CHAPTER 5 Flashcards
Cash and Investments
Day Co. received dividends from its common stock investments during the year ended December 31 as follows:
A stock dividend of 400 shares from Parr Corp. on July 25 when the market price of Parr’s shares was $20 per share. Day owns less than 1% of Parr’s stock.
A cash dividend of $15,000 from Lark Corp. in which Day owns a 25% interest. Day did not elect the fair value option to account for its investment in Lark.
What amount of dividend revenue should Day report in its income statement?
A. $8,000
B. $23,000
C. $15,000
D. $0
Answer (D) is correct.
Day Co. owns a 25% interest in Lark. Because the fair value option was not elected, the investment in Lark should be accounted for in accordance with the equity method. A stock dividend is not reported as dividend revenue under (1) the fair value method, or (2) the equity method. A cash dividend is not reported as dividend revenue under the equity method. Consequently, the amount of dividend revenue to be reported in the income statement is $0.
For available-for-sale debt securities included in noncurrent assets, which of the following amounts should be included in the period’s net income? Unrealized holding losses during the period Realized gains during the period Changes in fair value during the period A. I and II only. B. II only. C. I, II, and III. D. III only.
Answer (B) is correct.
The temporary decline below cost of the fair value of available-for-sale debt securities is recorded in OCI, assuming they are not designated as being hedged in a fair value hedge. Thus, temporary changes in the valuation of these securities do not flow through net income. A realized gain occurs when securities are sold at an amount greater than their cost basis. Realized gains are included in net income regardless of the classification of the securities.
Dawson Corporation just received its bank statement for the month of May. This statement revealed that $2,500 of Dawson’s deposits had not yet been recorded by the bank, outstanding checks totaled $1,500, a bank service charge of $100 had been assessed, and Dawson had erroneously recorded a check written for $1,000 as $100. As of May 31, Dawson’s records indicated a cash balance of $40,500. The ending cash balance as of May 31 reported on the bank statement would have been A. $39,900 B. $42,500 C. $41,100 D. $38,500
The entity’s cash balance at May 31 reported on the bank statement may be determined by a reconciliation from the book balance to the bank balance. The deposits in transit are included in the book balance but not the bank balance. The book balance but not the bank balance has already been reduced by the outstanding checks. The service charge and check understatement error are not yet reflected in the book balance. Balance per books $40,500 Minus: deposits in transit (2,500) Add: outstanding checks 1,500 Minus: bank service charge (100) Minus: check recording error (900) Balance per bank $38,500
The amount by which the fair value of a debt security exceeds its cost should be accounted for in the financial statements when the security is classified as
Trading
Available-for-Sale
Answer (A) is correct.
Unrealized holding gains and losses on trading debt securities must be recognized in earnings. Unrealized holding gains and losses on available-for-sale debt securities are recognized in other comprehensive income.
Question: 6 On July 1, Year 2, York Co. purchased as a long-term investment $1 million of Park, Inc.’s 8% bonds for $946,000, including accrued interest of $40,000. The bonds were purchased to yield 10% interest. The bonds mature on January 1, Year 8, and pay interest annually on January 1. York uses the effective interest method of amortization. In its December 31, Year 2, balance sheet, what amount should York report as investment in bonds? A. $953,300 B. $960,600 C. $911,300 D. $916,600
Answer (C) is correct.
The bond investment’s original balance was $906,000 ($946,000 price – $40,000 accrued interest) because the carrying amount does not include accrued interest paid. Under the effective interest method, interest income equals the yield or effective interest rate times the carrying amount of the bonds at the beginning of the interest period. The amortization of premium or discount is the difference between this interest income and the periodic cash payments. For Year 2, interest income is $45,300 [$906,000 × 10% × (6 ÷ 12)], and the actual interest is $40,000 [$1,000,000 × 8% × (6 ÷ 12)]. Hence, the carrying amount at year-end is $911,300 [$906,000 + ($45,300 – $40,000)].
