FAR 8

Question 1

In 2005, Elm Corp. bought 10,000 shares of Oil Corp. at a cost of $20,000. On January 15, 2006, Elm declared a property dividend of the Oil stock to shareholders of record on February 1, 2006, payable on February 15, 2006. During 2006, the Oil stock had the following market values:

January 15 $25,000
February 1 26,000
February 15 24,000

The net effect of the foregoing transactions on retained earnings during 2006 should be a reduction of

Answer 1

20,000

The property dividend is recorded at market value, with a debit of $25,000 to retained earnings at declaration. A gain of $5,000 on the securities is recognized as a gain on disposal (as if it were sold). The net effect is a decrease in retained earnings of $20,000.

Question 2

How are dividends in arrears recorded?

Answer 2

As a footnote only. They will be a liability upon declaration.

Question 3

How does a “large” stock dividend affect Paid in Capital and Retained Earnings?

Answer 3

A 100% stock dividend is a “large” stock dividend because it exceeds 20% - 25%. Large stock dividends are capitalized at par value. Retained earnings is reduced by the par value of the shares issued, and common stock is increased by the par value of stock issued. There is no effect on additional paid-in capital because the entire decrease in retained earnings is recorded in common stock. A large stock dividend permanently capitalizes the par value of the issued shares into common stock.

Question 4

A company whose stock is trading at $10 per share has 1,000 shares of $1 par common stock outstanding when the board of directors declares a 30% common stock dividend. Which of the following adjustments should be made when recording the stock dividend?

Answer 4

Retained earnings is debited for $300.

Question 5

How is a “small” stock dividend recorded?

Answer 5

At market value against additional paid in capital.

Question 6

How would the declaration of a 15% stock dividend by a corporation affect each of the following?

Answer 6

Retained earnings are debited in a stock dividend, and common stock and possibly additional paid-in capital are credited. Therefore, retained earnings are reduced, but total owners’ equity is unchanged, because all accounts affected by the stock dividend are owners’ equity accounts.

Question 7

How does a small stock dividend trading above par value affect Retained Earnings and PIC?

Answer 7

The stock dividend is a “small” stock dividend because it is less than 20% - 25%. Small stock dividends are capitalized at market value, which exceeds par in this case. Retained earnings is reduced by the market value of the shares issued, common stock is increased by the par value of stock issued, and additional paid-in capital is increased by the difference between market value and par value times the number of shares issued.

Question 8

In September 2001, West Corp. made a dividend distribution of one right for each of its 120,000 shares of outstanding common stock.
Each right was exercisable for the purchase of one-hundredth of a share of West’s $50 variable-rate preferred stock at an exercise price of $80 per share. On March 20, 2005, none of the rights had been exercised, and West redeemed them by paying each stockholder $0.10 per right.

As a result of this redemption, West’s stockholders’ equity was reduced by

Answer 8

$12,000
The dividend did not affect total OE, because no resources were expended or received. The payment of $0.10 per right reduces OE by a total of 120,000($0.10) = $12,000, because this amount of cash was paid.

Question 9

Zinc Co.’s adjusted trial balance at December 31, 2005 includes the following account balances:

Common stock, $3 par $600,000
Additional paid-in capital 800,000
Treasury stock, at cost 50,000
Net unrealized loss on non-current marketable equity securities 20,000
Retained earnings: appropriated for uninsured earthquake losses 150,000
Retained earnings: unappropriated 200,000

What amount should Zinc report as total stockholders’ equity in its December 31, 2005 balance sheet?

Answer 9

Each item listed belongs in owners’ equity. The treasury stock and net unrealized loss are negative items (debits), but the rest are positive items (credits).

Therefore, total owners’ equity is $1.68mn = $600,000 + $800,000 - $50,000 - $20,000 + $150,000 + $200,000.

Question 10

How does the purchase of treasury stock under the COST METHOD affect owners’ equity?

Answer 10

The purchase of treasury stock at any price decreases total owners’ equity under the cost method because treasury stock is a contra OE account. When the purchase price per share is less than book value per share, then the denominator decreases by a greater percentage than does the numerator, and book value per share increases.

Question 11

Hoyt Corp.’s current balance sheet reports the following stockholders’ equity:

5% cumulative preferred stock, par value $100 per share; 2,500 shares issued and outstanding $250,000
Common stock, par value $3.50 per share; 100,000 shares issued and outstanding 350,000
Additional paid-in capital in excess of par value of common stock 125,000
Retained earnings 300,000

Dividends in arrears on the preferred stock amount to $25,000. If Hoyt were to be liquidated, the preferred stockholders would receive par value plus a premium of $50,000. The book value of common stock is

Answer 11

Total owners’ equity is $1.025mn, the sum of the four items taken from the owners’ equity section of the balance sheet ($250,000 + $350,000 + $125,000 + $300,000).

Book value per share of common stock = $7.00 = ($1.025 - $250,000 - $50,000 premium - $25,000 dividends in arrears)/100,000.

Question 12

Lane Co., which began operations on January 1, 2005, appropriately uses the installment method of accounting. The following information pertains to Lane’s operations for 2005:

Installment sales $1,000,000
Regular sales 600,000
Cost of installment sales 500,000
Cost of regular sales 300,000
General and administrative expenses 100,000
Collections on installment sales 200,000

The deferred gross profit account in Lane’s December 31, 2005 balance sheet should be

Answer 12

$400,000

Deferred gross profit is the gross profit remaining on uncollected sales accounted for under the installment method. The gross profit percentage is 50% [($1mn - $500,000)/$1mn)] on these sales.

