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Accounting For Life Insurance

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  1. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Financial statements • Complete set includes • An accountant’s report • An income statement • A balance sheet • A statement of changes in stockholder’s equity • A statement of cash flows • Notes to financial statements

  2. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Financial statements (cont’d) • Accountant’s report • Compilation • Accountant presents the client’s information in the appropriate financial statement without expressing any assurance as to whether the numbers provided are correct or not • Review • Analytical review, inquiries of management, and other procedures to give limited assurance as to whether the statements are prepared in accordance with GAAP • Audit • Understanding of internal controls and assessment of risk • Designed to provide the highest degree of assurance that the statements are prepared in conformity with GAAP

  3. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Financial statements (cont’d) • Accountant’s report (cont’d) • Audit (cont’d) • Types • Unqualified • Qualified • No opinion • Disclaimer • Other important information • Departures from GAAP and the effect on the financial statement • Omissions • Concerns as to whether the company will continue operating

  4. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Financial statements (cont’d) • Income statement • Shows the current period’s income and expenses since the prior period’s financial statements • Interim, part-year, or full year basis • Broken down into operating activities and non-operating activities

  5. Income Statement Income Statement For the Year Ended December 31, xxxx For the Year Ended December 31, xxxx Gross Sales Gross Sales $ $ 1,000,000 1,000,000 Less: Returns and Allowances Less: Returns and Allowances 10,000 10,000 Net Sales Net Sales $ $ 990,000 990,000 Less: Cost of Goods Sold 490,000 490,000 Gross Profit Gross Profit $ $ 500,000 500,000 Less: General Selling and Administrative 300,000 300,000 Net Profit from Operations Net Profit from Operations $ $ 200,000 200,000 Less: Nonoperating Activities 0 0 Income before taxes and extraordinary items Income before taxes and extraordinary items 200,000 200,000 Less: Income taxes Less: Income taxes 30,000 30,000 Income before extraordinary item Income before extraordinary item $ $ 170,000 170,000 Less: Loss from extraordinary item Less: Loss from extraordinary item 100,000 100,000 Net Income Net Income $ $ 70,000 70,000 Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning

  6. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Financial statements (cont’d) • Balance sheet • Snapshot of the company’s financial position at the end of business activity on a given day • It will include the company’s assets, liabilities, and owners’ or shareholders’ equity. Assets are shown at their “historical cost” • Fundamental accounting equation: ASSETS = LIABILITIES + EQUITY • Exceptions to the historical cost rule • Obsolescent inventory • Loss on marketable securities • Fixed assets shown at original cost less depreciation

  7. Balance Sheet As of December 31, xxxx ASSETS Current Assets Cash and cash equivalents $ 40,000 Accounts receivable -trade 100,000 Inventories 50,000 Prepaid Insurance 10,000 Total current assets $ 200,000 Property Plant and Equipment (net of depreciation) 300,000 Other Asset- Cash Surrender Value of Insurance 10,000 Total Assets $ 510,000 LIABILITIES AND STOCKHOLDERS’ EQUITY Current Liabilities Accounts payable $ 25,000 Total current liabilities 25,000 Long-Term Debt 75,000 Deferred Income Taxes 10,000 Total Liabilities 110,000 $ STOCKHOLDERS’ EQUITY Common Stock 100,000 Retained earnings $ 300,000 Total Stockholders’ equity $ 400,000 Total Liabilities and Stockholders’ equity $ 510,000 Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning

  8. Statement of Changes in Stockholders’ equity For the Year Ended December 31, xxxx Total Common Retained Stockholders’ Stock Earnings Equity Balance as of January 1, xxxx $ 100,000 $ 250,000 $ 350,000 Net Income 70,000 70,000 Dividends (20,000) (20,000) Balance as of January 1, xxxx $ 100,000 $ 300,000 $ 400,000 Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Financial statements (cont’d) • Statement of changes (in stockholders’ equity) • Reflects all activity occurring to equity accounts during the financial statement period

  9. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Financial statements (cont’d) • Statement of cash flows • Shows changes in the cash element (in terms of sources and uses of cash) and cash flows of the company that took place during the financial statement period • It is relevant in determining whether sufficient cash flow is available to meet the needs of the business and fund other objectives such as • Life insurance premiums • Nonqualified deferred compensation contributions • Contributions to employee benefit or retirement plans

