F5 - Investments, Statement of Cash Flows, and Income Taxes

Question 1

Describe the financial instrument fair value option under U.S. GAAP.

Answer 1

On specified election dates, an entity may choose to measure eligible financial instruments at fair value with unrealized gains and losses reported in earnings. The fair value option is irrevocable .

Question 2

On the balance sheet, debt securities classified as trading or available-for-sale are valued how?

Answer 2

At fair value.

Question 3

How are unrealized gains/losses on debt securities classified as trading securities recognized?

Answer 3

Unrealized gains and losses on trading securities are recognized on the income statement.

Question 4

How are unrealized gains/losses on debt securities classified as available-for-sale recognized (assuming no expected credit loss)?

Answer 4

Unrealized gains and losses on available for sale securities with no expected credit loss are reported in other comprehensive income.

Question 5

On the balance sheet, debt securities classified as held-to-maturity are valued how (assuming no expected credit loss)?

Answer 5

At amortized cost.

Question 6

List three conditions when losses on debt securities classified as available-for-sale are recognized in income.

Answer 6

• Sale of security.
• Transfer of the secuirty to trading classification.
• When there is an expected credit loss on the available-for-sale security. The credit loss reported in net income cannot exceed the amount by which fair value is below amortized cost.

Question 7

When a marketable debt security is transferred from trading to available-for-sale, or vice versa, at what cost is it transferred?

Answer 7

• Transferred at fair value, which then becomes new basis.
• For a security transferred into the trading category, the difference is treated as a realized gain or loss and is recognized on the income statement.
• For a security transferred from the trading category, the unrealized holding gain or loss will already have been recognized in earnings.

Note: Transfers to and from the trading category should be rare.

Question 8

When does credit loss have to be booked for debt investments?

Answer 8

A credit loss must be reported on an available-for-sale or held-to-maturity debt security when it is probable that the amounts due (principal and interest) will not be collected.

Question 9

How is a credit loss recognized for an available-for-sale or held-to-maturity debt security?

Answer 9

When there is an expected credit loss, the investment should be reported at the present value of the principal and interest that is expected to be collected. The credit loss is the difference between amortized cost and the present value.
FOr an available-for-sale security, the credit loss cannot exceed the amount by which fair value is below amortized cost, because the investor has the option to sell an available-for-sale investment if the loss on the sale will be less than the expected credit loss.

Question 10

How is the realized gain or loss calculated for trading and available-for-sale debt securitieswhen they are sold?

Answer 10

Trading Securities
Realized gain/loss = Selling price versus the adjusted cost (Original cost +/- Unrealized gains or losses previously recognized in net income)

Available-for-Sale Securities
Realized gain/loss = Selling price versus the original cost, adjusted for any credit losses recorded on the income statement from previous periods (note that any unrealized gains or losses in AOCI must be reversed).

Question 11

How are equity securities typically valued?

Answer 11

Equity securities are typically carried at fair value through net income (FVTNI), with unrealized gains and losses included in earnings.

Question 12

Describe the “practicality exception” for equity securities.

Answer 12

For equity investments that do not have a readily determinable fair value, this exception allows an entity to measure equity investments at cost, less impairment, plus/minus observable price changes of identical or similar investments from the same owner.

Question 13

How are nonliquidating and liquidating dividends distributed by equity securities reported by the investor receiving them?

Answer 13

Nonliquidating dividends received by the investor are accounted for as dividend income.

Liquidating dividends received by the investor are accounted for as a return of capital.

Question 14

Describe the recognition of an impairment loss on equity securities if a qualitative assessment indicates that impairment exists.

Answer 14

Impairment losses apply to equity securities valued using the practicality exception. If impairment exists, the cost basis of the security will be written down to fair value with the write-down reflected as a realized loss and included in earnings.

Question 15

How is the realized gain or loss calculated for equity securities when they are sold?

Answer 15

Realized gain/loss = Selling price versus the adjusted cost (Original cost +/- Unrealized gains or losses previously recognized in net income)

Question 16

How is the year-end investment in investee reported on the balance sheet calculated under the equity method?

Answer 16

Question 17

How is an investor’s equity method investment reported on the income statement?

Answer 17

Question 18

When a parent company owns less than 100% of the stock of a subsidiary company, what amount of the subsidiary’s assets,* liabilities*, and equity are included on the consolidated balance sheet?

