Topic 3 and Topic 4 (FINAL)

Question 1

GAAP-reported four methods to report investments in other companies (B2B):

Answer 1

Fair-value method.

Cost method for equity securities without readily determinable fair values.

Consolidation of financial statements.

Equity method

Question 2

What is the GAAP method selection dependent on?

Answer 2

the degree of influence the investor (stockholder) has over the investee

Question 3

When do you use the fair-value method?

Answer 3

Investor holds a small percentage of equity securities of investee. (usually less than 20%)

Question 4

Initial investments in equity securities when significant influence and control are not present are:

Answer 4

Recorded at cost.

Adjusted to fair value if fair value is determinable.

If fair value not determinable, remains at cost

Changes in fair values are recognized as income.

Dividends declared on the securities are recognized as income

Question 5

journal entry for an investor recording investment in the investee at cost

Answer 5

Dr. Investment in securities
Cr. Cash (or other
assets/stock)

Question 6

journal entry for an investor recognizing dividend income for cash dividends received from investee

Answer 6

Dr. Cash
Cr. Income from investment

Question 7

journal entry for the investor adjustment to the investment account at fair-market value (FMV) if readily determinable at reporting date

If FMV>Cost

Answer 7

Dr. Investment
Cr. Unrealized gain on
investment

Question 8

Company X owns 10% of the common stock of Super X corporation and used the fair value method to account for this investment. Super X reported a net income $100,000 for 2020 and paid total dividends of $40,000 on September 1, 2020. How much income should Company X recognize on this investment in 2020?

$6,000
$4,000
$10,000
$60,000
$40,000

Answer 8

$4,000

Question 9

What is required when investor’s ownership exceeds 50 percent of an organization’s outstanding voting stock?

Answer 9

consolidation of financial statements

Question 10

What happens when a majority of voting stock is held?

Answer 10

investor-investee relationship is so closely connected that the two corporations are viewed as a single entity

Question 11

When is the equity method used?

Answer 11

Investor has the ability to exercise significant influence on investee operations (whether applied or not). Operating and financial decisions

Question 12

What is the ownership for the equity method?

Answer 12

20-50%

Question 13

How are the investor’s share of investee dividends declared recorded under the equity method?

Answer 13

as decreases in the investment account, not income.

Question 14

significant influence

Answer 14

Representation on the investee’s board of directors.

Participation in the investee’s policy-making process.

Material intra-entity transactions.
Interchange of managerial personnel.

Technological dependency.

Other investee ownership percentages

Question 15

What is the stock ownership level for the fair value or cost method?

Answer 15

0-20%

Question 16

What is the stock ownership level for the equity method or fair value?

Answer 16

20-50%

Question 17

What is the stock ownership level for consolidated financial statements?

Answer 17

50-100%

Question 18

fair value or cost method level of significant influence

Answer 18

inability to significantly influence

Question 19

equity method or fair value level of significant influence

Answer 19

ability to significantly influence

Question 20

consolidated financial statements level of significant influence

Answer 20

control through voting interests: financial statements of all related companies must be consolidated

Question 21

journal entry to record investment for equity method

Answer 21

Dr. Investment in investee
Cr. Cash (or other
assets/stock)

Question 22

journal entry to record net income % for equity method

Answer 22

Dr. Investment in investee
Cr. Equity in investee income

Question 23

journal entry to record net loss % for equity method

Answer 23

Dr. Equity in investee income
Cr. Investment in investee

Question 24

journal entry for the investor to reduce the investment account by the amount of cash dividends received from the investee for the equity method

Answer 24

Dr. Cash
Cr. Investment in investee

Question 25

what should be amortized

Answer 25

payment relating to each asset (except land, goodwill, and other indefinite life intangibles)

Question 26

how is goodwill measured for equity method investments

Answer 26

tested for declines in value and impairment

Question 27

journal entry for amortization

Answer 27

Dr. Equity in investee income
Cr. Investment in subsidiary

Question 28

when do you report a change to the equity method

Answer 28

An investment that was recorded using the cost or fair-value method reaches the point where significant influence is established.

