Diagnostic Assessment III.3

Question 1

In which of the following legal forms of business combination does at least one preexisting entity cease to exist?

Merger Consolidation Acquisition
Yes                 Yes            Yes 
Yes               Yes               No 
Yes               No                No 
No                No               Yes

Answer 1

The correct answer is: Merger Yes, Consolidation Yes, Acquisition No

Question 2

In which of the following legal forms of business combination are the assets and liabilities of an acquired entity or entities recorded on the books of the acquiring entity?

Merger  Acquisition Consolidation
Yes                Yes      Yes 
Yes               Yes       No
Yes              No        Yes 
No              Yes         No

Answer 2

The correct answer is: Merger Yes, Acquisition No, Consolidation Yes

In a merger and in a consolidation, the assets and liabilities of the acquired entity/entities are recorded on the books of the acquiring entity, but in an acquisition, the assets and liabilities of the acquired entity remain on the books of the acquired entity. In a merger and in a consolidation, at least one preexisting entity ceases to exist, and the assets and liabilities are recorded on the books of the surviving entity. In an acquisition, one preexisting entity acquires controlling interest in another preexisting entity, and both continue to exist as separate legal entities.

Question 3

Company Z is formed to consolidate three preexisting entities: Companies W, X, and Y. Company Z pays cash to acquire the net assets of Company W and issues debt to acquire the net assets of Company X. Company Z acquires all of the stock of Company Y in the market for cash. Which one of the companies is most likely the acquirer in the business combination?

Company W
Company X
Company Y
Company Z

Answer 3

The correct answer is: Company Z

Because Company Z only paid cash and issued debt to effect the combination (no new equity was issued to effect the combination), Company Z is most likely the acquirer.

Question 4

Changes in the fair value of contingent consideration transferred in a business combination resulting from occurrences after the acquisition date should be recognized as a gain or loss in the current income when the contingent consideration is classified as

An Asset or a Liability An Equity Item
Yes                                 Yes
Yes                                  No
No                                  Yes
No                                   No

Answer 4

The correct answer is: An Asset or a Liability Yes
An Equity Item No

Changes in the fair value of contingent consideration resulting from occurrences that occur after the acquisition date are recognized as gains or losses when the contingent consideration is classified as an asset or a liability. Contingent considerations classified as equity are not remeasured, and no gain or loss is recognized. The change in fair value of equity items is recognized as an adjustment within equity.

Question 5

Zooco, Inc. acquired 40% of the voting stock of Stubco, Inc. on September 1, 2008, and accounted for the investment using the equity method of accounting. On May 1, 2009, Zooco acquired an additional 20% of Stubco’s voting stock to achieve a business combination. Which one of the following is the value Zooco should use to measure its original 40% investment in Stubco when recording the combination?

Original cost, September 1, 2008
Carrying value, May 1, 2009
Fair value, May 1, 2009
40% of Stubco’s book value, May 1, 2009

Answer 5

The correct answer is: Fair value, May 1, 2009

When a business combination is accomplished in stages (or steps), the fair value of the investment on the date of the combination is used to value the business combination. In this case, that would be the fair value on May 1, 2009. Any difference between the carrying value and the fair value on the acquisition date would be recognized as a gain or loss for the period.

Question 6

On July 1, Dill, Inc. exchanged 10,000 shares of its common stock for all 20,000 shares of Ledo, Inc.’s outstanding common stock. Dill’s stock is closely held and seldom traded; it has a par value of $10 per share and a book value of $12 per share. Ledo’s stock is traded in an active market and has a par value of $5 per share, a book value of $8 per share, and a market price of $11 per share. Which one of the following amounts is most likely the appropriate value of Dill’s investment in Ledo?

$100,000
$110,000
$120,000
$220,00

Answer 6

The correct answer is: $220,000

Stock issued in a business combination should be measured at fair value. In some cases in which equities are exchanged, the fair value of the acquiree’s stock may be a more reliable measure of the value of the transaction than can be determined for the acquirer’s stock. In this question, that is the case. Since Dill’s stock is closely held and seldom traded, it is less likely to be the basis for determining fair value than is Ledo’s stock, which is traded in an active market. Therefore, the most likely value for the transaction would be the 20,000 shares of Ledo’s stock that were obtained multiplied by the $11 market price of those shares, or 20,000 shares × $11 = $220,000.

