Chapter 3 Flashcards
Income Statement Items
The best evidence of a standalone selling price of a promised good or service to a customer is
A. Expected cost plus an appropriate margin.
B. Expected cost.
C. An observable price.
D. Competitor’s selling price.
The standalone selling price is the price at which an entity would sell a promised good or service separately to a customer. The best evidence of a standalone selling price is the observable price of a good or service when it is sold separately in similar circumstances and to similar customers (e.g., a contractually stated price or list price of a good or service).
During all of the year just ended, Littlefield, Inc., had outstanding 100,000 shares of common stock and 5,000 shares of noncumulative, $7 preferred stock. Each share of the latter is convertible into three shares of common. For the year, Littlefield had $230,000 income from continuing operations and a $575,000 loss on discontinued operations; no dividends were paid or declared. Littlefield should report diluted earnings (loss) per share (DEPS) for income from continuing operations and for net income (loss), respectively, of A. $2.19 and $(3.29). B. $2.26 and $(3.39). C. $2.30 and $(3.45). D. $2.00 and $(3.00).
The noncumulative convertible preferred stock is dilutive because its assumed conversion will have no effect on the DEPS numerator and will increase the denominator by 15,000 (5,000 × 3) shares. DEPS for income from continuing operations is $2.00 ($230,000 ÷ 115,000 shares). Net loss equals the $230,000 income from continuing operations minus the $575,000 loss on discontinued operations, or $345,000. This amount divided by the 115,000 shares results in a diluted net loss per share of $3.00.
NOTE: When a discontinued operation is reported, the control number to establish whether potential common stock are dilutive or antidilutive is BEPS from continuing operations.
Question: 4 A change in warranty obligations because new information has been obtained is
A. An accounting change that should be reported in the period of change and future periods if the change affects both.
B. A correction of an error.
C. An accounting change that should be reported by restating the financial statements of all prior periods presented.
D. Not an accounting change.
Answer (A) is correct.
A change in estimate necessarily results from an assessment, in conjunction with the preparation of financial statements, of the current status and expected future benefits and obligations of assets and liabilities. Thus, accounting estimates change as new information is obtained. A change in accounting estimate is accounted for on a prospective basis. For example, a change in warranty obligations because of new information is an accounting change that should be reported in the period of change, as well as in future periods if the change affects them.
The per-share amount must be reported on the face of a public company’s income statement for which of the following items?
A. Income from continuing operations.
B. Compensation effect of fair value on stock options.
C. Preferred stock dividend.
D. U.S. Treasury stock.
Answer (A) is correct.
Earnings per share (EPS) is the amount of current-period earnings that can be associated with a single share of a corporation’s common stock. All corporations must report per-share amounts for income from continuing operations and net income on the face of the income statement. If an entity has no discontinued operations, income from continuing operations equals net income. Thus, one or two amounts of EPS (basic EPS) for net income available to common shareholders must be presented on the face of the income statement if the entity has only common stock outstanding. All other entities must present basic EPS and dilutive EPS for income from continuing operations and net income. The entity also must report a per-share amount or amounts for a discontinued operation on the face of the income statement or in the notes.
The following information pertains to Ceil Co., a company whose common stock trades in a public market: Shares outstanding at 1/1 100,000 Stock dividend at 3/31 24,000 Stock issuance at 6/30 5,000 What is the weighted-average number of shares Ceil should use to calculate its basic earnings per share (BEPS) for the year ended December 31? A. 126,500 B. 123,000 C. 120,500 D. 129,000
Answer (A) is correct. BEPS measures earnings performance based on common stock outstanding during all or part of the period. BEPS equals income available to common shareholders divided by the weighted-average number of shares of common stock outstanding. The weighted-average number of common shares outstanding is determined by relating the portion of the reporting period that the shares were outstanding to the total time in the period. Weighting is necessary because some shares may have been issued or reacquired during the period. The stock dividend is assumed to have occurred at the beginning of the period. The BEPS denominator is 126,500, based on 124,000 shares outstanding for the entire year (100,000 beginning balance + 24,000 stock dividend) and 5,000 additional shares issued on June 30. 124,000 × (6 ÷ 12) = 62,000 129,000 × (6 ÷ 12) = 64,500 126,50
Data pertaining to Pell Co.’s construction jobs, which commenced during Year 1, are as follows: Project 1 Project 2 Contract price $420,000 $300,000 Costs incurred during Year 1 240,000 280,000 Estimated costs to complete 120,000 40,000 Billed to customers during Year 1
150,000
270,000
Received from customers during Year 1
90,000 250,000 If Pell used the input method based on costs incurred to measure its progress toward completion of the contract, what amount of gross profit/loss would Pell report in its Year 1 income statement? A. $22,500 B. $20,000 C. $(20,000) D. $40,000
Answer (B) is correct.
