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1

On January 2, 2004, Lake Mining Co.'s Board of Directors declared a cash dividend of $400,000 to stockholders of record on January 18, 2004, payable on February 10, 2004. The dividend is permissible under law in Lake's state of incorporation.
Selected data from Lake's December 31, 2003 balance sheet are as follows:

Accumulated depletion $100,000
Capital stock 500,000
Additional paid-in capital 150,000
Retained earnings 300,000
The $400,000 dividend includes a liquidating dividend of

A. $0
B. $100,000
C. $150,000
D. $300,000

B. $100,000
A liquidating dividend is paid from contributed capital, rather than from earned capital (retained earnings). It is assumed that retained earnings is used first when dividends are paid.

Thus, $400,000 - $300,000 or $100,000 of the dividend is liquidating. The fact that accumulated depletion is also $100,000 justifies the amount of the liquidating dividend. Depletion is a reduction in earnings, but it represents the recognition in expense of an investment that will not be replaced (a depletable resource is never replaced). Thus, there is no capital maintenance requirement as there would be in the case of equipment, for example, which must be replaced.

Therefore, dividends in excess of earnings, to the extent of accumulated depletion, are permissible.

2

East Corp., a calendar-year company, had sufficient retained earnings in 2003 as a basis for dividends, but was temporarily short of cash.
East declared a dividend of $100,000 on April 1, 2003 and issued promissory notes to its stockholders in lieu of cash. The notes, which were dated April 1, 2003, had a maturity date of March 31, 2004 and an interest rate of 10%.

How should East account for the scrip dividend and related interest?

A. Debit retained earnings for $110,000 on April 1, 2003.
B. Debit retained earnings for $110,000 on March 31, 2004.
C. Debit retained earnings for $100,000 on April 1, 2003, and debit interest expense for $10,000 on March 31, 2004.
D. Debit retained earnings for $100,000 on April 1, 2003, and debit interest expense for $7,500 on December 31, 2003.

D. Debit retained earnings for $100,000 on April 1, 2003, and debit interest expense for $7,500 on December 31, 2003.
Retained earnings is reduced only by the amount of the dividend otherwise payable in cash, in this case $100,000. Interest on the notes is recognized as interest expense, not as a part of the dividend. 12/31/03 is three-fourths of the way into the note term. Thus, .75(.10)($100,000) or $7,500 of interest expense should be recognized on this date.

3

A property dividend should be recorded in retained earnings at the property's
A. Market value at date of declaration.
B. Market value at date of issuance (payment).
C. Book value at date of declaration.
D. Book value at date of issuance (payment).

A. Market value at date of declaration.

4

A corporation issuing stock should charge retained earnings for the market value of the shares issued in a(an)
A. Employee stock bonus.
B. Pooling of interests.
C. 10% stock dividend.
D. 2-for-1 stock split.

C. 10% stock dividend.
Stock dividends, like all dividends, cause a decrease (debit or charge) in retained earnings. A stock dividend is a permanent capitalization of retained earnings to contributed capital. Stock dividends are made in lieu of cash dividends. Small stock dividends (those less than 20% to 25%) are capitalized at the market value of the shares issued. Large stock dividends are capitalized at par.

5

Instead of the usual cash dividend, Evie Corp. declared and distributed a property dividend from its overstocked merchandise.
The excess of the merchandise's carrying amount over its market value should be

A. Ignored.
B. Reported as a separately disclosed reduction of retained earnings.
C. Reported as a decrease in other comprehensive income.
D. Reported as a reduction in income from continuing operations.

D. Reported as a reduction in income from continuing operations.

6

Bal Corp. declared a $25,000 cash dividend on May 8, 2005, to stockholders of record on May 23, 2005, payable on June 3, 2005. As a result of this cash dividend, working capital
A. Was not affected.
B. Decreased on June 3.
C. Decreased on May 23.
D. Decreased on May 8.

D. Decreased on May 8.

7

Ole Corp. declared and paid a liquidating dividend of $100,000. This distribution resulted in a decrease in Ole's
Paid-in capital Retained earnings
No No
Yes Yes
No Yes
Yes No

Paid-in capital Yes
Retained earnings No
A liquidating dividend is a return of capital. Its source is not earnings, and, therefore, it is not retained earnings. The firm is liquidating part of its permanent capital. The usual account to debit for a liquidating dividend is additional paid-in capital.

8

In 2005, Elm Corp. bought 10,000 shares of Oil Corp. at a cost of $20,000. On January 15, 2006, Elm declared a property dividend of the Oil stock to shareholders of record on February 1, 2006, payable on February 15, 2006. During 2006, the Oil stock had the following market values:
January 15 $25,000
February 1 26,000
February 15 24,000
The net effect of the foregoing transactions on retained earnings during 2006 should be a reduction of

A. $20,000
B. $24,000
C. $25,000
D. $26,000

A. $20,000
The property dividend is recorded at market value, with a debit of $25,000 to retained earnings at declaration. A gain of $5,000 on the securities is recognized as a gain on disposal (as if it were sold). The net effect is a decrease in retained earnings of $20,000.

9

The following stock dividends were declared and distributed by Sol Corp:

Percentage of common shares outstanding at declaration date Fair value Par value
10 $15,000 $10,000
28 40,000 30,800
What aggregate amount should be debited to retained earnings for these stock dividends?

A. $40,800
B. $45,800
C. $50,000
D. $55,000

B. $45,800
Small stock dividends (less than 25%) are capitalized at the fair value of stock issued and large stock dividends (greater than 25%) are capitalized at the par value of stock issued.

The total amount capitalized (debited) to retained earnings, therefore, is $15,000 for the 10% stock dividend (fair value), plus $30,800 for the 28% stock dividend (par value) for a total of $45,800.

10

A retained earnings appropriation can be used to
A. Absorb a fire loss when a company is self-insured.
B. Provide for a contingent loss that is probable and reasonable.
C. Smooth periodic income.
D. Restrict earnings available for dividends.

D. Restrict earnings available for dividends.

11

The following trial balance of Mint Corp. at December 31, 2005, has been adjusted except for income tax expense.
TRIAL BALANCE
December 31, 2005
Dr. Cr.
____________ ____________
Cash $600,000
Accounts receivable, net $3.5mn
Cost in excess of billings on long-term contracts $1.6mn
Billings in excess of costs on long-term contracts $700,000
Prepaid taxes 450,000
Property, plant, and equipment, net 1.48mn
Note Payable - non-current 1.62mn
Common stock 750,000
Additional paid-in capital 2mn
Retained earnings - unappropriated 900,000
Retained earnings - restricted for note payable 160,000
Earnings from long-term contracts 6.68mn
Costs and expenses 5.18mn
____________ ____________
$12.81mn $12.81mn
=========== ===========
Other financial data for the year ended December 31, 2005, are:

Mint uses the percentage-of-completion method to account for long-term construction contracts for financial statement and income tax purposes. All receivables on these contracts are considered to be collectible within 12 months.
During 2005, estimated tax payments of $450,000 were charged to prepaid taxes. Mint has not recorded income tax expense. There were no temporary or permanent differences, and Mint's tax rate is 30%.
In Mint's December 31, 2005 balance sheet, what amount should be reported as total retained earnings?

A. $1.95mn
B. $2.11mn
C. $2.4mn
D. $2.56mn

B. $2.11mn
The retained earnings balance in an adjusted trial balance does not reflect earnings for the year. Retained earnings are not adjusted for net income until the accounts are closed, which occurs after the trial balance is prepared. Therefore, the retained earnings accounts listed in the trial balance do not reflect current earnings.

Retained earnings per trial balance ($900,000 + $160,000) $1.06mn
Plus earnings, less costs and expenses $6.68mn - $5.18mn - $450,000 (tax) 1.05mn
Total ending retained earnings $2,110,000
The trial balance does not reflect the income tax expense. This amount was listed as prepaid taxes, but must be reclassified to income tax expense. When firms make estimated tax payments, the debit should be to income tax expense. Income tax has not been recorded. The estimated payments approximately cover the tax liability for the year that has ended. Therefore, the taxes cannot be said to be prepaid.

12

On November 2, 2003, Finsbury, Inc. issued warrants to its stockholders, giving them the right to purchase additional $20 par value common shares at a price of $30.
The stockholders exercised all warrants on March 1, 2004. The shares had market prices of $33, $35, and $40 on November 2, 2003, December 31, 2003, and March 1, 2004, respectively.

What were the effects of the warrants on Finsbury's additional paid-in capital and net income?

Additional paid-in capital Net income
Increased in 2004 No effect
Increased in 2003 No effect
Increased in 2004 Decreased in 2003 and 2004
Increased in 2003 Decreased in 2003 and 2004

Additional paid-in capital Net income
Increased in 2004 No effect
The issuance of warrants to shareholders does not require a journal entry, because no resources are expended or received. Therefore, in 2003, there is no effect on owners' equity.
When the warrants are exercised in 2004, the shareholders pay $30 per share for the stock purchased under the warrants. This issuance is recorded as a normal issuance at $30, even though that is not the market price at the date of issuance. Additional paid-in capital is increased by $10, the difference between the $30 exercise price and $20 par. Issuing warrants or stock has no effect on earnings. A firm does not profit on transactions with owners.

13

Zinc Co.'s adjusted trial balance at December 31, 2005 includes the following account balances:

Common stock, $3 par $600,000
Additional paid-in capital 800,000
Treasury stock, at cost 50,000
Net unrealized loss on non-current marketable equity securities 20,000
Retained earnings: appropriated for uninsured earthquake losses 150,000
Retained earnings: unappropriated 200,000
What amount should Zinc report as total stockholders' equity in its December 31, 2005 balance sheet?

A. $1.68mn
B. $1.72mn
C. $1.78mn
D. $1.82mn

A. $1.68mn
Each item listed belongs in owners' equity. The treasury stock and net unrealized loss are negative items (debits), but the rest are positive items (credits).

Therefore, total owners' equity is $1.68mn = $600,000 + $800,000 - $50,000 - $20,000 + $150,000 + $200,000.

14

Cricket Corp. issued, without consideration, rights allowing stockholders to subscribe for additional shares at an amount greater than par value, but less than both market and book values.
When the rights are exercised, how are the following accounts affected?

Retained earnings Additional paid-in capital
Decreased Not affected
Not affected Not affected
Decreased Increased
Not affected Increased

Not affected Increased
The exercise is treated as would be any issuance of stock. The exercise price determines the total proceeds, the common stock account is credited for the total par of stock issued, and additional paid-in capital is credited for the remainder. The exercise price exceeds par value, so additional paid-in capital is increased. Retained earnings are unaffected.

15

Gavin Co. grants all employees two weeks of paid vacation for each full year of employment. Unused vacation time can be accumulated and carried forward to succeeding years and will be paid at the salaries in effect when vacations are taken or when employment is terminated.
There was no employee turnover in 2005.
Additional information relating to the year ended December 31, 2005 is as follows:

Liability for accumulated vacations at December 31, 2004 $35,000
Pre-2005 accrued vacations taken from January 1, 2005 to 30 September 2005 (the authorized period for vacations) 20,000
Vacations earned for work in 2005 (adjusted to current rates) 30,000

Gavin granted a 10% salary increase to all employees on October 1, 2005, its annual salary increase date. For the year ended December 31, 2005, Gavin should report vacation pay expense of
A. $45,000
B. $33,500
C. $31,500
D. $30,000

C. $31,500

The total vacation pay expense for 2005 is $31,500. This is the sum of two amounts:
(1) the amount earned in 2005, plus
(2) the increase in cost from earlier periods owing to wage increases in 2005.
These two amounts are:
(1) $30,000 as given in the problem - this amount is already updated for the most current rate
(2) $1,500 = ($35,000 - $20,000).10 = the amount of vacation pay yet to be disbursed on benefits earned before 2005; the liability for this amount is increased by the 10% pay increase.
The increase in pay rate on the pre-2005 benefits is treated as an estimate change. Therefore, it is handled in current and future years. Retroactive application does not apply in this case.

16

On January 1, 2005, Rex Co. sold a used machine to Lake, Inc. for $525,000. On this date, the machine had a depreciated cost of $367,500
Lake paid $75,000 cash on January 1, 2005 and signed a $450,000 note, bearing interest at 10%.
The note was payable in three annual installments of $150,000 beginning January 1, 2006. Rex appropriately accounted for the sale under the installment method. Lake made a timely payment of the first installment on January 1, 2006 of $195,000, which included interest of $45,000 to date of payment.
At December 31, 2006, Rex has deferred gross profit of

A. $105,000
B. $99,000
C. $90,000
D. $76,500

C. $90,000
The gross profit percentage on the machine is 30% [($525,000 - $367,500)/$525,000]. Total gross profit is $157,500 ($525,000 - $367,500). This amount is deferred until cash is collected.

Under the installment method, 30% of each cash receipt is recognized gross profit. The $150,000 installments must be principal amounts, because they sum to the face value of the note. Interest is paid in addition to the installment amounts. As of December 31, 2006, only one $150,000 installment was collected.

Total gross profit on sale
$157,500
Less gross profit recognized on cash collections:
($75,000 + $150,000).30
(67,500)
Equals deferred gross profit at 31 December 2006
$90,000

17

Gow Constructors, Inc. has consistently used the percentage-of-completion method of recognizing income. In 2004, Gow starts work on an $18mn construction contract that is completed in 2005.
The following information is taken from Gow's 2004 accounting records:
Progress billings $6.6mn
Costs incurred $5.4mn
Collections $4.2mn
Estimated costs to complete $10.8mn

What amount of gross profit should Gow have recognized in 2004 on this contract?
A. $1.4mn
B. $1.2mn
C. $900,000
D. $600,000

D. $600,000
Percentage of completion for 2004= $5.4mn/($5.4mn + $10.8mn) = 33%. Gross profit recognized in 2004 = .33[$18mn - ($5.4mn + $10.8mn)] = $600,000.
The denominator of the proportion of completion, which is estimated total project cost, includes cost to date and costs remaining. The proportion is multiplied by total estimated project profit, the difference between contract price and total estimated project cost.

18

Bear Co., which began operations on January 2, 2005, appropriately uses the installment-sales method of accounting. The following information is available for 2005:
Installment sales $1.4mn

Realized gross profit on installment sales $240,000

Gross profit percentage on sales 40%

For the year ended December 31, 2005, what amounts should Bear report as accounts receivable and deferred gross profit?

Accounts receivable Deferred gross profit
$600,000 $320,000
$600,000 $360,000
$800,000 $320,000
$800,000 $560,000

$800,000 $320,000
Under the installment method of accounting, gross profit is recognized in proportion to cash collected on installment sales. Since this is the first year of operations for Bear Co., there is no beginning balance for accounts receivable and no previously deferred gross profit. The year-end balance in accounts receivable is determined by subtracting from total accounts receivable ($1.4mn) the amount collected during the period. Since the gross profit percentage of sales is 40%, the realized gross profit ($240,000) represents 40% of accounts receivable collected. Therefore:

.40 X (amount collected) = $240,000
X = $240,000/.40
X = $600,000 (total A/R collected)
The year-end balance in accounts receivable will be:

Sales on account $1,400,000
A/R collected (600,000)
A/R balance $800,000
The total deferred gross profit, less the amount realized during the period, will be the year-end deferred gross profit. The total deferred gross profit for the year is 40% of installment sales. Therefore:

Installment sales $1,400,000
Gross profit rate .40
Total deferred gross profit $ 560,000
Less: Amount realized 240,000
Year-end deferred gross profit $320,000

19

On July 1, 2005, Ran County issued realty tax assessments for its fiscal year ended June 30, 2006.
On September 1, 2005, Day Co. purchased a warehouse in Ran County. The purchase price was reduced by a credit for accrued realty taxes. Day did not record the entire year's real estate tax obligation, but instead records tax expenses at the end of each month by adjusting pre-paid real estate taxes or real estate taxes payable, as appropriate. On November 1, 2005, Day paid the first of two equal installments of $12,000 for realty taxes.

What amount of this payment should Day record as a debit to real estate taxes payable?

A. $4,000
B. $8,000
C. $10,000
D. $12,000

B. $8,000
The total annual real estate tax is 2($12,000) or $24,000. Therefore, the tax per month is $2,000. Day assumed the taxes, already assessed on the property, for the full year.
The payment on November 1 covers the four months July, August, September, and October, for a total cost of $8,000. This portion of the $12,000 payment is debited to real estate taxes payable, because the full annual property tax amount is already accrued on Day's books from the purchase of the property. Pre-paid real estate taxes are debited for the remaining $4,000 of the payment.

The $4,000 pre-pays the tax for the next two months (November and December). At the end of each of those two months, the payable is debited for $2,000 and the pre-paid is credited for $2,000. The cycle begins again when the second payment is made. In this jurisdiction, the tax is assessed for a year at the beginning of the year.

