FAR SU5

Question 1

(T/F) Restricted cash designated for special uses should be separately presented.

Answer 1

True

Restricted cash designated for special uses should be separately presented. Examples are bond sinking funds and new building funds.

Question 2

FVO Presentation of Financial Assets and Liabilities- Balance Sheet

Answer 2

1. Under the FVO, financial assets and liabilities are measured at fair value each balance sheet date.
2. Assets and liabilities measured using the FVO are reported by separating their reported fair values from the carrying amounts of similar items measured using another attribute, such as amortized cost or present value.

Question 3

FVO Presentation of Financial Assets and Liabilities- Income Statement

Answer 3

1. Transaction costs related to the acquisition of an item for which the FVO was elected must be expensed as incurred. They must not be capitalized at the initial cost of the item.
2. Dividends received from an investment that is accounted for using the FVO are recognized as dividend income.

Question 4

FVO Presentation of Financial Assets and Liabilities- Changes in the Fair Value of Financial Assets

Answer 4

Under the FVO, unrealized holding gains and losses on the remeasurement to fair value of financial assets are recognized in the income statement (net income) at each subsequent reporting date.

Question 5

FVO Presentation of Financial Assets and Liabilities- Changes in the Fair Value of Financial Liabilities

Answer 5

Under the FVO, unrealized gains and losses on the remeasurement to fair value of financial liabilities are recognized in the statement of comprehensive income.

a. The portion of the total change in the fair value attributable to the change in instrument-specific credit risk is recognized as an item of other comprehensive income (OCI).

Question 6

(T/F) If the fair value option is elected for one financial instrument obtained in a given transaction, it must be elected for all instruments obtained in that transaction.
True.

Answer 6

False

The FVO generally need not be applied to all instruments in a single transaction. For example, it might be applied only to some of the shares or bonds acquired in a transaction.

Question 7

Presumed level of influence the investor has over the investee

Answer 7

100%- Control
50%- Significant
20%- Little or none

Question 8

Accounting Method of a Controlled Ownership

Answer 8

Consolidation

Question 9

Accounting Method of a Significant Influence of Ownership

Answer 9

Equity Method or FVO

Question 10

Accounting Method with Little Ownership

Answer 10

Fair Value Measurement

Question 11

Impairment Test- Quantitative

Answer 11

If the qualitative assessment indicates potential impairment, the entity must estimate the fair value of the investment and perform a quantitative impairment test.

Impairment loss = Carrying amount – Fair value

Question 12

Impairment Test- Quantitative

Answer 12

If the qualitative assessment indicates potential impairment, the entity must estimate the fair value of the investment and perform a quantitative impairment test.

Impairment loss = Carrying amount – Fair value

Question 13

IFRS Difference- INVESTMENTS IN EQUITY SECURITIES

Answer 13

1. An investment in equity securities that does not result in significant influence or in control over the investee is measured at fair value through profit or loss (as under U.S. GAAP). However, the investor also may irrevocably elect at initial recognition to measure the investment in equity securities that is not held for trading at fair value through OCI. The holding gains and losses accumulated in OCI are never reclassified to profit or loss even when the investment is sold.
2. The measurement alternative is not an option under IFRS. Under IFRS, an investment in equity securities that does not result in significant influence or in control over the investee is measured at fair value.
3. Decision Tree for Classification and Measurement of an Investment in Equity Securities

Question 14

IFRS Difference- INVESTMENTS IN EQUITY SECURITIES

Answer 14

1. An investment in equity securities that does not result in significant influence or in control over the investee is measured at fair value through profit or loss (as under U.S. GAAP). However, the investor also may irrevocably elect at initial recognition to measure the investment in equity securities that is not held for trading at fair value through OCI. The holding gains and losses accumulated in OCI are never reclassified to profit or loss even when the investment is sold.
2. The measurement alternative is not an option under IFRS. Under IFRS, an investment in equity securities that does not result in significant influence or in control over the investee is measured at fair value.
3. Decision Tree for Classification and Measurement of an Investment in Equity Securities

Question 15

(T/F) An investment in equity securities that does not result in significant influence or control over the investee is measured at fair value at each balance sheet date. Unrealized gains and losses are recognized in other comprehensive income.