At the end of Year 1, Project 1 is 66 2/3% complete [$240,000 ÷ ($240,000 + $120,000)] and Project 2 is 87 1/2% complete [$280,000 ÷ ($280,000 + $40,000)]. Each project’s percentage of completion is multiplied by its expected total gross profit. Accordingly, Pell recognizes $40,000 [($420,000 contract price – $240,000 costs incurred – $120,000 additional estimated costs) × 66 2/3%] of gross profit for Project 1. However, Project 2 estimates indicate a loss of $20,000 ($300,000 – $280,000 – $40,000). Because the full amount of a loss is reported immediately irrespective of the accounting method used, a gross profit of $20,000 [$40,000 Project 1 + $(20,000) Project 2] is recognized.
On January 2, Year 4, Raft Corp. discovered that it had incorrectly expensed a $210,000 machine purchased on January 2, Year 1. Raft estimated the machine’s original useful life to be 10 years and its salvage value at $10,000. Raft uses the straight-line method of depreciation and is subject to a 30% tax rate. In its December 31, Year 4, financial statements, what amount should Raft report as a prior period adjustment? A. $105,000 B. $102,900 C. $168,000 D. $165,900
Answer (A) is correct.
Expensing the machine in Year 1 resulted in an after-tax understatement of net income equal to $147,000 [$210,000 × (1.0 – .30 tax rate)]. Not recognizing annual depreciation of $20,000 [($210,000 – $10,000 salvage value) ÷ 10 years] in Years 1-3 resulted in an after-tax overstatement of net income equal to $42,000 [($20,000 × 3 years) × (1.0 – .30 tax rate)]. Thus, the prior period adjustment is for a net understatement of $105,000 ($147,000 – $42,000).
An entity enters into a contract with a customer to sell products X, Y, and Z in exchange for $250,000. Control over the products will be transferred to the customer at different points in time. The entity determines that the delivery of each product is a distinct performance obligation. Products X and Y are regularly sold separately and their standalone selling prices of $40,000 and $120,000, respectively, are directly observable. The standalone selling price of product Z of $160,000 was estimated using the adjusted market assessment approach. The entity determined that the discount provided to the customer does not relate to one or more specific products in the contract. What revenue will be recognized by the entity on the sale of product X? A. $62,500 B. $31,250 C. $22,500 D. $40,00
Answer (B) is correct.
The transaction price should be allocated to performance obligations in the contract based on their standalone selling prices. The sum of the products’ standalone selling prices is $320,000 ($40,000 + $120,000 + $160,000), and the standalone selling price of product X is $40,000. Thus, $31,250 [($40,000 ÷ $320,000) × $250,000] of the total contract price should be allocated to product X.
During the current year, Moore Corp. had the following two classes of stock issued and outstanding for the entire year:
100,000 shares of common stock, $1 par.
1,000 shares of 4% preferred stock, $100 par, convertible share for share into common stock. This stock is cumulative, whether or not earned, and no preferred dividends are in arrears.