Answer 18

The consolidated balance sheet includes 100% of the parent’s subsidiary’s assets and liabilities, but does not include the subsidiary’s equity. Noncontrolling interest is presented as part of equity, separately from the equity of the parent company.

Question 19

State the criteria to consolidate subsidiaries.

Answer 19

• Consolidate when the parent is able to control the subsidiary. Usually this is indicated by greater than 50 percent ownership of the voting stock of the subsidiary.
• Do not consolidate when control is not with owners (as in bankruptcy of subsidiary).

Question 20

Name several simple workpaper elimination entries that are necessary to eliminate intercompany payables and receivables when producing consolidated financial statements.

Answer 20

Eliminate:
* Accounts payable/accounts receivable
* Bonds payable/bonds receivable
* Accrued bond interest payable/accrued bond interest receivable

Question 21

State the workpaper elimination entry for intercompany inventory transactions.

Answer 21

Dr Retained earnings (intercompany profit in beginning inventory)
Dr Intercompany sales
Cr Intercompany cost of goods sold
Cr Cost of goods sold (intercompany profit in goods sold)
Cr Ending inventory (intercompany profit in ending inventory)

Question 22

State the workpaper elimination entry for intercompany bond transactions

Answer 22

Dr Bond payable
Dr Premium (or credit discount)
Cr Investment in affiliates bonds
Cr Gain on extinguishment of bonds (or debit loss on extinguishment of bonds)

Question 23

State the workpaper elimination entry for intercompany land transactions.

Answer 23

Dr Intercompany gain on sale of land
Cr Land

Question 24

State the workpaper elimination entries for intercompany depreciable assets transactions.

Answer 24

Elimination Entry 1 - Eliminate intercompany gain and adjust asset and accumulated depreciation to original amounts:
Dr Intercompany gain on sale of machinery
Cr Machinery
Cr Accumulated depreciation

Elimination Entry 2 - Eliminate excess depreciation:
Dr Accumulated depreciation
Cr Depreciation expense

Question 25

What three considerations must be taken into account when preparing consolidated statements of cash flow that are not present when preparing statements of cash flow for a nonconsolidated entity?

Answer 25

1. When reconciling net income to net cash provided by operating activities, total consolidated net income (including net income attributable to both the parent and the noncontrolling interest) should be used.
2. The financing section should report dividends paid by the subsidiary to noncontrolling shareholders. Dividends paid by the subsidiary to the parent company should not be reported.
3. The investing section may report the acquisition of additional subsidiary shares by the parent if the acquisition was an open-market purchase.

Question 26

In acquisition accounting, state the consolidating workpaper elimination entry
CARINBIG

Answer 26

Dr Common stock - subsidiary
Dr APIC - subsidiary
Dr Retained earnings - subsidiary
Cr Investment in subsidiary
Cr Noncontrolling interest
Dr Balance sheet adjustments to fair value
Dr Identifiable intangible assets to fair value
Dr Goodwill

Question 27

In creating a new partnership interest with an investment of additional capital, what three methods can be used?

Answer 27

• Exact method
• Bonus method
• Goodwill method

Question 28

Describe the exact method of creating a new partnership interest with an investment of additional capital.

Answer 28

The purchase price equals the book value of the capital account purchased.
* No adjustment to the existing partners’ capital accounts
* No goodwill or bonus

Question 29

Describe the bonus method of creating a new partnership interest with an investment of additional capital.

Answer 29

Bonus Method
New partner’s capital account = (A + B + C) x C’s percentage ownership.
Excess of new partner’s contribution over capital interest received is a bonus to the old partners.
Excess of capital interest received over new partner’s contribution is a bonus to the new partner.

Question 30

Describe the goodwill method of creating a new partnership interest with an investment of additional capital.

Answer 30

• Goodwill is recognized based on the total value of the partnership implied by the new partner’s contribution.
• Goodwill is shared by the existing partners using the agreed profit/loss ratio.

Question 31

Describe the bonus method of withdrawal of a partner.

Answer 31

• The difference between the balance of the windrawing partner’s capital account and the amount that person is paid is the amount of the bonus.
• The bonus is allocated among the remaining partners’ capital accounts in accordance with their remaining profit and loss ratios.

Question 32

Describe the goodwill method of withdrawal of a partner.

