divided by the weighted average number of common shares outstanding during the period.
Net income available to common shareholders = Net income minus preferred dividends.
Diluted EPS
A hypothetical measure showing what EPS would be if all dilutive securities (stock options, convertible bonds, convertible preferred stock) were converted or exercised. Always less than or equal to basic EPS. If a security's inclusion would increase EPS, it is antidilutive and excluded.
Weighted Average Shares Outstanding
Shares are weighted by the fraction of the period they were outstanding. Stock dividends and stock splits are applied retroactively to all prior periods.
EPS Computation: Basic
Basic EPS = (Net income - Preferred dividends) / Weighted average common shares outstanding
Preferred dividends are subtracted regardless of whether they are declared (if cumulative) or only if declared (if non-cumulative).
EPS Computation: Diluted
Start with basic EPS numerator and denominator.
Convertible bonds (if-converted method): add back the after-tax interest expense to the numerator. Add the shares that would be issued upon conversion to the denominator.
Convertible preferred stock (if-converted method): add back the preferred dividends to the numerator. Add the shares that would be issued upon conversion to the denominator.
Stock options and warrants (treasury stock method): assume options are exercised at the beginning of the period (or date of grant if later). The proceeds from the assumed exercise are used to buy back shares at the average market price. Only the incremental shares (shares issued minus shares bought back) are added to the denominator. Nothing is added to the numerator.
If average market price is below the exercise price, the options are out of the money and antidilutive. They are excluded from diluted EPS.
Antidilution Sequencing
Test each potentially dilutive security individually.
Rank them from most dilutive to least dilutive.
Include them one at a time, recalculating diluted EPS after each.
Stop adding securities once including the next one would increase EPS (antidilutive).
Basic EPS = (Net Income - Preferred Dividends) / Weighted Average Shares
Treasury Stock Method incremental shares = Shares from exercise - (Proceeds / Average market price)
If-Converted Method: add back interest x (1 - tax rate) to numerator, add convertible shares to denominator
Technology companies with large stock option programmes often have significant differences between basic and diluted EPS. When a company's share price rises, more options move "into the money" and diluted EPS falls further below basic EPS. This is why analysts pay close attention to both figures and to the footnote disclosing the number and terms of outstanding options.
Date: Week 9 | Source: Ch. 16, pgs. 16.17-16.25 | Exercises: E 16; P 16 (part 1 only)
Tags: stock options, restricted stock, restricted stock units, RSU, fair value method, ASC 718, compensation expense, vesting period, grant date, exercise date, expiration date, Black-Scholes, forfeitures
Stock-based compensation is how companies pay employees with equity instruments instead of (or in addition to) cash. Under ASC 718, the fair value of the award is measured at the grant date and recognised as compensation expense over the vesting period. This topic connects directly to EPS (Topic 8) because outstanding options affect diluted EPS, and to the income statement (Topic 2) because compensation expense is an operating cost.
Stock Option
The right to purchase a specified number of shares at a fixed price (the exercise price or strike price) during a specified period. The option has value at the grant date, even if it is "at the money" (exercise price equals market price), because of its time value.
Restricted Stock (Restricted Stock Units / RSUs)
Shares (or the right to receive shares) granted to employees that vest over a service period or upon meeting performance conditions. Unlike options, restricted stock has value even if the share price does not increase above the grant-date price.
Grant Date
The date on which the company and the employee agree to the terms of the award. Fair value is measured on this date for most awards.
Vesting Period
The period during which the employee must provide service (or meet performance targets) to earn the right to the award. Compensation expense is recognised ratably over this period.
Fair Value Method (ASC 718)
The required approach under U.S. GAAP. Total compensation cost = Fair value of the award at grant date x Number of awards expected to vest. This cost is recognised over the requisite service period.
Stock Options: Journal Entries
Grant date: no entry (unless vesting is immediate). Fair value is measured using an option-pricing model (such as Black-Scholes or a lattice model).