Moore’s current-year net income was $900,000, and its income tax rate for the year was 30%. Diluted earnings per share (DEPS) for the current year are
A. $8.91
B. $8.96
C. $9.00
D. $8.87
DEPS is equal to the amount of earnings available to common shareholders and to holders of dilutive potential common stock, divided by the weighted-average number of shares of common stock and additional common shares that would have been outstanding if dilutive potential common shares had been issued. Dilution is tested by calculating EPS and the incremental effect of the potential common shares on EPS. BEPS equals income available to common shareholders (net income – cumulative preferred dividend) divided by the weighted average of common shares outstanding. Thus, BEPS is $8.96 {[$900,000 NI – (1,000 preferred shares × $100 par × 4%)] ÷ 100,000 common shares}. The incremental effect of the potential common shares equals the preferred dividends added back to the numerator if conversion is assumed divided by the potential common shares, or $4.00 ($4,000 ÷ 1,000). Because $4.00 is less than $8.96, the potential common shares are dilutive. Accordingly, the convertible preferred stock is assumed to be converted at the beginning of the year, and no dividends are deemed to have been paid. The DEPS calculation therefore adds the $4,000 preferred dividend to the BEPS numerator and the 1,000 common shares into which the preferred stock can be converted to the BEPS denominator. DEPS is $8.91 [($896,000 + $4,000) ÷ (100,000 + 1,000)].
B. $8.96
On January 1, Year 1, Big Co. enters into a contract with a customer to build a bridge on the customer’s land for $2,500,000. The construction of the bridge is expected to be completed at the end of Year 3. Big determines that the progress toward completion of the bridge is reasonably measurable using the input method based on costs incurred. At contract inception, Big estimates that the expected total cost of construction will be $1,700,000. Below are the (1) actual costs incurred during each year, (2) expected costs to complete the construction, and (3) amounts billed to the customer:
Year 1
Year 2
Year 3
Costs incurred each year
$ 700,000
$500,000
$800,000
Costs expected in the following years
1,300,000
675,000
0
Amounts billed to (and paid by) the customer each year
700,000
950,000
850,000
What amount of revenue on this contract is recognized by Big in its Year 3 income statement?
A. $900,000
B. $2,500,000
C. $850,000
D. $833,333Answer (A) is correct.
In this contract, revenue is recognized over time based on progress toward completion. The progress toward completion is measured using the input method based on costs incurred. The construction was completed in Year 3. Accordingly, by the end of Year 3, the entire $2,500,000 of revenues should be recognized. At the end of Year 2, 64% [($700,000 + $500,000) ÷ ($700,000 + $500,000 + $675,000)] of the estimated construction costs had been incurred. Thus, revenue of $900,000 [$2,500,000 × (100% – 64%)] is recognized in Year 3.
Under ASC 606, adjustment of the transaction price to reflect the time value of money results in
A. An item of other comprehensive income.
B. Revenue from contracts with customers in the income statement.
C. An unusual item in the income statement.
D. Interest income or expense that is presented in the income statement separately from revenue.
The transaction price should be adjusted for the effect of the time value of money when the contract includes a significant financing component. The interest income or expense is recognized using the effective interest method. Interest income or expense must be presented in the income statement separately from revenue from contracts with customers.
With respect to the computation of earnings per share, which of the following would be most indicative of a simple capital structure?
A simple capital structure has only common stock outstanding. A complex capital structure contains potential common stock. Potential common stock includes options, warrants, convertible securities, contingent stock requirements, and any other security or contract that may entitle the holder to obtain common stock.
According to ASC 606, the incremental costs of obtaining a contract with a customer that are expected to be recovered must be
A. Reported as an item of other comprehensive income.
B. Recognized directly in the income statement.
C. Recognized as an item of equity.
D. Recognized as an asset and amortized in subsequent periods.
Answer (D) is correct.
The incremental costs of obtaining a contract with a customer must be capitalized (recognized as an asset) if the entity expects to recover them. These costs would not have been incurred if the contract had not been obtained. The cost capitalized (asset recognized) must be amortized on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates.
Pubco is a public company that uses a calendar year and has a complex capital structure. Pubco reported in the first quarter income from continuing operations (net of tax) of $1 million and a loss on discontinued operations (net of tax) of $1.2 million.
The average market price of Pubco’s common stock for the first quarter was $25, the shares outstanding at the beginning of the period equaled 300,000, and 12,000 shares were issued on March 1.
At the beginning of the quarter, Pubco also had outstanding 120,000 shares of preferred stock paying a dividend of $.10 per share at the end of each quarter and convertible to common stock on a one-to-one basis. Holders of 60,000 shares of preferred stock exercised their conversion privilege on February 1.