Uncollected installment sales = $800,000 = $1mn - $200,000. Deferred gross profit = $400,000 = .50($800,000)

Question 13

When would a company use the installment sales method of revenue recognition?

Answer 13

When installment sales are material, and there is no reasonable basis for estimating collectibility.

Question 14

Mill Construction Co. uses the percentage-of-completion method of accounting. During 2005, Mill contracts to build an apartment complex for Drew for $20mn. Mill estimates that total costs would amount to $16mn over the period of construction.
In connection with this contract, Mill incurs $2mn of construction costs during 2005. Mill bills and collects $3mn from Drew in 2005.
What amount should Mill recognize as gross profit for 2005?

Answer 14

The project is 12.5% complete at the end of 2005 ($2mn/$16mn). Total gross profit through the end of 2005 is therefore $500,000 [= .125($20mn - $16mn)].
The $500,000 amount is the proportion of completion applied to the total contract profit of $4mn. 2005 is the first year of construction; therefore no gross profit from previous years is subtracted. The entire $500,000 gross profit is recognized in 2005.

Question 15

North Corp. has an employee benefit plan for compensated absences that gives employees ten paid vacation days and ten paid sick days per year.
Both vacation and sick days can be carried over indefinitely. Employees can elect to receive payment in lieu of vacation days; however, no payment is given for sick days not taken.

At December 31, 2004, North’s unadjusted balance of liability for compensated absences was $21,000. North estimated that there were 150 vacation days and 75 sick days available at December 31, 2004. North’s employees earn an average of $100 per day.

In its December 31, 2004 balance sheet, what amount of liability for compensated absences is North required to report?

Answer 15

$15,000

The liability must be accrued only for the vacation pay, because it is probable that paid vacations will be taken. Therefore, the liability is $15,000 (150 days x $100 per day).
The firm may, but is not required to, accrue a liability for sick days. If the employees were routinely paid for sick days not taken, then sick days would be required to be accrued. For this firm, there is no payment for sick days not taken, therefore there is no requirement to accrue this cost.
It may be argued that illness is the condition that mandates payment of sick pay. Illness cannot be predicted and therefore is not required to be accrued.

Question 16

On January 1 of the current year, a firm’s defined benefit pension plan is amended to increase the benefits for service already provided by employees through that date. The resulting immediate increase in projected benefit obligation (PBO) is $500 at January 1. The average remaining service period of employees covered by the amendment is ten years. Service cost for the year is $1,500. Actual and expected return on plan assets is $178. The discount rate is 10%. PBO at January 1, including the effect of the prior service grant, is $2,800. The funding contribution for the current year is $1,800. Compute pension expense for the current year.

Answer 16

$1,652

Pension expense = $1,500 service cost + $280 interest cost (= $2,800 x .10) - $178 expected return. $50 amortization of PSC (= $500/10) = $1,652. When PSC is initially recorded, another comprehensive income account is debited for $500. The amortization of $50 credits that account and debits pension expense for $50.

Question 17

The following information pertains to Seda Co.’s pension plan:

Actuarial estimate of projected benefit obligation at January 1, 2005 $72,000
Assumed discount rate 10%
Service costs for 2005 $18,000
Pension benefits paid during 2005 $15,000

If no change in actuarial estimates occurred during 2005, Seda’s projected benefit obligation at December 31, 2005 was

Answer 17

Projected benefit obligation (PBO), January 1, 2005 $72,000
Plus interest cost (growth in PBO), .10($72,000) $7,200
Plus service cost $18,000
Less benefits paid in 2005 ($15,000)
PBO, December 31, 2005 $82,200

Question 18

An employee covered by a post-retirement healthcare plan just completed her 18th year of service for a firm. Each year of employment to full eligibility provides credit for post-retirement healthcare benefits for this firm. She must work an additional seven years from today to be eligible for 75% healthcare coverage during retirement. She is expected to work ten more years from today. If this employee worked 15 more years from today, the firm would pay all her healthcare costs during retirement. Choose the correct statement.

Answer 18

Service cost will not be computed for the employee during her last three years of service to the firm.

The employee’s full eligibility date occurs seven years from today. At that time, she is fully eligible for 75% coverage. The last three years of her service do not increase the level of her benefit. There is no additional service cost beyond that date, although interest cost will continue. If she were expected to work 15 years after today, her full eligibility would not occur until 15 years from now, at which time she would be fully eligible for 100% coverage and service cost would continue through that date.

Question 19

On January 1, year 1, a company issued its employees 10,000 shares of restricted stock. On January 1, year 2, the company issued to its employees an additional 20,000 shares of restricted stock. Additional information about the company’s stock is as follows:

Date  Fair value of stock (per share)  
January 1, year 1 $20 
December 31, year 1 22 
January 1, year 2 25 
December 31, year 2 30 

The shares vest at the end of a four-year period. There are no forfeitures. What amount should be recorded as compensation expense for the 12-month period ended December 31, year 2?

Answer 19

Total compensation expense is computed as the fair value of the stock awarded, and is allocated evenly over the vesting period. The fair value at award date is the fair value used for this computation. The two awards are treated as separate awards, each with four year amortization periods. The total expense for year 2 is the sum of the compensation expense to be recognized for each plan for year 2 and is computed as 10,000($20)/4 + 20,000($25)/4 = $175,000. Total fair value is not updated after the award date.

Question 20

What is a deferred tax liability and how does it arise?

Answer 20

Deferred tax liabilities are the future tax effects of future taxable temporary differences. Such differences cause future taxable income to exceed future pre-tax accounting income.