Therefore, payments are debited to pre-paid real estate taxes unless previously accrued, as was the case here.

20

Amar Farms produced 300,000 pounds of cotton during the 2005 season. Amar sells all of its cotton to Brye Co., which has agreed to purchase Amar's entire production at the prevailing market price. Recent legislation assures that the market price will not fall below $.70 per pound during the next two years.
Amar's costs of selling and distributing the cotton are immaterial and can be reasonably estimated.
Amar reports its inventory at expected exit value. During 2005, Amar sold and delivered to Brye 200,000 pounds at the market price of $.70. Amar sold the remaining 100,000 pounds during 2006 at the market price of $.72.
What amount of revenue should Amar recognize in 2005?

A. $140,000
B. $144,000
C. $210,000
D. $216,000

C. $210,000
The question is not completely unambiguous. The statement that Brye has agreed to purchase all of Amar's production is not as strong a statement as would be hoped for in implying the use of the "completion-of-production" revenue recognition method.
The correct answer according to the AICPA is $210,000 = $.70 x (200,000 + 100,000). This is the total revenue on the cotton produced in 2005.

The "completion-of-production" method is appropriate when the sale of the output is assured and a definite price is also assured. Revenue is recognized at production, because there is no uncertainty as to the ultimate sale. Typically, the price used to measure the revenue is a market price that cannot be influenced by the producer, which is the case here.

A price of at least $.70 is assured. The additional $.02 received by Amar in 2006 is credited to revenue in that year.

Had the question said that the buyer was contractually obligated to purchase all the output, this answer would be more certainly correct. Likewise, if the question implied that there was a definite market for the cotton, rather than merely one buyer who had agreed to purchase all the output, then this answer would be unequivocally correct.

21

UVW Broadcast Co. entered into a contract to exchange unsold advertising time for travel and lodging services with Hotel Co. As of June 30, advertising commercials of $10,000 were used. However, travel and lodging services were not provided.
How should UVW account for advertising in its June 30 financial statements?

A. Revenue and expense are recognized when the agreement is completed.
B. An asset and revenue for $10,000 is recognized.
C. Both the revenue and expense of $10,000 are recognized.
D. Not reported.

B. An asset and revenue for $10,000 is recognized.
UVW has a receivable and revenue for the $10,000 of advertising services provided to date. Without receipt of any travel and lodging services, the firm reports a receivable for the unpaid advertising services. These services will be "paid" in the form of travel and lodging.

22

Lane Co., which began operations on January 1, 2005, appropriately uses the installment method of accounting. The following information pertains to Lane's operations for 2005:
Installment sales $1,000,000
Regular sales 600,000
Cost of installment sales 500,000
Cost of regular sales 300,000
General and administrative expenses 100,000
Collections on installment sales 200,000
The deferred gross profit account in Lane's December 31, 2005 balance sheet should be

A. $150,000
B. $320,000
C. $400,000
D. $500,000

C. $400,000
Deferred gross profit is the gross profit remaining on uncollected sales accounted for under the installment method. The gross profit percentage is 50% [($1mn - $500,000)/$1mn)] on these sales.

Uncollected installment sales = $800,000 = $1mn - $200,000. Deferred gross profit = $400,000 = .50($800,000)

23

Asp Co. appropriately uses the installment method of revenue recognition to account for its credit sales. The following information was abstracted from Asp's December 31, 2002, financial statements:

2002 2001
Sales $1,500,000 $1,000,000
Accounts receivable:
2002 sales 900,000
2001 sales 540,000 600,000
Deferred gross profit:
2002 sales 252,000
2001 sales 108,000 120,000
What was Asp's gross profit percentage for 2002 sales?

A. 20%
B. 25%
C. 28%
D. 40%

C. 28%
The installment method of revenue recognition recognizes deferred gross profit equal to the gross profit percentage multiplied by the related amount of gross accounts receivable. Deferred gross profit is a contra account to accounts receivable which reduces net accounts receivable to its cost equivalent. With $900,000 of Accounts Receivable remaining on 2002 sales and the related $252,000 Deferred Gross Profit balance, the gross profit percentage is 28% ($252,000/$900,000). Multiplying $900,000 by 28% yields $252,000. This is the amount of unrecognized (deferred) gross profit in accounts receivable.

24

When would a company use the installment sales method of revenue recognition?

A. When collectibility of installment accounts receivable is reasonably predictable.
B. When repossessions of merchandise sold on the installment plan may result in a future gain or loss.
C. When installment sales are material, and there is no reasonable basis for estimating collectibility.
D. When collection expenses and bad debts on installment accounts receivable are deemed to be immaterial.

C. When installment sales are material, and there is no reasonable basis for estimating collectibility.
The installment method of revenue recognition is used when the realizability criterion of revenue recognition is not met. In other words, there is significant uncertainty that the receivable will be collected. Until cash is collected (realizability is therefore assured for the amount collected), no gross profit is recognized. The cost-recovery method, which is even more conservative, may also be used in this situation.

25

A shoe retailer allows customers to return shoes within 90 days of purchase. The company estimates that 5% of sales will be returned within the 90-day period. During the month, the company has sales of $200,000 and returns of sales made in prior months of $5,000. What amount should the company record as net sales revenue for new sales made during the month?
A. $185,000
B. $190,000
C. $195,000
D. $200,000

B. $190,000
The effect of estimated returns is recognized in the month of sale. Net sales to be reported for the current month equal $200,000 less the returns expected on those sales (5% or $10,000), or $190,000. The actual returns granted in the current month on previous months' sales were recognized as reductions in net sales in those previous months.
Don't double-count returned merchandise against sales revenue.

26

The following information relates to a contract through its second year. The contract price is $50,000.

Year 1 Year 2
Cost incurred through end of $10,000 $34,000
Estimated cost remaining at end of 30,000 20,000
Under the completed contract method, by what amount will pretax income for the second year be affected?

A. Reduced $14,000
B. Reduced $4,000
C. Reduced $2,000
D. No effect

B. Reduced $4,000
Total estimated project cost at the end of year 2 is $54,000 ($34,000 + $20,000). Note that this problem provides cumulative cost, rather than cost by year. There is an overall loss on this contract. Overall loss = $54,000 – $50,000 (contract price) = $4,000. Under the completed contract method, the overall loss is recognized immediately.

27

At the end of the third year of a contract, total estimated project cost exceeds the contract price. In both of the first two years, the firm recognized gross profit on the contract under percentage of completion. What is the ending balance in the construction-in-progress account at the beginning of year four on the contract under the percentage-of-completion method (PC), and under the completed-contract method (CC), had that method been used?

PC CC
Cost to date less overall loss Cost to date less overall loss
Cost to date less billings Cost to date less billings
Cost to date Cost to date
Cost to date Cost to date, less overall loss

PC CC
Cost to date less overall loss Cost to date less overall loss
An overall loss is expected, because total estimated cost exceeds contract price. Under PC, the construction-in-progress account is increased by cost and gross profit. If the gross profit is negative (an overall loss), the loss is subtracted from construction in progress. The loss recognized in the year as overall loss becomes evident includes any previous profit. Therefore, the previously recognized gross profit is removed when the total loss is recognized. Under CC, the same idea applies, except that there is no gross profit from previous years to remove. The ending construction-in-progress balance is the same for both methods.

28

A contractor recognized $42,000 of gross profit on a contract at the end of year one of the contract under the percentage-of-completion method. At the end of year two, total estimated project cost exceeded the contract price by $100,000. What amount of loss is to be recognized for year two alone under the percentage-of-completion method (PC), and also under the completed-contract method (CC), had that method been used?

PC CC
-$142,000 -100,000
-$142,000 0
-100,000 0
-$42,000 -$100,000

PC CC
-$142,000 -100,000
The overall loss on this contract is $100,000—the excess of total estimated cost and contract price, as given in the problem. Under PC, the previously recognized gross profit (year one) must be removed. The $142,000 loss recognized in year two yields a $100,000 combined loss for both years—the amount of the overall loss. For CC, the overall loss is recognized immediately. There is no year-one gross profit to remove, because CC recognizes no gross profit until completion of the contract.

29

Choose the correct statement regarding accounting methods for revenue recognition on long-term contracts, for international and US accounting standards.
A. Only US standards require recognition of an overall loss in the year it becomes known.
B. Both sets of standards allow the completed contract method when the percentage of completion method is not appropriate.
C. International standards require the cost recovery method when the percentage of completion method is not appropriate.
D. The percentage of completion method is allowed only under US standards.

C. International standards require the cost recovery method when the percentage of completion method is not appropriate.
Contrary to US GAAP, international standards require a modified version of completed contract—the cost recovery method, when the percentage of completion method is not allowed.

30

Frame construction company's contract requires the construction of a bridge in three years. The expected total cost of the bridge is $2mn, and Frame will receive $2.5mn for the project. The actual costs incurred to complete the project were $500,000, $900,000, and $600,000, respectively, during each of the three years. Progress payments received by Frame were $600,000, $1.2mn, and $700,000 in each year, respectively. Assuming that the percentage-of-completion method is used, what amount of gross profit should Frame report during the last year of the project?

A. $120,000
B. $125,000
C. $140,000
D. $150,000

D. $150,000
The gross profit recognized for the first two years must be computed first. Then, the difference between the $500,000 final total gross profit on the project (= $2.5mn - $2mn), and the gross profit for the first two years, is the amount of gross profit recognized in the last (third) year. The percentage of completion at the end of the first two years is 70% (= $500,000 + $900,000)/$2mn). The gross profit recognized through the end of year two is $350,000 [= .70($2.5mn - $2mn)]. Therefore, gross profit for year three is $150,000 (= $500,000 total gross profit on project - $350,000).

31

A contractor recognizes $42,000 of gross profit on a contract at the end of year one of the contract under the percentage-of-completion method. At the end of year two, the gross profit to be recognized for both years together is $34,000. The total anticipated gross profit on the project estimated at the end of year two is $78,000. What amount of gross profit is to be recognized for year two alone?
A. $78,000
B. $34,000
C. $8,000
D. $0

C. $8,000
This is an example of a single-period loss on a profitable contract. The loss for year two is computed as: $34,000 gross profit through year two - $42,000 gross profit year one = - $8,000 single-period loss. The loss "reverses" $8,000 of the $42,000 gross profit recognized in year one.

32

The calculation of the income recognized in the third year of a five-year construction contract accounted for using the percentage of completion method includes the ratio of
A. Costs incurred in year three to total billings.
B. Costs incurred in year three to total estimated costs.
C. Total costs incurred to date to total billings.
D. Total costs incurred to date to total estimated costs.

D. Total costs incurred to date to total estimated costs.

33

Falton Co. has the following first-year amounts related to its $9mn construction contract:
Actual costs incurred and paid $2mn
Estimated costs to complete $6mn
Progress billings $1.8mn
Cash collected $1.5mn
What amount should Falton recognize as a current liability at year end, using the percentage-of-completion method?

A. $0
B. $200,000
C. $250,000
D. $300,000

A. $0
The percentage of completion is ($2mn)/($2mn + $6mn) = 25%. This is the ratio of cost incurred to date, divided by the total project cost, which is the sum of cost to date and estimated remaining costs. Gross profit recognized is therefore .25($9mn - $2mn - $6mn) = $250,000. The contract price is $1mn more than the total estimated project cost. At 25% complete, the firm recognizes $250,000 of gross profit. The construction-in-progress balance is therefore $2mn + $250,000 = $2.25mn, the sum of cost to date, plus gross profit to date. With billings only $1.8mn so far, the firm reports a net asset equal to the difference between $2.25mn, the balance in construction in progress, and $1.8mn of billings. Billings are contra to construction in progress for reporting. This $450,000 difference is labeled "cost and profit in excess of billings on long-term contracts" in the balance sheet. No current liability is reported, because the asset balance (construction in progress) exceeds billings.

34

On the first day of each month, Bell Mortgage Co. receives from Kent Corp. an escrow deposit of $2,500 for real estate taxes.
Bell records the $2,500 in an escrow account. Kent's 2005 real estate tax is $28,000, payable in equal installments on the first day of each calendar quarter. On December 31, 2004, the balance in the escrow account is $3,000.

On September 30, 2005, what amount should Bell show as an escrow liability to Kent?

A. $1,500
B. $4,500
C. $8,500
D. $11,500

B. $4,500
The September 30, 2005 liability balance equals the account's $3,000 beginning balance, plus the nine deposits of $2,500 received through September 1, 2005, less the three quarters of property tax installments paid in 2005 ($21,000 = .75 x $28,000). These installments were paid on January 1, April 1, and July 1.
The ending liability then is $4,500 = $3,000 + 9($2,500) - $21,000.

35

Kent Co., a division of National Realty, Inc., maintains escrow accounts and pays real estate taxes for National's mortgage customers. Escrow funds are kept in interest-bearing accounts. Interest, less a 10% service fee, is credited to the mortgagee's account and used to reduce future escrow payments.
Additional information follows:
Escrow accounts liability, 1 January, 2004
$700,000
Escrow payments received during 2004
$1.58mn
Real estate taxes paid during
$1.72mn
Interest on escrow funds during 2004
50,000
What amount should Kent report as escrow accounts liability in its December 31, 2004 balance sheet?

A. $510,000
B. $515,000
C. $605,000
D. $610,000

C. $605,000
The following equation is used to explain the changes in the escrow liability and the ending balance (31 December, 2004):
Beginning + Payments - Real estate + Interest - 10% (interest) = Ending
Balance Received Tax Payments Balance

$700,000 + $1.58mn - $1.72mn + $50,000 - $5,000 = $605,000

The interest increases the liability, because it is an amount owed to the mortgagee. This debt is extinguished by crediting the receivable from the mortgagee. The 10% fee reduces the portion of the liability owing to interest.

36

On January 1, year 1, Alpha Co. signed an annual maintenance agreement with a software provider for $15,000 and the maintenance period begins on March 1, year 1. Alpha also incurred $5,000 of costs on January 1, year 1, related to software modification requests that will increase the functionality of the software. Alpha depreciates and amortizes its computer and software assets over five years using the straight-line method. What amount is the total expense that Alpha should recognize related to the maintenance agreement and the software modifications for the year ended December 31, year 1?
A. $5,000
B. $13,500
C. $16,000
D. $20,000

B. $13,500
This question has two costs that occurred during the year. You are asked how much of these costs would be recognized in year 1. The $15,000 of maintenance cost is for a 1 year period beginning March 1. The maintenance cost would be allocated 1/12 evenly over the life of the service period or $1,250 a month x 10 months in year 1 = 12,500. The $5,000 modification to the software has increased its functionality and therefore should be capitalized and amortized over the life of the software $5,000 / 5 years = $1,000/year. The total expense recognized in year 1 would be $12,500 + 1,000 = $13,500.

37

On May 1, 2004, Marno County issued property tax assessments for the fiscal year ended June 30, 2005.
The first of two equal installments was due on November 1, 2004. On September 1, 2004, Dyur Co. purchased a 4-year old factory in Marno subject to an allowance for accrued taxes.
Dyur did not record the entire year's property tax obligation, but instead records tax expenses at the end of each month by adjusting prepaid property taxes or property taxes payable, as appropriate.

The recording of the November 1, 2004 payment by Dyur should have been allocated between an increase in prepaid property taxes and a decrease in property taxes payable in which of the following percentages?

Percentage allocated to Increase in prepaid property taxes Percentage allocated to Decrease in property taxes payable
66 2/3% 33 1/3 %
0% 100%
50% 50%
33 1/3% 66 2/3 %

Percentage allocated to Increase in prepaid property taxes Percentage allocated to Decrease in property taxes payable
33 1/3% 66 2/3 %

38

If the payment of employees' compensation for future absences is probable, the amount can be reasonably estimated, and the obligation relates to rights that accumulate, the compensation should be
A. Accrued if attributable to employees' services not already rendered.
B. Accrued if attributable to employees' services already rendered.
C. Accrued if attributable to employees' services, whether already rendered or not.
D. Recognized when paid.

B. Accrued if attributable to employees' services already rendered.
Only costs that are attributable to employee service already rendered can be accrued. The firm has received no benefit for services that employees have not yet rendered. The firm owes employees nothing for future services and therefore has no liability for these amounts and no cost or expense should be recognized.

39

North Corp. has an employee benefit plan for compensated absences that gives employees ten paid vacation days and ten paid sick days per year.
Both vacation and sick days can be carried over indefinitely. Employees can elect to receive payment in lieu of vacation days; however, no payment is given for sick days not taken.

At December 31, 2004, North's unadjusted balance of liability for compensated absences was $21,000. North estimated that there were 150 vacation days and 75 sick days available at December 31, 2004. North's employees earn an average of $100 per day.

In its December 31, 2004 balance sheet, what amount of liability for compensated absences is North required to report?