When an investment qualifies for use of the equity method, the investor adds the cost of acquiring additional interest in the investee to the current basis and adopts the equity method of accounting [(FASB ASC (para. 323-10-35-33)].

This prospective approach avoids the complexity of restating prior period amounts

Question 29

how does a decline in investment value result

Answer 29

a loss of major customers, changes in economic conditions, loss of a significant patent or other legal right, damage to the company’s reputation, etc.

A temporary drop in the fair value of an investment is simply ignored

Question 30

how is a permanent decline in the investee’s fair market value recorded

Answer 30

as an impairment loss and the investment account is reduced to the fair value

Question 31

if part of an investment is sold during the period,

Answer 31

The equity method is applied up to the transaction date.

At the transaction date, the Investment account balance is reduced by the percentage of shares sold.

If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded if the investor is required to change FROM the equity method to the fair-value method.

Note: A change TO the equity method is also treated prospectively

Question 32

downstream sales of inventory - investor sales to investee

Answer 32

Profit recognition is delayed until buyer disposes of the goods. *to defer gross profit on sale of inventory to investee

Investor decreases current equity income to reflect the deferred portion of the intra-entity profit.

When this inventory is eventually consumed or sold to unrelated parties, the deferral is no longer needed and the deferral entry is reversed.

Question 33

upstream sales of inventory - investee sales to investor

Answer 33

reported in the same manner as downstream sales.

Profit recognition is delayed until buyer disposes of the goods. *to defer recognition of gross profit until inventory is used or sold to outside parties

Investor decreases current equity income to reflect the deferred portion of the intra-entity profit.

When this inventory is eventually consumed or sold to unrelated parties, the deferral is reversed

Question 34

Perez, Inc. applies the equity method for its 25% investment in Senior, Inc. During 2021, Perez sold goods with a 40% gross profit to Senior. Senior sold all of these goods in 2021. How should Perez report the effect of the intra-entity sale on its 2021 income statement?

Sales and cost of goods sold should be reduced by the amount of intra-entity sales.

Sales and cost of goods sold should be reduced by 25% of the amount of intra-entity sales.

Investment income should be reduced by 25% of the gross profit on the amount of intra-entity sales.

No adjustment is necessary

Answer 34

No adjustment is necessary

Question 35

3 criticisms of the equity method

Answer 35

Emphasizing the 20–50 percent of voting stock in determining significant influence versus control.

Allowing off-balance-sheet financing.

Potentially biasing performance ratios

Question 36

7 reasons or motives for firms to combine

Answer 36

Vertical integration.

Cost savings.

Quick entry for products into markets.

Economies of scale.

More attractive financing opportunities.

Diversification of business risk.

Business expansion

Question 37

why consolidated financial reporting

Answer 37

these financial statements provide more meaningful information than separate statements.

these financial statements more fairly present the activities of the these companies.

these companies may retain their legal identities as separate corporations

Question 38

business combination

Answer 38

Refers to a transaction or other event in which an acquirer obtains control over one or more businesses.

Is formed by a wide variety of transactions or events with various formats.

Can differ widely in legal form.

Unites two or more enterprises into a single economic entity that requires consolidated financial statements

Question 39

statutory merger

Answer 39

Any business combination in which only one of the original companies continues to exist

Question 40

two types of statutory mergers

Answer 40

a. A business combination in which one company obtains all of the assets, and often the liabilities, of another company.

b. A business combination in which one company obtains all of the capital stock of another company. The acquiring company must gain 100 percent control of all shares of stock before legally dissolving the company

Question 41

statutory consolidation

Answer 41

A specific type of business combination that unites two or more companies under the ownership of a newly created company. Two or more companies transfer either their assets or their capital stock to a newly formed corporation

