10.05

Question 1

Even though the SEC delegates the creation of accounting standards to the private sector, the SEC frequently comments on accounting and auditing issues. The main pronouncements published by the SEC are:

• Federal Reporting Updates (FRU).
• Financial Reporting Releases (FRR).
• Staff Auditing Bulletins (SAB).
• Accounting Principles Opinions (APO).

Answer 1

Financial Reporting Releases (FRR).

**The main pronouncements published by the SEC are the Financial Reporting Releases (FRR) and the Staff Accounting Bulletins (SAB).

Question 2

Wood Co.’s dividends on noncumulative preferred stock have been declared but not paid. Wood has not declared or paid dividends on its cumulative preferred stock in the current or the prior year and has reported a net loss in the current year. For the purpose of computing basic earnings per share, how should the income available to common stockholders be calculated?

• The current-year dividends and the dividends in arrears on the cumulative preferred stock should be added to the net loss, but the dividends on the noncumulative preferred stock should NOT be included in the calculation.
• The dividends on the noncumulative preferred stock should be added to the net loss, but the current-year dividends and the dividends in arrears on the cumulative preferred stock should NOT be included in the calculation.
• The dividends on the noncumulative preferred stock and the current-year dividends on the cumulative preferred stock should be added to the net loss.
• Neither the dividends on the noncumulative preferred stock nor the current-year dividends and the dividends in arrears on cumulative preferred stock should be included in the calculation.

Answer 2

The dividends on the noncumulative preferred stock and the current-year dividends on the cumulative preferred stock should be added to the net loss.

**In general, the dividends subtracted in computing basic EPS are (1) the annual dividend commitment on cumulative preferred whether or not declared or paid, and (2) declared dividends on noncumulative preferred whether paid or not. The firm has negative income. This answer means that the dividends reduce the numerator further - beyond the loss. The final numerator amount is less than (more negative than) the loss. Also, arrear dividends are never included in EPS because they were subtracted in computing EPS in a previous year.

Question 3

The treasury stock method of entering stock options into the calculation of diluted EPS:

• Is used only for dilutive treasury stock.
• Computes the increase in common shares outstanding from assumed exercise of options to be the number of shares under option.
• Is called the treasury stock method because the proceeds from assumed exercise are assumed to be used to purchase treasury stock.
• Assumes the treasury shares are purchased at year-end.

Answer 3

Is called the treasury stock method because the proceeds from assumed exercise are assumed to be used to purchase treasury stock.

**Firms may use the proceeds from the exercise of stock options for any purpose. However, to promote uniformity in reporting, and to reduce the dilution from exercise, the assumption is that the proceeds are used to purchase the firm’s stock on the market. This reduces the net number of new shares outstanding from assumed exercise.

Question 4

If everything else is held constant, earnings per share is increased by:

• Purchase of treasury stock.
• Issuance of new shares of common stock.
• Payment of a cash dividend to common stockholders.
• Payment of a cash dividend to both preferred and common stockholders.

Answer 4

Purchase of treasury stock.

**Earnings per share is calculated by dividing earnings (profit) available to common stockholders by weighted average number of shares of common stock outstanding. If the denominator is decreased by purchasing treasury stock, then the EPS result is increased.

Question 5

Why do preferred stock dividends appear in the calculation of earnings per share (EPS)?

• Preferred stock may be converted into common stock at the option of the shareholder.
• Preferred stock dividends are not included in the calculation of EPS unless they have been outstanding for the entire year.
• The denominator includes the weighted average number of shares of both preferred and common shares outstanding.
• Preferred stock dividends are subtracted from the earnings for the period in the calculation of earnings per share.

Answer 5

Preferred stock dividends are subtracted from the earnings for the period in the calculation of earnings per share.

**Earnings per share (EPS) is calculated on net income available to the common stockholders, divided by weighted average shares of common stock outstanding. The preferred dividends must be subtracted from the net income, as that amount is not available to the common stockholders.

Question 6

Grum Corp., a publicly owned corporation, is subject to the requirements for segment reporting.

