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Chapter 9: Valuation of liabilities and equity.

Key Terms

Amortization schedule

Bargain purchase option

Capital leases

Current deferred taxes

Current liabilities

Estimated tax rate

Installment loans

Lessee

Non-Current Deferred Taxes

Non-current liabilities

Operating leases

Present value factor

Present value of the lease

payments

Promissory notes

Tax basis or taxable basis

Taxable income

**********

In Chapter 8, you learned about the valuation of perennial crops, the base value approach for valuing raised breeding livestock, the valuation of other non-current assets, such as purchased breeding livestock, machinery and equipment, land, buildings and improvements, and investments, how to allocate the cost of non-current assets, how to account for discarding non-current assets, and how to provide additional information in disclosure notes to accompany the financial statements.

This chapter discusses liabilities and equity. Liabilities are obligations to outside parties; in other words, the debts of the farm business. A farm business may have obligations to suppliers, lenders, government agencies, and customers. Amounts owed to suppliers include bills for various operating expenses. Amounts owed to lenders include the principal and interest of each loan. Amounts owed to government agencies are various taxes. If a customer pays for something in advance, the farm business owes goods or services to the customer. The farm business also owes money to the owners. We learned in Chapter 1 that this is the equity reported on the balance sheet.

Liabilities are classified into two categories, current liabilities and non-current liabilities. Current liabilities are debts due within the next year. Non-current liabilities are debts due after the next year. Current liabilities include accounts payable, interest payable, and taxes payable because they are normally due within a short period (less than one year). They also include principal payments on loans due within the next year. Non-current liabilities include the portion of loans not due within the next year (such as mortgage payments). Other liabilities include deferred taxes and capital leases, which have a current portion and may have a non-current portion. The amount of some liabilities is easy to determine. For other liabilities, the farm accountant has to calculate the amount.

In this chapter, you will review the measurement of current liabilities owed to suppliers, government agencies, and lenders that you have learned about in other chapters. You will also learn how to account for installment loans, how to calculate the current and non-current portions of deferred taxes, how to identify and account for capital leases, how to account for owner's withdrawals, valuation equity, and retained capital, and how to disclose in the notes to the financial statements the information relevant for current and non-current liabilities.

ACCOUNTS PAYABLE, TAXES PAYABLE, INTEREST PAYABLE, AND NOTES PAYABLE
Learning Objective 1 * To
identify common types of
liabilities of a farm business.

Learning Objective 2 * To
complete the accounting procedures
for installment loans.


You have learned about several current liabilities by reading the chapters thus far in this book. From your reading, you know that

* Accounts Payable refers to the amount owed to suppliers for operating expenses. A cost has occurred because the item or service has been received, but if it has not been paid for by the end of the year, the farm accountant reports the amount as Accounts Payable. Examples of Accounts Payable items include utility bills, telephone bills, charges at the local cooperative for supplies, fuel bills, and veterinary bills, to name a few.

* Costs of the farm business also include various taxes. Taxes Payable refers to the amount of taxes owed to various local, state, and federal agencies for income taxes, payroll taxes, and property taxes. If any taxes have not been paid by the end of the year, the farm accountant reports the amounts owed as Taxes Payable.

* When a farm business borrows money from a lending institution, a liability automatically occurs for the principal amount of the loan. If the loan has not been paid off in full by the end of the year, the farm accountant reports the debt as Notes Payable.

* Lending institutions charge interest on loans, so the farm accountant calculates the amount of interest owed at the end of the year, reported as Interest Payable on the balance sheet.

Determining the amount of these liabilities is usually quite straightforward. The amount owed to suppliers is the amount on the purchase receipt or on the bill received from the supplier. Government agencies determine the amount of the taxes and send a bill, or a tax accountant helps the farm accountant calculate these. The principal amount of loans is arranged when the money is borrowed. You learned in Chapter 6 how to calculate the interest on the loans.

Under the accrual-adjusted system, the farm accountant records accounts payable, taxes payable, and interest payable at the end of the year. You learned about these procedures in Chapters 4 and 5.

* The farm accountant compares the amounts owed at the end of the current year to amounts owed at the end of the last year (the beginning of the current year).

* The farm accountant adds the difference in these amounts to the appropriate payable account if the amount owed at the end of the current year is greater than the amount owed at the end of last year. Adjustments in journal entries are recorded as credits to the appropriate payable account. The income statement reports an adjustment as a "change" item. Adjustments in journal entries are debits in the "change" account (for example, Change in Accounts Payable). In this case, the "change" items add to the expenses.

* The reverse is true if the amount owed at the current year is less than the amount owed last year-the payable account is reduced (debited, if journal entries are recorded, and the change account is credited). The "change" item reduces expenses on the income statement.

[FIGURE 9-1 OMITTED]

Chapters 4 and 5 provide illustrations of these adjustments in detail, so they are not repeated here. Figure 9-1 shows the difference between expenses and payables.

The farm accountant should make every effort to keep bills paid up as soon as possible. If bills are not paid when due, some suppliers may charge finance charges, which increase the expenses to the farm business. The percentage rate for these finance charges vary.

You have also learned about the accounting for Notes Payable in Chapters 3 and 6. Unlike Accounts Payable, Taxes Payable, and Interest Payable, which are recorded at the end of the year, the farm accountant records Notes Payable when the money is borrowed. A farm business is likely to have several loans for various purposes; for example, to purchase assets or for operating expenses on a short-term basis. Each of the loans will have different terms for payment period, interest rate, payment amount, collateral, and so on. The farm producer signs promissory notes when the money is borrowed. Promissory notes are contracts or IOUs that specify these details and bind the borrower to the promise to pay back the money.

The farm accountant should keep track of each loan separately so that the balance sheet reports the correct amount of liabilities at the end of the year and the income statement reports the correct amount of interest expense for the year. If the entire debt is paid off in one lump sum, the amount of interest paid is the total amount of interest expense on the debt.
PRACTICE WHAT YOU HAVE LEARNED To reinforce these definitions and
concepts, complete Problem 9-1 at the end of the chapter.


Lenders sometimes request periodic payments on loans, which consist of interest and a portion of the principal. These loans are sometimes called installment loans. Figure 9-2 illustrates the payment schedule of installment notes compared to lump-sum notes.

Installment loans can require one payment per year or several payments per year. The example in Figure 9-2 illustrates payments made on a monthly basis. The farm accountant needs to keep track of the amount of each payment, the interest expense in each payment, and the amount of the principal paid in each payment.

The farm accountant obtains the information about the payments from the loan agreement. The loan agreement specifies

* The principal amount of the loan (the amount borrowed)

* The length of the loan period (the term of the loan)

* The annual interest rate

* The amount of each cash payment

* The total number of payments

Each cash payment is for the same amount. In other words, the farm accountant writes a check for the same amount each time a payment is made.

Farm accountants have to calculate the amount of interest expense in every payment they make. The amount of interest in each payment depends on the unpaid balance of the loan.

Interest expense = Interest rate for the period x Unpaid balance of the loan

Interest rate for the period = Annual interest rate

+ Number of payments in a year Unpaid balance of the loan = Total principal

- Amount of principal paid so far

The farm accountant also has to calculate the amount of the principal paid off in each payment. That amount is the difference between the total payment amount and the interest portion of the payment.

Principal portion of payment = Payment = Interest expense

Because a portion of the payment consists of principal, the unpaid balance of the principal is reduced with each payment. Because the unpaid balance is reduced with each payment, the interest portion of each subsequent payment is less than the one before.