A. $36,000
B. $22,500
C. $21,000
D. $15,000

D. $15,000
The liability must be accrued only for the vacation pay, because it is probable that paid vacations will be taken. Therefore, the liability is $15,000 (150 days x $100 per day).

40

At December 31, 2004, Taos Co. estimates that its employees have earned vacation pay of $100,000. Employees will receive their vacation pay in 2005.
Should Taos accrue a liability at December 31, 2004 if the rights to this compensation accumulated over time or if the rights are vested?

Accumulated Vested
Yes No
No No
Yes Yes
No Yes

Yes Yes
Under FAS 43, if compensated absences either accumulate OR vest, then the liability should be accrued. Benefits accumulate if they can be carried over to future years.
For example, assume an employee earns four weeks' vacation per year, but does not take a vacation for two years. If the employee can take an eight-week vacation in the third year, the benefits are said to accumulate (firms usually place restrictions on the total time that can be accumulated).

Benefits vest if they are no longer contingent on continued employment. This means that if an employee retires, he or she will receive their vested vacation pay.

Either way, through accumulation or vesting, it is probable that the vacation compensation will be paid. Therefore, a liability has been incurred as of the balance sheet date.

41

At December 31, 2005, the following information was provided by the Kerr Corp. pension plan administrator:
Fair value of plan assets $3.45mn
Accumulated benefit obligation $4.3mn
Projected benefit obligation $5.7mn

What is the amount of the pension liability that should be shown on Kerr's December 31, 2005 balance sheet?
A. $5.7mn
B. $2.25mn
C. $1.4mn
D. $850,000

B. $2.25mn
This answer is the underfunded projected benefit obligation - the plan's funded status and most critical number for the pension plan. This is the amount shown in the balance sheet. It can also be an asset, if plan assets exceed projected benefit obligation.

Pension liability = PBO - FV of plan assets

42

How many of the following four aspects of accounting for pension gains and losses contribute to the reduction in volatility of reported pension expense: (1) use of corridor amortization as an acceptable method, (2) gains and losses cancel, (3) spreading the amount subject to amortization over the average remaining service period of plan participants, (4) the use of expected return for component 3 of pension expense?
A. 1
B. 2
C. 3
D. 4

D. 4
All four items are relevant. The corridor is a value that reduces the amount subject to amortization.
The cancellation of gains and losses goes a long way to reducing the total amount amortized - in many cases, large gains are offset by large losses, resulting in considerable amounts never being amortized. Dividing the amount subject to amortization by average remaining service period spreads the amortization over many periods, rather than recognizing gains and losses immediately. The use of expected, rather than actual, return for component 3 smoothes the volatility from stock market returns.

43

The following information relates to a post-retirement benefit plan:
APBO beginning, $300mn
Plan assets beginning, $100mn
Net post-retirement benefit gain, beginning, $20mn
Amortization of net gain or loss is based on SL method, ten-year average remaining service period
Prior-service cost, initial amount, recognized four years ago, $50mn
Amortization of prior-service cost is based on SL method, ten-year average remaining service period
Service cost, $40mn
Discount rate, 5%
Expected rate of return, 6%
Actual return, $10mn
Change in estimated life expectancy caused a gain of $16mn, year-end
Funding contribution, $20mn
What amount will be reported in the ending balance sheet for post-retirement benefit liability?
A. $209mn
B. $213m
C. $9mn
D. $212mn

A. $209mn
Beginning post-retirement benefit liability equals $200mn ($300mn APBO - $100mn assets). Post-retirement benefit expense: $40mn SC + $15mn interest cost (.05 x $300mn) - $6mn expected return (.06 x $100mn) + $5mn amortization of PSC ($50mn/ten) - $2mn amortization of net gain ($20mn/10) = $52mn.
Entry: dr. post-retirement benefit expense 52, dr. postretirement gain/loss-OCI 2, cr. PSC-OCI 5, cr. post-retirement benefit liability 49. There is a $4mn asset gain = $10mn actual return - $6mn expected return.

Entry: dr. postretirement benefit liability 4, cr. postretirement gain/loss-OCI 4.
Entry for actuarial gain: dr. postretirement benefit liability 16, cr. post-retirement gain/loss-OCI 16.
Entry for funding: dr. post-retirement benefit liability 20, cr. cash 20.
From the entries: ending post-retirement benefit liability = 200 beginning + 49 - 4 - 16 - 20 = 209. Alternatively, ending post-retirement benefit liability = $200mn beginning post-retirement benefit + $40mn SC + $15mn interest cost - $10mn actual return - $16mn actuarial gain - $20mn funding = $209mn.

44

How should plan investments be reported in a defined benefit plan's financial statements?

A. At actuarial present value.
B. At cost.
C. At net realizable value.
D. At fair value.

D. At fair value.

45

An employer's obligation for post-retirement healthcare benefits that are expected to be fully provided to or for an employee must be fully accrued by the date the
A. Benefits are paid.
B. Benefits are utilized.
C. Employee retires.
D. Employee is fully eligible for benefits.

D. Employee is fully eligible for benefits.

46

A firm is applying international accounting standards to its defined-benefit pension plan. Owing to an amendment to the plan at the end of the current year, prior service cost (PSC) of $1mn is recognized (60% of which is vested). The appropriate period for amortization is ten years. As a result of the amendment, by what amount is pension expense for the following year increased?
A. $40,000
B. $100,000
C. $60,000
D. $0

A. $40,000
The vested portion of PSC is recognized immediately. The remainder (40% or $400,000) is gradually amortized to pension expense over ten years, or $40,000 per year.

47

Choose the correct statement regarding the treatment of prior service cost (PSC) for defined benefit plans under international accounting.
A. Firms have an option to record PSC directly into other comprehensive income or in earnings.
B. The entire PSC amount, at present value, is recognized immediately in pension expense.
C. The entire PSC amount, at present value, is recognized immediately in other comprehensive income, as per U.S. standards.
D. The vested portion of PSC, at present value, is recognized immediately in pension expense.

D. The vested portion of PSC, at present value, is recognized immediately in pension expense.

48

Accounting for non-retirement post-employment benefits is an example of :
A. Accrual accounting.
B. Cash-basis accounting.
C. Fair-value accounting.
D. Historical-cost accounting.

A. Accrual accounting.

49

Which of the following is not a criterion that must be met in order for nonretirement postemployment benefits to be accrued, rather than be treated as a cash expense upon payment.
A. The benefits are attributable to services rendered
B. The benefits accumulate or vest
C. The benefits are contingent on continued employment
D. The benefits are estimable

C. The benefits are contingent on continued employment
This answer is a description of vested benefits. Benefits need not vest for accrual to be mandatory.

50

Under certain circumstances, a firm provides severance pay and tuition assistance to employees who are laid-off. The beginning balance in the associated liability for the current year is $112,000. During the year, employees earned $48,000 of additional benefits, 60% of which are expected to be used by terminated employees, based on past experience. During the year, the firm paid $38,000 to reimburse previous employees for benefits taken. Compute the ending balance of the benefit liability.
A. $122,000
B. $102,800
C. $58,000
D. $77,200

B. $102,800
Only 60% of the benefits earned are expected to be taken by the covered employees. The amount recognized as expense is limited to this amount, because the criteria for recognition require that payments be probable in order for accrual to take place. The following equation (or T-account) provides the solution: $112,000 + (.60)($48,000) - $38,000 = $102,800.

51

Which of the following costs is unique to post-retirement healthcare benefits?

A. Per capita claims.
B. Service.
C. Prior service.
D. Interest.

A. Per capita claims.
The per capital claims cost is the basis for computing the obligation reported for a post-retirement healthcare plan. These costs are estimated based on historical norms adjusted for estimated healthcare cost-trend rates and are affected by the estimated age of employees at retirement, their health, and other factors. Only post-retirement healthcare plans require this type of estimate. Pension benefits, for example, are based on variables such as age at retirement, number of years of service, and final salary. Both defined-benefit pension plans and post-retirement healthcare plans involve the other three answer alternatives. Both have service-cost and interest-cost components for their respective expenses, and both can incur prior-service cost.

52

An overfunded single-employer defined benefit postretirement plan should be recognized in a classified statement of financial position as a
A. Noncurrent liability.
B. Current liability.
C. Noncurrent asset.
D. Current asset.

C. Noncurrent asset.
The excess of plan assets over the benefit liability (accumulated postemployment benefit liability or APBO) is reported as an asset and is classified as noncurrent. The plan assets and APBO are not reported separately but rather are offset. Given the long-term nature of such plans, the asset is classified as a noncurrent asset.

53

An employee covered by a post-retirement healthcare plan just completed her 18th year of service for a firm. Each year of employment to full eligibility provides credit for post-retirement healthcare benefits for this firm. She must work an additional seven years from today to be eligible for 75% healthcare coverage during retirement. She is expected to work ten more years from today. If this employee worked 15 more years from today, the firm would pay all her healthcare costs during retirement. Choose the correct statement.

A. The employee's full eligibility date is reached when she has worked 33 years in total.
B. Accumulated post-retirement benefit obligation equals expected post-retirement benefit obligation for the employee, as of today.
C. Service cost will not be computed for the employee during her last three years of service to the firm.
D. Expected post-retirement benefit obligation reflects only 18 years of service, as of today, for the employee.

C. Service cost will not be computed for the employee during her last three years of service to the firm.
The employee's full eligibility date occurs seven years from today. At that time, she is fully eligible for 75% coverage. The last three years of her service do not increase the level of her benefit. There is no additional service cost beyond that date, although interest cost will continue. If she were expected to work 15 years after today, her full eligibility would not occur until 15 years from now, at which time she would be fully eligible for 100% coverage and service cost would continue through that date.

54

Data for a defined benefit pension plan for the current year are as follows:

PBO, January 1, $200mn
Assets, January 1, $160mn
Pension expense, $60mn
Funding contribution, $50mn
The ending pension liability balance is

A. $40mn
B. $10mn
C. $50mn
D. $200mn

C. $50mn
The beginning pension liability balance was $40mn ($200mn PBO - $160mn assets). With pension expense of $60mn and funding of $50mn, the pension liability increased an additional $10mn, yielding an ending pension-liability balance of $50mn ($40mn + $10mn). There is no information about amortization of PSC or net gain or loss, or difference between expected and actual return, or gain, loss or PSC during the period.

55

Select the correct statement about executive compensation plans involving stock.

A. The total amount of compensation expense for a restricted stock award plan is recognized when the stock is issued.
B. The total amount of compensation expense for a restricted stock award plan is determined at the grant date.
C. For stock-appreciation rights plans payable in cash, compensation expense is recognized only during the service period.
D. For stock-appreciation rights plans payable in cash, compensation expense recognized in any given reporting period cannot be negative.

B. The total amount of compensation expense for a restricted stock award plan is determined at the grant date.
Total compensation expense is the product of the number of shares in the award and the market price of stock at the grant date. This amount is recognized over the service period required for the employee to receive or keep the shares.

56

On January 2, 2005, Morey Corp. granted Dean, its president, 20,000 stock appreciation rights for past services. Those rights are exercisable immediately and expire on January 1, 2008.
On exercise, Dean is entitled to receive cash for the excess of the stock's market price on the exercise date over the market price on the grant date. Dean did not exercise any of the rights during 2005. The market price of Morey's stock was $30 on January 2, 2005 and $45 on December 31, 2005.

As a result of the stock appreciation rights, Morey should recognize compensation expense for 2005 of

A. $0
B. $100,000
C. $300,000
D. $600,000

C. $300,000
The 2005 compensation expense for these stock-appreciation rights equals: (number of shares) x (ending market price - grant-date market price) = 20,000($45 - $30) = $300,000.
The rights are immediately vested, because they can be exercised immediately. Therefore, the entire $300,000 amount is recognized as expense in 2005. Changes in market price in future years, before the rights are exercised, are recognized on a current and prospective basis (change in estimate).

57

A restricted stock award was granted at the beginning of 2005 calling for 3,000 shares of stock to be awarded to executives at the beginning of 2009. The fair value of one option was $20 at grant date. During 2007, 100 shares were forfeited because an executive left the firm.

What amount of compensation expense is recognized for 2007?

A. $14,000
B. $15,000
C. $14,500
D. $13,500

D. $13,500
Total compensation expense at grant date is $60,000 (3,000 x $20). The service period is four years ($20x5 - $20x8). Annual expense recognized is $15,000 ($60,000/4).
Through $20x6, a total of $30,000 of compensation expense is recognized. After the forfeit, only 2,900 shares remain to be awarded.

Annual compensation expense for the remaining two years before considering forfeited shares is therefore $14,500 [(2,900 x $20)/4].

The expense for the two years associated with the 100 shares forfeited is $1,000 [(100 x $20)/2].

For $20x7, subtracting the reversal of the $1,000 yields $13,500 as the final amount of expense to be recognized.

Another way to calculate the $14,500 is: ($60,000 original total compensation expense - $30,000 expense for x5 and x6 - $1,000 expense for x7 and x8 on forfeited shares)/2.

58

On January 1, year 1, a company issued its employees 10,000 shares of restricted stock. On January 1, year 2, the company issued to its employees an additional 20,000 shares of restricted stock. Additional information about the company's stock is as follows:
Date Fair value of stock (per share)
January 1, year 1 $20
December 31, year 1 22
January 1, year 2 25
December 31, year 2 30
The shares vest at the end of a four-year period. There are no forfeitures. What amount should be recorded as compensation expense for the 12-month period ended December 31, year 2?

A. $175,000
B. $205,000
C. $225,000
D. $500,000

A. $175,000
Total compensation expense is computed as the fair value of the stock awarded, and is allocated evenly over the vesting period. The fair value at award date is the fair value used for this computation. The two awards are treated as separate awards, each with four year amortization periods. The total expense for year 2 is the sum of the compensation expense to be recognized for each plan for year 2 and is computed as 10,000($20)/4 + 20,000($25)/4 = $175,000. Total fair value is not updated after the award date.

59

Under the fair-value method of accounting for stock option plans, total compensation recognized

A. Is based on the value of the option at the grant date, adjusted for forfeitures.
B. Equals the net increase in OE after all relevant journal entries are recorded.
C. Is the difference between market price and option price at the grant date.
D. Is unaffected by the option price.

A. Is based on the value of the option at the grant date, adjusted for forfeitures.

60

The stockholders of Meadow Corp. approved a stock-option plan that grants the company's top three executives options to purchase a maximum of 1,000 shares each of Meadow's $2 par common stock for $19 per share. The options were granted on January 1 when the fair value of the stock was $20 per share. Meadow determined that the fair value of the compensation is $300,000 and the vesting period is three years. What amount of compensation expense from the options should Meadow record in the year the options were granted?
A. $20,000
B. $60,000
C. $100,000
D. $300,000

C. $100,000
The fair value of a fixed option plan at grant date is the fair value of the option. Typically the fair value of one option is given and that is multiplied by the number of options, but this problem provides the entire fair value. That total fair value is the total compensation expense to be recognized over the service period - the number of years from grant date to vesting. Once the options vest, no more compensation expense is recognized because the manager has provided the necessary service. Compensation expense per year is the total $300,000 compensation expense divided by 3 years, or $100,000 per year.

61

A stock option plan with a positive fair value at grant date caused compensation expense of $50,000 per year to be recorded over the five-year service period. During the exercise period (two years), the stock price never exceeded the option price. Therefore, none of the options was exercised.

Choose the correct statement about the accounting for these options.

A. the contributed capital increase from recording compensation expense is reversed, causing compensation expense to be reduced in the eighth year after grant.
B. The contributed capital increase from recording compensation expense is left intact.
C. The financial statements during the service period are retroactively restated by removing the compensation expense.
D. The compensation expense for later option grants is reduced by the amount recognized on the options that expired.

B. The contributed capital increase from recording compensation expense is left intact.
Expiration of stock options does not cause reversal of compensation expense because, at the grant date, the firm did provide value to the employee, given that the option had a fair value at that time.
The expense recognized for stock option plans is not based on the expected value of the employee services; rather, it is based on the value of what was given by the employer to the employee.

62

In a stock option plan, the estimated forfeitures rate is increased during the second year of a four-year service period. Therefore,

A. the remaining amount of expense based on the new estimate is allocated to years two-four.
B. the new estimate is retroactively applied.
C. Compensation expense for year two causes total recognized compensation expense through year two to be half of total compensation expense using the new estimate.
D. The effect of the change causes a reversal of previously recognized compensation expense.

C. Compensation expense for year two causes total recognized compensation expense through year two to be half of total compensation expense using the new estimate.
The new estimate is used to compute compensation expense on prior years and the year of change. The resulting total amount of expense through the year of change, less the expense already recognized, is the amount of expense recognized in the year of change.
The new estimate continues to be applied in later years.