Each period during vesting: Debit Compensation Expense, Credit Additional Paid-In Capital (Stock Options). The amount each period = Total compensation cost / Number of vesting periods.
Exercise date: Debit Cash (exercise price x shares), Debit APIC (Stock Options) for the accumulated balance, Credit Common Stock (par value), Credit APIC (excess over par).
Expiration (options not exercised): Debit APIC (Stock Options), Credit APIC (Expired Stock Options). No effect on income.
Restricted Stock: Journal Entries
Grant date: fair value = market price x number of shares. If shares are issued at grant, Debit Unearned Compensation (contra-equity), Credit Common Stock and APIC. (Under the more common RSU approach, no shares are issued until vesting.)
Each period during vesting: Debit Compensation Expense, Credit APIC (or reduce Unearned Compensation).
Vesting date for RSUs: shares are issued.
Forfeitures
Under current GAAP, companies can either estimate forfeitures at the grant date or recognise them as they occur.
If an employee leaves before vesting, previously recognised compensation expense is reversed.
Total compensation cost = Fair value per option (or share) at grant date x Number of awards expected to vest
Annual compensation expense = Total compensation cost / Vesting period (years)
Stock-based compensation is a significant expense for technology companies. Apple, Google, and Meta each report billions of dollars in stock-based compensation expense annually. Some analysts add it back when computing non-GAAP metrics, arguing it is a non-cash expense, but others argue this understates the true cost of running the business because it dilutes existing shareholders.
Students often confuse temporary and permanent differences. The test is simple: will the difference reverse? Municipal bond interest is never taxable, so it is permanent. Accelerated depreciation reverses over the asset's life, so it is temporary. Only temporary differences create deferred taxes.
A common error in bond accounting is using the stated rate to compute interest expense. Interest expense is always computed using the market (effective) rate applied to the carrying amount. The stated rate determines only the cash interest payment.
Students frequently forget that stock dividends and stock splits must be applied retroactively when computing the weighted average number of shares for EPS. If a 2-for-1 split occurs in October, shares outstanding in January through September are doubled in the calculation.
For stock-based compensation, students sometimes think compensation expense is recognised at the exercise date. It is not. The expense is measured at fair value on the grant date and recognised over the vesting period. What happens to the stock price after the grant date does not change the compensation expense for options.
Deferred tax computations are virtually guaranteed on Exam 2. Be able to identify temporary vs permanent differences, compute DTAs and DTLs, and record the journal entry for income tax expense.
The valuation allowance is a favourite exam question. Know when to record one (more likely than not the DTA will not be realised) and the journal entry.
Bond amortisation tables using the effective interest method are heavily tested. Practise building a full table: period, cash interest, interest expense, amortisation, and carrying amount.
Diluted EPS is the most computational part of the exam. Practise the treasury stock method for options and the if-converted method for convertible securities. Know how to identify and exclude antidilutive securities.
Stock-based compensation journal entries at grant, vesting, exercise, and expiration are testable. Know the accounts and the direction of each entry.
True or False: Permanent differences create deferred tax assets or liabilities.
Answer: False. Only temporary differences create deferred taxes. Permanent differences affect the effective tax rate but never reverse.
Fill in the blank: When a bond is issued at a discount, the carrying amount ______ over time toward face value.
Answer: Increases.
True or False: Under the treasury stock method, if the exercise price of options exceeds the average market price, the options are dilutive.
Answer: False. They are antidilutive (out of the money) and are excluded from diluted EPS.
Fill in the blank: Stock-based compensation expense is measured at the ______ date and recognised over the ______ period.
Answer: Grant; vesting.
True or False: A stock split requires a journal entry.
Answer: False. A stock split requires only a memo entry. Par value per share is reduced, shares outstanding increase, and total equity is unchanged.