Each time a payment is made, the farm accountant records the principal portion of the payment as a reduction of the debt by debiting Notes Payable. In this way, the balance of Notes Payable decreases with every payment. The farm accountant also records the amount of interest paid by debiting Interest Expense every time a payment is made. Lenders should provide an amortization schedule for the appropriate amount for interest expense in each payment. An amortization schedule is a table that lists each of the payments and the amount of interest and principal paid with each payment. Alternatively, the farm accountant can calculate the interest and principal portions of each payment with the calculations above.
In Chapter 3, Steve and Chris lease a harvester in 20X1 on a
long-term lease contract that allows them to own the harvester at
the end of the lease term. Suppose that they purchased the
harvester instead for the fair market value of $100,000. Instead of
borrowing money from a bank, they can finance the purchase with the
dealer. The dealer requires a down payment of $23,982, with annual
payments thereafter, and an annual interest rate of 10 percent. The
Farmers record the purchase of the harvester in the following way,
with a Notes Payable account for the liability:

Year 20X1:

           Aug. 1 1600 Machinery and Equipment           100,000
                         2300 Notes Payable--Non-Current    100,00

The down payment is a reduction of the liability:

Year 20X1:
           Aug. 1 2300 Notes Payable--Non-Current        23,9382
                         1000 Cash                          23,982

Subsequent payments for $23,982 include a portion fro interest and
reduction of the liability. The Farmers record the next payment
as follow:

Year 20X2:

           Aug. 1 8100 Interest Expense                   7,602
                  2300 Notes Payable--Non-Current        16,380
                         1000 Cash                          23,982

The Farmers decide to calculate the amounts for interest and
principal and develop an amortization schedule as follows:

                                             Reduction
               Beginning   Cash              of Unpaid
Date            Balance  Payment   Interest  Liability   Balance

Aug. 1, 20X1  $100,000   $23,982   $    0    $23,982     $76,018
Aug. 1, 20X2    76,018    23,982    7,602     16,380      59,638
Aug. 1, 20X3    59,638    23,982    5,964     18,018      41,620
Aug. 1, 20X4    41,620    23,982    4,162     19,820      21,800
Aug. 1, 20X5    21,800    23,980    2,180     21,800           0

The beginning balance is the amount of the liability before the
payment. Each cash payment is for $23,982. The interest is the
beginning balance multiplied by the 10 percent annual rate. The
first payment has no interest because it is a down payment on the
day they purchased the harvester. They calculate the interest on
the second payment as follows:

Unpaid balance of the loan = Total principal - Amount of principal
paid so far

                           = $100,000 - 23,982
                           = $76,018

Interest rate for the period = Annual interest rate = Number of
payments in a year
                             = 10% + 1
                             = 10%

Interest expense = Interest rate for the period =Unpaid balance of the
loan
                 = 10% x 76,018
                 = $7,602 (rounded)

They calculate the reduction of the liability in the second payment as
follows:

Principal portion of payment = Payment - Interest expense
                             = $23,982 - 7,602
                             = $16,380

They calculate the new unpaid balance after the second payment:
Unpaid balance of the loan = Total principal - Amount of principal
paid so far

                           = $100,000 - 23,982 - 16,380
                           = $59,638

PRACTICE WHAT YOU HAVE LEARNED Complete the procedures for the Farmers'
purchase of the harvester by completing Problem 9-2 at the end of the
chapter.


CURRENT DEFERRED TAXES
Learning Objective 3 * To
determine the amount of
current deferred taxes for a
farm operation.


In Chapter 4, you read about a current liability called current deferred taxes. You learned that

* The amount of income taxes actually paid by a farm operation depends mainly upon cash-basis income (cash received for farm income and cash payments for operating expenses).

* Income Tax Expense on the income statement is the amount of cash paid for income taxes.

Farm operations usually hire a certified public accountant to determine the amount of income to report on the tax return, called taxable income. Taxable income, based on cash-basis income and tax laws, forms the basis for calculating the amount of income tax to pay. Sometimes the farm business has to file its own tax return and sometimes the owners report the income of the farm business on their own tax return. Appendix K explains the general rules for filing tax returns for farm businesses. In this chapter, we assume that the farm business is filing its own tax return and therefore has to report income taxes on the farm financial statements.

* The balance sheet reports the amount of income taxes owed at the end of the year as Taxes Payable. The farm business owes income taxes at the end of the year because the tax returns are not completed and income taxes are not paid until after the end of the year.

* The total amount of taxes on the accrual-adjusted income statement includes Income Tax Expense plus or minus the Change in Taxes Payable.

* Change in Taxes Payable includes the difference between the amount of Taxes Payable at the end of the previous year and the amount of Taxes Payable at the end of the current year. Figure 9-3 illustrates these events.

[FIGURE 9-3 OMITTED]

You also learned that

* Accrual Adjusted Net Income on the accrual-adjusted income statement differs from the taxable income prepared for the tax return.

* Reported income tax on the accrual-adjusted income statement should reflect the income tax on accrual-adjusted net income. Not doing so could result in a misstatement of the income taxes of the farm business. Several items contribute to the differences between cash-basis and accrual-adjusted net income.

* The income statement reports the following cash receipts: crop cash sales, cash sales of market livestock and poultry, livestock products sales, proceeds from government programs, crop insurance proceeds, and cash received from miscellaneous revenue.

* The income statement also includes gains and losses from the sale of culled breeding livestock.

* The accrual-adjusted income statement may also include the following accrual adjustments that affect gross revenue: changes in crop inventories (excluding purchased feed), changes in market livestock and poultry inventories (raised only), and the change in accounts receivable.

When the amount of accrual adjustments is high, the difference between taxable income and accrual-adjusted net income becomes significant. Similarly, cash-basis expenses differ from the expenses reported on the accrual-adjusted income statement.

* The income statement reports the following cash expenses, which are also tax deductions for the tax return: purchase of feeder livestock, purchase of feed, cash paid for various operating and miscellaneous expenses, cash paid for interest expense.

* The income statement also reports gains and losses on the sale of farm capital assets.

* In addition to these items, the accrual-adjusted income statement may report the following accrual adjustments, which are used to calculate accrual-adjusted net income: change in purchased feeder livestock inventories, change in purchased feed inventories, change in accounts payable, change in prepaid insurance, change in investment of growing crop, change in interest payable, and gains and losses due to changes in base values of raised breeding livestock.

[FIGURE 9-4 OMITTED]

If the amount of the accrual adjustments is significant, they can have a big effect on the difference between taxable income and accrual-adjusted net income.

The accrual adjustments are included in the computation of accrual-adjusted net income, but not considered when calculating taxable income. The tax effects of these items should be included in the reported income tax for accrual-adjusted net income. To exclude them creates an inconsistency and distorts the true amount of income tax. If these items are part of accrual-adjusted net income, then their tax effects should also be part of accrual-adjusted net income.

The balance sheet reports the tax effects of the accrual adjustments as deferred taxes. Current deferred taxes are either liabilities or assets related to future tax payments or deductions from the accrual adjustments. These items affect paid income taxes in the future because the cash transactions of these items will occur in the future and will, therefore, either increase or decrease the amount of the tax liability. The income statement reports these tax effects as another part of Change in Taxes Payable (See Figure 9-4).

* These items affect the current year's reported income taxes because they occurred in the current year, but do not affect the amount of paid income taxes until the future event occurs.

* In the following year(s) when the cash transaction occurs, the reported income taxes will not be affected because the income tax related to the item was reported previously; it will, however, affect the amount of paid income taxes.

In Chapter 4, you learned how to make adjustments for current deferred taxes. Table 9-1 repeats those procedures.

This chapter shows you how to perform the first procedure:

* Estimate the amount of current deferred taxes for the year.