63

On January 1, 2003, Gel Inc. granted a maximum of 900 stock options to selected employees. The options are exercisable beginning in 2007. The fair value of one option is estimated to be $2. The options vest based on the extent to which Gel's sales increases from its 2002 base level:

500 shares vest if sales in 2006 increased 15% over 2002 sales
750 shares vest if sales in 2006 increased 25% over 2002 sales
900 shares vest if sales in 2006 increased 40% over 2002 sales
At December 31, 2003, Gel's management anticipates: (1) no forfeitures, and (2) based on 2003 results, the firm will meet the 15% performance target.

At December 31, 2004, Gel's management anticipates: (1) 5% total forfeitures, regardless of the performance target reached, and (2) based on 2004 results, the firm will meet the 25% performance target. Compute compensation expense for 2004.

A. $463
B. $250
C. $500
D. $361

A. $463
Service period is four years (2003-06).
Total estimated compensation expense at December 31, 2003: 500($2) = $1,000.

Compensation expense for 2003: ($1,000/4) = $250.

Total estimated compensation expense at December 31, 2004: 750(1 - .05)($2) = $1,425.

Compensation expense for 2004: $1,425(2/4) - $250 = $462.50.

64

According to FASB Statement No. 109, Accounting for Income Taxes, justification for the method of determining periodic deferred tax expense is based on the concept of
A. Matching of periodic expense to periodic revenue.
B. Objectivity in the calculation of periodic expense.
C. Recognition of assets and liabilities.
D. Consistency of tax-expense measurements with actual tax-planning strategies.

C. Recognition of assets and liabilities.

65

Nala Inc. reported deferred tax assets and deferred tax liabilities at the end of 2004 and at the end of 2005.
According to FASB 109, for the year ended 2005, Nala should report deferred income tax expense or benefit equal to the

A. Sum of the net changes in deferred tax assets and deferred tax liabilities.
B. Decrease in the deferred tax assets.
C. Increase in the deferred tax liabilities.
D. Amount of income tax liability, plus the sum of the net changes in deferred tax assets and deferred tax liabilities.

A. Sum of the net changes in deferred tax assets and deferred tax liabilities.

66

Ram Corp. prepared the following reconciliation of income per books with income per tax return for the year ended December 31, 2005:
Book income before income taxes $750,000
Add temporary difference construction contract revenue, which will reverse in 2009 $100,000
Deduct temporary difference depreciation expense, which will reverse in equal amounts in each of the next four years ($400,000)
Taxable income $450,000
=======

Ram's effective income tax rate is 34% for 2005. What amount should Ram report in its 2005 income statement as the current provision for income tax?
A. $34,000
B. $153,000
C. $255,000
D. $289,000

B. $153,000
The current provision for income tax, also called the tax liability for the year, is the current tax rate multiplied by taxable income: .34 x $450,000 = $153,000.

67

Orleans Co., a cash-basis taxpayer, prepares accrual-basis financial statements. Since 2002, Orleans has applied FASB Statement No. 109, Accounting for Income Taxes. In its 2005 balance sheet, Orleans' deferred income- tax liabilities increased compared to 2004.

Which of the following changes would cause this increase in deferred income tax liabilities?

I. An increase in pre-paid insurance.

II. An increase in rent receivable.

III. An increase in warranty obligations.

A. I only.
B. I and II.
C. II and III.
D. III only.

B. I and II.
Deferred tax liabilities are the future tax effects of future taxable temporary differences. Such differences cause future taxable income to exceed future pre-tax accounting income.
I. An increase in pre-paid insurance implies that future accounting insurance expense will exceed future tax insurance expense. Therefore, future taxable income will increase relative to future pre-tax accounting income. This increases the deferred tax liability.

II. An increase in rent receivable implies that future tax-rent revenue will exceed future accounting-rent revenue. A rent receivable is recorded when accounting-rent revenue is recognized before cash is received. Cash will be received in the future, which will be recognized as rent revenue for tax, but no revenue will be recognized for accounting. Therefore, again, future taxable income will increase relative to future pre-tax accounting income.

Therefore, only I and II increase the deferred tax liability.

68

Thorn Co. applies Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. At the end of 2005, the tax effects of temporary differences are as follows:

Tax Assets (Liabilities) Deferred Related Asset Classification
Accelerated tax depreciation ($75,000) Non-current asset
Additional costs in inventory for tax purposes $25,000 Current asset
($50,000)
========
A valuation allowance was not considered necessary. Thorn anticipates that $10,000 of the deferred tax liability will reverse in 2006. In Thorn's December 31, 2005 balance sheet, what amount should Thorn report as non-current deferred tax liability?

A. $40,000
B. $50,000
C. $65,000
D. $75,000

D. $75,000
Current and non-current deferred tax accounts are not netted together for balance sheet disclosure.
In this case, there is a non-current deferred tax liability, and a current deferred tax asset. Therefore, the full $75,000 of non-current deferred tax liability is separately disclosed in the balance sheet. Even though a portion of the liability is expected to reverse within one year of the balance sheet date, that does not change the classification of any of the deferred tax liability account.

It is the related asset classification that determines current or non-current classification. Because the deferred tax liability is related to a non-current asset, the entire amount is classified as non-current.

69

Two years ago, Aggre Inc. recognized the tax benefit of an uncertain tax position. income tax expense in that year was reduced by $20,000 as a result. In addition, Aggre recorded a $5,000 tax liability for unrecognized benefits for the same tax position. During the current year, the uncertainty is resolved and a benefit of $22,000 is upheld. By what amount is current-year income tax expense affected by the resolution of the prior uncertainty?

A. $2,000 decrease.
B. $22,000 decrease.
C. $5,000 decrease.
D. There is no effect.

A. $2,000 decrease.
Income tax expense was reduced two years ago by $20,000, but the final benefit upon resolution is $22,000. The $2,000 increase in benefit is recognized in the year of resolution.

70

At the end of year one, Cody Co. reported a profit on a partially completed construction contract by applying the percentage-of-completion method.
By the end of year two, the total estimated profit on the contract at completion in year three had been drastically reduced from the amount estimated at the end of year one.
Consequently, in year two, a loss equal to one-half of the year-one profit was recognized. Cody used the completed-contract method for income tax purposes and had no other contracts.

According to FASB Statement No. 109, Accounting for Income Taxes, the year-two balance sheet should include a deferred tax

Asset Liability
Yes Yes
No Yes
Yes No
No No

No Yes
More profit will be recognized under completed contract in year three for tax purposes than will be recognized under percentage-of-completion in year three for accounting purposes. The entire profit will be recognized under completed contract (tax purposes) in year three. But a portion of income has already been recognized for accounting purposes before year three. Therefore, less income will be recognized in year three for accounting purposes.
Consequently, at the end of year two, there is a future taxable difference because future taxable income will exceed future pre-tax accounting income. Taxable differences give rise to deferred tax liabilities.

71

In its first four years of operations ending December 31, 2002, Alder, Inc.'s depreciation for income tax purposes exceeds its depreciation for financial-statement purposes. This temporary difference is expected to reverse in 2003, 2004, and 2005. Alder had no other temporary difference and elected early adoption of FASB 109.
Alder's 2002 balance sheet should include

A. A non-current contra asset for the effects of the difference between asset bases for financial-statement and income tax purposes.
B. Both current and non-current deferred tax assets.
C. A current deferred tax liability only.
D. A non-current deferred tax liability only.

D. A non-current deferred tax liability only.
The classification of deferred tax accounts is based on the classification of the underlying account giving rise to the deferred tax effect.
In this case, depreciable assets are non-current assets, therefore the deferred tax account is also classified as non-current. Because the future temporary differences are taxable (future tax depreciation will be less than book depreciation, causing future taxable income to exceed pre-tax accounting income), the deferred tax account is a liability. Future taxable temporary differences give rise to deferred tax liabilities.

72

At the end of the current year, Swen Inc. prepares its tax return, which reflects an uncertain amount, reducing the firm's tax liability by $40,000. Swen estimates that, upon audit by the IRS, there is a 20% chance that the full $40,000 benefit will be upheld, and a 40% chance that the benefit will be only $25,000. As a result of the required recognition and measurement principles for uncertain tax positions, current-year income tax expense is reduced by what amount?

A. $18,000
B. $25,000
C. $40,000
D. $15,000

B. $25,000
This is the largest amount, which has at least a 50% probability of occurring. The cumulative probability through this amount is 60%. A liability is recognized for the $15,000 of the total $40,000, which has less than a 50% chance of occurring.

The purpose of the cumulative probability approach is to identify the largest amount, which has at least a 50% probability of occurring.

73

West Corp. leased a building and received the $36,000 annual rental payment on June 15, 2004.
The beginning of the lease is July 1, 2004. Rental income is taxable when received. West's tax rates are 30% for 2004 and 40% thereafter. West has elected early adoption of FASB Statement No. 109, Accounting for Income Taxes. West had no other permanent or temporary differences. West determined that no valuation allowance was needed.

What amount of deferred tax asset should West report in its December 31, 2004 balance sheet?

A. $5,400
B. $7,200
C. $10,800
D. $14,400

B. $7,200
2004 rent revenue recognized for financial-accounting purposes is $18,000 (.50 x $36,000).

Rent revenue to be recognized for financial-accounting purposes after 2004 (remaining rent revenue)
$18,000
Less rent revenue taxable after 2004 (the entire $36,000 is taxable in 2004)
( 0)
Equals future deductible difference (future taxable income will be less than future pre-tax accounting income by this amount)
$18,000
Times future enacted tax rate
x .40
Equals ending deferred tax asset balance
$7,200
The future enacted tax rate is used to measure the deferred tax asset, because that is the tax rate that will be in effect when the deferred tax asset is realized.

74

Shear, Inc. began operations in 2005. Included in Shear's 2005 financial statements were bad debt expenses of $1,400 and profit from an installment sale of $2,600.
For tax purposes, the bad debts will be deducted and the profit from the installment sale will be recognized in 2007. The enacted tax rates are 30% in 2005 and 25% in 2007.

Shear elected early application of FASB Statement No. 109, Accounting for Income Taxes. In its 2005 income statement, what amount should Shear report as deferred income tax expense?

A. $300
B. $360
C. $650
D. $780

A. $300
Deferred income tax is the net change in the deferred tax accounts for the year. Given that this is the first year of operations, the change equals the ending deferred tax balance. Deferred tax accounts are measured using the future enacted tax rates applicable in the period of reversal.
The future 2007 tax deduction for bad debt expense will cause 2007 taxable income to decrease relative to pre-tax accounting income (a deductible difference). Therefore, a deferred tax asset is recorded for $350 ($1,400 x .25) in 2005.

The future 2007 installment revenue will be taxable then and cause taxable income to increase relative to pre-tax accounting income (a taxable difference). Therefore, a deferred tax liability is recorded for $650 ($2,600 x .25) in 2005.

The net of the deferred tax asset and liability at the end of 2005 is $300 ($650 - $350). This is the amount by which total income tax expense exceeds income tax liability (current income tax expense) and therefore equals the deferred income tax expense.

75

Dunn Co.'s 2005 income statement reported $90,000 income before provision for income taxes.
To compute the provision for federal income taxes, the following 2005 data are provided:

Rent received in advance
$16,000
Income from exempt municipal bonds
20,000
Depreciation deducted for income tax purposes in excess of depreciation reported for financial-statement purposes
10,000
Enacted corporate income tax rate
30%
If the alternative minimum tax provisions are ignored, what amount of current federal income tax liability should be reported in Dunn's December 31, 2005 balance sheet?

A. $18,000
B. $22,800
C. $25,800
D. $28,800

B. $22,800
The tax liability is 30% of taxable income.

Pre-tax accounting income $90,000
Plus advance rent (taxable, but not included in pre-tax accounting income)
$16,000
Less municipal bond income (this is included in pre-tax accounting income, but is not taxable)
($20,000)
Less depreciation for tax in excess of depreciation for the books
(10,000)
Equals taxable income
$76,000
Times tax rate
x .30
Equals income tax liability
$22,800

76

Because Jab Co. uses different methods to depreciate equipment for financial statement and income tax purposes, Jab has temporary differences that will reverse during the next year and add to taxable income.
Deferred income taxes that are based on these temporary differences should be classified in Jab's balance sheet as a

A. Contra account to current assets.
B. Contra account to non-current assets.
C. Current liability.
D. Non-current liability.

D. Non-current liability.

77

Hut Co. has temporary taxable differences that will reverse during the next year and add to taxable income. These differences relate to non-current assets. Deferred income taxes based on these temporary differences should be classified in Hut's balance sheet as a
A. Current asset.
B. Non-current asset.
C. Current liability.
D. Non-current liability.

D. Non-current liability.

78

At December 31, 2005, Bren Co. has the following deferred income tax items:
A deferred income tax liability of $15,000 related to a non-current asset
A deferred income tax asset of $3,000 related to a non-current liability
A deferred income tax asset of $8,000 related to a current liability
Which of the following should Bren report in the non-current section of its December 31, 2005 balance sheet?

A. A non-current asset of $3,000 and a non-current liability of $15,000.
B. A non-current liability of $12,000.
C. A non-current asset of $11,000 and a non-current liability of $15,000.
D. A non-current liability of $4,000.

B. A non-current liability of $12,000.
The classification of deferred tax accounts is based on the underlying account to which they are related. The $15,000 income tax liability is related to a non-current asset. Therefore, that deferred tax liability is classified as non-current. Balance-sheet presentation of deferred tax accounts nets the non-current accounts and nets the current accounts, for a maximum of two net deferred accounts reported.
This firm would net the $15,000 non-current deferred tax liability with the $3,000 non-current deferred tax asset, to yield a net non-current deferred tax liability of $12,000.

79

Which of the following should be disclosed in a company's financial statements related to deferred taxes?
I. The types and amounts of existing temporary differences.

II. The types and amounts of existing permanent differences.

III. The nature and amount of each type of operating loss and tax credit carry-forward.

A. I and II only.
B. I and III only.
C. II and III only.
D. I, II, and III.

B. I and III only.
Deferred income tax accounts are not affected by permanent differences, because their effect on income tax is the same as their effect on income tax liability.
But temporary differences and operating loss and tax-credit carry-forwards produce deferred tax accounts. Temporary differences cause both deferred tax liabilities and assets to be recognized. Operating loss and tax credit carry-forwards generate only deferred tax assets.

To fully understand the nature of deferred tax accounts, the types and amounts of I and III are reported in a detailed footnote. For example, depreciation differences are major causes of deferred tax liabilities.

80

Venus Corp.'s worksheet for calculating current and deferred income taxes for 2004 is as follows:

2004 2005 2006
Pre-tax income $1,400
Temporary differences:
Depreciation ($800) ($1,200) $2,000
Warranty costs
$400 ($100) ($300)
______ ______ ______
Taxable income
$1,000 ($1,300) $1,700
Loss carry-back (1,000) $1,000
Loss carry-forward $300 ($300)
______ ______ ______
$0 $0 $1,400
===== ===== =====
Enacted rate 30% 30% 25%
Deferred tax liability (asset):
Current ($300)
=====
Non-current $350
=====
Venus elected early adoption of FASB Statement No. 109, Accounting for Income Taxes. Venus had no prior deferred tax balances. In its 2004 income statement, what amount should Venus report as:

Deferred income tax expense?

A. $350
B. $300
C. $120
D. $35

D. $35
Deferred income tax expense is the net change in deferred tax accounts for the year. Because the firm began the year without any deferred tax accounts, that change equals the net sum of the ending deferred tax accounts for 2004. Enacted tax rates are used to compute the change in deferred tax accounts.
Ending deferred tax liability (from depreciation temporary differences): $2,000(.25) - $1,200(.30) $140
Less ending deferred tax asset (from warranty temporary difference): $300(.25) + $100(.30) ($105)
Equals net change in deferred tax accounts, and deferred income tax expense $35
The 2005 temporary difference for depreciation is subtracted from the 2006 difference, because the 2005 difference is an originating difference, whereas the 2006 difference is the reversing difference.

81

At the end of the previous year, a firm reported a $6,000 deferred tax asset from a net-operating-loss carry-forward that can be carried forward several years into the future. The tax rate is 30%. For the current year, the firm records estimated warranty expense of $30,000 for the year and incurred $10,000 of warranty-claims costs. Taxable income for the current year is $12,000. Compute income tax expense (benefit) for the current year.

A. ($5,400)
B. $2,400
C. $3,600
D. Neither expense nor benefit.

B. $2,400
The unused net operating loss (NOL) at the beginning of the year is $20,000 (= $6,000/.3). The firm pays no tax for the current year, because $12,000 of the NOL is used to absorb the $12,000 of taxable income. $8,000 of the NOL remains to carry forward to the next year. Also, there is a future temporary difference of $20,000 from the future warranty deduction ($30,000 - $10,000 current-year claims). In total, then, the basis for the ending deferred tax asset is $28,000 (= $8,000 + $20,000). The ending deferred tax asset balance is $8,400 (= $28,000 x .3). The beginning deferred tax asset balance is $6,000. Therefore, the deferred tax asset is increased by $2,400 and income tax benefit of that amount also is recorded (credited) in the tax-accrual entry.