On January 2, Year 1, Kean Co. purchased a 30% interest in Pod Co. for $250,000. On this date, Pod’s equity was $500,000. The carrying amounts of Pod’s identifiable net assets approximated their fair values, except for land whose fair value exceeded its carrying amount by $200,000. Pod reported net income of $100,000 for Year 1, and paid no dividends. Kean accounts for this investment using the equity method. In its December 31, Year 1, balance sheet, what amount should Kean report as investment in Pod Co.? A. $220,000 B. $210,000 C. $280,000 D. $276,000
Answer (C) is correct.
The purchase price is allocated to the fair value of the net assets acquired, with the remainder allocated to goodwill. The fair value of Kean’s 30% interest in Pod’s net assets is $210,000 [($500,000 + $200,000) × 30%]. Goodwill is $40,000 ($250,000 – $210,000). The equity method requires the investor’s share of subsequent net income reported by the investee to be adjusted for the difference at acquisition between the fair value and the carrying amount of the investee’s net assets when the net assets are sold or consumed in operations. The land is assumed not to be sold, and the equity method goodwill is not amortized or separately reviewed for impairment. Thus, Kean’s share of Pod’s net income is $30,000 ($100,000 declared income × 30%), and the investment account at year-end is $280,000 ($250,000 acquisition balance + $30,000 investment income).
Election of the fair value option (FVO) for financial assets
A. Requires deferral of related upfront costs.
B. Results in recognition of unrealized gains and losses in earnings of a business entity.
C. Results in recognition of unrealized gains and losses in other comprehensive income of a business entity.
D. Permits only for-profit entities to measure eligible items at fair value.
Answer (B) is correct.
A business measures at fair value the eligible items for which the FVO election was made at a specified election date. The unrealized gains and losses on financial assets are reported in earnings at each subsequent reporting date.
Anchor Co. owns 40% of Main Co.’s common stock outstanding and 75% of Main’s noncumulative preferred stock outstanding. Anchor exercises significant influence over Main’s operations. During the current period, Main declared dividends of $200,000 on its common stock and $100,000 on its noncumulative preferred stock. What amount of dividend income should Anchor report on its income statement for the current period related to its investment in Main? A. $225,000 B. $120,000 C. $80,000 D. $75,000
Answer (D) is correct.
Under the equity method, the receipt of a cash dividend from the investee should be credited to the investment account. It is a return of, not a return on, the investment. However, the equity method is not applicable to preferred stock. Thus, Anchor should report $75,000 ($100,000 × 75%) of revenue when the preferred dividends are declared.
Sage, Inc., bought 40% of Adams Corp.’s outstanding voting common stock on January 2 for $400,000, which equaled a proportionate share of the fair value of the net assets. The carrying amount of the net assets at the purchase date was $900,000. Fair values and carrying amounts were the same for all items except for plant and inventory, for which fair values exceeded their carrying amounts by $90,000 and $10,000, respectively. The plant has an 18-year life. All inventory was sold during the year. During the year, Adams reported net income of $120,000 and paid a $20,000 cash dividend. What amount should Sage report in its income statement from its investment in Adams for the year ended December 31? A. $42,000 B. $48,000 C. $36,000 D. $34,000
Answer (A) is correct.
Sage holds 40% of the investee’s voting common stock and is assumed to exercise significant influence. It should therefore account for the investment on the equity basis by recognizing its proportionate share of the investee’s net income. For this purpose, the investee’s net income of $120,000 should be adjusted for the $10,000 excess of fair value over the carrying amount of the inventory sold and for the portion of the difference between the fair value and carrying amount of the plant that has been consumed (depreciated). This adjustment equals $5,000 ($90,000 difference ÷ 18 years). Thus, Sage should report investment income of $42,000 [($120,000 – $10,000 – $5,000) × 40%].
In Year 1, a company reported in other comprehensive income an unrealized holding loss on an investment in available-for-sale debt securities. During Year 2, these securities were sold at a loss equal to the unrealized loss previously recognized. The reclassification adjustment should include which of the following?