The FFSC Guidelines outline a set of procedures that use balance sheet accounts to estimate deferred taxes. Farm accountants need to understand the definition of tax basis to use these procedures. Tax basis or taxable basis, is the amount of cash paid for the asset, minus tax depreciation. Current assets have no depreciation, so for current assets, the tax basis is the balance of the account without accrual adjustments. In the accrual-adjustment system, the tax basis of some current assets is zero because no cash was paid and the current assets do not have a balance until after the accrual adjustments.

The farm accountant also needs to understand the definition of estimated tax rate. The estimated tax rate is a percentage multiplied by income to calculate the approximate income tax liability. The tax rate depends on the rates set by the federal and state governments and the level of income, because different levels of income are taxed at different rates. The farm accountant can consult a tax accountant to obtain an estimate of the tax rate for the farm operation. This tax rate applies to the current income tax liability to estimate Taxes Payable and also to deferred taxes to estimate Current Deferred Taxes and Non-Current Deferred Taxes.

Table 9-2 outlines the steps from the Guidelines for calculating and reporting current deferred taxes using balance sheet accounts. Steps 1 through 4 calculate the estimated current deferred taxes. Steps 5 and 6 are the same steps that you learned about in Chapter 4.
In Chapter 4, the Farmers made adjustments in journal entries (32) to
(42) (except for (39)) that resulted in several current asset and
current liability accounts reported on the 20X1 balance sheet.

Balance Sheet:
        Assets:
                Accounts Receivable                    $3,500
                Feed Inventory Purchased for Use          230
                Feed Inventory Raised for Use           2,300
                Crop Inventory Raised for Sale          6,000
                Feeder Livestock Inventory Purchased
                 for Resale                               750
                Feeder Livestock Inventory Raised
                 for Sale                              50,000
                Prepaid Expenses                          700
                Cash Investment in Growing Crops        2,500
        Liabilities:
                Interest Payable                        5,000
                Accounts Payable                          340

The Farmers did not have any income such as crop insurance proceeds
or disaster payments in 20X1. The tax basis for each of the current
assets and current liabilities is zero. After consulting with a tax
accountant, they decided to use an estimated tax rate of 30
percent. The Farmers applied the six steps for current deferred
taxes as follows:

Step 1. They calculated the difference between the accrual-adjusted
values and tax basis values for current assets.

Current Assets                     Balance        Tax
                                  Sheet Value    Basis   Difference

Accounts Receivable                $3,500         $0      $ 3,500
Feed Inventory Purchased for Use      230          0          230
Feed Inventory Raised for Use       2,300          0        2,300
Crop Inventory Raised for Sale      6,000          0        6,000
Feeder Livestock Inventory
 Purchased for Resale                 750          0          750
Feeder Livestock Inventory
 Raised for Sale                   50,000          0       50,000
Prepaid Insurance                     700          0          700
Cash Investment in Growing
 Crops                              2,500          0        2,500
Total                                                     $65,980

Step 2. They had no crop insurance proceeds or disaster payments.

Step 3. They listed the amount of accrual-adjusted current
liabilities.

  Current Liabilities        Balance Sheet Value
  Interest Payable                 $5,000
  Accounts Payable                    340
  Total                            $5,340

Step 4. They subtracted the total of Step 3 from the sum of Steps 1
and 2 and multiplied the result by the estimated tax rate of 30
percent.

  Steps 1 and 2           $65,980
  Step 3                  - 5,340
  Difference              $60,640
  Tax rate                x   30%
  Current Deferred Taxes  $18,192

The result is the amount of Current Deferred Taxes at the end of the
year.

Step 5. They subtracted the balance in the Current Deferred Taxes
account at the beginning of the year from the answer
in Step 4.

Current Deferred Taxes at the end of the year          $18,192
- Current Deferred Taxes at the beginning of the year  -     0
Change in Taxes Payable                                $18,192

Step 6. They recorded the following journal entry:

Dec. 31 9110 Change in Taxes Payable                   18,192
              2510 Current Deferred Taxes                     18,192

Their financial statements reported the following:

Income Statement:
    Income before Taxes                                 $ XXX
            Income Tax Expense                         (2,160)
            + Change in Taxes Payable                    (870)
            + Change in Taxes Payable                 (18,192)
               Effect on Accrual Adjusted Net Income ($21,222)

Balance Sheet:
    Liabilities:
            Taxes Payable                             $ 3,030
            Current Deferred Taxes                     18,192

PRACTICE WHAT YOU HAVE LEARNED Help the Farmers estimate the current
deferred taxes for the following year, 20X2, by completing Problem
9-3 at the end of the chapter.


NON-CURRENT DEFERRED TAXES
Learning Objective 4 * To
determine the amount of non-current
deferred taxes for a farm
operation.


In Chapters 4 and 5, you learned about the nature of non-current deferred taxes.

* Non-current deferred taxes arise from the differences between the book or base values of non-current assets and their tax basis, and from the differences between the market values of non-current assets and their book or base values.

* The balance sheet reports these tax liabilities as Non-Current Deferred Taxes because they are not likely to be resolved during the next year.

First Component of Non-Current Deferred Taxes

A non-current deferred tax may consist of two components. The balance sheet reports the liability for the first component as part of Non-Current Deferred Taxes. The adjustment on the income statement for the first component is part of Change in Taxes Payable. The first component relates to

* the difference between base values and tax basis of raised breeding livestock; and

* the difference between book values and tax basis of purchased non-current assets.

Determining the non-current deferred taxes for raised breeding livestock requires calculating the difference between the base values and the tax basis. As you learned in Chapter 8, when a farm operation raises breeding livestock, the costs of raising the livestock are recorded in expense accounts, not the Breeding Livestock account. Base values are assigned and reported in the Breeding Livestock account. When raised breeding livestock have base values for financial reporting purposes, the tax basis is zero. Tax basis is based on the cash paid for an asset, but no cash purchase occurred for raised livestock, so no tax basis exists. Therefore, the difference between the base value and the tax basis is simply the base value.

When depreciation methods for financial accounting and for tax purposes differ, the book value is different from the tax basis.

* Book Value = Original cost of an asset--Accumulated financial depreciation of the asset. Accumulated financial depreciation is based on depreciation methods for financial accounting.

* Tax Basis = Original cost of an asset--Accumulated tax depreciation of the asset. Accumulated tax depreciation is based on tax depreciation methods.

Depreciation expense on the accrual-adjusted income statement is different from depreciation on the tax return, so accrual-adjusted net income is different from taxable income. This means that income taxes paid on the taxable income do not reflect the income taxes on accrual-adjusted net income. The farm accountant has to perform an adjustment so that the income taxes on accrual-adjusted net income include the effects of the depreciation method used to calculate accrual-adjusted net income. Remember, Income Tax Expense is the amount of taxes paid (based on taxable income). Income Tax Expense along with the adjustments reports the income taxes on accrual-adjusted net income.

In Chapter 4, you learned about adjusting for the first component of non-current deferred taxes. Table 9-3 reviews these procedures. This chapter shows you how to perform the first procedure.

* Estimate the amount of the first component of non-current deferred taxes for the year.