Answer 15

False.

Under U.S. GAAP, an investment in equity securities that does not result in significant influence or control over the investee is measured at fair value at each balance sheet date. Unrealized gains and losses are reported in the income statement.

Question 16

(T/F) If an investment in equity securities that does not result in significant influence or control over the investee does not have a readily determinable fair value, it should be reported at amortized cost.

Answer 16

False.

The measurement alternative may be elected if an investment in equity securities does not have a readily determinable fair value. The investment then is measured at cost minus impairment (if any) plus or minus observable price changes of the identical or a similar investment of the same issuer.

Question 17

(T/F) When equity securities do not have readily determinable fair values, they are measured using the cost method.

Answer 17

False.

When equity securities do not have readily determinable fair values, i.e., when quoted market prices are unavailable, they may be measured at cost minus impairment (if any), plus or minus changes resulting from observable price changes for the identical or a similar investment of the same issuer. Thus, the cost method cannot be used.

Question 18

(T/F) When equity securities do not have readily determinable fair values, they are measured using the cost method.

Answer 18

False.

When equity securities do not have readily determinable fair values, i.e., when quoted market prices are unavailable, they may be measured at cost minus impairment (if any), plus or minus changes resulting from observable price changes for the identical or a similar investment of the same issuer. Thus, the cost method cannot be used.

Question 19

When is the Equity Method used?

Answer 19

The equity method, used when the investor has significant influence and has not elected the FVO.

An investment of 20% or more (but not more than 50%) in the voting stock of the investee generally results in significant influence over an investee.

Question 20

When is the Equity Method used under IFRS?

Answer 20

When the investor has significant influence, the equity method must be applied unless

1. The investment is classified as held for sale OR
2. Conditions exist similar to those that would exempt a parent from preparing consolidated statements.

Question 21

Applying the Equity Method at the Acquisition Date

Answer 21

Goodwill resulting from the acquisition is the difference between the consideration transferred (cost of the investment) and the investor’s equity in the fair value of the investee’s net assets.

The investor’s equity is the difference between the acquisition date fair value and the carrying amount of each identifiable asset or liability of the investee.

Question 22

Private Companies Goodwill Amortization

Answer 22

Under the goodwill accounting alternative, goodwill recognized must be amortized on a straight-line basis over 10 years. The amortization expense is recognized in the income statement.

A private company may amortize goodwill over a period shorter than 10 years if it can demonstrate that this useful life is more appropriate.

Question 23

Applying the Equity Method after the Acquisition Date

Answer 23

Under the equity method, the investor recognizes in income its share of the investee’s earnings or losses in the periods for which they are reported by the investee.

The investor’s share of the investee’s earnings or losses is recognized only for the portion of the year that the investment was held under the equity method.

Dividends from the investee are treated as a return of an investment. They decrease the investment balance but have no effect on the investor’s income.

Question 24

Change to the Equity Method – Increase in Level of Ownership

Answer 24

a. When ownership of the voting stock of an investee rises to the level of significant influence, the investor must adopt the equity method or the FVO. A 20% or greater ownership interest is presumed to permit such influence absent strong contrary evidence.
b. When significant influence is achieved in stages (step-by-step), the investor applies the equity method prospectively from the moment significant influence is achieved.
c. On the date the investment becomes qualified for the equity method, the equity method investment equals (1) the cost of acquiring the additional equity interest in the investee plus (2) the current basis of the previously held equity interest in the investee.

Question 25

Change from the Equity Method

Answer 25

If an investor can no longer be presumed to exercise significant influence (for example, due to a decrease in the level of ownership), it ceases to account for the investment using the equity method.