In its income statement for the year ending December 31, 2004, Grum reported revenues of $50,000,000, operating expenses of $47,000,000, and net income of $3,000,000. Operating expenses include payroll costs of $15,000,000. Grum’s combined identifiable assets of all industry segments at December 31, 2004 were $40,000,000.

In its 2004 financial statements, Grum should disclose major customer data if sales to any single customer amount to at least

$300,000.
$1,500,000.
$4,000,000.
$5,000,000.

Answer 6

$5,000,000.

**Under FAS 131 (1997), if revenues from transactions with a single customer amount to 10% or more of a firm’s total revenue, that fact must be disclosed, along with the total revenues from each such customer.

For this firm with revenues of $50,000,000, 10% of total revenues is $5,000,000.

Question 7

Kell Corp. reported $111,000 of net income for the quarter ended September 30, 20X5. Additional information for the quarter:

A $60,000 gain from discontinued operation, realized on April 30, 20X5, was allocated equally to the second, third, and fourth quarters of 20X5.
A $16,000 cumulative-effect adjustment (dr.) resulting from a change in inventory valuation method was recognized on August 2, 20X5. The new method was used for the quarter ended September 30. The $111,000 earnings amount does not reflect the cumulative effect.
In addition, Kell paid $48,000 on February 1, 20X5, for 20X5 calendar-year property taxes. Of this amount, $12,000 was allocated to the third quarter of 20X5.

For the quarter ended September 30, 20X5, Kell should report net income of:

$91,000
$75,000
$111,000
$95,000

Answer 7

$91,000

**The gain from discontinued operations should be recognized entirely in the second quarter. There is no meaningful basis on which to allocate the gain. It is a one-time occurrence. The cumulative effect is not recognized in income. The firm’s treatment of the property tax cost is correct. The cost relates to the entire year. Therefore, each quarter should bear 1/4 of the cost.

Third quarter net income = $91,000 = $111,000 − $60,000/3.

Question 8

Which one of the following is not an other comprehensive basis of accounting?

• Pure cash basis.
• Modified cash basis.
• Pure accrual basis.
• Income tax basis.

Answer 8

Pure accrual basis.

**Pure accrual basis accounting is not an other comprehensive basis of accounting. The concept of “other comprehensive basis” means a comprehensive basis of accounting other than pure (or full) accrual accounting.

Question 9

If a company that is not a public business entity wants to apply the simplified hedge accounting approach to a cash flow hedge of a variable rate borrowing with a receive-variable, pay-fixed interest rate swap, which of the following is a condition that must be met?

• The notional value of the swap is greater than the principal of the hedged borrowing.
• The fair value of the interest rate swap executed has a value equivalent to the hedged borrowing.
• The variable interest rate on the interest rate swap is capped at 250 basis points above the cap on the hedged borrowing.
• The variable interest rate on the interest rate swap and the variable interest rate on the hedged borrowing are linked to the same index.

Answer 9

The variable interest rate on the interest rate swap and the variable interest rate on the hedged borrowing are linked to the same index.

**To qualify for simplified hedge accounting, one of the criteria is that both the swap and the hedged borrowing are linked to the same index.

Question 10

Penn, Inc., a manufacturing company, owns 75% of the common stock of Sell, Inc., an investment company. Sell owns 60% of the common stock of Vane, Inc., an insurance company.

In Penn’s consolidated financial statements, should consolidation accounting or equity method accounting be used for Sell and Vane?

• Consolidation used for Sell and equity method used for Vane.
• Consolidation used for both Sell and Vane.
• Equity method used for Sell and consolidation used for Vane.
• Equity method used for both Sell and Vane.

Answer 10

Consolidation used for both Sell and Vane.

**If one looked just at Penn’s interest in Vane’s result of 45% (75% × 60%), one might say that the equity method would be appropriate.

However, because Sell owns 60% of Vane, it controls Vane and would need to consolidate Vane. Because Penn owns 75% of Sell, it controls Vane and would need to consolidate Sell, which consolidated Vane

Question 11

An investor will report an investment in its financial statements using a different method than it uses to carry the investment on its books if its minimum ownership of the investee is:
10+%.
20+%.
50+%.
100%.