Table 9-4 outlines the procedures for calculating the first component of non-current deferred taxes. Steps 1 through 3 show how to estimate the amount of the first component. Steps 4 and 5 are the same steps that you learned about in Chapter 4. For the raised breeding livestock, the farm accountant starts with the total base value of the raised breeding livestock and makes adjustments for changes in the value due to age progression and changes in base values (if not already done) to determine the current base value. Then, the farm accountant determines the current book value of purchased breeding livestock and other non-current assets by making the adjustment for depreciation (if not already done). For these purposes, values of raised breeding livestock and purchased breeding livestock should be kept separate. The farm accountant obtains the tax basis from the tax accountant, who calculates tax depreciation for the farm's assets.
Step 1. The example of the Farmers' dairy cattle herd in Chapter 8
illustrates these procedures. Using the individual animal approach
with multiple transfer points for Year 1 (assume that Year 1 is
20X1), the Farmers begin by determining the current base value of
the dairy herd. Assume that at the beginning of 20X1, they did not
report a value for the dairy herd because they inherited the cattle
during the first year of operation. Using journal entries, the
Farmers record the following journal entry at the end of 20X1 for
changes in value due to age progression to establish the base
values:

  Dec. 31 1500 Breeding Livestock                         8,700
               4600 Change in Value Due to Change in
                    Quantity of Raised Breeding Livestock        8,700
                       ($8,700 ??0 ??$8,700)

The result of this entry is a current base value of $8,700 for the
raised breeding livestock:

                      1500 Breeding Livestock

Date              Description                   Debits Credits Balance
Beginning Balance                                                    0
12/31/X1          To set up account for 3 bred
                  heifers and 7 dairy cows       8,700           8,700

They calculate the difference between the base value and the tax basis
as follows:

  Base value                                   $8,700
  Tax basis                                         0
  Difference between base value and tax basis  $8,700

Step 2. In Chapter 4, journal entry (39), the Farmers recorded
depreciation expense at the end of 20X1. Accumulated depreciation
is only for one year's depreciation at the end of their first year
of operation. Then they calculate the book values.

Asset                      Cost   Accumulated   Book Value
                                  Depreciation
Office Furniture         $ 1,000     $ 250          $ 750
Buildings, Improvements  110,000     4,400        105,600
Tractor                   50,000     3,333         46,667
Truck                     15,000     3,000         12,000
Leased Harvester         100,000     6,667         93,333
Orchard                   45,000     4,500         40,500
Total                              $22,150       $298,850

They obtain the tax basis from the tax accountant and calculate the
difference between the book values and the tax basis:

Asset                    Book Value  Tax Basis   Difference

Office Furniture            $ 750       $ 600      $ 150
Buildings, Improvements   105,600     100,000      5,600
Tractor                    46,667      38,000      8,667
Truck                      12,000       9,000      3,000
Leased Harvester           93,333      93,333          0
Orchard                    40,500      36,000      4,500
Total                    $298,850    $276,933    $21,917

Step 3. They calculate the sum of Steps 1 and 2 and the non-current
deferred taxes for the first component using the same estimated tax
rate that they used for the current deferred taxes:

  Step 1                     $ 8,700
  Step 2                      21,917
  Sum                        $30,617
  Tax Rate                   x  ??30%
  Non-Current Deferred Taxes $ 9,185

They report this amount on the balance sheet along with the amount
for the second component of non-current deferred taxes.

Step 4. They calculate the difference between the result from Step
3 and the amount of Non-Current Deferred Taxes at the beginning of
the year that pertains to the first component. Because 20X1 is the
first year of operation for the Farmers, the beginning balance is
zero.

  Non-Current Deferred Taxes at the end of the year
  (first component)                                         $9,185
  -Non-Current Deferred Taxes at the beginning of the year      -0
  Change in Taxes Payable                                   $9,185

Step 5. They record the following journal entry:

  Dec. 31 9110 Change in Taxes Payable          9,185
               2500 Non-Current Deferred Taxes        9,185

Their financial statements report the following so far:

Income Statement:
  Income before Taxes                           $ XXX
  Income Tax Expense                           (2,160)
  + Change in Taxes Payable                      (870)
  + Change in Taxes Payable                   (18,192)
  + Change in Taxes Payable                    (9,185)
       Effect on Accrual Adjusted Net Income ($30,407)

Balance Sheet:
  Current Liabilities:
          Taxes Payable                       $ 3,030
          Current Deferred Taxes               18,192
  Non-Current Liabilities:
          Non-Current Deferred Taxes            9,185

PRACTICE WHAT YOU HAVE LEARNED Practice what you have learned and
complete Problem 9-4 at the end of the chapter.


Second Component of Non-Current Deferred Taxes

In Chapter 5, you learned that the second component of non-current deferred taxes relates to the difference between book or base values and current market values of non-current assets.

* The difference between current market values and base values of raised breeding livestock; and

* The difference between current market values and book values of purchased non-current assets.

The farm accountant reports this component only if the balance sheet reports market values.

The liability for deferred taxes occurs because when assets are sold in the future, they will be sold for market value. As you have learned throughout this book, a gain or loss usually occurs because the market value received is seldom the same as the book value. Gains or losses are not reported for tax purposes because they do not represent cash income or deductions. However, they are a component of accrual-adjusted net income, so their tax effects should also be reported. The taxes are deferred because the sale has not occurred yet. Figure 9-5 shows you the events associated with the second component of non-current deferred taxes.

The farm accountant makes a deferred tax adjustment while preparing market-based financial statements to report the tax effects of market value adjustments. The balance sheet reports the deferred taxes as the second component of Non-Current Deferred Taxes. The difference between the amounts of non-current deferred taxes from the previous year to the current year is not reported on the income statement, but rather is reported on the statement of owner equity. The statement of owner equity reports the change in equity for market valuation (as Change in Excess of Market Value over Cost/Tax Basis of Farm Capital Assets), so it should also report the tax effects of these changes. Table 9-5 outlines the procedures that you learned about in Chapter 5.

This chapter shows you how to perform the first procedure.

* Estimate the amount of the second component of non-current deferred taxes for the year.

Table 9-6 outlines the procedures for calculating the second component of non-current deferred taxes. Steps 1 through 3 show you how to estimate the amount of the first component. Steps 4 and 5 are the same steps that you learned about in Chapter 5. After working on the first component, the farm accountant has the book values and base values. An appraisal from a qualified farm appraiser can provide the market values.
Chapter 5 presents an example of market value adjustments for the
Farmers' non-current assets. The Farmers calculate book values by
subtracting the accumulated depreciation for each asset (except
land and raised breeding livestock) from its cost. They also
conducted an appraisal of their non-current assets. The land that
Steve and Chris inherited had a value of $800 per acre at the time
of the inheritance. It consists mostly of cropland. Similar land in
the area recently sold for $900 per acre. The recently purchased
acreage has not changed much in value since the purchase. The
machinery and equipment have a book value of $58,667 and a total
market value of approximately $62,167. The 145 breeding cows have a
base value of $79,500 (after the adjustment for age progression)
and a market value of $64,500. The appraisal indicates that the
market values for other assets are as follows: office furniture and
equipment, $750; orchard, $40,500; buildings and improvements,
$105,600; and leased harvester, $93,333. Then they compute the
difference between the book or base values and the market values.

Steps 1 and 2. They calculate the difference between the market value
of each non-current asset and its book or base value.

Non-current assets                   Book/Base  Market
(cost--accumulated depreciation)      Values    Values   Difference

Breeding Livestock ($73,500 + 6,000
 age adjustment)                      79,500     64,500     (15,000)
Machinery and Equipment
($65,000 - 3,333 ??3,000)              58,667     62,167       3,500
Office Equipment and Furniture
($1,000 ??250)                           750         750           0
Perennial Crops
($45,000 ??4,500)                     40,500      40,500           0
Land ($240,000 ??120,000;
no depreciation)                    360,000     390,000       30,000
Buildings/Improvements
($110,000 ??4,400)                   105,600     105,600           0
Leased Assets ($100,000 ??6,667)      93,333      93,333           0
Excess of market value over cost                              18,500

Step 3. They multiply the results from Steps 1 and 2 times the
estimated tax rate.

