Unit 5 questions

Question 1

Should compensating balances and restricted cash be disclosed in notes to its FS?

Answer 1

Yes

Cash amounts designated for special uses should be separately presented. For example, cash restricted for bond sinking funds should be separately stated from cash and disclosed in the financial statements. As part of an agreement regarding either an existing loan or the provision of future credit, a borrower may be required to keep an average or minimum deposit with the lender. This compensating balance not only increases the effective rate of interest paid by the borrower but also creates a disclosure issue because the full amount reported in the cash account might not be available to meet general obligations.

Question 2

Compensating balances that are not legally restricted as to withdrawal as included or exclusded from cash on the BS?

Answer 2

Included. Only legally restricted amounts related to LT arrangements should be classfied separately as noncurrent.

Question 3

Companies A and B begin with identical account balances, and their revenues and expenses for the year are identical in amount except that Company A has a higher ratio of cash to noncash expenses. If the cash balances of both companies increase as a result of operations (no financing or dividends), the ending cash balance of Company A as compared to that of Company B will be

Answer 3

Lower.

A and B began with identical cash balances, and all revenues and expenses are identical except that A has a higher ratio of cash to noncash expenses. Thus, A must have a lower cash balance at the end of the year because more of A’s expenses required a credit to cash. More of B’s expenses would have been accrued (i.e., credited to liability accounts). This question assumes no financing, no cash dividends, and identical amounts of cash and credit sales for A and B. If A and B had the same amount of revenue but different proportions of cash and credit sales, it would not be possible to determine which had the higher cash balance from the facts given.

Question 4

The following are held by Smite Co.:

• Cash in checking account $20,000
• Cash in bond sinking fund account 30,000
• Post-dated check from customer dated one month from balance sheet date 250
• Petty cash 200
• Commercial paper (matures in two months) 7,000
• Certificate of deposit (matures in six months 5,000

What amount should be reported as cash and cash equivalents on Smite’s balance sheet?

Answer 4

$27,200

Answer (A) is correct.
Cash consists of (1) coin and currency on hand, (2) demand deposits (checking accounts), (3) time deposits (savings accounts), and (4) near-cash assets (e.g., deposits in transit or commercial paper, also known as negotiable instruments). Thus, the cash in checking and petty cash are included in cash and cash equivalents. Cash that is restricted to use for other than current operations, designated for the acquisition or construction of noncurrent assets, or segregated for the liquidation of long-term debts (e.g., a sinking fund) is noncurrent. Undeposited checks from customers are near-cash items, but they are excluded if they are undepositable (e.g., postdated or unsigned). Cash equivalents are short-term, highly liquid investments. Normally, only investments with original maturities of 3 months or less qualify. Hence, the CD is not included. However, commercial paper with an original maturity of two months is a cash equivalent. The balance reported is therefore $27,200 ($20,000 checking + $200 petty cash + $7,000 commercial paper).

Question 5

Which of the following is an election date for the purpose of determining whether to elect the fair value option (FVO)?

A.The entity enters into a firm commitment to purchase soybeans in 3 months.

B.The accounting treatment of an equity investment changes because the entity must consolidate the investee.

C.The accounting for an equity investment changes because the entity no longer consolidates a subsidiary.

D.The accounting treatment of an equity investment changes because the entity no longer has significant influence.

Answer 5

Answer (C) is correct.
An entity may choose the FVO only on an election date. For example, an election date occurs when the accounting for an equity investment in another entity changes because the investor retains an interest but no longer consolidates a subsidiary or a variable interest entity.

Question 6

When financial assets and liabilities are measured using the fair value option (FVO), their fair values should be reported

Answer 6

separately from the carrying amounts of similar items measured using other attributes.

Assets and liabilities measured using the FVO are reported in a way that separates their fair values from the carrying amounts of similar items measured using another attribute. To accomplish that purpose, an entity may (1) present the aggregate of fair value and non-fair-value amounts in the same line item in the balance sheet and parenthetically disclose the amount measured at fair value or (2) present two separate line items.