1. Any retained investment is measured based on the carrying amount of the investment on the date significant influence is lost.
2. The shares retained ordinarily are measured at fair value through net income, unless the measurement alternative was selected because the fair value of shares was not readily determinable.

Question 26

(T/F) An entity’s ownership of an investee has reached the level of significant influence but not control. If the investor does not elect the fair value option, it must adopt the equity method.

Answer 26

True.

When ownership of an investee reaches the level of significant influence, the investor must adopt the equity method unless it has elected the fair value option. A 20% or greater ownership interest is presumed to permit such influence absent strong contrary evidence.

Question 27

(T/F) Under the equity method, cash dividends received from the investee are recognized as income in the period in which the dividends were declared.
True.

Answer 27

False.

Under the equity method, a cash dividend from the investee is a return of an investment. It is credited to the investment but does not affect equity-based earnings.

Question 28

(T/F) When an investor can no longer be presumed to exert significant influence over an investee, the investor must stop using the equity method to account for the investment. This change from the equity method is one of the triggering events for the fair value option.

Answer 28

False.

If an investor can no longer be presumed to exert significant influence, it ceases to recognize its share of the undistributed earnings or losses of the investee. This change from the equity method is not a basis for the FVO election or any retroactive adjustment. The shares retained ordinarily are measured at fair value through net income. But the measurement alternative may be selected if the fair value of the shares is not readily determinable.

Question 29

INVESTMENTS IN DEBT SECURITIES

Answer 29

Held-to-maturity- Debt securities that the reporting entity has the positive intent and ability to hold to maturity

Trading-Debt securities intended to be sold in the near term

Available-for-sale- Debt securities not classified as held-to-maturity or trading

Question 30

What are not considered Debt Securities?

Answer 30

Leases, options, financial futures contracts, or forward contracts

Question 31

Held-to-Maturity Securities Presentation – balance sheet

Answer 31

Held-to-maturity securities are presented net of any unamortized premium or discount. No valuation account is used

Question 32

Held-to-Maturity Securities Presentation – income statement

Answer 32

Realized gains and losses and interest income (including amortization of premium or discount) are included in earnings.

Question 33

Held-to-Maturity Securities Presentation – cash flow statement

Answer 33

Cash flows are from investing activities.

Question 34

Trading Securities Presentation – balance sheet

Answer 34

The balances of the securities and valuation allowances are netted. One amount is displayed for fair value.

Trading securities are current assets.

Question 35

Trading Securities Presentation – income statement

Answer 35

Unrealized and realized holding gains and losses, dividends, and interest income (including premium or discount amortization) are included in earnings (income statement).

Question 36

Trading Securities Presentation – cash flow statement

Answer 36

Classification of cash flows depends on the nature of the securities and the purpose of their acquisition. They are typically considered to be from operating activities.

Question 37

Available-for-Sale Securities Presentation –balance sheet

Answer 37

The balances of the securities and valuation allowances are netted. One amount is displayed for fair value.

1. Individual securities are presented as current or noncurrent.
2. In the equity section, unrealized holding gains and losses are

Question 38

Available-for-Sale Securities Presentation – income statement

Answer 38

Realized gains and losses, dividends, and interest income (including premium or discount amortization) are included in earnings.

Question 39

Available-for-Sale Securities Presentation –cash flow statement

Answer 39

Cash flows are from investing activities.

Question 40

Available-for-Sale Securities Presentation –statement of comprehensive income

Answer 40

Unrealized holding gains and losses for the period are included in comprehensive income.
1. Reclassification adjustments also must be made for each component of OCI. Their purpose is to avoid double counting when an item included in net income also was included in OCI for the same or a prior period. For example, if a gain on available-for-sale securities is realized in the current period, the prior-period recognition of an unrealized holding gain must be eliminated by debiting OCI and crediting a gain.