  Steps 1 and 2               $18,500
  Tax rate                    x   30%
  Non-Current Deferred Taxes  $ 5,550

The result is the amount of Non-Current Deferred Taxes for the second
component.

Step 4. They calculate the difference between the result from Step
3 and the amount of Non-Current Deferred Taxes at the beginning of
the year that pertains to the second component. Because 20X1 is the
first year of operation for the Farmers, the beginning balance is
zero.

   Non-Current Deferred Taxes at the end of the year
   (second component)                                        $5,550
   -Non-Current Deferred Taxes at the beginning of the year  -    0
   Change in Non-Current Deferred Taxes                      $5,550

Step 5. They record the following journal entry:

  Dec. 31 3020 Change in Non-Current Deferred Taxes    5,550
               2500 Non-Current Deferred Taxes                5,550

Their financial statements report the following:

Income Statement:
  Income before Taxes                                     $ XXX
         Income Tax Expense                              (2,160)
         + Change in Taxes Payable                         (870)
         + Change in Taxes Payable                      (18,192)
         + Change in Taxes Payable                       (9,185)
               Effect on Accrual Adjusted Net Income   ($30,407)

Statement of Owner Equity:
  Valuation Equity:
      Change in Excess of Market Value over Cost/Tax
       Basis of Farm Capital Assets                     $18,500
      Change in Non-Current Deferred Taxes               (5,550)
           Effect on Equity                             $12,950

Balance Sheet:
  Current Liabilities:
      Taxes Payable                             $ 3,030
      Current Deferred Taxes                     18,192
  Non-Current Liabilities:
      Non-Current Deferred Taxes (9,185 ??5,550)  14,735
  Equity:
      Valuation Equity                            12,950


Both components of the non-current portion of deferred taxes will exist when the book or base values differ from the tax basis and the market values differ from the book values. The examples show that the farm accountant has to keep records of both components separately. If a beginning balance for Non-Current Deferred Taxes exists, the farm accountant needs to know the amount of the beginning balance that pertains to each component.
PRACTICE WHAT YOU HAVE LEARNED Practice what you have learned and
complete Problem 9-5 at the end of the chapter.


CAPITAL LEASES
Learning Objective 5 * To
explain the requirements for
reporting a lease as a capital
lease.

Learning Objective 6 * To
perform the accounting procedures
for a capital lease.


Farm operations may lease assets rather than purchase them. In some cases, the farm operation leases an asset for a very short period (for example, a machine for a day or a certain number of hours). In some cases, the farm operation leases an asset for many years (for example, land). The accounting for the lease depends on the nature of the lease arrangement. Many lease arrangements qualify as operating leases, which are rental arrangements that do not meet the criteria for a capital lease. The farm accountant records the rental payments for an operating lease as rent expense.

Capital leases are special types of leases that, in effect, are installment purchases. With most installment purchases, the buyer obtains ownership (the title) of the asset at the time of the purchase and then makes periodic payments. Many characteristics of a capital lease are very similar to an installment purchase. With capital leases, the lessee (the party that is using the asset) makes periodic payments similar to installment payments. The lessee might obtain ownership of the asset. Not all capital leases result in the lessee owning the asset. If the lessee obtains ownership, the transfer of the title will not happen until the end or near the end of the lease term. The arrangement is a lease because during the lease period, the ownership of the asset remains with the original owner.

A capital lease differs from an operating lease because in a capital lease, the lessee has all of the benefits and risks of the owner of the asset.

* In a capital lease, the lessee can report the leased asset along with other owned assets on the balance sheet and can record depreciation expense. In an operating lease, the lessee does not report the asset on the balance sheet and does not record depreciation.

* In a capital lease, the lessee also reports a liability for all of the lease payments in the future. In an operating lease, the lessee does not report a liability.

* In a capital lease, the lessee records lease payments, similar to loan payments. In an operating lease, the lessee only records rental expense for the payments.

* Often in a capital lease, the lessee is responsible for repairs and maintenance of the asset. Generally, in an operating lease, the responsibility for repairs and maintenance remains with the owner of the asset.

A lease is a capital lease when the following conditions are present:

* The lease is a non-cancelable lease contract, that is, the lease cannot be canceled.

* The lease contract specifies that the lessee will make a series of payments for a specific period in return for the use of a specified asset.

* The lease agreement meets one of four ownership tests.

The ownership tests determine whether the lessee is essentially acting as the owner of the asset. The farm lessee examines the lease agreement for ownership tests when the lease begins so that the farm accountant can perform the proper accounting for the lease.

Table 9-7 outlines the four ownership tests. In the first test, if the contract specifically states that the title will pass to the farm lessee at the end of the lease, the farm lessee will obviously become the owner of the asset and the lease arrangement is really a purchase. If the lease agreement does not specify a transfer of title, the farm accountant checks for the second test. In the second test, the farm accountant looks for an opportunity to buy the asset at a bargain price. Even though the lease contract does not specify ownership transfer explicitly, the farm lessee very likely will take advantage of purchasing the asset for a bargain. Again, the farm lessee looks like an owner. If the lease agreement does not pass the first two tests, the farm accountant checks the third test. In the third test, if the farm lessee uses the asset for 75 percent or more of its useful life, the farm lessee has had possession for the vast majority of the asset's life, similar to an owner. When the condition for the fourth test occurs, the farm lessee is virtually paying for the asset and, even if the contract does not specify that title passes to the lessee, the series of payments resembles an installment purchase.
PRACTICE WHAT YOU HAVE LEARNED To help you remember these concepts,
complete the matching exercise in Problem 9-6 at the end of the
chapter.


When a lease is classified as a capital lease, the balance sheet of the farm lessee reports a leased asset and a lease liability. The owner and the farm lessee agree on the amount of the payments. The value of the asset is depreciated by the farm lessee.

* The first step at the start of the lease is to determine the value of the asset and report this amount as Leased Asset and as Obligations on Leased Assets. In most cases, the value to record will be the fair market value of the asset.

Leased Asset XXXX

Obligations on Leased Asset XXXX

* The farm lessee makes and records the payments every month or every year, according to the lease arrangement. Most lease arrangements specify that the first lease payment be made at the start of the lease. The owner specifies to the farm lessee the amount of the payment.

Obligations on Leased Asset XXX

Cash XXX

* At the end of the year, the farm accountant calculates and records depreciation for the leased asset (unless the leased asset is land). The balance sheet reports the book value of the leased asset.

* At the end of the year, the farm accountant recalculates the amount of the lease liability based on the future payments and calculates the amount of interest paid in the lease payments for the year. The income statement includes this amount of interest. The balance sheet reports the recalculated lease liability.

Table 9-8 outlines the procedures for calculating the lease liability at the end of each year of the lease term and the interest for each year of the lease term.

In Step 1, the farm accountant calculates the present value of the lease payments. The present value of the lease payments is the amount of the future payments without the interest. Lease payments include a portion for interest, even though the lease agreement does not specify an interest rate. The owner includes an interest component when calculating the payment amount. If the farm lessee paid for the entire lease up front, the amount paid would be the present value of the payments. The present value of the payments at the start of the lease is most likely the fair market value of the asset (except for salvage value, which the owner excludes from the payments). The present value factor (PVF) is a multiplier that discounts the payments to their present value. The factor can be found by using present value tables found in some financial books, by using a financial calculator or computer, or by using a formula, as shown in Table 9-8.