Question 7

An election date for the FVO includes the date of an event requiring fair value measurement when it occurs but not subsequently (excluding recognition of impairment, e.g., of inventory or long-lived assets). Examples of events requiring either remeasurement at fair value or initial recognition of eligible items and that result in an election date are:

Answer 7

(1) a business combination,
(2) a consolidation or deconsolidation, or
(3) a significant modification of debt. A consolidation requires an initial recognition in the consolidated statements of eligible items on the books of the subsidiary but not measurement of those items at fair value. A business combination involves an initial recognition of the assets acquired and liabilities assumed, with measurement at fair value. However, an investment in a subsidiary required to be consolidated is not itself an item eligible for the FVO.

Question 8

The decision to elect the fair value option (FVO)

Answer 8

Is irrevocable until the next election date, if any.

The decision to elect the FVO is final and cannot be revoked unless a new election date occurs. For example, an election date occurs when an entity recognizes an investment in equity securities with readily determinable fair values issued by another entity. A second election date occurs when the accounting changes because the investment later becomes subject to equity-method accounting. An original decision to classify the equity securities as available-for-sale may then be revoked at the second election date by choosing the FVO instead of the equity method.

Question 9

Dates on which the fair value option (FVO) may be elected include

Answer 9

The date on which financial assets no longer qualify for fair value reporting under a specialized accounting principle.

Election dates include the date of an event that causes financial assets measured at fair value (with unrealized gains and losses reported in earnings because of a specialized accounting principle) no longer to qualify for such accounting treatment. An example is a transfer of assets from a subsidiary within the scope of the guidance on investment companies to an entity within the same consolidated entity that is not subject to that guidance.

Question 10

Items eligible for the FVO election do not include employers’ and plans’ obligations for:

Answer 10

(1) employee pension benefits,
(2) other postretirement employee benefits,
(3) postemployment benefits,
(4) employee stock option and stock purchase plans, or
(5) other deferred compensation.

Question 11

The reporting entity may elect the fair value option (FVO) for

Answer 11

Most financial assets and liabilities.

An entity may elect the FVO for most recognized financial assets and liabilities. For example, the FVO may be elected for most held-to-maturity and available-for-sale securities.

Question 12

Election of the fair value option (FVO)

Answer 12

Results in recognition of unrealized gains and losses in earnings of a business entity.

A business measures at fair value the eligible items for which the FVO election was made at a specified election date. The unrealized gains and losses on those items are reported in earnings at each subsequent reporting date.

Question 13

A company leases trucks and properly classifies the leases as capital leases. The leases have a 10-year term, and the lease calculations were done 3 years ago when interest rates were lower. Which of the following is the appropriate accounting treatment, if any, for the application of the fair value option to lease transactions?

A.Recognize the change to fair value accounting with an unrealized loss in the income statement.

B.Leases are not eligible for the fair value option.

C.Recognize the change to fair value accounting with an unrealized loss in accumulated other comprehensive income.

D.Recognize the change to fair value accounting with a cumulative adjustment to beginning retained earnings.

Answer 13

Answer (B) is correct.
Generally, the fair value option does not apply to financial assets and liabilities under leases. Therefore, the capital leases in the question are not eligible for the fair value option.

Question 14

What are the 3 Classifications of debt securities?

Answer 14

Held to Maturity

Trading Security

Available for Sale Security

Question 15

Beach Co. determined that the decline in the fair value (FV) of an investment was below the amortized cost and permanent in nature. The investment was classified as available-for-sale on Beach’s books. The controller would properly record the decrease in FV by including it in?

Answer 15

Earnings section of the income statement and writing down the cost basis to FV.

The amortized cost basis is used to calculate the amount of any impairment. The amortized cost basis should be distinguished from fair value, which equals the cost basis plus or minus the net unrealized holding gain or loss. If a decline in fair value of an individual available-for-sale security below its amortized cost basis is other than temporary, the amortized cost basis is written down to fair value as a new cost basis. The write-down is deemed to be a realized loss and is included in earnings.

Question 16

On July 2, Year 4, Wynn, Inc., purchased as a short-term investment a $1 million face-value Kean Co. 8% bond for $910,000 plus accrued interest to yield 10%. The bonds mature on January 1, Year 11, and pay interest annually on January 1. On December 31, Year 4, the bonds had a fair value of $945,000. On February 13, Year 5, Wynn sold the bonds for $920,000. In its December 31, Year 4, balance sheet, what amount should Wynn report for the bond if it is classified as an available-for-sale security?