A. The unrealized loss should be credited to the other comprehensive income account.
B. The unrealized loss should be credited to the investment account.
C. The unrealized loss should be debited to the other comprehensive income account.
D. The unrealized loss should be credited to beginning retained earnings.
Answer (A) is correct. Available-for-sale debt securities are measured at fair value, with unrealized holding gains and losses recognized in OCI. The Year 1 entry to recognize the loss was a debit to OCI for a loss and a credit to the allowance for securities fair value adjustments (or directly to available-for-sale securities). The Year 2 sale of the securities was at a loss equal to the recognized unrealized loss. Accordingly, the sale was at their carrying amount. Assuming the securities had a cost of $100 and the unrealized loss was $10, the Year 2 entry was Cash $90 Allowance 10 Loss 10 Securities $100 OCI 10 This entry reclassifies the loss from OCI to earnings.
On January 2 of the current year, Otto Co. purchased 40% of Penn Co.’s outstanding common stock. The carrying amount of Penn’s depreciable assets was $1,000,000 on January 2. Penn’s depreciable assets had an original useful life of 10 years and a remaining useful life of 5 years. Otto recognized $8,000 amortization for the current year ending December 31 related to its investment in Penn due to the excess of fair value over book value on these assets. What was the fair value of Penn’s depreciable assets on January 2 of the current year? A. $1,100,000 B. $900,000 C. $100,000 D. $1,000,000
Answer (A) is correct.
The equity method requires the investor’s share of the investee’s earnings or losses and the investment account to be adjusted for the difference at the acquisition date between the fair value and the carrying amount of the investee’s net assets. This adjustment (amortization) is made as the assets are sold or consumed in operations (depreciated). The difference between the fair value and the carrying amount of Penn’s depreciable assets on the purchase date is depreciated over 5 years. Therefore, Otto’s share of this difference is $40,000 ($8,000 total annual amortization × 5 years). Since Otto holds 40% of Penn, the entire difference between the fair value and the carrying amount of Penn’s depreciable assets is $100,000 ($40,000 ÷ 40%). Accordingly, the fair value of Penn’s depreciable assets on January 2 of the current year is $1,100,000 ($1,000,000 + $100,000).
On July 2, Year 4, Wynn, Inc., purchased as a short-term investment a $1 million face-value Kean Co. 8% bond for $910,000 plus accrued interest to yield 10%. The bonds mature on January 1, Year 11, and pay interest annually on January 1. On December 31, Year 4, the bonds had a fair value of $945,000. On February 13, Year 5, Wynn sold the bonds for $920,000. In its December 31, Year 4, balance sheet, what amount should Wynn report for the bond if it is classified as an available-for-sale security? A. $920,000 B. $945,000 C. $910,000 D. $950,000
Answer (B) is correct.
Available-for-sale debt securities should be measured at fair value in the balance sheet. Thus, the bond should be reported at its fair value of $945,000 to reflect the unrealized holding gain (change in fair value).
Poe, Inc., had the following bank reconciliation at March 31: Balance per bank statement, 3/31 $46,500 Add deposit in transit 10,300 $56,800 Minus outstanding checks (12,600) Balance per books, 3/31 $44,200 Data per bank for the month of April follow: Deposits $58,400 Disbursements 49,700 All reconciling items at March 31 cleared the bank in April. Outstanding checks at April 30 totaled $7,000. There were no deposits in transit at April 30. What is the cash balance per books at April 30? A. $58,500 B. $48,200 C. $55,200 D. $52,900
Answer (B) is correct. The balance per bank statement on March 31 is $46,500. In accordance with the bank’s records, April deposits were $58,400 and April disbursements were $49,700. These deposits should be added to the beginning balance; the disbursements should be subtracted. Also, the $7,000 in outstanding checks at month-end should be subtracted to determine the $48,200 balance per books at the end of the month. Balance per bank statement, 3/31 $46,500 April deposits per bank 58,400 April disbursements per bank (49,700) Outstanding checks, 4/30 (7,000) Balance per books, 4/30 $48,200
Beach Co. determined that the decline in the fair value (FV) of an investment in debt securities was below the amortized cost and permanent in nature. The investment was classified as available-for-sale on Beach’s books. The controller would properly record the decrease in FV by including it in which of the following?