Table 9-8 shows that the formula for the present value factors requires an interest rate (i) and the number of lease payments (n). The farm lessee should estimate an interest rate if the owner does not specify the interest rate used to calculate the lease payment. The estimated interest rate should be a rate that the farm operation would have to pay to borrow a similar amount of money for a similar amount of time. The number of payments made in a year is 12 if monthly payments are made, 4 if quarterly payments are made, or 1 if payments are made only once per year. Each year the total number of remaining payments has to be determined, and this is the value for n. Just as in an installment loan, the amount of each payment and the interest rate remain the same throughout the entire lease term. The only element that changes each year is the number of remaining payments. The result of Step 1 is the current value of the lease liability.

In Step 2, the farm accountant calculates the difference in the value of the lease liability from the end of last year and the current value of the lease liability (calculated in Step1). The change in lease liability is the amount of the lease payments without the interest. Then, in Step 3, the change in lease liability is subtracted from the total amount of lease payments paid during the year. The difference is the amount of the interest included in the lease payments. The adjustment results in the correct amount of interest reported on the income statement and the correct amount of the lease liability. Without the adjustment, the lease liability amount is incorrect because the balance at the end of the year before the adjustment is from the payments, but the payments include some interest. This means that the entire payment did not go toward reducing the liability, so it has to be adjusted back up to the amount still owed on the lease liability.
Suppose that the Farmers enter into a 5-month lease arrangement for
some equipment beginning October 1. The owner, an equipment dealer,
has agreed to give the Farmers the title to the equipment at the
end of the lease term. Because of the ownership transfer, the lease
is a capital lease. The fair market value of the leased equipment
is $10,000. The owner has decided on monthly payments of $2,040
each. The Farmers estimate an annual interest rate of 12 percent.

At the start of the lease, the Farmers record the following entry to
show that they have acquired a lease asset:

  Oct. 1, 20X1 1910 Leased Assets                      10,000
                     2600 Obligations on Leased Assets          10,000

The following journal entry is recorded for the payment of the first
lease payment at the beginning of the lease:

  Oct. 1, 20X1 2600 Obligations on Leased Assets        2,040
                     1000 Cash                                   2,040

The subsequent payments would be recorded in the following way before
the end of the year:

  Nov. 1, 20X1 2600 Obligations on Leased Assets        2,040
                     1000 Cash                                   2,040
  Dec. 1, 20X1 2600 Obligations on Leased Assets        2,040
                     1000 Cash                                   2,040

By the end of the year, the schedule of payments looks as follows:

Date          Beginning   Cash    Interest  Reduction  Ending Balance
              Balance    Payment               of
                                            Liability

Oct. 1, 20X1  $10,000     $2,040     $0       $2,040      $7,960
Nov. 1, 20X1               2,040      0        2,040       5,920
Dec. 1, 20X1               2,040      0        2,040       3,880
Total                     $6,120              $6,120

The ending balance of $3,880 is the lease liability before the
adjustment. The lease liability is recalculated for the remaining
two payments (n = 2) at the 12 percent annual interest rate (i =
annual interest rate / the number of payments made in a year = 12%
/ 12 = 1%):

  Year-end lease liability = Lease payment x PVF
                           = $2,040 x 1.97040
                           = $4,020 (rounded)
  PVF = present value factor
      = {1 - [1 /[(1 + i).sup.n]]} / i
      = {1 - [1 /[(1 + .01).sup.2]]} / .01
      = 1.97040

Interest expense is the total payments minus the difference between
the beginning lease liability and the year-end lease liability:

Change in lease liability = Beginning lease liability - Year-end lease
liability
                          = $10,000 - 4,020
                          = $ 5,980

The total of the payments is $2,040 x 3 = $6,120.

  Interest = Total payments - Change in lease liability
           = $6,120 - 5,980
           = $  140

An adjustment is required to adjust the liability account to the
correct amount and to report the interest. If the Farmers use
journal entries to record adjustments, they would record the
following:

   Dec. 31, 20X1 8110 Change in Interest Payable            140
                      2600 Obligations on Leased Assets          140


At the end of the lease term, the balance sheet will no longer report a lease liability after the last payment, just like a loan. At the end of the lease term, the balance sheet will no longer report a leased asset. The leased asset will be completely depreciated and returned to the owner, unless the lessee owns it at the end of the lease term. If the lessee owns the asset, the farm accountant reclassifies it from Leased Asset to an appropriate account, such as Machinery and Equipment or Land. The balance sheet reports the value of the asset at its appraised value.
PRACTICE WHAT YOU HAVE LEARNED Practice what you have learned by
completing Problem 9-7 at the end of the chapter.


OWNER WITHDRAWALS, OTHER DISTRIBUTIONS, NON-FARM INCOME
Learning Objective 7 * To
review the components of
retained capital pertaining to
owners and explain the reporting
of these items on the statement
of cash flows.


The statement of owner equity reports the activities of the owners in the farm business and the total amount of profit earned by the farm business that has not been distributed to the owners. The two main components of the statement of owner equity are Retained Capital and Valuation Equity. Retained Capital consists of the following items:

* Net Income (amount earned by the farm business in the current year)

* Owner Withdrawals

* Non-Farm Income

* Gifts and Inheritances (Other Distributions)

Table 9-9 shows the example from Appendix A to help you recall the format for the statement of owner equity.

Owner Withdrawals must be accurately recorded or reasonably estimated, regardless of the form of organization of the farm business. The amount should be reported on the statement of cash flows and the statement of owner equity (or net worth) to make comparisons between farm operations more feasible. Owner Withdrawals are distributions from the farm business to cover family living expenses, personal taxes, purchases of personal assets, and other non-farm items. Owner Withdrawals can be shown in either the operating section or the financing section of the statement of cash flows. Other Distributions should be reported on the statement of cash flows in the financing section. Any Non-Farm Income contributed to the farm business can be shown separately from the owner withdrawals on the statement of owner equity or net worth or can be netted with owner withdrawals. On the statement of cash flows, this item should be shown separately in the financing section. As you learned in Chapter 5, the balances in the Owner Withdrawals, Non-Farm Income, and Gifts and Inheritances accounts are closed to the Retained Capital account, along with Net Income.

VALUATION EQUITY
Learning Objective 8 * To
explain the purpose of the components
of valuation equity.


Valuation equity consists of the effects of market value changes on the farm financial statements. Market value changes are reported separate from Retained Capital because not all farm operations will decide to report market values. Lenders and other parties reading financial statements can more easily compare a farm that reports market values with a farm not reporting market values with this format.

Valuation equity is the sum of two accounts:

* Change in Excess of Market Value over Cost

* Change in Non-Current Deferred Taxes.

These two accounts can be shown separately on the balance sheet or combined and shown as Valuation Equity. The computations for these items are discussed throughout this book and are not repeated here.

DISCLOSURE NOTES
Learning Objective 9 * To list
the information on liabilities disclosed
in the notes to the financial
statements.


Lenders request details about the farm debts when evaluating whether or not to lend money to a farm operation. Common types of information in disclosure notes for this purpose include the following:

* Disclosure notes for accounts payable and taxes payable should indicate the amounts owed, the parties owed, and the due date.

* Information in the disclosure notes should include all relevant information on all notes payable-name of lender, original principal amount, amount left to pay on the loan, interest rate, due dates of payments, the term of the loan, and the amount of the payments on installment loans.

The farm accountant can create separate Notes Payable accounts for each loan, such as Real Estate Notes Payable shown in Appendix C, to help keep track of payments. Whether one or several Notes Payable accounts are used, the disclosure notes should outline details of the loans according to the arrangements with lenders.

Disclosure notes for deferred taxes should be quite explicit concerning the details of the calculations for current and non-current portions of deferred taxes. Accurate and complete records can be facilitated by disclosing the computations for the current deferred taxes and both components of non-current deferred taxes in the notes to the financial statements each year.