Question 42

control without dissolution

Answer 42

When one company achieves legal control over another by acquiring a majority of voting stock, although control is present, no dissolution takes place. Each company remains in existence as an incorporated operation

Question 43

if dissolution occurs

Answer 43

Dissolved company’s records are closed out. Surviving company’s accounts are adjusted to include appropriate balances of the dissolved company

Question 44

if separate incorporation is maintained

Answer 44

Each company continues to retain its own records. Worksheets facilitate the periodic consolidation process without disturbing individual accounting systems

Question 45

steps if dissolution occurred

Answer 45

1. All account balances are physically consolidated in the financial records of the survivor.
2. Permanent consolidation occurs at the combination date.
3. Dissolved company’s records are closed out.
4. Surviving company’s accounts are adjusted to include appropriate balances of the dissolved company.

Question 46

steps if separate incorporation is maintained

Answer 46

1. Only the financial statement information (on work papers, not the actual records) is consolidated.
2. The consolidation process is carried out at regular intervals whenever F/S are prepared.
3. Each company continues to retain its own records.
4. Worksheets facilitate the periodic consolidation process without disturbing individual accounting systems

Question 47

acquisition method

Answer 47

Required to account for a business combination. It embraces the fair value in measuring the acquirer’s interest in the acquired business

Question 48

Applying the acquisition method involves using fair value to recognize and measure:

Answer 48

The consideration transferred for the acquired business and any noncontrolling interest.

Separately identified assets acquired and liabilities assumed.

Goodwill, or a gain from a bargain purchase.

Question 49

when should fair value of the assets acquired and liabilities assumed in a business combination be determined?

Answer 49

at the acquisition date

Question 50

fair value

Answer 50

The price that would be received from selling an asset or paid for transferring a liability in an orderly transaction between market participants at the measurement date

Question 51

3 valuation techniques

Answer 51

The market approach estimates fair values using other market transactions involving similar assets or liabilities.

The income approach relies on multi-period estimates of future cash flows projected to be generated by an asset. (DCF  NPV, IRR)

The cost approach estimates fair values by reference to the current cost of replacing an asset with another of comparable economic utility. i.e. PPE

Question 52

What if the amount paid does NOT EQUAL the Fair Value of the Assets acquired?

Answer 52

If the purchase price is MORE than the Fair Value of the Assets acquired, the difference is attributed to GOODWILL

If the purchase price is LESS than the Fair Value of the Assets acquired, we got a BARGAIN!! And we will record a ”GAIN on Bargain Purchase”

Question 53

when does an exception to the general rule of recording business acquisitions at fair value of the consideration transferred occur?

Answer 53

the rare circumstance of a bargain purchase

Question 54

bargain purchase

Answer 54

Thefair value of the consideration transferred by the acquirer is less than the fair value received in an acquisition, which is considered more relevant for asset valuation than the consideration transferred.

A gain is recognized

Question 55

Three additional categories of costs are incurred in business combinations, regardless of whether dissolution takes place:

Answer 55

Attorneys, accountants, investment bankers, and other professionals engaged for combination-related services. These service fees are expensed in the period incurred.

An acquiring firm’s internal costs (secretarial and management time allocated to the acquisition activity). Such indirect costs are reported as current year expenses, too.

Amounts incurred to register and issue securities (if any) in connection with a business combination simply reduce the otherwise determinable fair value of those securities.

Question 56

the acquisition method when separate incorporation is maintained

Answer 56

Significant differences are evident in combinations in which each company remains a legally incorporated separate entity.

Consolidation is only simulated  Acquiring company does not physically record the acquired assets and liabilities

Dissolution does not occur; each company maintains independent record-keeping

A worksheet and consolidation entries are employed using data gathered from these separate companies although neither company ever records consolidation worksheet entries in its journals

Question 57

what happens with the acquisition method when the subsidiary is not dissolved?

Answer 57

Prepare a worksheet to consolidate the financial statements of two companies that form a business combination in the absence of dissolution

Question 58

3 key points of the acquisition method when the subsidiary is not dissolved

Answer 58

Fair value is the basis for initial consolidation of subsidiary’s net assets.