Question 41

Transfers between Categories

Answer 41

1. From trading to any category. Amounts already recognized in earnings are not reversed.
2. To trading from any category. Amounts not already recognized in earnings are recognized in earnings.
3. To available-for-sale from held-to-maturity. Amounts are recognized in OCI.
4. To held-to-maturity from available-for-sale. Amounts recognized in OCI are not reversed but are amortized in the same way as a premium or discount.

Question 42

Investment in Debt Securities IFRS Difference

Answer 42

The classification and measurement of investments in debt securities depends on (1) the investor’s business model for managing them and (2) the nature of cash flows from them.

Question 43

Trading Securities –Unrealized holding gains and losses

Answer 43

Unrealized holding gains and losses on trading securities are reported in the income statement (net income). A holding gain or loss is the net change in fair value during the period, not including recognized dividends or interest not received.

To retain historical cost in the accounts while reporting changes in the carrying amount from changes in fair value, a valuation allowance may be established.

Question 44

Available-for-Sale Securities –Unrealized holding gains and losses

Answer 44

Unrealized holding gains and losses resulting from the remeasurement to fair value are reported in other comprehensive income (OCI).

1. Tax effects are debited or credited directly to OCI.
2. Amortization of any discount (premium) is reported by a debit (credit) to available-for-sale securities or an allowance and a credit (debit) to interest income.
3. Receipt of cash dividends is recorded by a debit to cash and a credit to dividend income.
4. All or part of unrealized gains and losses for an available-for-sale security designated and qualifying as the hedged item in a fair value hedge are recognized in earnings.

Question 45

(T/F) At each balance sheet date, trading debt securities are remeasured at fair value.

Answer 45

True.

At each balance sheet date, trading debt securities are remeasured at fair value.

Question 46

(T/F) The accounting for available-for-sale debt securities is similar to that for trading securities except that unrealized holding gains and losses are reported in earnings.

Answer 46

False.

The accounting for available-for-sale debt securities is similar to that for trading securities except that unrealized holding gains and losses are reported in other comprehensive income (OCI), not earnings.

Question 47

(T/F) Unrealized holding gains and losses on available-for-sale debt securities are reported in the equity section of the balance sheet in accumulated other comprehensive income.

Answer 47

True.

In the equity section, unrealized holding gains and losses are reported in accumulated OCI (the real account to which OCI is closed).

Question 48

(T/F) Transfers between categories of debt securities are recorded at cost.

Answer 48

False.

Transfers between categories of debt securities are recorded at fair value.

Question 49

On August 1, Dragon, Inc., acquired $10,000 face amount, 5% bonds of Elroy, Inc., at 106. The bonds were dated May 1 and mature in 5 years on April 30, with interest payable each October 31 and April 30. Dragon has the positive intent and ability to hold bonds until they mature. What journal entry should Dragon make to record the purchase of the bonds?

Answer 49

To record the bond purchase:
(D) Held-to-maturity securities - bonds $10,600
(D) Interest receivable $125
(C) Cash $10,725

Question 50

(T/F) If the bond’s stated rate is less than the current market rate, the bond is purchased at a premium.

Answer 50

False.

If the bond’s stated rate is less than the current market rate, the purchase price is lower than the face amount, and the bond is purchased at a discount.

Question 51

(T/F) When debt securities with detachable stock warrants are purchased, the price should be allocated between the warrants and the securities based upon their cost at issuance.

Answer 51

False.

When debt securities with detachable stock warrants are purchased, the price should be allocated between the warrants and the securities based upon their relative fair values at issuance. The amount debited to investment in stock warrants relative to the total amount paid increases the discount or decreases the premium on the investment.

Question 52

(T/F) A discount on a bond is amortized using the straight-line method.

Answer 52

False.

Any premium or discount is amortized over the life of the bond using the effective-interest method. The straight-line method can be used only if its results are not materially different from those of the effective-interest method.