A. Other comprehensive income section of the income statement, and writing down the cost basis to FV.
B. Earnings section of the income statement and writing down the cost basis to FV.
C. Other comprehensive income section of the income statement only.
D. Discontinued operations section of the income statement, net of tax, and writing down the cost basis to FV.
Answer (B) is correct.
The amortized cost basis is used to calculate the amount of any impairment. The amortized cost basis should be distinguished from fair value, which equals the cost basis plus or minus the net unrealized holding gain or loss. If a decline in fair value of an individual available-for-sale debt security below its amortized cost basis is other than temporary, the amortized cost basis is written down to fair value as a new cost basis. The write-down is deemed to be a realized loss and is included in earnings.
Pear Co.’s income statement for the year ended December 31, as prepared by Pear’s controller, reported income before taxes of $125,000. The auditor questioned the following amounts that had been included in income before taxes: Equity in earnings of Cinn Co. $ 40,000 Dividends received from Cinn 8,000 Adjustments to profits of prior years for arithmetical errors in depreciation (35,000) Pear owns 40% of Cinn’s common stock, and no acquisition differentials are relevant. Pear’s December 31 income statement should report income before taxes of A. $117,000 B. $85,000 C. $152,000 D. $120,000
Answer (C) is correct.
Under the equity method, the investor’s share of the investee’s net income (adjusted for any acquisition differentials, such as impairment of goodwill) is accounted for as an addition to, and losses and dividends are reflected as reductions of, the carrying amount of the investment. Consequently, the equity in earnings of Cinn Co. was correctly included in income, but the dividends received should have been excluded. In addition, error corrections related to earlier periods are treated as prior-period adjustments and are not included in net income. Thus, income before taxes should have been $152,000 ($125,000 – $8,000 dividends + $35,000 depreciation error).
Vanity Corporation holds investments in debt securities. These investments were acquired last year and have been properly classified as available-for-sale (AFS) securities. During the current year, the company sold some of the AFS securities at a loss. At year end, the remaining portfolio of AFS securities had appreciated in total value compared with the value at the end of last year. Based on these facts, which one of the following should Vanity report in its financial statements at the end of the current year?
Income Statement
Balance sheet
AFS debt securities are measured at fair value at each balance sheet date. Realized losses on the sale of available-for-sale securities are included in the calculation of current period earnings. However, unrealized holding gains and losses on available-for-sale securities are excluded from earnings and are reported as components of other comprehensive income.
When valuing certain financial instruments, a company that has elected the fair value measurement option must apply the accounting measurement based on which of the following criteria? . Instrument-by-instrument basis. B. At the entity level. C. A portion of an asset or liability. D. Type-by-type basi
Answer (A) is correct.
An entity may elect the fair value option (FVO) for most recognized financial assets and liabilities. The decision whether to elect the FVO is made irrevocably at the election date. The decision is made instrument by instrument and only for an entire instrument.
An investor purchased a bond classified as a long-term investment between interest dates at a discount. At the purchase date, the carrying amount of the bond is more than the
Cash Paid
Face Amount
to Seller
of Bond
Answer (C) is correct.
At the date of purchase, the carrying amount of the bond equals its face amount minus the discount. The cash paid equals the initial carrying amount plus accrued interest. Hence, the initial carrying amount is less than the cash paid by the amount of the accrued interest.
An investor purchased a bond as a long-term investment between interest dates at a premium. At the purchase date, the cash paid to the seller is
A. More than the face amount of the bond.
B. The same as the face amount of the bond plus accrued interest.
C. Less than the face amount of the bond.
D. The same as the face amount of the bond.
Answer (A) is correct.
At the date of purchase, the cash paid to the seller is equal to interest accrued since the last interest date, plus the face amount of the bonds, plus the premium. The carrying amount of the bonds (face amount plus the premium) is equal to the present value of the cash flows associated with the bond discounted at the market rate of interest (yield).
Investments classified as held-to-maturity are measured at
A. Fair value, with unrealized gains and losses reported in other comprehensive income (OCI).
B. Amortized cost, with no unrealized gains or losses reported.
C. Replacement cost, with no unrealized gains or losses reported.
D. Fair value, with unrealized gains and losses reported in net income.
Answer (B) is correct.
