CPA Core 1 - Week 4

Question 1

Under IFRS, intangible assets that may be capitalized include:

a)

Internally generated goodwill

b)

Internally developed brands

c)

Overhead costs directly related to development activities

d)

Borrowing costs related to research activities

Answer 1

c) is correct because overhead costs directly related to development activities of preparing the asset for use are eligible for capitalization. These costs have a future benefit, they can be distinguished from other costs, and they can be appropriately measured (IAS 38.66).

Question 2

You are an audit senior. Your client, Fundmuch Inc., has developed a new software program to enable online donations/pledges. The client wants to capitalize the expenses to date. After reviewing the criteria, you determine that Fundmuch can capitalize its internally generated intangible asset. Fundmuch’s controller provides you with the following expense detail:

Description Expense
Legal fees $ 2,000
General advertising and promotional costs 10,000
General administration and overhead 3,000
Staff software training 20,000
Cost of materials 25,000
Fees to register legal rights 5,000
Research phase 10,000
Total $75,000
What is the total amount that is eligible to be capitalized?

a)

$75,000

b)

$62,000

c)

$42,000

d)

$32,000

Answer 2

d) is correct because the total amount that is eligible to be capitalized is correctly calculated as legal fees ($2,000) + cost of materials ($25,000) + fees to register legal rights ($5,000).

Question 3

You, CPA, are employed as the chief accountant for Draw Pro Inc. (Draw), a computer software company. Over the past year, Draw has been developing a new software program called Graphics Tool. At the end of the year, Draw’s director of research estimated that $1 million was spent during the year on the Graphics Tool program. The director of research has asked you to reduce Draw’s expenses for the year by capitalizing the $1 million spent on the development of Graphics Tool as development costs.

Which of the following questions would NOT need to be considered when determining whether the development costs can be capitalized under IFRS?

a)

Has a future market for the Graphics Tool been clearly defined?

b)

Is the Graphics Tool program technologically feasible?

c)

Are the costs related to research activities or development activities?

d)

How soon will the Graphics Tool program be ready to begin marketing?

Answer 3

d) is correct because an analysis of the timeline to eventual marketing of the asset is not a criterion considered when determining whether costs can be capitalized as development costs per IAS 38.57.

Question 4

You, CPA, are the audit senior on the Louise’s Landscaping (Louise’s) file. The year-end financial statements of Louise’s were prepared in accordance with ASPE. Which of the following items has been reported correctly?

a)

Louise’s has been sued by a customer to whom Louise inadvertently sold poison ivy instead of Virginia creeper. The lawsuit is for $500,000. A liability for $500,000 has been recognized. Louise’s legal counsel believes that Louise’s is liable, but is unable to estimate the amount.

b)

Louise’s has been sued by a supplier for a disputed payment of $280,000. Louise’s legal counsel believes that there is a 35% probability that she will have to pay. There is no liability recognized on the statements, but a description of the lawsuit and an estimate of the amount of loss is disclosed.

c)

Louise’s has sued Bruce’s Manure, a supplier of bovine manure, for defamation. Louise’s legal counsel has advised that Louise’s is 95% certain to win the lawsuit and estimates the amount of the proceeds to be between $300,000 and $350,000. A receivable for $300,000 has been recognized.

d)

Louise’s has sued Rimmer’s Reeds, a supplier of water flowers for $400,000. Louise’s legal counsel has advised that Louise’s is 90% certain to win, but cannot accurately estimate the amount that Louise’s will collect. A receivable for $400,000 has been recognized.

Answer 4

b) is correct. Because the probability of loss is less than 50%, it is not likely and no accrual is required. Disclosure of the nature and estimate of the amount of the contingent loss is required.

Question 5

An employee of Riker Goods Ltd. (Riker) is suing the company for termination without cause.

The employee is suing for $2,700,000 for severance and defamation of character.
Riker’s lawyers estimate that the company will be held liable with an 80% probability.
Counsel estimates that there is a 35% probability that the court would award $1,500,000, a 35% probability that $1,000,000 would be awarded, and a 30% probability that $800,000 would be awarded.
Riker follows IFRS.
Which of the following is the proper accounting treatment for this lawsuit?

a)

Record a provision for $800,000 and disclose the nature of the lawsuit.

b)

Record a provision for $1,115,000 and disclose the nature of the lawsuit.

c)

Record a provision for $1,500,000 and disclose the nature of the lawsuit.

d)

Record a provision for $2,700,000 and disclose the nature of the lawsuit.