The BEPS amount for Pubco’s net income or loss available to common shareholders for the first quarter is A. $(0.58) B. $2.89 C. $(3.49) D. $(0.60)
Answer (D) is correct.
The weighted-average number of shares used in the BEPS denominator is 344,000 {300,000 + [12,000 × (1 ÷ 3)] + [60,000 × (2 ÷ 3)]}. The numerator equals net income or loss minus preferred dividends. Thus, it equals $(206,000) [$1,000,000 income from continuing operations – $1,200,000 loss on discontinued operations – (60,000 × $0.1) preferred dividends]. The BEPS amount for the net income or loss available to common shareholders is $(0.60) [$(206,000) ÷ 344,000 shares].
Birch Corporation had net income for the year of $101,504 and a simple capital structure consisting of the following common shares outstanding: Months Outstanding Number of Shares January - February 24,000 March - June 29,400 July - November 36,000 December 35,040 Total 124,440
Question: 23 Also assume that Birch Corporation issued a 20% stock dividend on August 1. This distribution is not reflected in the data given in the statement of facts. Accordingly, BEPS (rounded to the nearest cent) equals A. $2.67 B. $2.88 C. $2.72 D. $2.41
Answer (A) is correct. The amounts of common shares outstanding given in the statement of facts do not include the 20% stock dividend on August 1. But stock dividends are assumed to have occurred at the beginning of the year. Thus, the weighted-average number of shares is calculated by adjusting the amounts given for (1) the time held and (2) the 20% stock dividend. BEPS equals income available to common shareholders divided by the weighted-average number of shares outstanding. The latter is calculated as follows: 24,000 × (2 ÷ 12) = 4,000 × 1.2 = 4,800 29,400 × (4 ÷ 12) = 9,800 × 1.2 = 11,760 36,000 × (5 ÷ 12) = 15,000 × 1.2 = 18,000 35,040 × (1 ÷ 12) = 2,920 × 1.2 = 3,504 31,720 38,064 The BEPS amount is therefore $2.67 ($101,504 ÷ 38,064).
A company began work on a long-term construction contract in Year 1. The contract price was $3,000,000. Year-end information related to the contract is as follows: Year 1 Year 2 Year 3 Estimated total cost $2,000,000 $2,000,000 $2,000,000 Cost incurred 700,000 900,000 400,000 Billings 800,000 1,200,000 1,000,000 Collections 600,000 1,200,000 1,200,000 Under the input method based on costs incurred, the gross profit to be recognized in Year 1 is A. $350,000 B. $(100,000) C. $200,000 D. $100,000
Answer (A) is correct.
The input method based on costs incurred recognizes revenue based on the stage of completion of the contract. The progress toward completion of the project is the calculation of ratio of the contract costs incurred to date to the estimated total costs. The percentage-of-completion at year-end on the cost-to-cost basis is 35% ($700,000 ÷ $2,000,000). The gross profit for Year 1 is the anticipated gross profit on the contract times the completion percentage. Thus, profit for Year 1 is $350,000 [($3,000,000 – $2,000,000) × 35%].
he following is used in calculating the gross profit recognized in the fourth and final year of a contract accounted for under the input method based on costs incurred to measure progress toward completion of the contract?
Actual Gross Profit :Yes
Total Costs Previously Recognized:Yes
The cost-to-cost method recognizes revenues, costs, and gross profit depending on the progress made on the contract. Gross profit recognized in the last year of the contract equals the contract price, minus actual total costs, minus gross profit previously recognized.
Loire Co. has used the FIFO method since it began operations in Year 3. Loire changed to the weighted-average method for inventory measurement at the beginning of Year 6. This change was justified. In its Year 6 financial statements, Loire included comparative statements for Year 5 and Year 4. The following shows year-end inventory balances under the FIFO and weighted-average methods: Year FIFO Weighted-Average 3 $ 90,000 $108,000 4 156,000 142,000 5 166,000 150,000 What adjustment, before taxes, should Loire make retrospectively to the balance reported for retained earnings at the beginning of Year 4? A. $4,000 increase. B. $18,000 decrease. C. $18,000 increase. D. $0
Answer (C) is correct.