82

For 2003, Pac Co. estimates its two-year equipment warranty costs based on $100 per unit sold in 2003. Experience during 2004 indicates that the estimate should have been based on $110 per unit.
The effect of this $10 difference from the estimate is reported

A. In 2004 income from continuing operations.
B. As an accounting change, net of tax, below 2004 income from continuing operations.
C. As an accounting change requiring 2003 financial statements to be restated.
D. As a correction of an error requiring 2003 financial statements to be restated.

A. In 2004 income from continuing operations.
This is a change in accounting estimate, because experience in the current period implies that a different estimate should be used. This new information does not invalidate the good-faith estimate made in 2003, because the new information was not known at that time. These changes are treated currently and prospectively; that is, in the current and future periods, if affected. They are not applied retroactively.
In this instance, the $10 increase in warranty costs per unit is recognized as an increase in warranty expense of 2004. Therefore, income from continuing operations will reflect this increase.

83

On January 2, 2005, to better reflect the variable use of its only machine, Holly, Inc. elects to change its method of depreciation from the straight-line method to the units-of-production method. The original cost of the machine on January 2, 2003, is $50,000, and its estimated life is ten years. Holly estimates that the machine's total life is 50,000 machine hours.
Machine-hour usage was 8,500 during 2004 and 3,500 during 2003. Machine-hour usage for 2005 is 3,800.

Holly's income tax rate is 30%. Holly should report the accounting change in its 2005 financial statements as a(an)
A. Estimate change recognizing $3,800 of depreciation in 2005.
B. Estimate change recognizing $4,000 of depreciation in 2005.
C. Cumulative effect of a change in accounting principle of $1,400 in its income statement.
D. Adjustment to beginning retained earnings of $1,400.

B. Estimate change recognizing $4,000 of depreciation in 2005.
A change in depreciation method is accounted for as an estimate change. The remaining book value at the beginning of the year of change is allocated over the remaining useful life using the new method.
Book value January 1, 2005 = $50,000 - ($50,000/10)2 = $40,000.

Estimated remaining machine hours at January 1, 2005 = $50,000 - $8,500 - $3,500 = $38,000.

Depreciation expense for 2005 = $3,800($40,000/$38,000) = $4,000.

84

Finch Co. reported a total asset retirement obligation of $257,000 in last year's financial statements. This year, Finch acquired assets subject to unconditional retirement obligations measured at undiscounted cash flow estimates of $110,000 and discounted cash flow estimates of $68,000. Finch paid $87,000 toward the settlement of previously recorded asset retirement obligations and recorded an accretion expense of $26,000. What amount should Finch report for the asset retirement obligation in this year's balance sheet?
A. $238,000
B. $264,000
C. $280,000
D. $306,000

B. $264,000
Beg. Bal. 257
+ DCF estimate 68
- Settle old ARO (87)
+ Accretion expense 26
End. Bal. 264

85

A firm's natural resources exploitation site will require an expenditure of $5 million to reclaim the site for environmental purposes. That expenditure is expected to be made five years from now. The present value today of that amount is $3.5 million. Because of this obligation, (1) by what amount will total depletion on the site increase, and (2) how much accretion expense will be recognized over the five years? (in millions)
1 2
$3.5 $1.5
$5.0 $1.5
$0 $0
$3.5 $3.5

1 2
$3.5 $1.5

Total depletion increases by the ARO, which is the PV of the expenditure.
Accretion expense = amount of expenditure - PV of expenditure, or growth of ARO over time.

86

Is the cumulative effect of an inventory-pricing change on prior years' earnings reported as an adjustment to retained earnings for
LIFO to weighted average? FIFO to weighted average?
Yes Yes
Yes No
No No
No Yes

LIFO to weighted average? FIFO to weighted average?
Yes Yes

87

At the end of 2003, Ritzcar Co. fails to accrue sales commissions earned during 2003, but paid in 2004. The error is not repeated in 2004.
What was the effect of this error on 2003 ending working capital and on the 2004 ending retained earnings balance?

2003 ending working capital 20x4 ending retained earnings
Overstated Overstated
No effect Overstated
No effect No effect
Overstated No effect

Overstated No effect

88

During 2006, Orca Corp. decides to change from the FIFO method of inventory valuation to the weighted-average method. Inventory balances under each method were as follows:
FIFO Weighted-average
January 1, 2006 $71,000 $77,000
December 31, 2006 $79,000 $83,000
Orca's income tax rate is 30%.

Orca should report the cumulative effect of this accounting change as a(an)

A. Prior period adjustment.
B. Adjustment to retained earnings.
C. Extraordinary item.
D. Component of income after discontinued operations.


B. Adjustment to retained earnings.
Accounting-principle changes are reported as an adjustment to retained earnings at the beginning of the year of change. Prior financial statements are retrospectively adjusted.

Only corrections of errors in prior-year income are classified as Prior period adjustments.

89

Goddard has used the FIFO method of inventory valuation since it began operations in 2002. Goddard decides to change to the weighted-average (WA) method for determining inventory costs at the beginning of 2005.
The following schedule shows year-end inventory balances under the FIFO and weighted-average methods:

Year FIFO Weighted-average
2002 $45,000 $54,000
2003 $78,000 $71,000
2004 $83,000 $78,000
What amount, before income taxes, should be reported in the 2005 financial statements as the cumulative effect of the change in accounting principle?

A. $5,000 decrease.
B. $3,000 decrease.
C. $2,000 increase.
D. $0

A. $5,000 decrease.
The cumulative effect is computed as of the beginning of the year of change (2005), because the new method (WA) is used in 2005 to compute cost of goods sold and ending inventory. The pre-tax effect of the change on the previous three years is the difference between ending 2004 inventory under the two methods. The only income account affected by the method change is cost of goods sold. The cumulative effect adjusts the beginning of 2005 retained earnings balance.

At the beginning of operations in 2002, there was no beginning inventory. Purchases are the same under either method. Therefore, the difference in cost of goods sold and therefore pre-tax income for the three years between the two methods is $5,000 = ($83,000 - $78,000). WA recognizes more cost of goods sold. Therefore, the cumulative effect reduces 2005 pre-tax income by $5,000.

90

Foy Corp. failed to accrue warranty costs of $50,000 in its December 31, 2003 financial statements. In addition, a change from straight-line to accelerated-depreciation made at the beginning of 2004 resulted in a $30,000 decrease in income for the year. Both the $50,000 and the $30,000 are net of related income taxes.
What amount should Foy report as Prior period adjustments in 2004?

A. $0
B. $30,000
C. $50,000
D. $80,000

C. $50,000
The failure to accrue warranty expense is an accounting error. It gives rise to a Prior period adjustment in the year of discovery (2004).
Prior period adjustments are limited to corrections of errors affecting prior-year net income. They adjust the beginning balance of retained earnings in the year of correction. The change in depreciation method is an estimate change, which is reported in earnings. It is not a Prior period adjustment.

91

The cumulative effect of a change in accounting principle should be recorded as an adjustment to retained earnings, when the change is:
A. Cash basis of accounting for vacation pay to the accrual basis.
B. Straight-line method of depreciation for previously recorded assets to the double-declining-balance method.
C. Longer useful life of equipment to shorter useful life.
D. Completed-contract method of accounting for long-term construction-type contracts to the percentage-of-completion method.

D. Completed-contract method of accounting for long-term construction-type contracts to the percentage-of-completion method.
Accounting-principle changes such as this one are recorded by retroactively restating prior-year financial statements. The entry to record the change results in an adjustment to the beginning balance of retained earnings in the year of the change.

92

How should a company report its decision to change from a cash-basis to an accrual-basis of accounting?
A. As a change in accounting principle, requiring the cumulative effect of the change (net of tax) to be reported in the income statement.
B. Prospectively, with no amounts restated and no cumulative adjustment.
C. As an extraordinary item (net of tax).
D. As a Prior period adjustment (net of tax), by adjusting the beginning balance of retained earnings.

D. As a Prior period adjustment (net of tax), by adjusting the beginning balance of retained earnings.

The accrual basis of accounting is required by GAAP. A change from an inappropriate method to the correct method is treated as an error correction. The procedure requires retrospective application, resulting in an after-tax cumulative adjustment to prior years' earnings (called a Prior period adjustment) to the beginning balance in retained earnings.

93

In 2005, Brighton Co. changed from the individual-item approach to the aggregate approach in applying the lower of FIFO cost or market to inventories.
The cumulative effect of this change should be reported in Brighton's financial statements as a

A. Prior period adjustment, with separate disclosure.
B. Component of income from continuing operations, with separate disclosure.
C. Component of income from continuing operations, without separate disclosure.
D. Cumulative-effect adjustment to retained earnings, with separate disclosure.

D. Cumulative-effect adjustment to retained earnings, with separate disclosure.

This accounting change is a change in the application of an accounting principle, which merits the reporting of a cumulative effect of accounting principle change.
Accounting-principle changes, as well as changes in the application of principles, are accounted for using the retrospective approach, which recognizes the effect of the change on all prior years affected as an adjustment to retained earnings at the beginning of the year of change.

94

During 2005, Orca Corp. decided to change from the FIFO method of inventory valuation to the weighted-average method. Inventory balances under each method were as follows:
FIFO Weighted-average
January 1, 2005 $71,000 $77,000
December 31, 2005 $79,000 $83,000
Orca's income tax rate is 30%.

In its 2005 financial statements, what amount should Orca report as the cumulative effect of this accounting change?

A. $2,800
B. $4,000
C. $4,200
D. $6,000

C. $4,200
$6,000 is the cumulative pre-tax income difference between the two methods as of January 1, 2005.
The after-tax difference is .70($6,000) or $4,200. Accounting changes are measured as of the beginning of the year of change. The $6,000 represents the total difference in cost of goods sold between the two methods for the entire life of the firm, because under weighted-average, the firm has $6,000 more in inventory than under FIFO at January 1, 2005. This is the "ending" inventory for that firm, as of that date, for the firm's entire existence.

The $6,000 difference completely explains the pre-tax difference in income under the two methods for years up to January 1, 2005; the $4,200 is the after-tax difference.

Cumulative effects are reported net of tax as an adjustment to the beginning balance of retained earnings in the year of the change.

95

At the beginning of the year, the carrying value of an asset was $1,000,000 with 20 years of remaining life. The fair value of the liability for the asset retirement obligation was $100,000. At year end, the carrying value of the asset was $950,000. The risk-free interest rate was 5%. The credit-adjusted risk-free interest rate was 10%. What was the amount of accretion expense for the year related to the asset retirement obligation?
A. $10,000
B. $50,000
C. $95,000
D. $100,000

A. $10,000
The ARO increases over time while the book value of the asset decreases through the depreciation or depletion of the asset. The accretion rate for the ARO is based on the liability (not the asset) at the credit-adjusted risk-free rate. Therefore, the ARO $100,000 x .10 = $10,000 of accretion expense for the year.

Accretion expense = FV of ARO liability * credit-adjusted RF-rate

96

At the beginning of the current year, a firm invested $30 million in a natural resources site. This amount was applied to the acquisition of the mineral rights, exploring for the resource (full-costing method is used), and development. In addition, the firm must bring the property back to its original state three years from today. Two estimates of the future cost for that future effort are: (1) $6 million with 30% probability, and (2) $4 million with 70% probability. 6% is the appropriate risk adjusted rate of return. The present value of $1 in three years at 6% is 0.83962. By the end of the current year, the firm had removed 20% of the total estimated resource in the deposit. Compute depletion and accretion expense for the current year.

Depletion Accretion expense
$5,631,280 $187,429
$6,772,450 $231,735
$7,569,302 $312,876
$6,105,280 $251,678

Depletion Accretion expense
$6,772,450 $231,735
Asset retirement obligation beginning balance = [$6,000,000(.30) + $4,000,000(.70)](0.83962) = $3,862,252. This is the present value of the expected future cost of reclaiming the property. The risk-adjusted rate of return is used because the probabilities account for the uncertainty of the cash flow amounts. This beginning balance is added to the $30 million figure for a total of $33,862,252 capitalized depletion base. Depletion is 20% of that amount or $6,772,450. Accretion expense is the growth in the asset retirement obligation for the year or .06($3,862,252) = $231,735.

97

On January 1, 2004, Taft Co. purchases a patent for $714,000. The patent is being amortized over its remaining legal life of 15 years, expiring on January 1, 2019.
During 2007, Taft determined that the economic benefits of the patent would not last longer than ten years from the date of acquisition.
What amount should be reported in the balance sheet for the patent, net of accumulated amortization, at December 31, 2007?

A. $428,400
B. $489,600
C. $504,000
D. $523,600

B. $489,600
This is a change in accounting estimate. The beginning 2007 patent balance is $714,000(12/15) = $571,200, because three years of amortization would have been recorded as of that date, based on 15 years. Amortization in 2007, therefore, is $571,200(1/7) = $81,600.
As of the beginning of 2007, only seven years remain in the useful life, because the total useful life as of that date was changed to ten years, and the patent had been used for three years as of that date.

Therefore, the ending net balance in the patent is $571,200 - $81,600 = $489,600.

98

At December 31, 2004, Off-Line Co. changes its method of accounting for demo costs from writing off the costs over two years to expensing the costs immediately.
Off-Line makes the change in recognition of an increasing number of demos placed with customers that did not result in sales. Off-Line has deferred demo costs of $500,000 at December 31, 2003, $300,000 of which were to be written off in 2004 and the remainder in 2005.

Off-Line's income tax rate is 30%. In its 2004 retained-earnings statement, what amount should Off-Line report as cumulative effect of change in accounting principle?

A. $0
B. $200,000
C. $350,000
D. $500,000

A. $0
The change in accounting principle is indistinguishable from a change in accounting estimate. This change can be effected by changing the useful life of the demo costs to zero - a change in estimate. The firm should write off the remaining unamortized costs at the beginning of the year of change. Earnings in 2004 will be reduced by $500,000 before tax as a result.

99

On January 1, 2003, Lane, Inc. acquires equipment for $100,000 with an estimated ten-year useful life. Lane estimates a $10,000 salvage value and uses the straight-line method of depreciation. During 2007, after its 2006 financial statements have been issued, Lane determines that, owing to obsolescence, this equipment's remaining useful life was only four more years and its salvage value would be $4,000.
In Lane's December 31, 2007 balance sheet, what was the carrying amount of this asset?

A. $51,500
B. $49,000
C. $41,500
D. $39,000

B. $49,000
Original cost $100,000
Less depreciation 2003-06 (four years):
4[($100,000 - $10,000)/10] ($36,000)
Book value January 1, 2007 $64,000
Less depreciation, 2007: ($64,000 - $4,000)/4 ($15,000)
Equals carrying value, December 31, 2007 $49,000
This is a change in estimate. The new salvage and useful life estimates are used starting at the beginning of the year of the estimate change. Estimate changes are not applied retroactively.

100

Belle Co. determined after four years that the estimated useful life of its labeling machine should be ten, rather than 12 years. The machine originally cost $46,000 and had an estimated salvage value of $1,000. Belle uses straight-line depreciation. What amount should Belle report as depreciation expense for the current year?
A. $3,200
B. $3,750
C. $4,500
D. $5,000

D. $5,000
The asset has a depreciable base of $46,000-$1,000=$45,000. The depreciation expense for years one through four is $45,000/12=$3,750.
Accumulated depreciation after four years is $3,750 X 4 =$15,000.
The carrying value after four years is $46,000-$15,000=$31,000.
Depreciation based on the new estimated useful life is $31,000-$1,000 = $30,000 for the depreciable base. The remaining useful life is 10-4=6 years.
Depreciation for the current year is $30,000/6 = $5,000.

101

Miller Co. discovers that in the prior year, it failed to report $40,000 of depreciation related to a newly constructed building. The depreciation was computed correctly for tax purposes. The tax rate for the current year is 40%.
What was the impact of the error on Miller's financial statements for the prior year?

A. Understatement of accumulated depreciation of $24,000.
B. Understatement of accumulated depreciation of $40,000.
C. Understatement of depreciation expense of $24,000.
D. Understatement of net income of $24,000.

B. Understatement of accumulated depreciation of $40,000.

Accumulated depreciation is a pre-tax amount. The journal entry omitted in the past is:
dr. Depreciation expense, $40,000;
cr. Accumulated depreciation, $40,000.
The beginning balance of accumulated depreciation in the year the error was discovered is understated by $40,000 because that amount was not recorded in a prior year.

102

On January 2, 2003, Raft Corp. discovers that it had incorrectly expensed a $210,000 machine purchased on January 2, 2000. Raft estimates the machine's original useful life to be ten years and its salvage value at $10,000. Raft uses the straight-line method of depreciation and is subject to a 30% tax rate. In its December 31, 2003, financial statements, what amount should Raft report as a Prior period adjustment?