Answer 5

b) is correct. Since it is probable (the probability being greater than 50%) that Riker will have to pay, a provision is recorded equal to the weighted average of the expected outcomes. The provision is calculated as (35% × $1,500,000) + (35% × $1,000,000) + (30% × $800,000) = $1,115,000.

Question 6

A customer of Soltike Manufacturing Ltd. (Soltike) is suing the company for breach of contract. Soltike’s legal counsel estimates that likelihood of success is about 40%, and that, if successful, there is an 80% chance that the customer will be awarded $1,200,000. Soltike reports under IFRS.

Which of the following is the proper accounting treatment for this lawsuit?

a)

Record a provision for $1,200,000 and disclose the nature of the lawsuit.

b)

Record a provision for $960,000 and disclose the nature of the lawsuit.

c)

Record no provision and disclose the lawsuit along with the estimate.

d)

Record no provision, and no disclosure is required.

Answer 6

c) is correct. Since the lawsuit is only 40% likely to succeed, then it is not probable and no provision is recognized. However, because it is possible for a loss to occur, disclosure of the nature of the lawsuit and the estimate is required.

Question 7

An entity’s functional currency is the dollar (or equivalent) in the environment:

a)

Where the largest purchases occurred

b)

In which its CEO resides

c)

Where it has its head office located at the end of the year

d)

In which it operates day to day

Answer 7

d) is correct because an entity’s functional currency is the dollar (or equivalent) that it primarily uses in day-to-day operations.

Question 8

Maple Leaf Inc. purchased inventory from an Australian supplier, Aussie Inc., on December 16, 20X1. Maple Leaf’s year end is December 31 and the inventory was purchased for A$100,000.

Exchange rates:

December 16, 20X1 A$1.00 = C$1.30
December 31, 20X1 A$1.00 = C$1.21
What is the appropriate journal entry required to record the purchase?

a)

Dr. Inventory $100,000, Dr. Foreign exchange expense $30,000; Cr. Accounts payable $130,000

b)

Dr. Inventory $100,000, Dr. Foreign exchange expense $21,000; Cr. Accounts payable $121,000

c)

Dr. Inventory $121,000; Cr. Accounts payable $121,000

d)

Dr. Inventory $130,000; Cr. Accounts payable $130,000

Answer 8

d) is correct. The purchase is translated using the spot rate at December 16, 20X1: A$100,000 × C$1.30 = $130,000.

Question 9

Which of the following is considered a non-monetary item?

a)

Accounts payable

b)

Customer list

c)

Foreign exchange gain/loss

d)

Sales

Answer 9

b) is correct. A customer list is an intangible asset and is considered a non-monetary item.

Question 10

Lazer Force Company (Lazer) is a manufacturer of cold medication with a strategic objective of improving operational efficiency. The company is reviewing possible ways to reduce costs related to distribution. Any arrangement will be temporary and will initially last for three years. Which of the following is the most likely type of arrangement to meet Lazer’s objectives?

a)

Acquire control of a company that distributes similar products in similar markets to Lazer.

b)

Outsource the logistics of product distribution.

c)

Undertake a joint venture with a competitor to share distribution resources.

d)

Purchase bonds in a publicly listed pharmaceutical distribution company.

Answer 10

b) is correct. Outsourcing to a company that specializes in distribution logistics will help to reduce costs. This can be a temporary arrangement that can be easily terminated in three years.

Question 11

Acro Inc. has some excess cash and is considering purchasing a corporate bond. The bond has a face value of $500,000, a coupon of 8%, payable semi-annually, and it matures in five years. Yields on bonds of similar risk and maturity have been found to be 11% at this time.

Which of the following statements best describes the current market price of this bond? (Round to the nearest $1,000.)

a)

It is trading at a discount of $32,000.

b)

It is trading at a premium of $32,000.

c)

It is trading at a discount of $57,000.

d)

It is trading at a premium of $57,000.