Retrospective application requires that the carrying amounts of assets, liabilities, and retained earnings at the beginning of the first period reported be adjusted for the cumulative effect of the new principle on periods prior to the first period reported. The pretax cumulative-effect adjustment to retained earnings at the beginning of Year 4 equals the $18,000 increase ($108,000 – $90,000) in inventory. If the weighted-average method had been applied in Year 3, cost of goods sold would have been $18,000 lower. Pretax net income and ending retained earnings for Year 3 (beginning retained earnings for Year 4) would have been $18,000 greater.
A construction company recognizes revenue from construction contracts over time using the input method based on costs incurred. It reports the following:
Year 1 Year 2 Construction costs $100 $200 Estimated cost to complete at year-end 300 0 The contract price is $1,000. What is the profit recognized in Year 2? A. $550 B. $400 C. $800 D. $150
Answer (A) is correct.
At the end of Year 1, total cost was expected to be $400 ($100 incurred + $300 estimated cost to complete), and estimated total profit was $600 ($1,000 price – $400 estimated total cost). Thus, the amount of profit recognized in Year 1 was $150 [$600 × ($100 cost incurred ÷ $400 estimated total cost)]. The project was completed in Year 2 at an additional cost of $200. Actual profit was therefore $700 ($1,000 – $300 actual total cost). Profit recognized in Year 2 is $550 ($700 total – $150 recognized in Year 1).
Under ASC 606, a contract modification is accounted for as a separate contract if the additional promised goods are and the price for these additional goods is .
A contract modification exists when the parties approve a change in the scope or price of a contract. A contract modification is accounted for as a separate contract if (1) it results in the addition to the contract of promised goods or services that are distinct and (2) the price for these additional goods or services is their standalone selling price.
A software developer enters into a contract with a new customer to sell a software license and perform installation services. The entity sometimes sells the license and installation services separately. The installation service is routinely performed by other entities and does not significantly modify the software. The entity historically provided to new customers technical support for a 5-year period for no additional consideration. The contract does not specify the terms or conditions for the technical support services. Under ASC 606, which of the following represents the performance obligations identified by the entity in this contract?
A. Three performance obligations: (1) Software license, (2) installation services, and (3) technical support services.
B. Two performance obligations: (1) Software license plus installation services and (2) technical support services.
C. Two performance obligations: (1) Software license and (2) installation services.
D. One performance obligation: (1) Software license plus installation services.
Answer (A) is correct.
The transfer of the software license and the performance of installation services are separately identifiable from other promises in the contract. The installation services do not significantly modify or customize the software itself. In addition, on the basis of the entity’s customary business practice, at contract inception, it made an implicit promise to provide technical support services. The entity’s past practice of providing these services creates a valid expectation that the customer will receive these services. Consequently, the entity identifies the following performance obligations in the contract: (1) software license, (2) installation services, and (3) technical support services.
A firm has basic earnings per share of $1.29. If the tax rate is 30%, which of the following securities would be dilutive?
A. Six percent, $100 par cumulative convertible preferred stock, issued at par, with each preferred share convertible into four shares of common stock.
B. Ten percent convertible bonds, issued at par, with each $1,000 bond convertible into 20 shares of common stock.
C. Seven percent convertible bonds, issued at par, with each $1,000 bond convertible into 40 shares of common stock.
Cumulative 8%, $50 par preferred stock.
Answer (C) is correct.
The calculation of dilutive EPS (DEPS) gives effect to dilutive potential common shares (e.g., options and convertible securities). Dilution is a reduction in basic EPS (BEPS) resulting from the assumption that (1) convertible securities were converted, (2) options or warrants were exercised, or (3) contingently issuable shares were issued. The conversion of the bonds would eliminate after-tax interest expense per bond of $49 [($1,000 par × 7%) × (1.0 – 30% tax rate)]. (The bonds were issued at par, so amortization of premium or discount does not affect the calculation.) The per-share effect is $1.225 ($49 ÷ 40 shares per bond). Thus, the convertible debt is dilutive ($1.225 < $1.29 BEPS).