Question 53

Burr Company had the following account balances at December 31, Year 1:

Cash in banks $2,250,000
Cash on hand 125,000
Cash legally restricted for additions to plant (expected to be disbursed in Year 2) 1,600,000

Cash in banks includes $600,000 of compensating balances related to short-term borrowing arrangements. The compensating balances are not legally restricted as to withdrawal by Burr. In the current assets section of Burr’s December 31, Year 1, balance sheet, total cash should be reported at

Answer 53

$2,375,000

Legally restricted amounts related to long-term arrangements should be classified separately as noncurrent. Thus, the amount restricted for additions should be classified as noncurrent because it relates to a plant asset. Compensating balances against short-term borrowing arrangements that are legally restricted should be reported separately among the cash and cash equivalents in the current assets section. Total cash reported as current assets therefore equals $2,375,000 ($2,250,000 + $125,000).

Question 54

Clark Co.’s advertising expense account had a balance of $146,000 at December 31, Year 1, before any necessary year-end adjustment relating to the following:

Included in the $146,000 is the $15,000 cost of printing catalogs in Year 1 for a sales promotional campaign in January Year 2.

Radio advertisements broadcast during December Year 1 were billed to Clark on January 2, Year 2. Clark paid the $9,000 invoice on January 11, Year 2.

Clark’s policy is to expense advertising costs when incurred. What amount should Clark report as advertising expense in its income statement for the year ended December 31, Year 1?

Answer 54

$155,000

Advertising and promotion costs are expensed either (1) as incurred or (2) when advertising first occurs. The accounting policy chosen must be applied consistently to similar advertising activities. Thus, advertising expense must be recognized when incurred in accordance with Clark’s policy. It must include an accrual for the $9,000 for radio advertisements broadcast in Year 1. The $15,000 cost of printing catalogs also must be recognized as an expense in Year 1 because a liability was incurred in Year 1. Consequently, Year 1 advertising expense is $155,000 ($146,000 + $9,000).

Question 55

A reclassification of available-for-sale debt securities to the held-to-maturity category results in

The amortization of an unrealized gain or loss existing at the transfer date.
The recognition in earnings on the transfer date of an unrealized gain or loss.
The reversal of any unrealized gain or loss previously recognized in other comprehensive income.
The reversal of any unrealized gain or loss previously recognized in earnings.

Answer 55

The amortization of an unrealized gain or loss existing at the transfer date.

The unrealized holding gain or loss on the date of transfer for available-for-sale debt securities transferred to the held-to-maturity category continues to be reported in OCI. However, it is amortized as an adjustment of yield in the same manner as the amortization of any discount or premium. This amortization offsets or mitigates the effect on interest income of the amortization of the premium or discount. Fair value accounting may result in a premium or discount when a debt security is transferred to the held-to-maturity category.

Question 56

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?

Answer 56

$911,300

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)].

Question 57

Sun Corp. had investments in trading debt securities costing $650,000. On June 30, Year 2, Sun decided to hold the investments indefinitely and accordingly reclassified them as available-for-sale debt securities on that date. The investments’ fair value was $575,000 at December 31, Year 1, $530,000 at June 30, Year 2, and $490,000 at December 31, Year 2.
What amount of loss should Sun report in its Year 2 earnings?

$160,000
$120,000
$45,000
$85,000

Answer 57

45,000

Trading debt securities are recorded at fair value, and unrealized holding gains and losses are included in earnings. When a trading security is reclassified, it should be transferred at fair value at the date of transfer. The unrealized holding gain or loss at the date of transfer has already been recognized in earnings and is not reversed. Accordingly, Sun must have recognized an unrealized holding loss of $75,000 ($650,000 cost – $575,000 fair value) in Year 1 net income. The additional unrealized holding loss at June 30, Year 2, of $45,000 ($575,000 fair value at 12/31/Yr 1 – $530,000 fair value at 6/30/Yr 2) is included in Year 2 net income. The unrealized holding loss that occurred after the transfer ($530,000 fair value at the date of transfer – $490,000 fair value at 12/31/Yr 2 = $40,000) is included in other comprehensive income, not Year 2 net income, because the securities were deemed to be available-for-sale debt securities after June 30, Year 2.