A. $102,900
B. $105,000
C. $165,900
D. $168,000

B. $105,000
Depreciation for three years (2000-02) is 3($210,000 - $10,000)/10 or $60,000. Through the beginning of 2003, retained earnings before tax, therefore, is understated $150,000 ($210,000 from immediate expensing of the asset, less $60,000 of depreciation, that would have been taken through 2002). The after-tax understatement is .70 x $150,000 = $105,000. Prior period adjustments are recorded as of the beginning of the year in which the error is discovered

103

The senior accountant for Carlton Co., a public company with a complex capital structure, has just finished preparing Carlton's income statement for the current fiscal year. While reviewing the income statement, Carlton's finance director noticed that the earnings-per-share data have been omitted. What changes will have to be made to Carlton's income statement as a result of the omission of the earnings-per-share data?
A. No changes will have to be made to Carlton 's income statement. The income statement is complete without the earnings-per-share data.
B. Carlton's income statement will have to be revised to include the earnings-per-share data.
C. Carlton's income statement will only have to be revised to include the earnings-per-share data if Carlton's market capitalization is greater than $5mn.
D. Carlton's income statement will only have to be revised to include the earnings-per-share data if Carlton's net income for the past two years is greater than $5mn.

B. Carlton's income statement will have to be revised to include the earnings-per-share data.
All publicly traded companies are required to report EPS information. However, only the current year is affected. Restatement of prior-year statements is not required.

104

Conn Co. reports a retained-earnings balance of $400,000 at December 31, 2004.
In August 2005, Conn determines that insurance premiums of $60,000 for the three-year period beginning January 1, 2004 had been paid and fully expensed in 2004. Conn has a 30% income tax rate.

What amount should Conn report as adjusted beginning retained earnings in its 2005 statement of retained earnings?

A. $420,000
B. $428,000
C. $440,000
D. $442,000

B. $428,000
The 2005 statement of retained earnings must disclose a Prior period adjustment to the beginning retained-earnings balance for the amount required to correct prior-year net income.
2004 insurance expense actually recognized (in error) $60,000
Less 2004 correct insurance expense - the amount that should have been recognized ($60,000/3 - a three-year policy) (20,000)
Equals the error in pre-tax income before 2005(income understated) $40,000
Times (1 - tax rate) to determine after-tax error x .70
Equals the error correction, the amount by which retained earnings at January 1, 2005 must be increased(the Prior period adjustment) $28,000
Plus unadjusted retained earnings at January 1, 2005 $400,000
Equals adjusted retained earnings at January 1, 2005 $428,000

105

While preparing its 2005 financial statements, Dek Corp. discovers computational errors in its 2004 and 2003 depreciation expense. These errors result in overstatement of each year's income by $25,000, net of income taxes. The following amounts were reported in the previously issued financial statements:

2004 2003
__________ __________
Retained earnings, January 1 $700,000 $500,000
Net income $150,000 $200,000
__________ __________
Retained earnings, December 31 $850,000 $700,000
========== ==========
Dek's 2005 net income is correctly reported at $180,000. Which of the following amounts should be reported as Prior period adjustments and net income in Dek's 2005 and 2004 comparative financial statements?

Yr Prior period adj. NI
2004 - $125,000
2005 ($50,000) $180,000
2004 ($50,000) $125,000
2005 - $180,000
2004 ($25,000) $125,000
2005 - $180,000
2004 - $125,000
2005 - $180,000

2004 ($25,000) $125,000
2005 - $180,000

A Prior period adjustment is an adjustment to the beginning balance of retained earnings for a particular year, and reflects the effect of an error on income before that year.
Therefore, only 2004 will show an adjustment. 2004 will have a debit Prior period adjustment (reduction in retained earnings) of $25,000, because 2003 income was overstated by that amount. 2005 will not have any adjustment, because 2004's income will have been restated to the correct amount, and the 2003 error is adjusted in the 2004 retained-earnings statement adjustment.

Comparative income statements are adjusted to reflect the correct earnings amount. Therefore, net income in 2004 will be restated to $125,000 ($150,000 - $25,000). 2005 income is correctly reported at $180,000. It is not affected by the error.

106

On January 1, year one, Newport Corp. purchases a machine for $100,000. The machine is depreciated using the straight-line method over a ten-year period with no residual value. Because of a bookkeeping error, no depreciation was recognized in Newport's year-one financial statements, resulting in a $10,000 overstatement of the book value of the machine on December 31, year one. The oversight was discovered during the preparation of Newport's year-two financial statements. What amount should Newport report for depreciation expense on the machine in the year-two financial statements?

A. $9,000
B. $10,000
C. $11,000
D. $20,000

B. $10,000
The year-one error has no bearing on the amount of depreciation to be recognized in subsequent years. Annual depreciation is $10,000 (= $100,000/10). In year two, a Prior period adjustment will be recorded, correcting beginning retained earnings and accumulated depreciation. Year-one statements reported comparatively with year two's statements will be shown correctly. Year two will report $10,000 of depreciation expense.

107

In which one of the following cases will a non-cash asset transferred as consideration in a business combination be measured at carrying value, not at fair value?
A. The asset transferred is a non-monetary asset.
B. The asset transferred is a non-depreciable asset.
C. The asset transferred remains under the control of the acquiring entity.
D. The asset transferred has a fair value less than the carrying value.

C. The asset transferred remains under the control of the acquiring entity.
When the transferred asset remains under the control of the acquiring entity, the asset is transferred at carrying value, not fair value; for example, when the acquirer transfers a non-cash asset (e.g., land) as consideration and the asset remains with the acquiree, over which the acquirer has control. Otherwise, all assets (and liabilities and equity) transferred as consideration in a business combination are measured at fair value, not carrying value.

108

Which of the following general types of information about a business combination must be disclosed?

I. The primary reason for a business combination.

II. How the acquirer gained control of the business.

III. The acquisition-date fair value of consideration transferred and each major class of asset acquired and liability assumed.

A. I and II only.
B. I and III only.
C. II and III only.
D. I, II, and III.

D. I, II, and III.

109

Under IFRS which of the following would not be recognized as part of a business combination.
A. Contingent asset.
B. Contingent liability.
C. Goodwill.
D. Fair value of the consideration transferred.

A. Contingent asset.
Under IFRS, contingent assets are not recognized. Under U.S. GAAP, contingent assets are recognized if the item meets the criteria of the definition of an asset.

110

If an acquiree elects to apply pushdown accounting, which of the following accounts of the acquiree cannot be recorded at acquisition date fair value?
A. Goodwill.
B. Property and Equipment.
C. Common Stock.
D. Bonds Payable.

C. Common Stock.
The acquiree cannot apply pushdown accounting to revalue its common stock to fair value as of the acquisition date.

111

On September 30, 2001, Payne, Inc. exchanged some of its shares for all of the common stock of Salem, Inc. in a business combination. Salem continued as a wholly owned subsidiary of Payne. How should Salem's January 1, 2001, Retained Earnings and income for January 1 to September 30 be reported in 2001 consolidated statements?

1/1/01 Retained Earnings Income: 1/1/01 - 9/30/01
Added to Consolidated R/E Added to Consolidated Income
Added to Consolidated R/E Excluded from Consolidated Income
Excluded from Consolidated R/E Added to Consolidated Income
Excluded from Consolidated R/E Excluded from Consolidated Income

Excluded from Consolidated R/E Excluded from Consolidated Income
Both Salem's 1/1/01 retained earnings and its income for the period January 1 through September 30 would be excluded from 2001 consolidated financial statements. Both Salem's 1/1/01 retained earnings and its income earned January 1 through September 30 would be part of the shareholders' equity acquired by Payne on September 30 and eliminated in the consolidating investment eliminating entry.

112

Which of the following statements, if any, concerning a contingency that arises in a business combination is/are correct?

I. After an acquisition and until it is settled, a contingency that is a liability will be measured at no less than the fair value reported on the acquisition date.

II. After an acquisition and until it is settled, a contingency that is an asset will be measured at no less than the fair value reported on the acquisition date.

A. Neither I nor II.
B. I only.
C. II only.
D. Both I and II.

B. I only.
Statement I is correct. After an acquisition, a contingency that is a liability will be measured and reported at the higher of the amount reported on the acquisition date or the amount that would be recognized if the requirements of FASB #5 were followed. Thus, such a liability would not be measured at less than the fair value on the acquisition date (Statement I). Statement II is not correct. After an acquisition, a contingency that is an asset will be measured at the lower of the amount reported on the acquisition date or the best estimate of its future settlement amount. Thus, such an asset would be measured at no more than, not at no less than, the fair value reported on the acquisition date.

113

Parco has the following three subsidiaries: Finco, Serco, and Euroco. Finco is a 100% owned finance subsidiary. Serco is an 80% owned service company. Euroco is a 100% owned foreign subsidiary that conducts operations in Western Europe. Which one of the following is the most likely number of entities, including Parco, to be included in Parco's consolidated financial statements?
A. One.
B. Two.
C. Three.
D. Four.

D. Four.
The consolidated statements would include not only Parco, but also all three of its subsidiaries, for a total of four. Even if it is a foreign entity, it is included in consolidated F/S.

114

On July 1, 2009, Nexto, Inc. had the following summarized balance sheet with the book values and fair values shown:

Book Value Fair Value
Accounts Receivable (net) $ 40,000 $ 40,000
Inventories 80,000 80,000
Plant and Equipment (net) 160,000 200,000
Land 120,000 160,000
TOTAL ASSETS $400,000 $480,000
Accounts Payable $ 20,000 $ 20,000
Short-term Note 30,000 30,000
Bonds Payable 70,000 70,000
TOTAL LIABILITIES $120,000 $120,000
On that date Pesto, Inc. acquired 100% of Nexto's voting stock from its shareholders by paying the following consideration:

Cash $200,000
10,000 newly-issued shares of Pesto's $10 par common stock 100,000 (par)
Prior to the combination Pesto had 1,000,000 shares of voting stock outstanding trading in an active market at $15 per share. Pesto paid $25,000 for legal and accounting fees to carry out the combination.

Which one of the following is the total amount of consideration that Pesto should recognize as its cost of acquiring Nexto?

A. $300,000
B. $325,000
C. $350,000
D. $375,000

C. $350,000
The total cost (consideration transferred) of acquiring Trace should be the cash paid plus the fair value of the stock issued. Therefore, the cost would be $200,000 + (10,000 share x $15 market price = $150,000), or $200,000 + $150,000 = $350,000. The cost of carrying out the combination ($25,000) should be expensed in the period incurred.

115

Which one of the following is not a characteristic of a variable-interest entity?
A. A variable-interest entity is thinly capitalized.
B. The equity holders in a variable-interest entity control the entity.
C. The risks and rewards associated with a variable-interest entity mostly accrue to the variable-interest holders.
D. The value of a variable-interest entity depends on the net asset value of the variable-interest entity.

B. The equity holders in a variable-interest entity control the entity.
The equity holders in a variable-interest entity do not control the entity. Control of the activities and decision-making in a variable-interest entity generally resides with the variable-interest holders (not the equity holders) as established by agreement or other instrument.

116

Which of the following statements, if any, concerning a noncontrolling interest in an acquiree is/are correct?

I. The value assigned to a noncontrolling interest in an acquiree should be based on the proportional share of that interest in the net assets of the acquiree.

II. The fair value per share of the noncontrolling interest in an acquiree must be the same as the fair value per share of the controlling (acquirer) interest.

A. Both I and II.
B. I only.
C. II only.
D. Neither I nor II.

B. I only.
Statement I is not correct; neither is Statement II. The value assigned to a noncontrolling interest in an acquiree would not be based simply on the proportional share of that interest in the net assets of the acquiree (Statement I), but rather on the separately determined fair value of the noncontrolling interest. The fair value per share of the noncontrolling interest in an acquiree does not have to be the same as the fair value per share of the controlling interest (Statement II), because there is likely to be a premium in value associated with having control of an entity that the noncontrolling interest would not enjoy.

117

In which of the following circumstances will goodwill be recognized in a business combination?
A. The acquired entity had the asset "Goodwill" on its books immediately prior to the business combination.
B. The fair value of the investment by the acquiring entity and any noncontrolling interest in the acquired entity is greater than the book value of the acquired entity's net assets.
C. The fair value of the investment by the acquiring entity and any noncontrolling interest in the acquired entity is greater than the fair value of the acquired entity's net assets.
D. The fair value of the investment by the acquiring entity and any noncontrolling interest in the acquired entity is less than the fair value of the acquired entity's net assets.

C. The fair value of the investment by the acquiring entity and any noncontrolling interest in the acquired entity is greater than the fair value of the acquired entity's net assets.
Goodwill is based on the excess of investment value over the fair value of net assets. Thus, an acquirer will recognize goodwill only when the fair value of its investment and that of any noncontrolling interest in the acquiree exceeds the fair value of the acquiree's net assets.

118

Seashell Corp. was organized to consolidate Sea Company and Shell Company in a business combination. Seashell issued 25,000 shares of its newly authorized $10 par value common stock in exchange for all of the outstanding common stock of Sea and Shell. At the time of the consolidation, the fair market value of Sea's and Shell's assets and liabilities are equal to their book values. The shareholders' equity accounts of Sea and Shell on the date of the consolidation were:
Sea Shell Total
Common stock, at par $100,000 $200,000 $300,000
Additional paid-in capital 50,000 75,000 125,000
Retained Earnings 22,500 47,500 70,000
Totals $172,500 $322,500 $495,000
Which one of the following is the amount of goodwill Seashell would recognize upon issuing its common stock to effect the consolidation?

A. $-0-
B. $50,000
C. $195,000
D. $245,000

A. $-0-
Since Seashell's stock is newly issued to effect the consolidation, it has no prior market value. In the absence of a market value, the fair value of Seashell's stock is determined by the fair value of the net assets acquired in the consolidation. Therefore, the consideration given (common stock issued) is equal to the fair value of net assets acquired, and no goodwill is recognized.

119

Under which one of the following circumstances will goodwill be recognized in a business combination carried out as a legal merger?
A. Book value of net assets acquired > Cost of investment.
B. Fair value of net assets acquired > Book value of net assets acquired.
C. Fair value of net assets acquired > Cost of investment.
D. Fair value of net assets acquired

D. Fair value of net assets acquired

120

Which of the following statements concerning the nature of an acquired business in a business combination is/are correct?

I. A business may be a group of assets.

II. A business may be a group of net assets.

III. A business may be a separate legal entity.

A. I only
B. I and III only.
C. III only.
D. I, II, and III.

D. I, II, and III.
All three statements are correct. A business may be a group of assets (that constitute a business), a group of net assets (that constitute a business), or a separate legal entity (that is a business).

121

For business combinations, which one of the following statements correctly reflects the determination of the accounts and amounts for the entry to record the combination?
A. Legal form determines both the entry accounts and entry amounts.
B. Legal form determines the entry accounts; accounting method determines entry amounts.
C. Legal form determines entry amounts; accounting method determines entry accounts.
D. Accounting method determines both the entry accounts and entry amounts.

B. Legal form determines the entry accounts; accounting method determines entry amounts.
The legal form of a business combination determines the entry accounts (i.e., which accounts to debit and/or credit), and the accounting method (acquisition method) determines the amounts at which the entries will be made (i.e., fair value).

122

In which of the following legal forms of business combination does at least one preexisting entity cease to exist?

Merger Consolidation Acquisition
Yes Yes Yes
Yes Yes No
Yes No No
No No Yes

Yes Yes No
In a merger and a consolidation, at least one preexisting entity ceases to exist, but in an acquisition, no entity ceases to exist. In an acquisition, one preexisting entity acquires controlling interest in another preexisting entity, and both continue to exist as separate legal entities. In a legal merger, one preexisting entity is combined into another preexisting entity; one entity ceases to exist. In a legal consolidation, two or more existing entities are combined into one new entity; two or more entities cease to exist.

123

On December 1, 200X, Betaco agreed to be acquired 100% by Alphaco at a cost equal to Betaco's book value. The combination was initiated at that time, and the closing date for the acquisition was December 31, 200X. Both firms have December 31 fiscal year-ends. There were no other transactions between the firms during 200X or 200Y. Each firm had the following net incomes for the periods shown:
Alphaco Betaco
1/1/0X - 11/30/0X $20,000 $5,000
12/1/0X - 12/31/0X 4,000 1,000
1/1/0Y - 1/31/0Y 2,000 3,000
Which one of the following is the consolidated net income that Alphaco should recognize for 200X?
A. $24,000
B. $25,000
C. $29,000
D. $30,000

A. $24,000

If closing date is 12/31, no income of subsidiary included in consolidated NI.
The consolidated net income recognized by Alphaco for 200X would be its net income only. Therefore, the amount would be $20,000 for January 1 through November 30 and $4,000 for December, or a total of $24,000. Betaco's net income before the closing of the combination (the acquisition date) would not be included in consolidated net income. Basically, Betaco's net income for all of 200X was "paid for" by Alphaco in the consideration it transferred to acquire Betaco.