* The first section in the notes should list each of the current assets and their values from the previous and current years so that the computations for Steps 1 and 2 for current deferred taxes are clear.

* The next items to list are the current liabilities and their values from both last year and this year.

* The amount of current deferred tax liability (results of Step 4) should be shown for both years (last year and this year).

* The next section should provide base value and tax basis information for each class of raised breeding livestock (for last year and this year).

* The amount of the first component of non-current deferred taxes related to base values of raised breeding livestock is shown for both years.

* The next section continues with the purchased non-current assets, listing each asset, its book, its tax basis, and the difference between the two for each asset, again providing this information for both last year and this year.

* The next section should provide market values and the book or base values of all non-current assets for both last year and this year.

* The deferred tax liabilities for the second component of non-current deferred taxes for each year are shown.

* The deferred tax liabilities for the second component are added to the deferred tax liabilities for the first component for each year.

Disclosure information for operating leases should include

* Descriptions of all assets involved in capital leases

* The amount of the lease payments

* The interest rate used in each present value

* The number of payments

* Method of depreciation

The computations for the change in lease liabilities, total payments, and interest should be clear from the information in the notes.

The computation for the valuation equity should be explicit in the disclosure notes if not reported on the statement of owner equity.

CHAPTER SUMMARY

Valuation procedures for liabilities such as Accounts Payable, Taxes Payable, and Interest Payable are quite straightforward because the amount of each liability is presented in the form of a bill from some outside party. However, the valuation of other liabilities can involve extensive procedures, such as those for deferred taxes. Deferred tax liabilities should be performed after all adjustments have been made. In many respects, the accounting procedures for capital leases resemble the procedures for installment notes payable. Accounting for capital leases involves the present value computation for the lease liability.

The components of valuation equity should be reported, to accurately present the information related to the non-current deferred taxes and retained capital. The more complete the disclosure information on liability and equity accounts, the more informative and the more useful the financial reports will be. Because of the complex nature of some of these items, the amount of disclosure information is crucial for lending and other decisions that rely on the accuracy of the financial information for the farm business.

PROBLEMS

9-1 * For each of the transactions below, identify whether you would report it as an expense (E), a liability (L), or a "change" item (C), the name of the account that you would use to report it, and on which financial statement it would appear.

a. The farm accountant receives the telephone bill and pays the bill immediately.

b. The farm operation owes $310 to the local cooperative at the end of the year.

c. The farm accountant compares the $500 accounts payable owed at the beginning of the year to the $310 owed at the end of the year.

d. The farm accountant pays the bill in (b) after the beginning of the year.

e. The farm accountant pays the feed bill.

f. The farm accountant estimates that the farm operation owes $2,800 in income taxes at the end of the year. The farm accountant compares the $3,100 taxes payable at the beginning of the year to the $2,800 owed at the end of the year.

g. The farm accountant pays the income taxes.

h. The farm accountant estimates that the farm operation owes $5,000 in interest at the end of the year.

i. The farm accountant pays off a loan including interest.

9-2 * a. Repeat the procedures for the Farmers' remaining payments on the purchase of the harvester. Verify the amounts for interest expense and reduction of liability by calculating the interest and principal portions for the third, fourth, and fifth payments. Then, prepare the journal entries for these payments.

b. Suppose that the Farmers are making monthly payments, instead of annual payments. Explain how the amount for interest would be calculated differently with monthly payments instead of annual payments. (Do not do the actual calculations.)

9-3 * Help the Farmers estimate the current deferred taxes for the year 20X2. Use the information in Chapter 5 for the subsequent year's adjustments to make your calculations.

9-4 * Help the Farmers estimate the first component of non-current deferred taxes for the year 20X2. Use the individual animal approach with multiple transfer points and the changes in base values illustrated in Chapter 8 for the raised breeding livestock. Use the same depreciation methods that the Farmers used in Chapter 4.

9-5 * Help the Farmers estimate the second component of non-current deferred taxes for the year 20X2. Use the market values below and the book values that you calculated in Problem 9-4.
                                 Market Values

Breeding Livestock                   70,000
Machinery and Equipment              64,000
Office Equipment and Furniture          700
Perennial Crops                      42,000
Land                                400,000
Buildings/Improvements              100,000
Leased Assets                        93,333


9-6 * Identify each of the descriptions below as a characteristic of an operating lease (O), or a capital lease (C), or as an installment purchase (I). Some of the descriptions may apply to more than one.

a. Rental arrangements that do not meet the criteria for a capital lease.

b. Special types of leases that, in effect, are installment purchases.

c. The buyer obtains the title of the asset at the time of the purchase and then makes periodic payments.

d. The buyer obtains the title of the asset after making periodic payments.

e. The farm accountant records the rental payments as rent expense.

f. One party continues to have title of an asset while another party uses it, but will transfer the title to the party using it.

g. The party using the asset has all of the benefits and risks of the owner of the asset.

h. The risks of owning an asset remain with the owner while another party uses the asset.

i. The party using the asset can report the asset along with other owned assets on the balance sheet and can record depreciation expense.

j. The party using the asset does not report the asset on the balance sheet and does not record depreciation.

k. The payments for the asset include interest.

l. The payments for the asset do not include interest.

m. The party using the asset reports a liability.

9-7 * Calculate the interest on each of the capital leases below.
Beginning lease liability    Year end lease liability   Total payments

a. $100,000                     $45,020                 $64,000
b. $ 20,000                     $14,680                 $ 6,120
c. $ 45,000                     $34,900                 $ 3,600
d. $ 10,000                     $ 6,020                 $ 3,000

TABLE 9-1 Procedures for Making Adjustments for Current
Deferred Taxes.

1. Estimate the amount of current deferred taxes
for the year.

2. Make adjustment:

a. Balance sheet shows amount of current deferred
taxes Current Deferred Taxes

b. Income statement shows amount of income tax
for the year (Income Tax Expense)

+/- Change in Taxes Payable (for difference in
Taxes Payable from last year)

+/- Change in Taxes Payable (for difference in
Current Deferred Taxes from last year)

TABLE 9-2 * Steps for Calculating Current Deferred Taxes.

Step 1. The first step in determining current deferred taxes is to
        determine the difference between the accrual-adjusted values
        and tax basis values for current assets. For each current
        asset, the tax basis values are subtracted from the
        accrual-adjusted values. The differences between the
        accrual-adjusted values and the tax basis values are summed.

Step 2. The next step is to determine if there was any income
        reported on financial statements but not on the tax
        return for  which no asset appears on the balance sheet.
        According to the FFSC Guidelines, some examples of this
        income include crop insurance proceeds and disaster
        payments.

Step 3. The next step is to determine the amount of
        accrual-adjusted current liabilities, such as accounts
        payable.

Step 4. Add the results of Steps 1 and 2.
        Subtract the total of Step 3 from the sum of
        Steps 1 and 2.

        Multiply the result times the estimated tax rate. The
        result is the amount of Current Deferred Taxes
        at the end of the year.

Step 5. Subtract the balance in the Current Deferred Taxes
        account at the beginning of the year from the
        answer in Step 4.

Step 6. Prepare the journal entry or make the adjustment
        directly to the income statement with the answer
        in Step 5 as you learned in Chapter 4, using the
        Change in Taxes Payable account.

TABLE 9-3 * Procedures for Making Adjustments for the
First Component of Non-Current Deferred Taxes.