Answer 11

c) is correct. The price of the bond is determined as follows: FV = 500,000; PMT = 20,000 (500,000 × 8% / 2); I/Y = 11% / 2 = 5.5%; N = 10 (5 × 2). With these inputs, PV = $443,470. Since the price is below its face value, this bond is selling at a discount equal to $56,530 ($500,000 – $443,470).

Question 12

Rescue Corp. (Rescue) has decided to purchase 100% of Snowscape Inc. (Snowscape). The transaction will be accomplished with a share exchange. Currently, Rescue has 1,500 shares outstanding and Snowscape has 800 shares outstanding. The shareholders of Snowscape will receive 0.25 shares of Rescue in exchange for one share of Snowscape.

Which of the following statements regarding the outcome of this transaction is true?

a)

The selling shareholders of Snowscape will own 11.8% of the new combined company.

b)

The selling shareholders of Snowscape will own 15.4% of the new combined company.

c)

The selling shareholders of Snowscape will now own 20% of the new combined company.

d)

The selling shareholders of Snowscape will own 34.8% of the new combined company.

Answer 12

a) is correct. Rescue will issue 200 (800 × 0.25) new shares to the shareholders of Snowscape. This will give the selling shareholders 11.8% [200 / (1,500 + 200)] ownership in the new combined company.

Question 13

Leslie Zhan is the sole shareholder of Plastics Molding Inc. (PMI). Currently the company has two divisions and Leslie is considering selling one of the divisions to his management team. He has come to you, CPA, to assist with this divestiture. He is looking for information on how to best complete this divestiture and is confused about spin-offs and equity carve-outs.

Which of the following statements best describes a spin-off?

a)

Net assets for the division are identified and sold to the new owners. The cash consideration paid by the buyers is received by PMI.

b)

The assets and liabilities are set up in a separate corporation, which is owned initially by Leslie. The shares of the new corporation are then sold by Leslie to the management team. The consideration paid by the buyers is directly received by Leslie.

c)

The assets and liabilities are set up in a separate corporation, which is initially owned by PMI. Some portion of these shares is then sold to the management team, but control is maintained by PMI. The cash consideration paid by the buyers is received by PMI.

d)

PMI issues new shares to the management team, resulting in the management team owing a portion of PMI, but Leslie retaining control.

Answer 13

b) is correct. This transaction describes a spin-off.

Question 14

A troubled company has growing liabilities and the owner does not believe it can continue to operate. You are asked to estimate the value of the company.

Which valuation approach would be most relevant to use in this circumstance?

a)

Adjusted net asset

b)

Capitalized cash flow

c)

Liquidation

d)

Discounted cash flow

Answer 14

c) is correct. The company is not operating under the going-concern assumption, and there is indication from the owner that the business should be liquidated.

Question 15

The definition of fair market value for valuation purposes includes which of the following terms:

a)

Acting at arm’s length

b)

Closed and restricted market

c)

Lowest price available

d)

Under a compulsion to act

Answer 15

a) is correct. Acting at arm’s length is part of the definition of fair market value.

Question 16

A new startup company is looking to go public and has asked you to estimate what the price of its shares should be. The company has yet to achieve profitability and expects a high-growth period for the next five years.

Which valuation approach would be most relevant to use in this circumstance?

a)

Capitalized earnings

b)

Capitalized cash flow

c)

Liquidation

d)

Discounted cash flow

Answer 16

d) is correct. By using the discounted cash flow approach, you can model the financial statements during the high-growth period and then calculate a terminal value when the business reaches maturity.

Question 17

You have been hired by a lawyer to prepare a preliminary valuation of a holding company in Bermuda in relation to a divorce case. The company has no active operations but is considered a going concern.

Which valuation approach would be most relevant to use in this circumstance?

a)

Adjusted net asset

b)

Capitalized cash flow

c)

Liquidation

d)

Discounted cash flow

Answer 17

a) is correct. The company does not have active operations but is considered a going concern with investments that can be valued.

Question 18

The objective of business valuations is to determine the fair market value of the enterprise, and several different approaches can be used.

Which of the following is correct with regard to business valuations?

a)

The only theoretically correct value of a going-concern enterprise is the discounted present value of its future cash flows.

b)

Fair market value is the highest price available in an open and unrestricted market.

c)

Income statements are normalized to adjust net earnings to the highest amount possible.

d)

The adjusted net asset approach is used to determine the multiple to be used for the market approach.