Answer 16

$945,000

Available-for-sale securities should be measured at fair value in the balance sheet. Thus, the bond should be reported at its fair value of $945,000 to reflect the unrealized holding gain (change in fair value).

Question 17

During Year 6, Wall Co. purchased 2,000 shares of Hemp Corp. common stock for $31,500 that are classified as trading securities. The fair value of this investment was $29,500 at December 31, Year 6. Wall sold all of the Hemp common stock for $14 per share on December 15, Year 7, incurring $1,400 in brokerage commissions and taxes. In its income statement for the year ended December 31, Year 7, Wall should report a recognized loss of

Answer 17

$2,900

A realized loss or gain is recognized when an individual security is sold or otherwise disposed of. Wall would have included the $2,000 ($31,500 – $29,500) decline in the fair value of the trading securities (an unrealized holding loss) in earnings at 12/31/Yr 6. Consequently, the realized loss on disposal at 12/15/Yr 7 is $2,900 {$29,500 carrying amount – [(2,000 shares × $14) – $1,400]}.

Question 18

For available-for-sale securities included in noncurrent assets, which of the following amounts should be included in the period’s net income?

1. Unrealized holding losses during the period
2. Realized gains during the period
3. Changes in fair value during the period

Answer 18

A. 2 only.

The temporary decline below cost of the fair value of available-for-sale securities is recorded in OCI, assuming they are not designated as being hedged in a fair value hedge. Thus, temporary changes in the valuation of these securities do not flow through net income. A realized gain occurs when securities are sold at an amount greater than their cost basis. Realized gains are included in net income regardless of the classification of the securitie

Question 19

Securities held primarily for sale in the near term to generate income on short-term price differences are known as

Answer 19

Trading securities.

Trading securities are bought and held primarily for sale in the near term. They are purchased and sold frequently. They are initially recorded at cost but are remeasured at fair value at each balance sheet date, with the unrealized holding gains or losses recognized in earnings.

Question 20

Investments classified as held-to-maturity are measured at

Answer 20

Amortized cost, with no unrealized gains or losses reported.

Assuming the fair value option has not been elected, held-to-maturity securities are reported at amortized cost, with no unrealized gains or losses reported.

Question 21

An entity should report the marketable equity securities that it has classified as trading at

Answer 21

Fair value, with holding gains and losses included in earnings.

Trading securities are those held principally for sale in the near term. They are classified as current and consist of debt securities and equity securities with readily determinable fair values. Unrealized holding gains and losses on trading securities are reported in earnings. On a statement of financial position, these securities are reported at fair value.

Question 22

Unrealized gains and losses on trading securities should be presented in the

Answer 22

Income statement.

Unrealized holding gains and losses on trading securities are included in earnings and are therefore reported in the income statement.

Question 23

Long Co. invested in marketable securities. At year-end, fair-value changes in this investment were included in Long’s other comprehensive income. How would Long classify this investment?

Answer 23

Available-for-sale securities.

Available-for-sale securities are measured at fair value at each balance sheet date. Unrealized holding gains and losses resulting from the remeasurement to fair value are reported in other comprehensive income (OCI).

Question 24

Trading securities and available-for-sale securities are reported at their _______ at each balance sheet date. Held-to-maturity securities are reported at ________.

Answer 24

Trading securities and available-for-sale securities are reported at their fair values at each balance sheet date. Held-to-maturity securities are reported at amortized cost.

Question 25

Where are unrealized losses and gains reproted for available for sale securities and trading securities?

Answer 25

Available for sale- Unrealized holding gains and losses resulting from the remeasurement to FV are reported in OCI

Trading securities- Unrealized gains and losses on trading securities are included in earnings.

Question 26

An investor uses the fair value method to account for an investment in common stock. A portion of the dividends received this year were in excess of the investor’s share of investee’s earnings subsequent to the date of investment. The amount of dividend revenue that should be reported in the investor’s income statement for this year is

Answer 26

The portion of the dividends received this year that were not in excess of the investor’s share of investee’s earnings subsequent to the date of investment.