Question 58

On January 1, Welling Company purchased 100 of the $1,000 face value, 8%, 10-year bonds of Mann, Inc. The bonds mature on January 1 in 10 years, and pay interest annually on January 1. Welling purchased the bonds to yield 10% interest. Information on present value factors is as follows:

Present value of $1 at 8% for 10 periods is 0.4632
Present value of $1 at 10% for 10 periods is 0.3855
Present value of an annuity of $1 at 8% for 10 periods is 6.7101
Present value of an annuity of $1 at 10% for 10 periods is 6.1446

How much did Welling pay for the bonds?
   $95,477
   $100,000
   $92,230
   $87,707

Answer 58

$87,707

An investment in a bond should be recorded at its fair value, i.e., the present value of its cash flows discounted at the market (yield) rate of interest. The present value of the investment has two components: the value of the periodic cash interest payments and the value of the bond proceeds at maturity. The interest payment at 8% on each bond will be $80 per year for 10 years. Applying a present value factor of 6.1446 (annuity, 10 periods, 10%) gives a present value of the periodic interest payments of $491.57. The proceeds of each bond at maturity of $1,000 are multiplied by a factor of .3855 (10%, 10 periods) for a present value of $385.50. The resulting total price per bond of $877.07 ($491.57 + $385.50) multiplied by 100 bonds gives a total payment of $87,707.

Question 59

On January 1, Jennie Corporation purchased 30% of the common stock of Katlee Company for $500,000. The following information relates to Katlee at the date of acquisition.
Cash $  50,000
Accounts receivable (net) $250,000
Building (net) $700,000
Land $100,000
Liabilities $100,000

Additional information relating to the purchase appears below.

1. Jennie has the ability to exercise significant influence over Katlee and did not elect the fair value option.
2. Both the carrying amount and the fair value are the same for receivables, land, and liabilities.
3. The fair value of the building is $900,000.
4. Jennie depreciates its assets on a straight-line basis. Both tangible and intangible assets are amortized over 10 years.
5. For the current year, Katlee had net income of $400,000 and declared and paid dividends of $100,000.

What amount should Jennie report for its investment in Katlee at the end of the current year?
   $584,000
   $500,000
   $620,000
   $600,000

Answer 59

$584,000

Jennie’s investment in Katlee is accounted for using the equity method. Jennie’s initial investment is $500,000. To this, Jennie adds its proportional share of Katlee’s earnings ($400,000 × 30% = $120,000) and subtracts its proportional share of Katlee’s dividend distribution ($100,000 × 30% = $30,000). Jennie also subtracts its proportional share of depreciation on the excess of Katlee’s building’s fair value over its carrying amount {[($900,000 – $700,000) ÷ 10  years] = $20,000}. Jennie’s share is $6,000 ($20,000 × 30%). Jennie’s year-end investment in Katlee can thus be calculated as follows:
Initial investment
$500,000
Share of earnings
120,000
Payment of dividends
(30,000)
Share of excess depreciation
(6,000)
Ending balance
$584,000

Question 60

Janson traded stock in Flax Co. marketable equity securities during Year 1 as follows:

Number of shares purchased (sold), Price per share

February 3, Year 1-   1,100, $11
April 15, Year 1- 2,500, $9
May 28, Year 1- (750), $13
July 5, Year 1- 1,400, $12
September 30, Year 1- (4,000), $15

No other transactions took place for Flax during the remainder of the year. At December 31, Year 1, Flax is trading at $10 per share. Janson trades securities on a last in, first out basis. What amount is the net value of the investment in Flax at year end?
   $(250)
   $3,750
   $2,500
   $2,750

Answer 60

$2,500

At each balance sheet date, an investment in equity securities that does not result in significant influence or control over the investee is measured at fair value. During the year, Janson purchased 5,000 shares and sold 4,750 shares for an ending balance of 250 shares. At year end, the fair value of each share is $10, so the year-end balance is $2,500 (250 shares × $10 per share).