Answer 32

The partners may elect to record the implied goodwill in the partnership based on the payment to the withdrawing partner. The amount of the implied goodwill is allocated to all the partners in accordance with their profit and loss ratios.

After allocating goodwill, the balance in the withdrawing partner’s capital account should equal the final distrubtion to the withdrawing partner.

Question 33

In liquidating a partnership, what is the order of preference?

Answer 33

• Creditors
• Loans and advances to partners
• Capital accounts of partners

Remember that all losses must be provided for before disposal; that is, maximum potential losses before distribution of cash.

Question 34

What are the three sections of the statement of cash flows? What cash flows are included in each section?

Answer 34

• Operating activities - cash flows from income statement transactions and current assets/liabilities
• Investing activities - cash flows from non-current assets
• Financing activities - cash flows from debt and equity

Question 35

Define cash equivalents.

Answer 35

Cash equivalents: cash equivalents are highly liquid investments with maturities of three months or less that are readily convertible into cash with insignificant risk of changes in value.

Note: “Maturities of three months or less” is of original instrument or from purchase date of instrument.

Question 36

Name the two methods of presentation of cash flows from operating activities. Which method is preferred?

Answer 36

• Direct and indirect methods
• Direct method is preferred

Only the indirect method is testable on the CPA Exam

Question 37

Name the common adjustments made to cash flows from operating activities using the indirect method.
CLAD

Answer 37

Current assets and liabilities
Losses and gains
Amortization and depreciation
Deferred items

Question 38

Define permanent differences and list examples.

Answer 38

Permanent differences are transactions that affect either taxable income or financial income, but not both, and only in the period in which they occur. They do not affect future financial or taxable income.
* Premium on key-officer life insurance policy when entity is owner and beneficiary
* Proceeds from key-officer life insurance
* Tax-exempt interest on state and municipal bonds
* Nondeductible portion of meals and entertainment
* Fines and expenses in violation of law
* Dividends-received deduction

Question 39

Define temporary differences and list examples.

Answer 39

Temporary differences are differences between taxable income and financial income that result in taxable or deductible amounts in future years and necessitate the recognition of deferred tax assets or liabilities.
* Depreciation (financial vs. MACRS)
* Gross profit on long-term construction contracts (percentage completion vs. completed contract)
* Estimated warranty costs
* Gross profit on installment sales (accrual vs. cash)
* Bad debt expense using the allowance method vs. actual bad debt expense

Question 40

Define deferred tax liability.

Answer 40

Anticipating future tax liabilities derived from situations in which future taxable income will be greater than future financial income due to temporary differences.

A deferred tax liability is measured by applying the applicable enacted tax rate and provisions of the enacted tax law to temporary differences in the periods in which they are expected to reverse.

Question 41

Define deferred tax asset.

Answer 41

Anticipated future taxable income will be less than future financial income due to temporary differences.

A deferred tax asset is recognized for all deductible temporary differences, operating losses, and tax credit carryforwards by applying the applicable enacted tax rate and provisions of the enacted tax law to temporary differences in the period in which they are expected to reverse. Deferred tax assets are also subject to recording a valuation allowance to reduce the asset to its net realizable value if it is more liekly than not that its full value will not be recognized.

Question 42

What is the valuation allowance?

Answer 42

If it is more likely than not (> 50 percent) that some portion or all of the deferred tax asset will not be realized, a valuation allowance needs to be created to recognize the reduction in the carrying amount of the deferred tax asset (DTA).

Question 43

Identify the tax rate used to measure deferred tax assets and liabilities under U.S. GAAP.

Answer 43

The enacted tax rate expected to apply to taxable items (temporary differences) in the periods the taxable item is expected to be paid (liability) or realized (asset).

Do not allow the examiners to trick you into using the anticipated, proposed, or unsigned tax rate.

Question 44

How are deferred tax assets and liabilities classified on the balance sheet under U.S. GAAP?

Answer 44

Deferred tax assets and deferred tax liabilities are reported as non-current on the balance sheet. Deferred tax assets and deferred tax liabilities may be netted if the entity has a legally enforceable right to offset current tax assets against current tax liabilities and the deferred tax assets and deferred tax liabilities relate to income taxes levied by the same tax authorities. Deferred tax assets and liabilities are not netted if they are attributable to different tax-paying components of the entity or to different tax jurisdictions.