Question 7

In recording its acquisition of Lambda, Inc., Omega, Inc. properly recognized a contingent consideration liability of $28,000 associated with a possible payment based on a target amount of post-combination cash flow from operations. Shortly after the combination, but during the measurement period, the national economy experienced a significant downturn which made it unlikely that the target amount would be reached. As a consequence, at the end of Omega’s fiscal period, the liability was properly revalued to a fair value of $9,000. Which one of the following is the amount of increase or decrease, if any, in the consideration paid to acquire Lambda that results from the change in the fair value of the contingent liability?

$ - 0 - (no increase or decrease)
$19,000 increase
$19,000 decrease
$ 9,000 decrease

Answer 7

The correct answer is: $ - 0 - (no increase or decrease)

A contingent consideration liability is the obligation of an acquirer to transfer additional consideration, if specific conditions are met. Contingent consideration liabilities are initially recognized at fair value and adjusted to fair value each period until the contingency is resolved or expires. A change in fair value resulting from occurrences after the acquisition date would be recognized as a gain or loss in income in the period of the change, not as an adjustment to the consideration paid to acquire the acquiree. In this question, a $19,000 gain (reduction in liability) would be recognized ($28,000 − $9,000 = $19,000) and no change in the consideration paid will be recognized.

Question 8

When goodwill is recognized in a business combination, which of the following types of information about that goodwill must be disclosed?

I. A quantitative description of the factors that make up the goodwill.

II. The amount of goodwill that is expected to be deductible for tax purposes.

III. The amount of goodwill allocated to each reportable segment.

I and II only.
I and III only.
II and III only.
I, II, and III.

Answer 8

The correct answer is: I, II, and III.

Statements I, II, and III are all required. When goodwill is recognized in a business combination, a quantitative description of the factors that make up the goodwill (Statement I), the amount of goodwill that is expected to be deductible for tax purposes (Statement II), and the amount of goodwill allocated to each reportable segment (Statement III) must all be disclosed.

Question 9

Pine Company acquired all of the assets and liabilities of Straw Company for cash in a legal merger. Which one of the following would not be recognized by Pine on its books in recording the business combination?

Accounts receivable.
Investment in Straw.
Intangible asset—Patent.
Accounts payable.

Answer 9

The correct answer is: Investment in Straw.

Pine will not recognize on its books an investment in Straw. Because the business combination is a legal merger, Pine recognizes on its books almost all of Straw’s assets and liabilities, not an investment in Straw. There can be no investment in Straw, because Straw will cease to exist.

Question 10

Per IFRS, intangible assets acquired in a business combination should be initially measured at:

Fair value at the acquisition date.

Purchase price excluding any discounts.

Purchase price excluding import duties.

Amortized cost.

Answer 10

The correct answer is: Fair value at the acquisition date.

An intangible asset that is acquired in a business combination is initially measured at acquisition date fair value.

Question 11

For financial accounting purposes, which one of the following is not a type of hedge carried out using derivatives?

Fair value.
Cash flow.
Speculative.
Foreign currency.

Answer 11

The correct answer is: Speculative.

When derivatives are used for speculative purposes, the intent is not to hedge an existing position, because there is no existing position to hedge. Rather, when used for speculative purposes, the intent is to make a profit.

Question 12

Which of the following describes an “accounting mismatch” as that expression is used in IFRS?

Debts don’t equal credits.

Liabilities exceed assets.

Related assets and liabilities are valued using different measures.

The value of a hedging instrument does not equal the value of the hedged item.

Answer 12

The correct answer is:
Related assets and liabilities are valued using different measures.

An “accounting mismatch” refers to a circumstance where related assets and liabilities are valued using different measures.

Question 13

Fair value disclosure of financial instruments may be made in the:
Body of

Financial Statements Footnotes to Financial Statements
Yes Yes
Yes No
No Yes
No No

Answer 13

The correct answer is: Body of Financial Statements Yes and Footnotes to Financial Statements Yes

Fair value disclosure of financial instruments may be made in either the body of the financial statements or in the footnotes to the financial statements. If in the footnotes, one note must show fair values and carrying amounts for all financial instruments.

Question 14

Smythe Co. invested $200 in a call option for 100 shares of Gin Co. $.50 par common stock, when the market price was $10 per share. The option expired in three months and had an exercise price of $9 per share. What was the intrinsic value of the call option at the time of initial investment?