  10. Statement of Cash Flows For the Year Ended December 31, xxxx Cash Flows Provided from (Used by) Operating activities Income from continuing operations $ 170,000 Adjustment to reconcile income from continuing operations to net cash provided from continuing operations 10,000 Depreciation and amortization 10,000 Changes in assets and liabilities: Accounts receivable-trade 1,000 Inventories (2,200) Accounts payable 1,000 Other assets and liabilities 250 Net Cash provided from Operating Activities $ 180,050 Cash Flows provided from (Used by) Investing Activities Capital additions $ (120,000) Net cash (Used by) Investing Activities $ (120,000) Repayment of long-term debt $ (10,000) Cash dividends paid (20,000) Net Cash (Used by) Financing Activities $ (30,000) $ Increase (Decrease) in Cash and Cash Equivalents 30,050 Cash and Cash Equivalents as of January 1, xxxx 9,950 Cash and Cash Equivalents as of December 31, xxxx $ 40,000 $ Interest Paid (Continuing Operations) 7,500 $ Income Taxes Paid (Continuing Operations) 30,000 Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning

  11. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Financial statements (cont’d) • Notes to the financial statement • Accounting methods utilized • leases and terms • Loans and loan repayment terms • Detained fixed asset information • Related party transactions • Income taxes • Subsequent events information, after financial statement closing but before financial statement release

  12. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Accounting basics • Double entry accounting • Assets = Liabilities + Equity • Debts = Credits • Assets generally have debit balances. Therefore, liability and equity accounts must have credit balances. • Expense and loss accounts ordinarily have debit balances. Revenue and gain accounts must therefore ordinarily have credit balances. • Journal Entries • Debit (Dr.) Cash 100 • Credit (Cr.) Sales 100

  13. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Accounting basics (cont’d) • Basic Rules – Accounting for life insurance • Cash surrender values will generally be assets of the company • Assuming the company is the owner and beneficiary of the policy • Cash values will carry debit balances on the balance sheet • The current insurance expense will also carry a debit balance on the income statement • Any income from the policy, including a death benefit, or any increase in the cash surrender value in excess of premiums paid in the current period will be a credit entry to an income (credit) account

  14. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Accounting rules specifically affecting life insurance • Accounting guidelines • Unearned premiums are classified as part of “working capital,” but cash surrender values are not • Policy loans should be classified as current liabilities, when they are expected to be repaid within 12 months • If a loan is intended to be liquidated from the policy death benefit or upon the policy’s maturity or cancellation, the obligation should be excluded from current liabilities • The amount of the loans should be shown to reduce the cash surrender value • For corporate life insurance maintained for the purposes of stock redemption, the footnote disclosure should first show the cash surrender value on the balance sheet and then indicate disclosure of any commitments

  15. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Accounting rules specifically affecting life insurance (cont’d) • Examples of accounting journal entries • Corporation pays an insurance premium of $4,800 on a $100,000 policy on its president. The cash value increases from $20,000 to $22,000. Life Insurance Expense (Dr.) $2,800 Cash Surrender Value of Insurance (Dr.) 2,000 Cash (Cr.) $4,800 If the insured died half-way through the most recent period of coverage (assuming cash surrender value of $21,000 and refund of one-half of premium paid): Cash $102,400 Cash Surrender Value of Insurance 21,000 Life Insurance Expense 2,400 Gain on Life Insurance Coverage $ 79,000

  16. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Accounting rules specifically affecting life insurance (cont’d) • Alternative methods • Ratable charge method • Amortizes or expenses the true cost of the insurance coverage in a straight line • Based on the premise that a company buys a policy to cover a fixed period of time and the net costs should be recognized evenly over that period of time • FASB Technical Bulletin 85-4 (Accounting for Purchases of Life Insurance) • The amount that could be realized under the life insurance contract, as of the date of the statement of financial position, should be reported as an asset • The change in cash surrender value or contract value during the period is an adjustment of premiums paid in determining the expense or income to be recognized under the contract for the period

  17. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Summary • GAAP continues to recognize only the cash surrender value method of accounting • Accounting for key employee life insurance • Term insurance • Premium payments represent a pure current expense. Such costs should be charged against current income rather than retained earnings. • Permanent (cash value) • Premium payments are bifurcated. To the extent that a premium payment generates an increase in the cash value, a charge should be made to an asset account. • To the extent that a premium payment exceeds the increase in the cash value, a charge should be made to expense.

  18. Accounting For Life Insurance Appendix H Tools & Techniques of Life Insurance Planning • Summary (cont’d) • Accounting for key employee life insurance (cont’d) • Cash values • The firm’s balance sheet should show policy cash values as a “non-current” asset • Death proceeds • When an insured dies, the gain upon receipt of the insurance payment is typically reflected as a “special entry for non-recurring amounts” on the annual statement of operations. • Alternatively, the gain on receipt by a corporation of death proceeds may be carried directly to the business’s retained earnings account since it is, in effect, adjusting prior years’ activities.