Q: A company has pretax book income of $500,000. It includes $20,000 of municipal bond interest and $30,000 of depreciation expense (tax depreciation is $50,000). The tax rate is 21%. What is income tax expense?
A: Taxable income = $500,000 - $20,000 (permanent, tax-exempt) - $20,000 (excess tax depreciation) = $460,000. Current tax expense = $460,000 x 21% = $96,600. The $20,000 temporary difference creates a DTL of $4,200 ($20,000 x 21%). Income tax expense = $96,600 + $4,200 = $100,800. Alternatively: ($500,000 - $20,000 permanent difference) x 21% = $100,800.
Q: A company issues $1,000,000 of 5-year, 6% bonds when the market rate is 8%. Interest is paid semi-annually. The bonds sell for $918,891. What is interest expense for the first semi-annual period?
A: $918,891 x 4% (semi-annual market rate) = $36,756. Cash interest = $1,000,000 x 3% = $30,000. Discount amortisation = $36,756 - $30,000 = $6,756.
Q: A company has 100,000 shares outstanding all year, net income of $250,000, and 10,000 stock options with an exercise price of $20 when the average market price is $50. There are no preferred dividends. What is diluted EPS?
A: Basic EPS = $250,000 / 100,000 = $2.50. Treasury stock method: 10,000 options exercised, proceeds = 10,000 x $20 = $200,000. Shares repurchased at average price = $200,000 / $50 = 4,000. Incremental shares = 10,000 - 4,000 = 6,000. Diluted EPS = $250,000 / 106,000 = $2.36.
Q: A company grants 5,000 stock options on 1 January with a fair value of $12 per option and a 4-year vesting period. What is compensation expense in year 1?
A: Total compensation cost = 5,000 x $12 = $60,000. Annual expense = $60,000 / 4 = $15,000.
Q: On 1 January, a company has a DTA of $50,000 based on a 25% tax rate. The enacted tax rate changes to 20%. What adjustment is required?
A: The underlying temporary difference = $50,000 / 25% = $200,000. New DTA = $200,000 x 20% = $40,000. The DTA decreases by $10,000. Journal entry: Debit Income Tax Expense $10,000, Credit Deferred Tax Asset $10,000.
Q: A company repurchases 2,000 shares of its own stock at $45 per share using the cost method. It later reissues 500 of those shares at $50 per share. What are the journal entries?
A: Repurchase: Debit Treasury Stock $90,000, Credit Cash $90,000. Reissue: Debit Cash $25,000 (500 x $50), Credit Treasury Stock $22,500 (500 x $45), Credit APIC - Treasury Stock $2,500.
Deferred taxes (Topic 6) appear in nearly every subsequent topic. Lease accounting (Topic 11) creates book-tax differences because the right-of-use asset and lease liability follow different patterns for book and tax. Debt (Topic 7) shares present-value mechanics with leases. Stock-based compensation (Topic 9) affects diluted EPS (Topic 8), and the interaction between the two is commonly tested. Equity transactions (Topic 8) link forward to intercorporate investments (Topic 12), where one company's equity is another company's asset.
Deferred tax asset, DTA, deferred tax liability, DTL, temporary difference, permanent difference, valuation allowance, ASC 740, tax rate change, book-tax difference, current tax expense, deferred tax expense, bonds payable, bond premium, bond discount, effective interest method, straight-line amortisation, carrying amount, face value, par value, stated rate, coupon rate, market rate, effective rate, debt issuance costs, early extinguishment, gain loss on extinguishment, common stock, preferred stock, treasury stock, cost method, retained earnings, dividends, stock dividends, stock splits, basic EPS, diluted EPS, weighted average shares, dilutive securities, antidilutive, if-converted method, treasury stock method, convertible bonds, stock options, restricted stock, RSU, restricted stock units, ASC 718, fair value method, compensation expense, vesting period, grant date, Black-Scholes, forfeitures, intermediate accounting, ACC 326