Unless the investor accounts for the investment using the equity method, dividends from an investee should be accounted for as dividend income unless a liquidating dividend is received. A liquidating dividend occurs when the total accumulated dividends received by the investor since the date of acquisition exceed the investor’s proportionate share of the investee’s net accumulated earnings during that time. A liquidating dividend is treated as a reduction in the carrying amount of the investment rather than as dividend income. The portion of the dividends received that were not in excess of the investor’s share of investee’s earnings subsequent to the date of investment are reported as dividend revenue.

Question 27

A reclassification of available-for-sale securities to the held-to-maturity category will result in

Answer 27

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 securities transferred to the held-to-maturity category continues to be reported in OCI, assuming these securities were not designated as being hedged in a fair value hedge, in which case the unrealized holding gain or loss would have previously been recognized in earnings. 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 28

On both December 31, Year 1, and December 31, Year 2, Kopp Co.’s only available-for-sale security had the same fair value, which was below amortized cost. Kopp considered the decline in value to be temporary in Year 1 but other than temporary in Year 2. At the end of both years the security was classified as a noncurrent asset. Kopp could not exercise significant influence over the investee, and the security was not the hedged item in a fair value hedge. What should be the effects of the determination that the decline was other than temporary on Kopp’s Year 2 net noncurrent assets and net income?

Answer 28

No effect on net noncurrent assets and decrease in net income.

Unrealized holding gains and losses on available-for-sale securities not designated as being hedged in a fair value hedge and not accounted for under the equity method because of the investor’s inability to exercise significant influence over the investee, including those classified as current assets, are not included in earnings but are reported in other comprehensive income until realized, net of tax effect. Thus, the unrealized holding loss would have been reflected in the measurement of the asset at the end of Year 1 but not in Year 1 earnings. The other-than-temporary decline identified in Year 2 should be included in net income. Given that the decline in fair value below amortized cost judged to be temporary in Year 1 equaled the impairment recognized in Year 2, the measurement of the asset and of net noncurrent assets does not change. However, if the available-for-sale securities are designated as being hedged in a fair value hedge, the Year 1 decline would have been included in earnings in Year 1.

Question 29

Peel Co. received a cash dividend from a common stock investment. Should Peel report an increase in the investment account if it uses the fair value method or the equity method of accounting?

Answer 29

Neither the fair value method nor the equity method recognizes a cash dividend by increasing the investment account.

Under the fair value method and the cost method, (used only if the fair value method and the equity method are not applicable), dividends from an investee should be accounted for by the investor as dividend income unless a liquidating dividend is received. Thus, assuming that the dividend is not liquidating, it has no effect on the investment account under the fair value method. Under the equity method, the investor recognizes its equity in the undistributed earnings of the investee. Consequently, cash dividends decrease the investment account because the dividend is considered to be a return of investment.

Question 30

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
• Cash Dividends from Investee

Answer 30

The difference between the cost of an investment and the investee’s underlying equity should be accounted for as if the investee were a consolidated subsidiary. Thus, the difference is assigned first to any undervalued or overvalued assets, with the remainder allocated to goodwill. 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 31

Company A holds 25% of Company B’s voting interests. What methods can a company use?

Answer 31

Under US GAAP, Company A may account for its investment in Company B at FV or accounting to the equity method.

Question 32

A company has a 22% investment in another company that it accounts for using the equity method. What should be the disclosure included in the company’s annual financial statements?

Answer 32

The company’s accounting policy for the investment.

A company is required to disclose its accounting policies for equity method investees. Disclosures for an investment accounted for under the equity method should also include

(1) the names and company’s percentage of ownership in each investee;
(2) the difference, if any, between the carrying amount of the investment and the underlying equity in the net assets of the investee; and
(3) the accounting method applied to the difference.

Question 33

An investor in common stock received dividends in excess of the investor’s share of the investee’s earnings subsequent to the date of the investment. How will the investor’s investment account be affected by those dividends under the cost method and under the equity method?

Answer 33

Decrease under both.

The total accumulated dividends received by the investor since the date of acquisition of the stock exceeds the investor’s proportionate share of the investee’s net accumulated earnings for the same period. Thus, a liquidating dividend has been distributed. Such a dividend decreases the investment because it is a return of, not a return on, the investment. Under the equity method, the investment is increased by the investor’s share of the investee’s earnings. It is decreased by cash dividends received. If dividends received exceed the investor’s share of the investee’s earnings, the investment will therefore be decreased under either the cost method (applied only when the fair value and equity methods do not apply) or the equity method.