Answer 18

b) is correct. Fair market value is the highest price that an arm’s length purchaser would be willing to pay in order to complete the transaction in an open and unrestricted market.

Question 19

You have been asked to value a business by an owner who intends to shut the business down due to lack of productivity. The owner still has control over the assets and is not being forced to sell them immediately.

Which valuation approach should you use?

a)

Capitalized cash flow

b)

Adjusted net asset

c)

Orderly liquidation

d)

Forced liquidation

Answer 19

c) is correct. The company is not a going concern, but the owner is not being forced to sell the assets.

Question 20

You have been asked to value a company with ongoing operations that are expected to continue into the future. You have valued the company a number of different ways and arrived at the following values:

capitalized cash flow approach: $300,000
market approach: $305,000
adjusted net asset approach: $250,000
liquidation approach: $200,000
What is considered the “floor” value of the company?

a)

$200,000

b)

$250,000

c)

$300,000

d)

$305,000

Answer 20

b) is correct. When an operating company is a going concern, the adjusted net asset approach is often used to determine a “floor” value.

Question 21

You have been asked to value a company using the adjusted net asset approach. The company has:

cash of $100,000
accounts receivable of $50,000
marketable securities with a book value of $30,000 (fair market value [FMV] of $60,000 and latent taxes and selling costs of $7,500)
fixed assets with a book value of $100,000 (FMV of $150,000 and latent taxes, selling costs, and forgone tax shield of $20,000)
long-term debt of $75,000
What is the value of the company?

a)

$205,000

b)

$257,500

c)

$285,000

d)

$332,500

Answer 21

b) is correct. The value of the company under the adjusted net asset approach = cash ($100,000) + accounts receivable
($50,000) + FMV securities ($60,000) – latent taxes and selling costs ($7,500) + FMV fixed assets ($150,000) – latent taxes, selling costs, and forgone tax shield ($20,000) – long-term debt ($75,000) = $257,500.

Question 22

The adjusted net asset approach is one method for valuing a company.

Which of the following statements is correct with respect to when the adjusted net asset approach is most commonly used?

a)

For entities that have stable earnings

b)

For entities with currently active operations but that will be closed down in the coming year

c)

For entities that are holding companies with real estate investments

d)

For entities that have volatile earnings

Answer 22

c) is correct. The adjusted net asset approach is often used for valuation of holding companies.

Question 23

You are valuing a company using a capitalized cash flow approach. You have determined that the company has the following:

maintainable earnings before interest, tax, depreciation, and amortization (EBITDA) of $200,000
sustaining capital reinvestment net of taxes of $50,000
a tax rate of 30%
a capitalization rate of 10%
a present value (PV) of the undepreciated capital cost (UCC) tax shield on existing assets of $20,000
interest-bearing debt of $130,000
What is the equity value of the company?

a)

$1,290,000

b)

$920,000

c)

$790,000

d)

$770,000

Answer 23

c) is correct. The equity value of the company = EBITDA after tax [$200,000 × (1 – 30%)] – sustaining capital reinvestment ($50,000) = $90,000 / capitalization rate (10%) = $900,000 + PV of UCC tax shield ($20,000) – interest-bearing debt ($130,000) = $790,000.

Question 24

You are calculating a preliminary valuation for TQ Enterprises Inc. using the capitalization of earnings method. Which of the following types of expenses would be considered normalizing items that should be adjusted?

a)

Owner’s salary, which is an amount that is comparable to salaries in the market for the same position.

b)

Costs for student employees who were hired under a one-time government program.

c)

Ongoing new product development costs.

d)

Annual vacation pay and bonuses paid to employees.

Answer 24

b) is correct. As the one-time government program is now finished and a new owner would not incur these costs, this is a normalized item that would be adjusted.

Question 25

You are calculating the value of a brand-name piece of equipment using the market-based approach.

Which of the following is the most appropriate factor to consider when evaluating the comparability of recent sales transactions?

a)

Net operating income earned from using the asset

b)

Location, age, and operating condition

c)

The appropriate discount rate

d)

Obsolescence

Answer 25

b) is correct. Location, age, and operating condition are considered when assessing how similar or different comparable transactions are.