Answer 11

50+%.

**If an investor owns 50+% (up to and including 100%) of an investee, it will normally carry the investment on its books using the cost method, the equity method, or some other method, but it will report the investment in its financial statements as a consolidated subsidiary. The method used on the investor’s books will be different than the method used to report the investment in financial statements.

Question 12

Which of the following information that exists at the date of an acquisition will be needed to carry out the consolidating process?

I. Book values of a subsidiary’s assets and liabilities.
II. Fair values of a subsidiary’s assets and liabilities.
III. Parent’s cost of its investment in the subsidiary.

Answer 12

I, II, and III.

**In order to prepare consolidated financial statements, the parent needs the book values and fair values of a subsidiary’s assets and liabilities at the date of the business combination as well as the cost of its investment in the subsidiary.

Question 13

On November 30, 2004, Parlor, Inc. purchased for cash at $15 per share all 250,000 shares of the outstanding common stock of Shaw Co.

On November 30, 2004, Shaw’s balance sheet showed a carrying amount of net assets of $3,000,000. On that date, the fair value of Shaw’s property, plant, and equipment exceeded its carrying amount by $400,000.

In its November 30, 2004, consolidated balance sheet, what amount should Parlor report as goodwill?

$750,000
$400,000
$350,000
$0

Answer 13

$350,000

**Goodwill is the difference between the purchase price of $3,750,000 (250,000 × $15.00) and the fair value of the net assets ($3,000,000 + $400,000) or $350,000.

Question 14

Beni Corp. purchased 100% of Carr Corp.’s outstanding capital stock for $430,000 cash. Immediately before the purchase, the balance sheets of both corporations reported the following:

Beni Carr
Assets $2,000,000 $750,000
Liabilities $750,000 $400,000
Common stock 1,000,000 310,000
Retained earnings __250,000 __40,000
Liabilities and stockholders’ equity $2,000,000 $750,000
On the date of purchase, the fair value of Carr’s assets was $50,000 more than the aggregate carrying amounts. In the consolidated balance sheet prepared immediately after the purchase, the consolidated stockholders’ equity should amount to:

$1,680,000
$1,650,000
$1,600,000
$1,250,000

Answer 14

$1,250,000.

**On the date of a business combination using acquisition accounting, the consolidated stockholders’ equity will exactly equal the parent company stockholders’ equity. This will continue to be the case as long as the parent company uses a complete equity method of accounting for the subsidiary.

Question 15

King, Inc. owns 70% of Simmon Co.'s outstanding common stock. King's liabilities total $450,000, and Simmon's liabilities total $200,000. Included in Simmon's financial statements is a $100,000 note payable to King. What amount of total liabilities should be reported in the consolidated financial statements?
$520,000
$550,000
$590,000
$650,000

Answer 15

$550,000

**The consolidated financial statements should reflect 100% of the assets and liabilities of the subsidiary less any intercompany balances. Therefore the balance on the consolidated balance sheet should be: $450,000 + 200,000 − 100,000 = $550,000.

Question 16

Which one of the following is not a characteristic of intercompany bonds?

• Intercompany bonds may occur on the date of a business combination or subsequent to a business combination.
• When bonds become intercompany, it is as though the bonds have been retired for consolidated purposes.
• Intercompany bonds can result in the recognition of a gain or a loss for consolidating purposes.
• When bonds become intercompany, they are written off of the books of the issuing affiliate and the investing affiliate.

Answer 16

When bonds become intercompany, they are written off of the books of the issuing affiliate and the investing affiliate.

**The liability and investment related to intercompany bonds are eliminated only on the consolidating worksheet. They are not written off the books of either the issuing or the investing affiliate. From the perspective of the separate companies, the liability and investment related to the bonds continue to exist, but for consolidated purposes, they have been constructively retired.