1. Estimate the amount of the first component of
non-current deferred taxes for the year.

2. Make adjustment:

a. Balance sheet shows amount of non-current deferred taxes
Non-Current Deferred Taxes

b. Income statement shows amount of income tax for the year
(Income Tax Expense)
+/- Change in Taxes Payable (for difference in
Taxes Payable from last year)

+/- Change in Taxes Payable (for difference
in Current Deferred Taxes from last year)

+/- Change in Taxes Payable (for difference in
first component of Non-Current Deferred
Taxes from last year)

TABLE 9-4 * Steps for Calculating First Component
of Non-Current Deferred Taxes.

Step 1. Make adjustments for change in value due to age
        progression and change in base values
        (if applicable) for raised breeding livestock
        (if not already done).

        Calculate the difference between the base value
        and the tax basis for raised breeding livestock.

Step 2. Make adjustment for depreciation on purchased
        non-current assets (if not already done).

        Calculate current book values of purchased
        non-current assets.

        Book value = Original cost--Accumulated
        depreciation

        Obtain tax basis of purchased non-current
        assets from tax accountant.

        Calculate the difference between the book
        value and the tax basis for purchased
        non-current assets.

Step 3. Add the results from Steps 1 and 2 and multiply
        the sum times the estimated tax rate.

        The result is the amount of Non-Current Deferred
        Taxes for the first component.

Step 4. Calculate the difference between the result from
        Step 3 and the amount of Non-Current Deferred
        Taxes at the beginning of the year that pertains
        to the first component.

Step 5. Prepare the journal entry or make the adjustment
        directly to the income statement with the answer
        in Step 4 as you learned in Chapter 4, using the
        Change in Taxes Payable account.

TABLE 9-5  Procedures for Making Adjustments for the
Second Component of

Non-Current Deferred Taxes.

1. Estimate the amount of the second component of
non-current deferred taxes for the year.

2. Make adjustment:

a. Balance sheet shows amount of non-current deferred
taxes
Non-Current Deferred Taxes

b. Statement of owner equity shows the market value
adjustments and the tax effect of the market value
adjustments for the year

Change in Excess of Market Value over Cost/Tax Basis
of Farm Capital Assets
+/- Change in Non-Current Portion of Deferred Taxes

TABLE 9-6 * Steps for Calculating Second Component of
Non-Current Deferred Taxes.

Step 1. Determine market values for all non-current
        assets from a farm appraiser.

        Calculate the difference between the market
        value of each purchased non-current asset and their
        book value.

Step 2. Calculate the difference between the market
        value and the base value for raised breeding livestock.

Step 3. Add the results from Steps 1 and 2 and
        multiply times the estimated tax rate.

        The result is the amount of Non-Current Deferred
        Taxes for the second component.

Step 4. Calculate the difference between the result from Step 3
        and the amount of Non-Current Deferred Taxes at the
        beginning of the year that pertains to the second
        component.

Step 5. Prepare the journal entry or make the adjustment
        directly to the statement of owner equity with the
        answer in Step 4 as you learned in Chapter 5,
        using the Change in Non-Current Deferred Taxes
        account.

TABLE 9-7 * Ownership Tests for Capital Leases.

1. The lease agreement specifies that the ownership of the asset
   transfers to the lessee.

2. The lease agreement contains a bargain purchase option. A bargain
   purchase option offers the lessee the option to purchase the asset
   at the end of the lease term for a price well below the estimated
   fair market value of the asset at the end of the lease term.

3. The lease term is equal to 75 percent or more of the expected
   economic life of the asset. The expected economic life of an asset
   is subjective and a reasonable estimate should be used. Some lease
   arrangements may contain a renewal option. In that case, the lease
   term in question is the initial term plus any amount of time
   covered by renewal periods.

4. The present value of the lease payments is equal to or greater than
   90 percent of the fair market value of the asset. This ownership
   test will also not apply if the lease begins during the last 25
   percent of the asset's economic life.

TABLE 9-8 * Calculation of Capital Lease Liability and Annual Interest
on Capital Leases.

Step 1. For the year-end lease liability, compute the present value of
        the remaining payments. The lease payment is the amount
        specified in the lease contract, paid by the lessee.

        Year-end lease liability = Lease payment x PVF
              PVF = present value factor
                  = {1 - [1 - [(1 + i).sup.n]]} / i
              n = the total number of payments remaining on the lease
              i = annual interest rate the number of payments made
                  in a year

Step 2. Calculate the change in the lease liability. Subtract the
        result from Step 1 from the amount of the lease liability
        reported at the end of the previous year.

        Lease liability at the beginning of the year
        - Lease liability at the end of the year
        = Change in lease liability

Step 3. Calculate the amount of interest for the year.

        Interest = Total payments - Change in lease liability

Step 4. An adjustment is required to adjust the liability account to
        the correct amount and to report interest. In the
        accrual-adjusted system, the amount from Step 3 is reported as
        Change in Interest Payable on the income statement and is
        added to the year-end lease liability amount.

TABLE 9-9 * The Farmers' Statement of Owner Equity for 20X1.

Owners' Equity, Beginning of Period
Net Income                                                 $40,905.80
Owner Withdrawals                              ($150.00)

Non-farm Income                                   100.00
  Net Owner Withdrawals                                         (50.00)
Gifts and Inheritances                                      350,000.00
  Addition to Retained Capital
Valuation Equity
  Change in Excess of Market Value over
    Cost                                                     18,500.00
  Change in Non-current Deferred Taxes                       (6,850.00)
  Total Valuation Equity
Addition to Retained Capital and Valuation
  Equity
Owners' Equity, End of Period

Owners' Equity, Beginning of Period                        $104,540.00
Net Income
Owner Withdrawals
Non-farm Income
  Net Owner Withdrawals
Gifts and Inheritances
  Addition to Retained Capital               $390,855.80
Valuation Equity
  Change in Excess of Market Value over
    Cost
  Change in Non-current Deferred Taxes
  Total Valuation Equity                       11,650.00
Addition to Retained Capital and Valuation
  Equity                                                    402,505.80
Owners' Equity, End of Period                              $507,045.80

FIGURE 9-2 * Payment Schedules of Loans (P = Principal,
I = Interest).

Lump-sum payment: P borrowed on March 1, 20X1 and paid
back March 1, 20X2

                    20X1                       20X2

Jan. Feb. Mar. Apr. May June July Aug. Sept.
Oct. Nov. Dec.

Jan. Feb. Mar. Apr. May June

        Mar.1                          Mar. 1
            P                               P & I

Installment note: P borrowed on March 1, 20X1,
payments on the first of each month:

                   20X1                       20X2

Jan. Feb. Mar. Apr. May June July Aug. Sept.
Oct. Nov. Dec.

Jan. Feb. Mar. Apr. May June

       Mar.1  First of each month

           P  P&I P&I P&I P&I P&I P&I P&I P&I P&I P&I P&I P&I

FIGURE 9-5 * Non-Current Deferred Tax Events (Second Component).

           20X1                                  Future

 Market values are reported                 Assets are sold
       Dec. 31                                  Dec. 31
     Deferred Taxes                          Taxes Payable
    (Balance sheet)                         (Balance sheet)
Change in Non-Current Deferred Taxes        Gain/Loss on Sale
    (Statement of Owner Equity)            (Income Statement)

           20X1                              Following Year

  Market values are reported                 Taxes are paid
         Dec. 31                         Feb. 28 Taxes paid for 20X2
     Deferred Taxes                          Income Tax Expense
   (Balance sheet)                           (Income statement)
Change in Non-Current Deferred Taxes
  (Statement of Owner Equity)
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Publication:Introduction to Agricultural Accounting
Geographic Code:1USA
Date:Jan 1, 2008
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Previous Article:Chapter 8: Asset valuation, part 2--non-current assets.
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