On January 1, Year 4, Dart, Inc., entered into an agreement to sell the assets and product line of its Jay Division, which met the criteria for classification as an operating segment. The sale was consummated on December 31, Year 4, and resulted in a gain on disposal of $400,000. The division’s operations resulted in losses before income tax of $225,000 in Year 4 and $125,000 in Year 3. For both years, Dart’s income tax rate is 30%, and the criteria for reporting a discontinued operation have been met. In a comparative statement of income for Year 4 and Year 3, under the caption discontinued operations, Dart should report a gain (loss) of
Year 4
Year 3
A. $122,500 $0 B. $(157,500) $0 C. $(157,500) $(87,500) D. $122,500 $(87,500)
Answer (D) is correct.
When a component (e.g., an operating segment) has been disposed of or is classified as held for sale, and the criteria for reporting a discontinued operation have been met, the income statements for current and prior periods (in this case, Year 3 and Year 4) must report its operating results in discontinued operations. The gain from operations of the component for Year 4 is the net of the $225,000 operating loss for Year 4 and the $400,000 gain on disposal. The pretax gain is therefore $175,000 ($400,000 – $225,000), and the after-tax amount is $122,500 [$175,000 × (1.0 – .30)]. The $125,000 pretax loss for Year 3 should be reported in the comparative statements for Years 3 and 4 as an $87,500 [$125,000 × (1.0 – .30)] loss from discontinued operations.
Question: 22 When computing diluted earnings per share (DEPS), convertible securities that are potential common stock are
A. Ignored.
B. Recognized only if they are antidilutive.
C. Recognized only if they are dilutive.
D. Recognized whether they are dilutive or antidilutive.
Answer (C) is correct.
The objective of DEPS is to measure the performance of an entity during an accounting period while giving effect to all dilutive potential common shares that were outstanding during the period. Convertible securities are potential common stock.
Althouse Co. discovered that equipment purchased on January 2 for $150,000 was incorrectly expensed at the time. The equipment should have been depreciated over 5 years with no salvage value. What amount, if any, should be adjusted to Althouse’s depreciation expense at January 2, the beginning of the third year, when the error was discovered? A. $60,000 B. $30,000 C. $150,000 D. $0
Answer (D) is correct.
Any error related to a prior period discovered after the statements are, or are available to be, used must be reported as an error correction by restating the prior-period statements. The carrying amounts of (1) assets, (2) liabilities, and (3) retained earnings at the beginning of the first period reported are adjusted for the cumulative effect of the error on the prior periods. Corrections of prior-period errors must not be included in net income. Thus, no adjustment to depreciation expense should be made for the prior-period errors. The adjustment would be reflected through a restatement of the prior-period statements and/or an adjusting entry to beginning retained earnings.
A company decided to sell an unprofitable major line of its business. The company can sell the entire operation for $800,000, and the buyer will assume all assets and liabilities of the operations. The tax rate is 30%. The assets and liabilities of the discontinued operation are as follows: Buildings $5,000,000 Accumulated depreciation 3,000,000 Mortgage on buildings 1,100,000 Inventory 500,000 Accounts payable 600,000 Accounts receivable 200,000 What is the after-tax net loss on the disposal of the division? A. $1,540,000 B. $2,200,000 C. $140,000 D. $200,000
Answer (C) is correct.
None of the items is measured at fair value under U.S. GAAP, assuming that the fair value option was not elected for the mortgage. Thus, the after-tax loss is calculated as follows based on the carrying amounts given:
Sale price
$800,000
Buildings, net ($5,000,000 – $3,000,000 acc. dep.)