Question 17

On December 31, 2008, Pico acquired $250,000 par value of the outstanding $1,000,000 bonds of its subsidiary, Sico, in the market for $200,000. On that date, Sico had a $100,000 premium on its total bond liability.

Which one of the following is the net carrying value of Sico’s total bond liability?

$900,000
$1,000,000
$1,050,000
$1,100,000

Answer 17

$1,100,000

**A premium on a bond liability results from the sale of the bonds at a price in excess of par (face) value. Therefore, a premium would be added to par value to get net carrying value. Sico’s premium on its bond liability ($100,000) should be added to the par (or face) value of its bond liability ($1,000,000) to determine the net carrying value of the liability. Thus, the answer should be $1,000,000 par value + $100,000 premium = $1,100,000 net carrying value.

Question 18

On December 31, 2008, Pico acquired $250,000 par value of the outstanding $1,000,000 bonds of its subsidiary, Sico, in the market for $200,000. On that date, Sico had a $100,000 premium on its total bond liability.

Which one of the following is the net amount of gain or loss that will be recognized by Pico in its December 31, 2008, consolidated financial statements as a result of its intercompany bonds?

$25,000
$50,000
$75,000
$150,000

Answer 18

$75,000

**In the elimination of intercompany bonds, the intercompany bond liability at par will be eliminated against the intercompany bond investment at par. Therefore, the gain or loss recognized as a result of constructive retirement of intercompany bonds is the net of the premium or discount on the bond liability and the premium or discount on the bond investment. In this case, there is a total $100,000 premium on the bond liability, but because only one-fourth ($250,000/$1,000,000 = 1/4) of the bonds are intercompany, only one fourth of the premium is eliminated. Thus, $25,000 of premium on the bond liability (a credit) will be eliminated against the $50,000 discount on the bond investment (also a credit). As a result of eliminating the two credits ($25,000 + $50,000 = $75,000), a $75,000 gain on constructive retirement will be recognized.

Question 19

On December 31, 2008, Pico acquired $250,000 par value of the outstanding $1,000,000 bonds of its subsidiary, Sico, in the market for $200,000. At that date, Sico had a $100,000 premium on its total bond liability.

Assume each company maintains its premium or discount in a separate account. Which one of the following will be the intercompany bond elimination entry made on the December 31, 2008 consolidating worksheet?

-DR:	Bonds Payable
Discount on Bond Investment
Loss on Constructive Retirement
CR: Investment in Bonds
    Premium on Bonds Payable

-DR:	Bonds Payable
Premium on Bonds Payable
CR: Investment in Bonds
    Discount on Bond Investment
    Gain on Constructive Retirement

-DR:	Bonds Payable
Premium on Bonds Payable
Discount on Bond Investment
CR: Investment in Bonds
    Gain on Constructive Retirement

-DR:	Investment in Bonds
Gain on Constructive Retirement
CR: Bonds Payable
    Premium on Bonds Payable
    Discount on Bond Investment

Answer 19

DR:	Bonds Payable
Premium on Bonds Payable
Discount on Bond Investment
CR: Investment in Bonds
    Gain on Constructive Retirement

**The Investment in Bonds (a debit balance, so it will be credited) and the Bonds Payable (a credit balance, so it will be debited) will be eliminated against each other at par value ($250,000). The Discount on Bond Investment $50,000 (a credit balance, so it will be debited) and the Premium on Bonds Payable $25,000 (a credit balance, so it will be debited) will be eliminated resulting in a Gain on Constructive Retirement of $75,000, a credit balance.

Question 20

In the preparation of combined financial statements, would the following issues be treated in the same way as when preparing consolidated financial statements or in a different way?
Minority Interest
Foreign Operations
Different Fiscal Periods

Answer 20

Minority Interest-SAME
Foreign Operations-SAME
Different Fiscal Periods-SAME

**According to ASC 810, if problems associated with minority interest, foreign operations, different fiscal periods, or income taxes occur in the preparation of combined financial statements, they should be treated in the same manner as in the preparation of consolidated financial statements. Therefore, all three items should be treated in the same manner as in consolidated statements.