Question 61

On December 1, Wall Company purchased trading debt securities. Pertinent data are as follows:

Debt Security Cost Fair Value at 12/31
A $39,000 $36,000
B 50,000 55,000
C 96,000 85,000

On December 31, Wall reclassified its investment in security C from trading to available-for-sale because Wall intends to retain security C. What net loss on its securities should be included in Wall’s income statement for the year ended December 31?
   $0
   $9,000
   $14,000
   $11,000

Answer 61

$9,000

Unrealized holding gains and losses on trading debt securities are included in earnings, and reclassification is at fair value. Furthermore, if a security is transferred from the trading category, the unrealized holding gain or loss at the date of transfer has already been recognized in earnings and is not reversed. Thus, the net unrealized holding loss at 12/31 is $9,000 ($3,000 loss on A – $5,000 gain on B + $11,000 loss on C).

Question 62

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

Discount and amortized by the effective interest method.
Premium and amortized by the effective interest method.
Premium and amortized by the straight-line method.
Discount and amortized by the straight-line method.

Answer 62

Premium and amortized by the effective interest method.

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.

Question 63

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?

The unrealized loss should be debited to the other comprehensive income account.
The unrealized loss should be credited to beginning retained earnings.
The unrealized loss should be credited to the investment account.
The unrealized loss should be credited to the other comprehensive income account.

Answer 63

The unrealized loss should be credited to the other comprehensive income account.

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.

Question 64

On January 1, Year 1, Peabody Co. purchased an investment for $400,000 that represented 30% of Newman Corp.’s outstanding voting stock. For Year 1, Newman reported net income of $60,000 and paid dividends of $20,000. At year end, the fair value of Peabody’s investment in Newman was $410,000. Peabody elected the fair value option for this investment. What amount should Peabody recognize in net income for Year 1 attributable to the investment?
   $18,000
   $16,000
   $10,000
   $6,000

Answer 64

$16,000

Financial assets measured using the FVO are reported at their fair values, and unrealized gains and losses are recognized in the income statement at subsequent reporting dates. The investor selected the FVO. Thus, it does not apply the equity method even though its 30% interest is presumed to give it significant influence over the investee. Under the FVO, dividends received are accounted for as dividend income, not a reduction of the investment. Accordingly, the investor recognizes an unrealized gain of $10,000 ($410,000 – $400,000) and dividend income of $6,000 ($20,000 × 30%), a total of $16,000.

Question 65

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
   $215,000
   $212,000
   $214,400
   $214,200

Answer 65

$212,000

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.

Question 66

When the equity method is used to account for investments in common stock, which of the following affects the investor’s reported investment income?

Goodwill Amortization Related to the Purchase
AND
Cash Dividends from Investee

Yes
No

Yes
Yes

No
Yes

No
No

Answer 66

No
No

Amortization of goodwill is prohibited and therefore does not reduce investment income. Moreover, equity method goodwill is not separately reviewed for impairment because it is not separate from the investment. The receipt of a cash dividend from the investee also does not affect equity-based earnings. The entry is to debit cash and credit the investment.

Question 67

On July 1, Year 1, Cody Co. paid $1,198,000 for 10%, 20-year bonds with a face amount of $1 million. Interest is paid on December 31 and June 30. The bonds were purchased to yield 8%. Cody uses the effective interest rate method to recognize interest income from this investment. The bonds are properly classified as held-to-maturity. What should be reported as the carrying amount of the bonds in Cody’s December 31, Year 1, balance sheet?

$1,195,920
$1,198,000
$1,207,900
$1,193,050

Answer 67

$1,195,920

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 1, interest income is $47,920 [$1,198,000 × 8% × (6 months ÷ 12 months)], and interest received is $50,000 [$1,000,000 × 10% × (6 months ÷ 12 months)]. Hence, the carrying amount at year end is $1,195,920 [$1,198,000 – ($50,000 – $47,920)].