Consolidation of financial information is simulated.

Neither company physically records the transaction.

Question 59

consolidation worksheet entries

Answer 59

1. Prior to constructing a worksheet, the parent prepares a formal allocation of the acquisition-date fair value similar to the equity method procedures
2. Acquisition-date financial information for parent (after journal entry for the investment and combination costs) and sub is recorded in the first two columns of the worksheet (sub’s prior revenue and expense already closed).
3. Remove the sub’s equity account balances and remove the Investment in Sub balance (Entry S).
4. Remove the excess payment in the investment account at acquisition date and assign it to the specific accounts indicated by the fair-value allocation schedule (Entry A)
5. Combine all account balances and extend into the Consolidated Totals column.
6. Subtract consolidated expenses from revenues to arrive at net income

Question 60

acquisition date fair value allocations additional issues

Answer 60

Preexisting goodwill recorded in the acquired company’s accounts is ignored in the acquisition-date fair value.

Acquired IPR&D (acquired businesses in-process research and development) is measured at acquisition-date fair value, recognized as an asset, and tested for impairment. It is not amortized until its useful life is determined to be no longer indefinite.

Question 61

What is the typical % range of ownership level when using the equity method of accounting for stock investments? (For example, 0-20%)

Answer 61

20-50%

Question 62

When an investor uses the equity method to account for investments in common stock, the investor’s share of cash dividends from the investee should be recorded as

A. a deduction from the investor’s share of the investee’s profits

B. dividend income

C. a deduction from the stockholders’ equity account, Dividends to Stockholders

D. a deduction from the investment account

Answer 62

D. a deduction from the investment account

Question 63

The equity method tends to be most appropriate if

A. an investment represents 50 percent or more of the voting stock of an investee

B. an investment enables the investor to influence the operating and financial decisions of the investee

C. majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor

D. the investor is unable to obtain representation on the investee’s board of directors

Answer 63

B. an investment enables the investor to influence the operating and financial decisions of the investee

Question 64

Under fair-value accounting for an equity investment, which of the following affects the income the investor recognizes from its ownership of the investee?

A. the investee’s reported income adjusted for excess cost over book value amortizations

B. changes in the fair value of the investor’s ownership shares of the investee

C. Intra-entity profits from upstream sales

D. Other comprehensive income reported by the investee

Answer 64

B. changes in the fair value of the investor’s ownership shares of the investee

Question 65

Pretend you own your company. If your company purchases an equity investment (i.e. stock in another company) at a price in excess of the investee’s book value, the difference must be identified and accounted for correctly in your accounting records (TRUE/FALSE)

Answer 65

True

Question 66

If the difference between the purchase price and the investee’s book value cannot be attributed to a specific asset or liability, it is assigned as which intangible asset on your books?

Answer 66

Goodwill

Question 67

What is the term used to describe sales between an investor and its equity method investee?

Answer 67

Intra-entity

Question 68

Hawkins Company has owned 10 percent of Larker, Inc., for the past several years. This ownership did not allow Hawkins to have significant influence over Larker. Recently, Hawkins acquired an additional 30 percent of Larker and now will use the equity method. How will the investor report change?

a. A cumulative effect of an accounting change is shown in the current income statement

b. A retrospective adjustment is made to restate all prior years presented using the equity method

c. No change is recorded; the equity method is used from the date of the new acquisition

d. Hawkins will report the change as a component of accumulated other comprehensive income

Answer 68

c. No change is recorded; the equity method is used from the date of the new acquisition

Question 69

When an equity method investment account is reduced to a zero balance

a. The investor should establish a negative investment account balance for any future losses reported by the investee

b. The investor should discontinue using the equity method until the investee begins paying dividends

c. Future losses are reported as unusual items in the investor’s income statement

d. The investment retains a zero balance until subsequent investee profits eliminate all unrecognized losses

