unrealized gain tax adjustment question

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annexguy

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Kemper Company purchased 100,000 shares of Able, Inc. on January 2, 2004 for $50 per share. The securities were classified as available for sale investments, and were Kemper’s only investment security. On December 31, 2004 the securities were valued at $75 per share. Kemper’s tax rate was 40 percent. On its 2004 financial statements Kemper did not list the unrealized gain on its income statement but reported an adjustment to shareholder’s equity.
Kemper should report its potential tax liability relating to the Able, Inc. securities by:
A) recording deferred tax liability of $1,000,000.
B) recording taxes payable of $1,000,000.
C) recording a deferred tax adjustment decrease of $1,000,000 in shareholders equity.
D) making no recording until a realization event occurs.
Your answer: A was incorrect. The correct answer was C) recording a deferred tax adjustment decrease of $1,000,000 in shareholders equity.
Available for sale securities’ market value changes are reported as adjustments to shareholder’s equity. The taxes that would be payable are recorded as an offset to this unrealized gain adjustment.
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why A was incorrect?
what’s the meaning of last sentence? “The taxes that would be payable are recorded as an offset to this unrealized gain adjustment.”
 
The increase in the market value of available for sale securities is an unrealized gain, for which you have a deferred liability of .4*2.5mil = 1mil.
As described in the answer, changes are reported as adjustments to the shareholder’s equity. What I have been able to find:
http://www.fasb.org/pdf/fas115.pdf
“Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders’ equity.”
Further in the document:
“Unrealized holding gains and losses for available-for-sale securities (including those classified as current assets) shall be excluded from earnings and reported as a net amount in a separate component of shareholders’ equity until realized. Paragraph 36 of FASB Statement No. 109, Accounting for Income Taxes, provides guidance on reporting the tax effects of unrealized holding gains and losses reported in a separate component of shareholders’ equity.”
http://www.fasb.org/pdf/fas109.pdf In SFAS109, paragraph 36:
“The tax effects of the following items occurring during the year are charged or credited directly to related components of shareholders’ equity:
…
b. Gains and losses included in comprehensive income but excluded from net income (for example, translation adjustments under Statement 52 and changes in the carrying amount of marketable securities under FASB Statement No. 12, Accounting for Certain Marketable Securities)…”
http://www.fasb.org/pdf/fas12.pdf, SFAS 12:
“Unrealized gains and losses on marketable securities, whether recognized in net income or included in the equity section of the balance sheet, shall be considered as timing differences, and the provisions of APB Opinion No. 11, “Accounting for Income Taxes,” shall be applied in determining whether such net unrealized gain or loss shall be reduced by the applicable income tax effect.”
 
I guess A is not correct because unrealized gain on available-for-sale securities is not recorded on income statment. It is “other comprehensive income”, which trespasses income statement, in equity portion of balance sheet. Recall DTL is the temporary difference between income statement tax and IRA tax. So for this question, the difference is not DTL.
However, if the question is about stock for trading, the answer should be A. Anyone?
 
ok, the unrealized gain on available-for-sale securities is recorded to owner’s equity directly, not through income statement.
meanwhile, what’s the meaning of last sentence? “The taxes that would be payable are recorded as an offset to this unrealized gain adjustment.”
tks.
 
In other words you’re stating the value of equity in the same consistent manner as if it were actually earnings flowing to equity: the value is net of taxes.
So when it is said that “taxes that would be payable are recorded as an offset” to the unrealized gain, it means that you factor in the tax expense that would occur if you actually realized those gains. Remember, expenses are a reduction in income, and therefore equity.
(a) is wrong because deferred tax liabilities are derived from differences in the reporting of income and expenses on the income statement and tax statements. Gains on available for sale securities flow through the income statement to OCI.
(b) taxes payable applies if this gain were realized and reported. But neither is the case.
(d) this is what we’d all like to do to make life easier. But we must be consistent with the way we report equity, and we must net out any potential tax expense to maintain consistency.
Map1, great post by the way.
 
I think the same procedure is done for comprehensive income items also..
 
thanks to all of you.
the sample in the link: www.principlesofaccounting.com/chapter%209.htm#AVAILABLE%20FOR%20SALE%20...
is very clear and easy understand.
if they add the tax effect to owner’s equity, it will be perfect.
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Let’s also discuss opposed scenario. share’s price dropped from $50 to $25 with 100,000 available for sale shares .
shall we record a deferred tax adjustment increase of $1,000,000 in shareholders equity
 
annexguy Wrote:
——————————————————-
> thanks to all of you.
>
> the sample in the link:
> www.principlesofaccounting.com/chapter%209.htm#AVA
> ILABLE%20FOR%20SALE%20SECURITIES
> is very clear and easy understand.
> if they add the tax effect to owner’s equity, it
> will be perfect.
> ————————————————–
> ———————
> Let’s also discuss opposed scenario. share’s price
> dropped from $50 to $25 with 100,000 available for
> sale shares .
>
> shall we record a deferred tax adjustment increase
> of $1,000,000 in shareholders equity
Assuming other comprehensive loss is tax deductible, I would say yes. In reality, many companies report this item as net of tax. For this question, for example, if stock increase, they would report —> adjestment to shareholder’s equity: 1,500,000; if stock decrease —> adjustment: -1,500,000
 
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