Question 34

An investor uses the equity method to account for an investment in common stock. After the date of acquisition, the investment account of the investor is

Answer 34

Increased by its share of the earnings of the investee, and is decreased by its share of the losses of the investee.

Question 35

On January 1, Point, Inc., purchased 10% of Iona Co.’s common stock. Point purchased additional shares bringing its ownership up to 40% of Iona’s common stock outstanding on August 1. During October, Iona declared and paid a cash dividend on all of its outstanding common stock. How much income from the Iona investment should Point’s income statement report?

Answer 35

10% of Iona’s income for January 1 to July 31 plus 40% of Iona’s income for August 1 to December 31.

Once the ownership percentage increased from 10% to 40%, Point was presumed to exercise significant influence over Iona. Thus, the investment should be accounted for retroactively under the equity method. Given that Point held 10% of Iona’s common stock for the first 7 months of the year, it should recognize in earnings 10% of Iona’s income for that period. It should recognize 40% of Iona’s income for the balance of the year. Point’s share of the dividend is credited to the investment account and is not included in earnings.

Question 36

Under IFRS, which of the following is an exemption from applying the equity method?

Answer 36

• The investment is classified as held for sale or
• Conditions exist similar to those that would exempt a parent from preparing consolidated statements

Question 37

When an investor uses the equity method to account for investments in common stock, the investment account will be increased when the investor recognizes

Answer 37

A proportionate interest in the net income of the investee.

Under the equity method, the investor’s share of the investee’s net income is accounted for as an addition to the carrying amount of the investment on the investor’s books. Losses and dividends are reflected as reductions of the carrying amount.

Question 38

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?

Answer 38

$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 39

Park Co. uses the equity method to account for its January 1 purchase of Tun, Inc.’s common stock. On January 1, the fair values of Tun’s FIFO inventory and land exceeded their carrying amounts. How do these excesses of fair values over carrying amounts affect Park’s reported equity in Tun’s earnings for the year?

Answer 39

Inventory excess- decrease

Land Excess- no effect

The equity method of accounting requires the investor’s proportionate share of the investee’s reported net income to be adjusted for acquisition differentials. Thus, the difference at the date of acquisition of the investee’s stock between the fair value and carrying amount of inventory is such an adjustment when the inventory is sold. A similar adjustment for land is required when the land is sold. Assuming that the FIFO inventory was sold during the year and the land was not, Park’s proportionate share of Tun’s reported net income is decreased by the inventory differential allocated at the date of acquisition.

Question 40

According to IFRS, which of the following is a true statement about the use of accounting policies in the application of the equity method?

A.The associate’s accounting information used by the investor may be based on different accounting policies as long as they are acceptable according to IFRS.

B.The investor and associate are required to have uniform accounting policies in their separate financial statements.

C.Uniform accounting policies are required for like transactions and events in similar circumstances.

D.The use of uniform accounting policies is required only at the date when the investee becomes an associate.

Answer 40

Uniform accounting policies are required for like transactions and events in similar circumstances.

Answer (C) is correct.
To apply the equity method, uniform accounting policies are required. But an associate’s accounting policies may differ from the investor’s for like transactions and events in similar circumstances. Consequently, when the investor uses the associate’s financial statements, it must adjust them to conform the associate’s accounting policies to the investor’s

Question 41

Pal Corp’s current year dividend income included only part of the dividend received from its Ima Corp. investment. The balance of the dividend reduced Pal’s carrying amount for its Ima investment. This reflects the fact that Pal accounts for its Ima investment by the

Answer 41

Fair value method or cost method, and only a portion of Ima’s dividends represent earnings after Pal’s acquisition.

Under the fair value method or cost method, dividends from an investee should be accounted for by the investor as dividend income unless a liquidating dividend is received. A liquidating dividend occurs when the total accumulated dividends received by the investor since the date of acquisition exceed the investor’s proportionate share of the investee’s net accumulated earnings during that time. A liquidating dividend is treated as a reduction in the carrying amount of the investment rather than as dividend income. The portion of the dividends received that was not in excess of the investor’s share of investee’s earnings subsequent to the date of investment is reported as dividend revenue.