Answer 69

d. The investment retains a zero balance until subsequent investee profits eliminate all unrecognized losses

Question 70

Perez, Inc., applies the equity method for the 25 percent investment in Senior, Inc. During 2021, Perez sold goods with a 40 percent gross profit to Senior, which sold all of these goods in 2021. How should Perez report the effect of the intra-entity sale on its 2021 income statement?

a. Sales and cost of goods sold should be reduced by the amount of the intra-entity sales

b. Sales and cost of goods sold should be reduced by 25 percent of the amount of intra-entity sales

c. Investment income should be reduced by 25 percent of the gross profit on the amount of intra-entity sales

d. No adjustment is necessary

Answer 70

d. No adjustment is necessary

Question 71

Creating a huge organization with a widely diverse group of businesses (i.e. conglomerates) is always a reason and the primary motivator for business combinations (TRUE/FALSE)

Answer 71

False

Question 72

During a statutory merger through an asset acquisition, the acquired company will dissolve and go out of business. (TRUE/FALSE)

Answer 72

True

Question 73

The acquisition method uses which method to measure and assess business activity for a business combination? {book value, fair value, pooling of interests, or purchase method}

Answer 73

Fair value

Question 74

Which of the following does not represent a primary motivation for business combinations?

a. Combinations are often a vehicle to accelerate growth and competitiveness

b. Cost savings can be achieved through elimination of duplicate facilities and staff

c. Synergies may be available through quick entry for new and existing products into markets

d. Larger firms are less likely to fail

Answer 74

d. Larger firms are less likely to fail

Question 75

What is a statutory merger?

a. a merger approved by the Securities and Exchange Commission

b. An acquisition involving the purchase of both stock and assets

c. A takeover completed within one year of official tender offer

d. A business combination in which only one company continues to exist as a legal entity

Answer 75

d. A business combination in which only one company continues to exist as a legal entity

Question 76

What is goodwill?

a. An intangible asset representing the excess of consideration transferred over the collective fair values of the net identifiable assets acquired in a business combination

b. An expense that an acquiring firm recognizes for the excess of consideration transferred over the collective fair values of the net identifiable assets acquired in a business combination

c. A concept representing synergies resulting from a business combination but not recognized for financial reporting purposes

d. An internally developed intangible asset that is recognized on a business firm’s balance sheet as the business generates profits in excess of normal rate of return on its identifiable net assets

Answer 76

a. An intangible asset representing the excess of consideration transferred over the collective fair values of the net identifiable assets acquired in a business combination

Question 77

FASB ASC 805, “Business Combinations,” provides principles for allocating the fair value of an acquired business. When the collective fair values of the separately identified assets acquired and liabilities assumed exceed the fair value of the consideration transferred, the difference should be

a. Recognized as an ordinary gain from a bargain purchase

b. Treated as negative goodwill to be amortized over the period benefited, not to exceed 40 years

c. Treated as goodwill and tested for impairment on an annual basis

d. Applied pro rata to reduce, but not below zero, the amounts initially assigned to specific non-current assets of the acquired firm

Answer 77

a. Recognized as an ordinary gain from a bargain purchase

Question 78

If fair value of the consideration transferred by the acquirer (for example, cash paid to purchase control of another company) exceeds the net identified asset fair value, what is recognized on the financial records?

Answer 78

Goodwill

Question 79

In the example above, if the difference between the fair value of the purchase price is less than the net asset fair value, a bargain purchase is recognized. These combinations are rather rare and create a “Gain on Bargain Purchase” on the financial records (TRUE/FALSE)

Answer 79

True

Question 80

When separate incorporation is maintained during the acquisition method, consolidation is simulated using worksheet entries that do not adjust or eliminate account balances of either the parent or subsidiary (TRUE/FALSE)

Answer 80

True

Question 81

Acquired in-process research and development (IPR&D) is considered an intangible asset always subject to amortization (TRUE/FALSE)

Answer 81

False