Assuming the fair value option has not been elected, held-to-maturity securities are reported at amortized cost, with no unrealized gains or losses reported.
Birk Co. purchased 30% of Sled Co.’s outstanding common stock on December 31 for $200,000. On that date, Sled’s equity was $500,000, and the fair value of its net assets was $600,000. On December 31, what amount of equity method goodwill results from this acquisition? A. $0 B. $30,000 C. $20,000 D. $50,000
Answer (C) is correct.
The equity method of accounting is used when the investor has significant influence over the investee (investment is at least 20% but not more than 50% of the voting interests) and the FVO was not elected. Equity method goodwill is the difference between the cost of the $200,000 investment and the investor’s equity in the fair value of the investee’s net assets of $180,000 (30% × $600,000). Accordingly, equity method goodwill equals $20,000 ($200,000 – $180,000).
An investor purchased a bond as a long-term investment on January 2. The investor’s carrying amount at the end of the first year will be highest if the bond is purchased at a
A. Discount and amortized by the effective interest method.
B. Premium and amortized by the effective interest method.
C. Discount and amortized by the straight-line method.
D. Premium and amortized by the straight-line method
Answer (B) is correct.
When a bond is purchased at a premium (discount), its initial carrying amount is greater (less) than the maturity amount. The carrying amount of a bond acquired at a premium will decrease over time as the premium is amortized. Under the effective interest method, interest revenue is equal to the carrying amount of the bond at the beginning of the interest period multiplied by the yield. The amount of periodic amortization is the excess of the nominal interest received over the interest revenue. Because the carrying amount of the bond will decrease over time, the amount of interest revenue will also diminish. Subtracting the decreasing interest revenue from the constant periodic cash flow results in increasing amounts of premium amortization over the term of the bond. Under the straight-line method of amortization, equal amounts are amortized over the life of the bond. Accordingly, the least amount of premium will be amortized in the first year under the interest method, and the result will be the highest carrying amount of the bond at the end of this year.
On October 1, Year 1, Park Co. purchased 200 of the $1,000 face amount, 10% bonds of Ott, Inc., for $220,000, including accrued interest of $5,000. The bonds, which mature on January 1, Year 8, pay interest semiannually on January 1 and July 1. Park used the straight-line method of amortization and appropriately recorded the bonds as a long-term investment. On Park’s December 31, Year 2, balance sheet, the bonds should be reported at A. $214,200 B. $212,000 C. $214,400 D. $215,000
Answer (B) is correct.
The carrying amount of a bond investment does not include the amount of accrued interest paid. Thus, these bonds were initially recorded at $215,000 ($220,000 – $5,000). Under the straight-line method, the $15,000 premium should be amortized over the 75-month period extending from October 1, Year 1, to January 1, Year 8. For the 15 months from October 1, Year 1, through December 31, Year 2, $3,000 of the premium [$15,000 × (15 months ÷ 75 months)] should be amortized. The unamortized premium of $12,000 ($15,000 – $3,000) plus the $200,000 (200 bonds × $1,000 face amount) maturity amount of the bonds equals a carrying amount at December 31, Year 2, of $212,000.
Reed, Inc., began operations on January 1. The following information pertains to Reed’s December 31 investments in debt securities:
Trading Available-for-Sale Cost $360,000 $550,000 Fair value 320,000 450,000 Lower of cost or fair value applied to each security 304,000 420,000 If the declines are judged to be temporary, what amounts should Reed report for its trading and available-for-sale debt securities in the assets section of its December 31 balance sheet?
Trading
Available-for-Sale
A. $304,000 $420,000 B. $360,000 $550,000 C. $320,000 $450,000 D. $360,000 $450,000
Answer (C) is correct.
Fair value accounting applies to both trading and available-for-sale debt securities. The difference in treatment is that the unrealized holding gains and losses are included in earnings for trading securities and in other comprehensive income for available-for-sale securities, assuming the latter are not designated as being hedged in a fair value hedge. Thus, these securities should be reported in the assets section of the balance sheet at their fair values of $320,000 and $450,000, respectively.