124

Topco owns 60% of the voting common stock of Midco and 40% of the voting common stock of Botco. Topco wishes to gain control of Botco by having Midco buy shares of Botco's voting stock. Which one of the following minimum levels of ownership of Botco must Midco have in order for Topco to have controlling interest of Botco's voting stock?
A. 11%
B. 17%
C. 26%
D. 50+%

A. 11%
In order for Topco to gain control of Botco, it must own, either directly or indirectly, more than 50% of Botco's voting stock. Since it directly owns 40% of Botco's voting stock, it must acquire control over 10+% more. Also, since Topco owns 60% of Midco, it controls Midco. Therefore, if Midco acquires 11% of Botco, Topco will be able to exercise 51% of Botco's voting stock - 40% directly and 11% indirectly through its control of Midco.

125

In recording its acquisition of Lambda, Inc., Omega, Inc. properly recognized a contingent consideration liability of $28,000 associated with a possible payment based on a target amount of post-combination cash flow from operations. Shortly after the combination, but during the measurement period, the national economy experienced a significant downturn which made it unlikely that the target amount would be reached. As a consequence, at the end of Omega's fiscal period, the liability was properly revalued to a fair value of $9,000. Which one of the following is the amount of increase or decrease, if any, in the consideration paid to acquire Lambda that results from the change in the fair value of the contingent liability?
A. $ - 0 - (no increase or decrease)
B. $19,000 increase.
C. $19,000 decrease.
D. $ 9,000 decrease.

A. $ - 0 - (no increase or decrease)
A contingent consideration liability is the obligation of an acquirer to transfer additional consideration, if specific conditions are met. Contingent consideration liabilities are initially recognized at fair value and adjusted to fair value each period until the contingency is resolved or expires. A change in fair value resulting from occurrences after the acquisition date would be recognized as a gain or loss in income in the period of the change, not as an adjustment to the consideration paid to acquire the acquiree. In this question, a $19,000 gain (reduction in liability) would be recognized ($28,000 - $9,000 = $19,000) and no change in the consideration paid will be recognized.

126

In recording its acquisition of Lambda, Inc., Omega, Inc. properly recognized a contingent consideration liability of $28,000 associated with a possible payment based on a target amount of post-combination cash flow from operations. Shortly after the combination, but during the measurement period, the national economy experienced a significant downturn which made it unlikely that the target amount would be reached. As a consequence, at the end of Omega's fiscal period, the liability was properly revalued to a fair value of $9,000. Which one of the following is the amount of gain or loss that will be recognized in income as a result of the reevaluation of the contingent liability?
A. $ - 0 - (no gain or loss).
B. $19,000 gain.
C. $19,000 loss
D. $ 9,000 loss

B. $19,000 gain.
A contingent consideration liability is the obligation of an acquirer to transfer additional consideration, if specific conditions are met. Contingent consideration liabilities are initially recognized at fair value and adjusted to fair value each period until the contingency is resolved or expires. A change in fair value resulting from occurrences after the acquisition date would be recognized as a gain or loss in income in the period of the change. In this question, a $19,000 gain (reduction in liability) would be recognized ($28,000 - $9,000 = $19,000).

127

Which one of the following items that was acquired in a business combination is most likely to be accounted for using post-combination accounting requirements specific for the item?
A. Plant and equipment.
B. Investments held-to-maturity.
C. Contingency-based assets.
D. Patents.

C. Contingency-based assets.
Assets (and liabilities) arising from contingencies are likely to be accounted for using specific post-combination accounting requirements. Those requirements provide that when new information is obtained about a contingency-based asset, it will be measured at the lower of (1) its acquisition-date fair value or (2) the best estimate of its future settlement amount.

128

Which one of the following assets recognized in a business combination will require that the amount recognized be amortized over future periods?
A. An asset arising from a contingency.
B. A reacquired right asset.
C. An indemnification asset.
D. A contingent consideration asset.

B. A reacquired right asset.
A reacquired right is a right granted by an acquirer to the acquiree prior to a business combination that is reacquired when the acquirer gains control of the acquiree or the asset in a business combination. For example, the acquiree may have acquired the right to use the acquirer's trade name as part of a franchise agreement. A reacquired right is an intangible asset that is amortized by the acquirer over the remaining contractual period of the contract that grants the right.

129

How should the acquirer recognize a bargain purchase in a business acquisition?
A. As negative goodwill in the statement of financial position.
B. As goodwill in the statement of financial position.
C. As a gain in earnings at the acquisition date.
D. As a deferred gain that is amortized into earnings over the estimated future periods benefited.

C. As a gain in earnings at the acquisition date.
A bargain purchase means that the acquirer paid less than the fair market value of the identifiable net assets. The seller must have been under some sort of duress (perhaps eminent bankruptcy) and was willing to accept a price less than the value of the net assets. In this case the acquirer recognizes that gain on the date of the acquisition.

130

On July 1, 2009, Nexto, Inc. had the following summarized balance sheet with the book values and fair values shown:

Book Value Fair Value
Accounts Receivable (net) $ 40,000 $ 40,000
Inventories 80,000 80,000
Plant and Equipment (net) 160,000 200,000
Land 120,000 160,000
TOTAL ASSETS $400,000 $480,000
Accounts Payable $ 20,000 $ 20,000
Short-term Note 30,000 30,000
Bonds Payable 70,000 70,000
TOTAL LIABILITIES $120,000 $120,000
On that date, Pesto, Inc. acquired 100% of Nexto's voting stock from its shareholders by paying the following consideration:

Cash $200,000
10,000 newly-issued shares of Pesto's $10 par common stock 100,000 (par)
Prior to the combination, Pesto had 1,000,000 shares of voting stock outstanding trading in an active market at $15 per share. Pesto paid $25,000 for legal and accounting fees to carry out the combination.

Which one of the following is the amount of goodwill or bargain purchase gain that Pesto should recognize as a result of its acquisition of Nexto?

Goodwill Bargain Purchase Gain
$10,000 $- 0 -
$15,000 $- 0 -
$- 0 - $10,000
$- 0 - $60,000

$- 0 - $10,000
A bargain purchase gain is the excess of the fair value of the net assets acquired in a business combination over the fair value of the cost of the investment. The cost of investment to Pesto is $350,000, consisting of $200,000 cash and $150,000 fair value of stock issued (10,000 shares x $15 per share). The fair value of Nexto's net assets is $360,000 ($480,000 assets - $120,000 liabilities). Therefore, the fair value of the net assets exceeds the cost of the investment by $10,000, resulting in a bargain purchase gain.

131

Damon Co. purchased 100% of the outstanding common stock of Smith Co. in an acquisition by issuing 20,000 shares of its $1 par common stock that had a fair value of $10 per share and providing contingent consideration that had a fair value of $10,000 on the acquisition date. Damon also incurred $15,000 in direct acquisition costs. On the acquisition date, Smith had assets with a book value of $200,000, a fair value of $350,000, and related liabilities with a book and fair value of $70,000. What amount of gain should Damon report related to this transaction?
A. $ 55,000
B. $ 70,000
C. $ 80,000
D. $250,000

B. $ 70,000
Damon should report a $70,000 gain, calculated as:
Fair value of net assets acquired:
Assets ($350,000) - Liabilities ($70,000) = $280,000
Cost of Investment:
Stock (20,000 shares x $10/share) =$200,000
Contingent consideration @ fair value = 10,000
Total cost of investment = 210,000
FV of net assets > Cost of investment = Gain = $ 70,000

132

Windco, Inc. acquired 100% of the voting common stock of Trace, Inc. by transferring the following consideration to Trace's shareholders:

Cash $100,000
5,000 new shares of Windco's $10 par common stock $ 50,000 (par)
(which is less than 1% of Windco’s outstanding stock)
In addition, Windco paid $12,000 direct cost of carrying out the combination.

At the date of the acquisition, Windco's common stock was selling in an active market for $18 per share. Also, at the date of the acquisition, Trace had the following assets and liabilities with the book values and fair values shown:

Book Value Market Value
Accounts Receivable $ 20,000 $ 20,000
Property and Equipment 80,000 100,000
Land 60,000 80,000
Other Assets 40,000 40,000
Total Assets $200,000 $240,000
Accounts Payable $ 15,000 $ 15,000
Other Short-term Debt 10,000 10,000
Long-term Debt 35,000 35,000
Total Liabilities $ 60,000 $ 60,000
Which one of the following is the amount of gain Windco will recognize in connection with its acquisition of Trace?

A. $ - 0 - (no gain)
B. $10,000
C. $40,000
D. $80,000

A. $ - 0 - (no gain)
No gain will be recognized by Windco in connection with its acquisition of trace. Neither the cash transferred nor the common stock issued had a carrying value less than (or different than) fair value. The carrying value and fair value of the cash are the same, $100,000. And, since the common stock was newly issued, it would be valued at the market price of the stock, with the excess over par value recognized as additional paid-in capital, not as a gain. Further, there was no bargain purchase amount to be recognized as a gain.

Newly issued stock cannot create a gain. Excess of market over par value is APIC.

133

Windco, Inc. acquired 100% of the voting common stock of Trace, Inc. by transferring the following consideration to Trace's shareholders:

Cash $100,000
5,000 new shares of Windco's $10 par common stock $ 50,000 (par)
(which is less than 1% of Windco’s outstanding stock)
In addition, Windco paid $12,000 direct cost of carrying out the combination.

At the date of the acquisition, Windco's common stock was selling in an active market for $18 per share. Also, at the date of the acquisition, Trace had the following assets and liabilities with the book values and fair values shown:

Book Value Market Value
Accounts Receivable $ 20,000 $ 20,000
Property and Equipment 80,000 100,000
Land 60,000 80,000
Other Assets 40,000 40,000
Total Assets $200,000 $240,000
Accounts Payable $ 15,000 $ 15,000
Other Short-term Debt 10,000 10,000
Long-term Debt 35,000 35,000
Total Liabilities $ 60,000 $ 60,000
Which one of the following is the amount that Windco should treat as its cost consideration for the acquisition of Trace?

A. $150,000
B. $162,000
C. $190,000
D. $202,000

C. $190,000
The total cost (consideration transferred) of acquiring Trace should be the cash paid plus the fair value of the stock issued. The cost of carrying out the combination ($12,000) should be expensed. Therefore, the cost would be $100,000 + (5,000 share x $18 market price = $90,000), or $100,000 + $90,000 = $190,000.

134

Which of the following statements concerning the primary beneficiary of a variable-interest entity is/are correct?
I. The primary beneficiary has the ability to direct the most significant economic activities of the variable-interest entity.

II. Only one entity can be the primary beneficiary of a variable-interest entity.

III. The investor that has the greatest equity ownership in a variable-interest entity will be the primary beneficiary of the entity.

A. I only.
B. I and II only.
C. II and III only.
D. I, II, and III.

B. I and II only.
Both Statement I and Statement II are correct; Statement III is not correct. By definition, the primary beneficiary of a variable-interest entity is the entity that is able to direct the most significant economic activities of the variable-interest entity (Statement I). Only one entity can be the primary beneficiary of a variable-interest entity, because only one entity will have the ability to direct the activities of the variable-interest entity that most significantly impacts its economic performance (Statement II).
While Statement I and Statement II are correct, Statement III is not correct. By definition, the primary beneficiary of a variable-interest entity is the entity that is able to direct the most significant economic activities of the variable-interest entity (Statement I). In addition, only one entity can be the primary beneficiary of a variable-interest entity, because only one entity will have the ability to direct the activities of the variable-interest entity that most significantly impacts its economic performance (Statement II). The investor that has the greatest equity ownership in a variable-interest entity will not be the primary beneficiary of the entity, because in a variable-interest entity, the variable-interest holders, not the equity holders, have the ability to direct the most significant economic activities of the variable-interest entity (Statement III).

135

In which one of the following cases is the subsidiary most likely to be reported as an unconsolidated subsidiary?
A. The subsidiary is in an industry unrelated to the parent.
B. The subsidiary has a fiscal year-end that is one month different from the parent's year-end.
C. The subsidiary is in legal bankruptcy.
D. The subsidiary has a controlling interest in another entity.

C. The subsidiary is in legal bankruptcy.
When a subsidiary is in bankruptcy, it is under the control of the bankruptcy court and, therefore, not under the control of the parent. When a parent cannot exercise financial and/or operating control of a subsidiary, the subsidiary would not be consolidated, but would be reported as an unconsolidated subsidiary by the parent.

136

Which of the following legal forms of business combination will result in the need to prepare consolidated financial statements?

Merger Acquisition Consolidation
Yes Yes Yes
Yes Yes No
No No Yes
No Yes No

No Yes No
Only an acquisition form of business combination will require the preparation of consolidated financial statements. In the merger and consolidation forms of business combination, only one firm will remain after the combination. Therefore, there will not be two (or more) sets of financial statements to consolidate.

137

When a bargain purchase occurs in a business combination, which of the following types of information must be disclosed in the period of the combination?

I. The amount of gain recognized.

II. The income statement line item that includes the gain.

III. A description of the basis for the bargain purchase amount.

A. I only.
B. I and II only.
C. I and III only.
D. I, II, and III.

D. I, II, and III.

138

Which of the following occurrences in a business combination, if any, identify circumstances that require extensive disclosures in the period of the combination?

I. The existence of a noncontrolling interest.

II. Achieving control in step acquisition.

A. Neither I nor II.
B. I only.
C. II only.
D. Both I and II.

D. Both I and II.

139

When goodwill is recognized in a business combination, which of the following types of information about that goodwill must be disclosed?

I. A quantitative description of the factors that make up the goodwill.

II. The amount of goodwill that is expected to be deductible for tax purposes.

III. The amount of goodwill allocated to each reportable segment.

A. I and II only.
B. I and III only.
C. II and III only.
D. I, II, and III.

D. I, II, and III.

140

Plant Company acquired controlling interest in Seed Company in a legal acquisition. Which one of the following could not be part of the entry to record the acquisition?
A. Debit: Investment in Seed Company.
B. Debit: Goodwill.
C. Credit: Cash
D. Credit: Common stock

B. Debit: Goodwill.
Goodwill cannot be debited at the time of the acquisition, though it may be recognized at the time of consolidation.

141

Seashell Corp. was organized to consolidate Sea Company and Shell Company in a business combination. Seashell issued 25,000 shares of its $10 par value common stock in exchange for all of the outstanding common stock of Sea and Shell. At the time of the consolidation, the fair market value of Sea's and Shell's assets and liabilities are equal to their book values. The shareholders' equity accounts of Sea and Shell on the date of the consolidation were:
Sea Shell Total
Common stock, at par $100,000 $200,000 $300,000
Additional paid-in capital 50,000 75,000 125,000
Retained Earnings 22,500 47,500 70,000
Totals $172,500 $322,500 $495,000
What is the balance in Seashell's additional retained earnings account immediately following its issuing common stock to effect the consolidation?

A. $-0-
B. $70,000
C. $195,000
D. $245,000

A. $-0-
As a newly formed entity, Seashell will have no retained earnings until after an operating period. Seashell's shareholders' equity immediately following the consolidation will consist of the common stock issued (at par), $250,000, and additional paid-in capital, $245,000. Immediately after the consolidation, there will be no retained earnings.

142

Seashell Corp. was organized to consolidate Sea Company and Shell Company in a business combination. Seashell issued 25,000 shares of its $10 par value common stock in exchange for all of the outstanding common stock of Sea and Shell. At the time of the consolidation, the fair market value of Sea's and Shell's assets and liabilities are equal to their book values. The shareholders' equity accounts of Sea and Shell on the date of the consolidation were:
Sea Shell Total
Common stock, at par $100,000 $200,000 $300,000
Additional paid-in capital 50,000 75,000 125,000
Retained Earnings 22,500 47,500 70,000
Totals $172,500 $322,500 $495,000
Which of the following is the balance in Seashell's additional paid-in capital account immediately following its issuing common stock to effect the consolidation?

A. $-0-
B. $50,000
C. $125,000
D. $245,000

D. $245,000
Since Seashell's stock is newly issued to effect the consolidation, it has no prior market value.

In the absence of a market value, the fair value of Seashell's stock is determined by the fair value of the net assets acquired in the consolidation.

Therefore, the fair value of the stock issued is equal to the fair value (and book value) of the net assets acquired (i.e., A - L = SE), or $495,000. The par value of the stock issued is $250,000 (25,000 x $10). Therefore, additional paid-in capital is $495,000 - $250,000 = $245,000.