$2,000,000 Inventory 500,000 Accounts receivable 200,000 Mortgage (1,100,000) Accounts payable (600,000) Net carrying amount 1,000,000 Pre-tax loss $(200,000) Tax benefit ($200,000 × 30%) 60,000 After-tax loss $(140,000)
Based on the stock transactions below, what is the weighted average number of shares outstanding as of December 31, Year 1, that should be used in the calculation of basic earnings per share in financial statements issued on March 1, Year 2? Date Transactions January 1, Year 1 Beginning balance 100,000 April 1, Year 1 Issued 30,000 shares for cash June 1, Year 1 50% stock dividend February 15, Year 2 2 for 1 stock split March 15, Year 2 Issued 40,000 shares for cash A. 295,000 B. 367,500 C. 183,750 D. 147,500
Answer (B) is correct. The weighted-average number of common shares outstanding is determined by relating the portion of the period that the shares were outstanding to the total time in the period. Weighting is necessary because some shares may have been issued or reacquired during the period. Stock dividends and stock splits require an adjustment to the weighted-average of common shares outstanding. EPS amounts for all periods presented are adjusted retroactively to reflect the change in capital structure as if it had occurred at the beginning of the first period presented. The following is the calculation: Date Transaction Common Shares Outstanding Restate for Stock Dividend Restate for Stock Split Portion of Year Equals: Weighted Average January 1 Beginning balance 100,000 1.5 2 3/12 75,000 April 1 Issue 30,000 shares 130,000 1.5 2 9/12 292,500
Total
367,500
On June 30, Year 2, Lomond, Inc., issued 20, $10,000, 7% bonds at par. Each bond was convertible into 200 shares of common stock. On January 1, Year 3, 10,000 shares of common stock were outstanding. The bondholders converted all the bonds on July 1, Year 3. The following amounts were reported in Lomond’s income statement for the year ended December 31, Year 3: Revenues $977,000 Operating expenses (920,000) Interest on bonds (7,000) Income before income tax 50,000 Income tax at 30% (15,000) Net income $ 35,000 What amount should Lomond report as its Year 3 diluted earnings per share (DEPS)? A. $2.85 B. $3.50 C. $2.50 D. $3.00
DEPS should be calculated even though no potential common shares were outstanding at year end. The reason is that the purpose of DEPS is to measure the performance of the entity over the reporting period while giving effect to all potential common shares that were outstanding during the period. The bonds were converted into 4,000 (20 bonds × 200 shares) shares of common stock on July 1, Year 3. Thus, the weighted-average number of shares of common stock outstanding is 12,000 shares [(10,000 × 12 ÷ 12) + (4,000 × 6 ÷ 12)]. BEPS therefore equals $2.92 ($35,000 net income ÷ 12,000). To determine if the potential common shares are dilutive, their incremental effect on EPS is calculated. This effect is equal to the after-tax interest that would be added back to net income divided by the potential common shares that would be added to the denominator. After-tax interest equals $4,900 [20 shares × $10,000 par value × 7% × (1 – 30% tax rate) × (6 months ÷ 12 months)], and the dilutive potential common shares equal 2,000 [20 bonds × 200 shares × (6 months ÷ 12 months)]. The computation is based on a half-year period because the convertible bonds were outstanding for only 6 months. The incremental effect on EPS of the assumed conversion at the beginning of the year is $2.45 ($4,900 ÷ 2,000 shares). This amount is less than BEPS, so the convertible bonds are dilutive. Thus, DEPS equals $2.85 [($35,000 + $4,900) ÷ (12,000 + 2,000)].
The Treasurer of Barker Corporation is considering the impact of the company’s convertible debt on its earnings per share. The firm has $10,000,000 of convertible debt outstanding, with a 10% coupon. It is convertible into Barker’s common stock at $200 per share. If this convertible debt remains outstanding, the income statement next year is forecast to appear as follows: Operating income $11,000,000 Interest expense (1,000,000) Pretax income $10,000,000 Tax expense (4,000,000) Net income $ 6,000,000 Shares outstanding 1,000,000 Basic earnings per share $6.00 Barker has a 40% tax rate. Assuming conversion of the debt occurs at the beginning of the year, the forecast effect on Barker’s basic earnings per share for the next year will be A. Not determinable. B. No impact. C. Antidilutive.
Answer (C) is correct. Barker’s operating income will increase by $1,000,000 of pre-tax interest expense avoided if its convertible debt is converted. Forecast net income after conversion is calculated as follows: Operating income $11,000,000 Tax expense (40%) (4,400,000) Net income $ 6,600,000 The conversion adds 50,000 shares of common stock to those outstanding ($10,000,000 ÷ $200 per share). The new BEPS forecast is $6.29 ($6,600,000 ÷ 1,050,000), an amount greater than the forecast $6.00 BEPS without conversion. Thus, the convertible debt is antidilutive.
