5.1 Flashcards
A company leases trucks and properly classifies the leases as finance 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?
Leases are not eligible for the fair value option.
Generally, the fair value option does not apply to financial assets and liabilities under leases. Accordingly, finance leases are not eligible for the fair value option.
When valuing certain financial instruments, a company that has elected the fair value measurement option must apply the accounting measurement based on which of the following criteria?
Instrument-by-instrument basis.
An entity may elect the fair value option (FVO) for most recognized financial assets and liabilities. The decision whether to elect the FVO is made irrevocably at the election date. The decision is made instrument by instrument and only for an entire instrument.
Beach Co. determined that the decline in the fair value (FV) of an investment in debt securities 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 which of the following?
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 debt 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.
Sage, Inc., bought 40% of Adams Corp.’s outstanding voting common stock on January 2 for $400,000, which equaled a proportionate share of the fair value of the net assets. The carrying amount of the net assets at the purchase date was $900,000. Fair values and carrying amounts were the same for all items except for plant and inventory, for which fair values exceeded their carrying amounts by $90,000 and $10,000, respectively. The plant has an 18-year life. All inventory was sold during the year. During the year, Adams reported net income of $120,000 and paid a $20,000 cash dividend. What amount should Sage report in its income statement from its investment in Adams for the year ended December 31?
$42,000.
Sage holds 40% of the investee’s voting common stock and is assumed to exercise significant influence. It should therefore account for the investment on the equity basis by recognizing its proportionate share of the investee’s net income. For this purpose, the investee’s net income of $120,000 should be adjusted for the $10,000 excess of fair value over the carrying amount of the inventory sold and for the portion of the difference between the fair value and carrying amount of the plant that has been consumed (depreciated). This adjustment equals $5,000 ($90,000 difference ÷ 18 years). Thus, Sage should report investment income of $42,000 [($120,000 – $10,000 – $5,000) × 40%].
For available-for-sale debt securities included in noncurrent assets, which of the following amounts should be included in the period’s net income?
I. Unrealized holding losses during the period
II. Realized gains during the period
III. Changes in fair value during the period
II only.
The temporary decline below cost of the fair value of available-for-sale debt 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 securities.
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
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.
Dawson Corporation just received its bank statement for the month of May. This statement revealed that $2,500 of Dawson’s deposits had not yet been recorded by the bank, outstanding checks totaled $1,500, a bank service charge of $100 had been assessed, and Dawson had erroneously recorded a check written for $1,000 as $100. As of May 31, Dawson’s records indicated a cash balance of $40,500. The ending cash balance as of May 31 reported on the bank statement would have been
$38,500.
The entity’s cash balance at May 31 reported on the bank statement may be determined by a reconciliation from the book balance to the bank balance. The deposits in transit are included in the book balance but not the bank balance. The book balance but not the bank balance has already been reduced by the outstanding checks. The service charge and check understatement error are not yet reflected in the book balance. Balance per books: $40,500 Minus: Deposits in transit: (2,500) Add: Outstanding checks: 1,500 Minus: Bank service charge: (100) Minus: Check recording error: (900) Balance per bank: $38,500
In Year 5, Lee Co. acquired, at a premium, Enfield, Inc., 10-year bonds as a long-term investment. At December 31, Year 6, Enfield’s bonds were quoted at a small discount. Which of the following situations is the most likely cause of the decline in the bonds’ fair value?
Interest rates have increased since Lee purchased the bonds.
To adjust the yield on a bond investment to equal the market rate, the price of the bond must fluctuate inversely with the market rate because the nominal interest rate is fixed. Bonds selling at a premium have a nominal rate in excess of the market rate. If the market rate subsequently increases, the price of the bonds must decrease to provide a yield equal to the new market rate.
A company has a 22% investment in another company that it accounts for using the equity method. Which of the following disclosures should be included in the company’s annual financial statements?
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.
At the beginning of the fiscal year, End Corp. purchased 25% of Turf Co. for $550,000. At the end of the fiscal year, Turf reported net income of $65,000 and declared and paid cash dividends of $30,000. End uses the equity method of accounting. At year end, what amount should End report in its balance sheet for the investment in Turf?
$558,750.
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. Therefore, the investment in Turf account is increased by the investor’s share of the investee’s income of $16,250 ($65,000 × 25%). Dividends from the investee are treated as a return of an investment. Thus, the investment account is decreased by the dividends received of $7,500 ($30,000 × 25%). The year-end carrying amount of investment in Turf is therefore $558,750 ($550,000 + $16,250 – $7,500).
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?
$945,000
Available-for-sale debt 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).
Fact Pattern:
Grant, Inc., acquired 30% of South Co.’s voting stock for $200,000 on January 2, Year 1, and did not elect the fair value option. The price equaled the carrying amount and the fair value of the interest purchased in South’s net assets. Grant’s 30% interest in South gave Grant the ability to exercise significant influence over South’s operating and financial policies. During Year 1, South earned $80,000 and paid dividends of $50,000. South reported earnings of $100,000 for the 6 months ended June 30, Year 2, and $200,000 for the year ended December 31, Year 2. On July 1, Year 2, Grant sold half of its stock in South for $150,000 cash. South paid dividends of $60,000 on October 1, Year 2.
Before income taxes, what amount should Grant include in its Year 1 income statement as a result of the investment?
$24,000.
Under the equity method, Grant’s share of South’s revenue reported in the income statement is $24,000 ($80,000 × 30%). The cash dividends received are recorded as a decrease in the investment’s carrying amount.
Company A holds 25% of Company B’s voting interests. Which of the following statements is true?
Under U.S. GAAP, Company A may account for its investment in Company B at fair value or according to the equity method.
Under U.S. GAAP, an entity that is presumed to have significant influence over an investee may elect to adopt the fair value option or the equity method.
On both December 31, Year 1, and December 31, Year 2, Kopp Co.’s only available-for-sale debt 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. 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?
No effect on net noncurrent assets and decrease in net income.
Unrealized holding gains and losses on available-for-sale debt securities, 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 earnings. 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.
The following information pertains to Grey Co. at December 31, Year 4:
Checkbook balance: $12,000
Bank statement balance: 16,000
Check drawn on Grey’s account, payable to a vendor, dated and recorded 12/31/Yr 4 but not mailed until 1/10/Yr 5: 1,800
On Grey’s December 31, Year 4, balance sheet, what amount should be reported as cash?
$13,800.
The cash account on the balance sheet should consist 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 checks written to creditors but not yet mailed). Thus, the cash balance should be $13,800 ($12,000 checkbook balance + $1,800 check drawn but not mailed). The checkbook balance is used instead of the bank balance in the calculation. It more closely reflects the amount of cash that is unrestricted at the balance sheet date.