Question 68

On January 2, Year 4, Early Co. purchased as a short-term investment a $1 million face amount Thomas Co. 8% bond for $910,000 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, Early sold the bonds for $920,000. In its December 31, Year 4, income statement, what amount should Early report in earnings as a gain or loss on the bond (disregarding interest), if it elected the fair value option (FVO) on January 2, Year 4?

$35,000
$0
$(1,000)
$24,000

Answer 68

$24,000

Given the FVO election, the bond (a financial asset) should be measured at fair value with unrealized gains and losses recognized in earnings. Thus, the bond should be reported at its fair value of $945,000 to reflect the unrealized holding gain (change in fair value). The unrealized holding gain at year end is recognized in earnings. It equals the fair value of the bond minus the carrying amount at year end. The carrying amount equals the initial cost plus amortization of the bond discount. Amortization is $11,000 [($910,000 × 10% yield) interest revenue – ($1,000,000 face amount × 8% nominal rate) interest receivable]. The unrealized holding gain therefore is $24,000 [$945,000 FV at 12/31 – ($910,000 cost + $11,000 discount amortization)].

Question 69

The following pertains to Smoke, Inc.’s investment in debt securities:

On December 31, Year 3, Smoke reclassified a security acquired during the year for $70,000. It had a $50,000 fair value when it was reclassified from trading to available-for-sale.
An available-for-sale security costing $75,000, written down to $30,000 in Year 2 because of an other-than-temporary impairment of fair value, had a $60,000 fair value on December 31, Year 3.
What is the net effect of the above items on Smoke’s net income for the year ended December 31, Year 3?

$20,000 decrease.
$30,000 increase.
No effect.
$10,000 increase.

Answer 69

$20,000 decrease.

Unrealized holding gains and losses on trading debt securities are included in net income, and reclassification is at fair value. Furthermore, if a security is transferred from the trading category, the unrealized holding gain or loss at the date of transfer already has been recognized in net income and is not reversed. Smoke therefore should include a $20,000 ($70,000 cost – $50,000 fair value at 12/31/Yr 3) unrealized holding loss in the determination of net income. After an available-for-sale debt security has been written down to reflect an other-than-temporary decline in fair value, with the loss included in net income, subsequent increases in its fair value are included in OCI. Thus, the appreciation of this security has no effect on Year 3 net income.

Question 70

Green Corp. owns 30% of the outstanding common stock and 100% of the outstanding noncumulative nonvoting preferred stock of Axel Corp. In Year 1, Axel declared dividends of $100,000 on its common stock and $60,000 on its preferred stock. Green exercises significant influence over Axel’s operations and uses the equity method to account for the investment in the common stock. What amount of dividend revenue should Green report in its income statement for the year ended December 31, Year 1?

$0
$90,000
$30,000
$60,000

Answer 70

$60,000

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, Green should report $60,000 of revenue when the preferred dividends are declared.

Question 71

Sun Corp. had investments in trading debt securities costing $650,000. On June 30, Year 2, Sun decided to hold the investments indefinitely and accordingly reclassified them as available-for-sale debt securities on that date. The investments’ fair value was $575,000 at December 31, Year 1, $530,000 at June 30, Year 2, and $490,000 at December 31, Year 2.
What amount should Sun report as net unrealized loss on available-for-sale securities in its Year 2 other comprehensive income?

$160,000
$40,000
$45,000
$85,000

Answer 71

$40,000

The securities were available-for-sale securities after the reclassification, which was at fair value ($530,000 at 6/30/Yr 2). Subsequent unrealized holding gains and losses are excluded from net income and reported in other comprehensive income until realized. Accordingly, the amount reported as net unrealized loss on available-for-sale securities is $40,000 ($530,000 – $490,000 fair value at 12/31/Yr 2).