Peters Corp.’s capital structure was as follows:
December 31
Year 7 Year 8 Outstanding shares of stock: Common 100,000 100,000 Convertible preferred 10,000 10,000 9% convertible bonds $1,000,000 $1,000,000 During Year 8, Peters paid dividends of $3.00 per share on its preferred stock. The preferred shares are convertible into 20,000 shares of common stock, and the 9% bonds are convertible into 30,000 shares of common stock. Assume that the income tax rate is 30%.
Question: 27 If net income for Year 8 is $170,000, Peters should report DEPS as A. $1.40 B. $1.42 C. $1.56 D. $1.70
Answer (A) is correct.
Potential common stock is included in the calculation of DEPS if it is dilutive. When two or more issues of potential common stock are outstanding, each issue is considered separately in sequence from the most to the least dilutive. This procedure is necessary because a convertible security may be dilutive on its own but antidilutive when included with other potential common shares in the calculation of DEPS.
The incremental effect on EPS determines the degree of dilution. The lower the incremental effect, the more dilutive. The incremental effect of the convertible preferred stock is $1.50 [($3 preferred dividend × 10,000) ÷ 20,000 potential common shares]. The numerator effect of the conversion of the bonds is $63,000 [$1,000,000 × 9% × (1.0 – .30 tax rate)]. The incremental effect of the convertible debt is $2.10 ($63,000 ÷ 30,000 potential common shares). Given net income of $170,000, the BEPS amount equals $1.40 [($170,000 – $30,000) ÷ 100,000]. Thus, both convertible securities are antidilutive, and Peters should report that DEPS is equal to BEPS.
Which of the following situations may result in recognition over time of revenue from a contract with a customer by an entity?
A. The customer has accepted the asset, and the entity has a present right to payment.
B. The entity’s performance creates or enhances an asset not controlled by the customer during the process.
C. The entity can enforce payment for work completed to date on an asset with an alternative use to the entity.
D. The customer simultaneously receives and consumes the benefits from performance as the entity performs.
Answer (D) is correct.
An entity recognizes revenue when (or as) it satisfies each performance obligation in the contract by transferring the promised good or service (an asset) to a customer. An asset is transferred when the customer obtains control of that asset. When the customer simultaneously receives and consumes the benefits from performance as the entity performs, revenue is recognized over time.
On December 31, Year 2, Case, Inc., had 300,000 shares of common stock issued and outstanding. Case issued a 10% stock dividend on July 1, Year 3. On October 1, Year 3, Case purchased 24,000 shares of its common stock for its treasury and recorded the purchase by the cost method. What number of shares should be used in computing basic earnings per share for the year ended December 31, Year 3? A. 324,000 B. 330,000 C. 309,000 D. 306,000
Answer (A) is correct. When a stock dividend, stock split, or a reverse split occurs other than at the beginning of a year, a retroactive adjustment for the change in capital structure should be made as of the beginning of the earliest accounting period presented. Shares outstanding during the year must then be weighted by the number of months for which they were outstanding in calculating the weighted-average number of shares that is to be used in determining BEPS. For the first 9 months of Year 3, Case is deemed to have had 330,000 shares outstanding [300,000 + (300,000 × 10%)]. After the treasury stock purchase, 306,000 shares (330,000 – 24,000) were outstanding for the last 3 months of the year. The weighted-average share calculation is shown below. 330,000 × (9 ÷ 12) = 247,500 306,000 × (3 ÷ 12) = 76,500 Year-end weighted-average shares 324,000
Which of the following is not a criterion that must be met for a contract with a customer to be accounted for under the revenue recognition standard (ASC 606)?
A. The costs to fulfill the contract are expected to be recovered.
B. The contract must have commercial substance.
C. Each party’s rights regarding goods or services to be transferred can be identified.
D. The payment terms can be identified
Answer (A) is correct.
One of the criteria for capitalizing the costs to fulfill a contract is that such costs are expected to be recovered. A contract is accounted for under the revenue recognition standard if all the following criteria are met: (1) The contract was approved by both parties, (2) the contract has commercial substance, (3) each party’s rights regarding (a) goods or services to be transferred and (b) the payment terms can be identified, and (4) it is probable that the entity will collect the consideration to which it is entitled according to the contract.