$50
$100
$200
$900

Answer 14

The correct answer is: $100

The intrinsic value of a call option is the difference between the exercise (strike) price and the market price. This call option has an exercise price of $9 / share and the market price is $10 / share. Therefore, there is a $1 / share intrinsic value (I can buy the stock at a price less than the market). The option is to purchase 100 shares so the total intrinsic value is $100.

Question 15

Which of the following are basic kinds of risks that can be hedged for accounting purposes?

Fair Value Cash Flows
Yes           Yes
Yes            No
No            Yes
No            No

Answer 15

The correct answer is: Fair Value Yes, Cash Flows Yes

The two basic kinds of risks that can be hedged for accounting purposes are fair value risks and cash flow risks.

Question 16

On October 1, 2008, Buyco entered into a legally enforceable contract to acquire raw material inventory in 180 days for $20,000. In order to mitigate the risk of a change in the value of the raw materials, Buyco also entered into a qualified 180-day forward contract to hedge the fair value of the raw materials. At December 31, 2008, the value of the raw materials had decreased by $500, and the fair value of the futures contract had increased by $480. On March 29, 2009, the date the raw materials were delivered to Buyco, they had a fair value of $19,300, and the forward contract had a fair value of $700. Which one of the following is the net gain or loss that would be recognized on the raw material and related forward contract by Buyco in its 2009 net income?

$ -0-
$20
$200
$220

Answer 16

The correct answer is: $20

Because Buyco entered into the forward contract (hedging instrument) to hedge the risk of change in the fair value of the raw materials (hedged item), the change in fair value of the forward contract during 2009 offsets the change in the fair value of the raw materials. Specifically, the decrease in the value of the raw materials, $200 ($19,500 − $19,300 = $200), was offset by the increase in the value of the forward contract of $220 ($700 − $480 = $220), so the net gain recognized in 2009 was $220 − $200 = $20, which is the correct answer.

Question 17

In a cash flow hedge, the item being hedged is measured using:

The nominal value of expected cash inflows.

The present value of expected cash inflows.

The nominal value of expected cash inflows or outflows.

The present value of expected cash inflows or outflows.

Answer 17

The correct answer is:
The present value of expected cash inflows or outflows.

The item being hedged in a cash flow hedge is measured using the present value of expected cash inflows or cash outflows. The item being hedged in a cash flow hedge may be associated with an asset, a liability, or a forecasted transaction. The value of such items is measured using the present value of either cash inflows (e.g., receivable) or cash outflows (e.g., payable), depending on the nature of the item being hedged.

Question 18

Which of the following statements concerning derivatives used as foreign currency hedges is/are correct?

I. Can be used to hedge the risk of exchange rate changes on planned transactions.

II. Can be used to hedge the risk of exchange rate changes on available-for-sale investments.

III. Can be used to hedge the risk of exchange rate changes on accounts receivable and accounts payable.

I only.
I and II only.
II and III only.
I, II, and III.

Answer 18

The correct answer is: I, II, and III.

Foreign currency hedges can be used to hedge the risk of exchange rate changes on planned (forecasted) transactions, available-for-sale investments, and accounts receivable/accounts payable (and unrecognized firm commitments and net investments in foreign operations).

Question 19

Which one of the following is not a required disclosure for derivatives used as fair value hedges?

The amount of net gain or loss recognized in earnings during the period.

The location in the financial statements where any gain or loss is reported.

The net gain or loss in earnings from firm commitment hedges that no longer qualify for hedge treatment.

The amount of gain or loss arising during the period that was deferred.

Answer 19

The correct answer is:
The amount of gain or loss arising during the period that was deferred.

When derivatives are used for fair value hedges, the amount of gain or loss arising during the period that was deferred does not exist (and therefore is not required). When fair value hedges are used, any resulting gain or loss is recognized in current income, not deferred.

Question 20

Which of the following statements, if either, concerning differences between U.S. GAAP and IFRS in accounting for hedges is/are correct?

I. IFRS permits hedging a forecasted business combination that is subject to foreign exchange risk; U.S. GAAP does not permit hedging in that case.

II. IFRS permits hedging part of the life of a hedged item; U.S. GAAP does not permit hedging of part of the life of a hedged item.

I only.
II only.
Both I and II.
Neither I nor II.

Answer 20

The correct answer is: Both I and II.

Both Statement I and Statement II are correct. IFRS permits (1) hedging a forecasted business combination that is subject to foreign exchange risk, and (2) hedging part of the life of a hedged item. U.S. GAAP does not permit hedging in either case.