143

Sayon Co. issues 200,000 shares of $5 par value common stock to acquire Trask Co. in an acquisition-business combination. The market value of Sayon's common stock is $12 per share. Legal and consulting fees incurred in relation to the acquisition are $110,000. Registration and issuance costs for the common stock are $35,000. What should be recorded in Sayon's additional paid-in capital account for this business combination?
A. $1,545,000
B. $1,400,000
C. $1,365,000
D. $1,255,000

C. $1,365,000

While legal and consulting fees and finder's fees are expensed as incurred, registration and issuance costs deduct from APIC.

144

When a new entity is formed to effect a business combination, which of the following statements, if any, is/are correct?

I. A legal consolidation has occurred.

II. The new entity is always the acquirer in the business combination.

A. Neither I nor II.
B. I only.
C. II only.
D. Both I and II.

B. I only.
Statement I is correct; Statement II is not correct. When a new entity is formed to effect a business combination, a legal consolidation has occurred (Statement I), but the new entity is not always the acquirer in the combination (Statement II). If the new entity transfers cash or other assets or incurs liabilities to effect the combination, the new entity is likely the acquirer, but if the new entity issues equity interest to effect the business combination, one of the pre-existing combining entities must be the acquirer.

145

The acquisition date of a business combination is generally which one of the following?
A. The effective date.
B. The closing date.
C. The settlement date.
D. The recording date.

B. The closing date.
The acquisition date of a business combination is the date on which the acquiring entity obtains control of the acquired business; usually, it is also the closing date (of the business combination).

146

In which one of the following cases is Company A most likely to be the acquirer of Company B in a business combination?
A. Company A owns 80% of Company B's long-term debt.
B. Company A owns 40% of Company B's voting stock and 40% of Company C's voting stock, which owns 20% of Company B's voting stock.
C. Company A owns 35% of Company B's voting stock and 60% of Company C's voting stock, which owns 20% of Company B's voting stock.
D. Company A owns 40% of Company B's outstanding bonds and 20% of Company B's voting stock.

C. Company A owns 35% of Company B's voting stock and 60% of Company C's voting stock, which owns 20% of Company B's voting stock.

Generally, to be an acquirer, an entity must own, either directly or indirectly, more than 50% of the voting stock of another entity. In this case, Company A owns 35% of Company B directly and would control 20% indirectly, or a total of 55%. (Since Company A owns 60% of Company C, it has absolute control of C and could control C's 20% ownership of B.) Thus, Company A would control Company B and likely would be an acquirer in a business combination.

147

Which one of the following correctly describes the maximum length of the measurement period for a business combination?
A. The acquisition date of the business combination.
B. The end of the annual fiscal period in which the combination occurs.
C. One year from the acquisition date of the combination.
D. Indefinite, until all information about accounts and amounts is known.

C. One year from the acquisition date of the combination.

148

Which of the following statements, if any, concerning the accounting for business combinations is/are correct?

I. All business combinations in the U.S. are subject to the acquisition accounting requirements of ASC 805, "Business Combinations."

II. The acquisition accounting requirements of ASC 805, "Business Combinations," are identical to those of IFRS #3, "Business Combinations."

A. Neither I nor II.
B. I only.
C. II only.
D. Both I and II.

A. Neither I nor II.

149

Which one of the following would be subject to the acquisition accounting requirements of ASC 805, "Business Combinations?"
A. Formation of a joint venture.
B. Acquisition of a manufacturing entity by a holding company.
C. Acquisition of a for-profit entity by a not-for-profit organization.
D. Combination of entities under common control.

B. Acquisition of a manufacturing entity by a holding company.
The acquisition of a manufacturing entity by a holding company would be subject to the acquisition accounting requirements of ASC 805. The formation of a joint venture, the acquisition of assets that do not constitute a business, a combination between entities under common control, a combination between not-for-profit organizations, and the acquisition of a for-profit entity by a not-for-profit organization are the only combinations specifically excluded from the scope of ASC 805.

150

The requirements of ASC 805, "Business Combinations," apply to all of the following business combinations except for which one?
A. Combination between financial institutions.
B. The acquisition of a foreign entity by a U.S. entity.
C. Combination between not-for-profit organizations.
D. The acquisition of a group of assets that constitutes a business.

B. The acquisition of a foreign entity by a U.S. entity.

The requirements of ASC 805 apply to most business combinations, including the acquisition of a foreign entity by a U.S. entity. The requirements of ASC 805 do not apply to combinations between not-for-profit organizations (or to the formation of a joint venture, an acquisition of assets that do not constitute a business, a combination of entities under common control, or the acquisition of a for-profit entity by a not-for-profit organization).

151

Which of the following is/are acceptable methods to account for a business combination?

Purchase Method Acquisition Method Pooling of interests Method
Yes Yes Yes
Yes Yes No
Yes No No
No Yes No

No Yes No
Only the acquisition method is acceptable in accounting for a business combination.

152

Which one of the following is not a characteristic associated with the concept of a "business" for the purposes of ASC 805, "Business Combinations?"
A. Is an integrated set of activities and assets.
B. Uses inputs and processes.
C. Is intended to provide economic benefits to owners or others.
D. Must be in the form of a separate legal entity.

D. Must be in the form of a separate legal entity.

153

Bale Co. incurred $100,000 of acquisition costs related to the purchase of the net assets of Dixon Co. The $100,000 should be
A. Allocated on a pro rata basis to the nonmonetary assets acquired.
B. Capitalized as part of goodwill and tested annually for impairment.
C. Capitalized as an other asset and amortized over five years.
D. Expensed as incurred in the current period.

D. Expensed as incurred in the current period.

154

The terms of a business combination can provide that former shareholders of the acquired firm may receive additional compensation based on post-combination earnings or post-combination market share price. Would additional compensation based on such earnings or market price be considered an additional cost of the business combination?

Based on Earnings Based on Share Price
Yes Yes
Yes No
No Yes
No No

No No
Additional compensation to former shareholders of an acquired entity based on either post-combination earnings or post-combination share price would not be recognized as changes in the cost of the business combination. Changes in the fair value of contingent consideration resulting from occurrences after the acquisition date, including meeting earnings targets and reaching a specified share price, are not measurement period adjustments and do not enter into the cost of a business combination.

155

Which of the following statements concerning the acquisition of a business is/are correct?

I. Most consideration transferred to effect a business combination should be measured at fair value.

II. Contingent consideration should be included in the cost of an acquired business at fair value existing on the acquisition date.

III. The cost of carrying out a business combination should be included in the cost of an acquired business.

A. I only.
B. I and II only.
C. I and III only.
D. I, II, and III.

B. I and II only.
Statement I and Statement II are correct; Statement III is not correct. Most consideration used to effect a business combination should be measured at fair value (Statement I). The only exception is when the consideration transferred remains under the control of the acquirer. Contingent consideration should be included in the cost of an acquired business at fair value as of the acquisition date (Statement II). The cost of carrying out a business combination should not be included in the cost of an acquired business (Statement III); most such costs should be expensed.

156

Changes in the fair value of contingent consideration transferred in a business combination resulting from occurrences after the acquisition date should be recognized as a gain or loss in the current income when the contingent consideration is classified as

An Asset or a Liability An Equity Item
Yes Yes
Yes No
No Yes
No No

Yes No
Changes in the fair value of contingent consideration resulting from occurrences that occur after the acquisition date are recognized as gains or losses when the contingent consideration is classified as an asset or a liability. Contingent considerations classified as equity are not remeasured, and no gain or loss is recognized. The change in fair value of equity items is recognized as an adjustment within equity.

157

An obligation of an acquirer to pay contingent consideration to the former owners of an acquired entity in a business combination can be recognized as which of the following?

A Liability An Equity Item
Yes Yes
Yes No
No Yes
No No

A Liability An Equity Item
Yes Yes
An obligation to pay contingent consideration in a business combination may be recognized by the acquirer as either a liability or as an equity item, depending on the nature of the obligation under the provisions of FASB #150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity."

158

On January 2, 2009, the beginning of its fiscal year, Zable, Inc. acquired all of the stock of Sideco, Inc. from its owners using the following forms and amounts of consideration to pay Sideco owners:

Cash $50,000
An investment in Loco, Inc. bonds which Zable had designated as held-for-trading, and which had a cost of $100,000 and a carrying amount of $102,000.
Land, with a cost of $50,000 and a fair value of $60,000.
Which one of the following is the amount of gain or loss, if any, that Zable should recognize in connection with the transfer of these assets to Sideco owners?

A. $ - 0 - (no gain or loss).
B. $ 2,000
C. $ 10,000
D. $ 12,000

C. $ 10,000

Cash would be transferred at face amount, $50,000, with no gain or loss.
The investment in Loco would be transferred at carrying value ($102,000), which is also fair value because the bonds are held-for-trading and would have been adjusted to fair value at December 31, 2008, with any gain or loss recognized at that time. So, no gain or loss would be recognized on January 2, 2009, in connection with the business combination.
The land would be transferred at fair value, $60,000, and a $10,000 gain would be recognized in connection with the business combination.

159

On May 1, 2008, Hico, Inc. acquired 20% of the voting securities of Lowco, Inc. for $400,000 cash. The investment did not give Hico significant influence over Lowco and was classified as an available-for-sale investment. On July 1, 2009, Hico acquired the remaining 80% of Lowco's voting securities for $1,800,000 cash. At that time, Hico's original 20% investment in Lowco had a carrying value and a fair value of $450,000. Which one of the following is the amount of gain that Hico should recognize in July, 2009 net income as a result of the effect of the business combination on Hico's original investment in Lowco?
A. $- 0 - (no gain)
B. $40,000
C. $50,000
D. $400,000

C. $50,000
Because the original investment was treated as available-for-sale, between May 1, 2008, and July 1, 2009, it would have been adjusted to fair value ($450,000) and the increase recognized in other comprehensive income (not in net income). The cumulative entries would have been DR: Investment $50,000 and CR: Unrecognized Gain/Other Comprehensive Income $50,000. In connection with the combination, the $50,000 unrecognized gain in Accumulated Other Comprehensive Income would be reclassified and recognized as a gain in net income of the period. The $450,000 carrying amount/fair value of the original investment would be included as part of the total consideration used in acquiring Lowco.

160

Zooco, Inc. acquired 40% of the voting stock of Stubco, Inc. on September 1, 2008, and accounted for the investment using the equity method of accounting. On May 1, 2009, Zooco acquired an additional 20% of Stubco's voting stock to achieve a business combination. Which one of the following is the value Zooco should use to measure its original 40% investment in Stubco when recording the combination?
A. Original cost, September 1, 2008.
B. Carrying value, May 1, 2009.
C. Fair value, May 1, 2009.
D. 40% of Stubco's book value, May 1, 2009.

C. Fair value, May 1, 2009.
When a business combination is accomplished in stages (or steps), the fair value of the investment on the date of the combination is used to value the business combination. In this case, that would be the fair value on May 1, 2009. Any difference between the carrying value and the fair value on the acquisition date would be recognized as a gain or loss for the period.

161

Which one of the following items acquired in a business combination is least likely to require that the acquirer reconsider the acquiree's classification?
A. An investment classified as held-to-maturity by the acquiree.
B. An investment classified as held-for-trading by the acquiree.
C. A lease classified as a sales-type capital lease by the acquiree.
D. A derivative instrument used for speculative purposes by the acquiree.

C. A lease classified as a sales-type capital lease by the acquiree.
In a business combination, an acquirer that obtains a lease contract should continue to classify the contract as established at the inception of the contract. The classification of a lease contract is established at the inception of the lease and would not change as a result of a transfer of ownership in a business combination.

A contract will not change even as ownership changes, but company-designated classifications may change in a business combination.

162

On July 1, 2009, Lazer, Inc. acquired all of the assets, with a fair value of $400,000, and liabilities, with a fair value of $150,000, of Tipco, Inc. for $250,000 cash. In addition, Lazer paid $20,000 in legal and accounting fees for the combination and expects to pay $50,000 to close one of Tipco's plants and relocate its employees. Which one of the following is the total amount of consideration that Lazer paid for Tipco in the business combination?
A. $250,000
B. $270,000
C. $300,000
D. $320,000

A. $250,000
The total consideration paid by Lazer to acquire Tipco is $250,000, the cash paid. The other cost of carrying out the business combination ($20,000) and the expected cost of closing one of Tipco's plants and relocating its employees ($50,000) would not be part of the cost of the acquisition. The $20,000 legal and accounting fees will be expensed as cost of carrying out the combination. The expected cost of closing one of Tipco's plants and relocating its employees will not be recognized until there is an actual liability.

163

On July 1, 2009, Lazer, Inc. acquired all of the assets, with a fair value of $400,000, and liabilities, with a fair value of $150,000, of Tipco, Inc. for $250,000 cash. In addition, Lazer paid $20,000 in legal and accounting fees for the combination and expects to pay $50,000 to close one of Tipco's plants and relocate its employees. Which one of the following is the amount of liability that Lazer should recognize in recording the business combination?
A. $- 0 - (no liability)
B. $150,000
C. $170,000
D. $200,000

B. $150,000
Lazer will recognize $150,000 in liabilities, the fair value of the amount acquired from Tipco. The $20,000 legal and accounting fees will be expensed as cost of carrying out the combination. The expected cost of closing one of Tipco's plants and relocating its employees will not be recognized until there is an actual liability.

164

If the parent uses the cost method to account for its investment in a subsidiary, the parent will recognize:
A. the parent's share of the subsidiary's net income.
B. the parent's share of the subsidiary's dividends.
C. amortization of parent's excess cost of investment over the book value of the subsidiary.
D. the parent's share of the subsidiary's net loss.

B. the parent's share of the subsidiary's dividends.

When a parent company uses the cost method to account for its investment in a subsidiary, the parent will recognize its share of the subsidiary's dividends declared as income to the parent.

165

On January 1, 20x6 Ritt Corp. purchased 80% of Shaw Corp.'s $10 par common stock for $975,000. On this date, the carrying amount of Shaw's net assets was $1,000,000. The fair values of Shaw's identifiable assets and liabilities were the same as their carrying amounts except for plant assets (net) which were $100,000 in excess of the carrying amount. Those plant assets had a 10-year remaining life, depreciated on a straight-line basis. The fair value of the 20% noncontrolling interest in Shaw was properly determined to be $200,000 at that time. For the year ended December 31, 20x6, Shaw had net income of $190,000 and paid cash dividends totaling $125,000. Which one of the following is the amount of goodwill that should be recognized as a result of the business combination?
A. $ 43,000
B. $ 75,000
C. $ 95,000
D. $175,000

B. $ 75,000
Goodwill is determined as the excess of investment value over the fair value of the subsidiary's net assets. Investment value is the sum of the parent’s investment (which is the fair value of consideration paid) + the fair value of any noncontrolling interest, which in this question is $975,000 + $200,000 = $1,175,000. The fair value of Shaw's identifiable net assets is book value $1,000,000 + write up in plant assets $100,000 = $1,100,000. Therefore, goodwill is investment value $1,175,000 - fair value of identifiable assets $1,100,000 = $75,000, the correct answer.

Add noncontrolling interest to investment value. Don't use % of stock in computing value of identifable assets.

166

On January 1, 20X1, Prim, Inc. acquired all the outstanding common shares of Scarp, Inc. for cash equal to the book value of the stock. The carrying amount of Scarp's assets and liabilities approximated their fair values, except that the carrying amount of its building was more than fair value. In preparing Prim's 20X1 consolidated income statement, which of the following adjustments would be made?
A. Depreciation expense would be decreased, and goodwill would be recognized.
B. Depreciation expense would be increased, and goodwill would be recognized.
C. Depreciation expense would be decreased, and no goodwill would be recognized.
D. Depreciation expense would be increased, and no goodwill would be recognized.

A. Depreciation expense would be decreased, and goodwill would be recognized.
Although the cost of the investment was equal to book values, the cost of the investment was greater than the fair values, because the carrying amount of Scarp's building was more than its fair value. For consolidated statement purposes, the building would be written down to its lower fair value, and the excess of cost over fair values would be assigned to recognize goodwill. Since for consolidated purposes the building has a lower fair value than its carrying value, the depreciation expense taken on the carrying value would be greater than the depreciation expense for consolidated purposes. Thus, depreciation expense would be decreased in the consolidating process, and goodwill would be recognized.

167

Lion, Inc. owns 60% of Gray Corp.'s common stock. On December 31, 2005, Gray owes Lion $400,000 for a cash advance.
In preparing the consolidated balance sheet on that date, what amount of the advance should be eliminated?

A. $400,000
B. $240,000
C. $160,000
D. $0

A. $400,000
When consolidated statements are prepared, 100% of all reciprocal accounts are eliminated regardless of the ownership fraction. Thus, the whole $400,000 must be eliminated.

168

Which one of the following methods, if any, may a parent use on its books to carry an investment in a subsidiary that it will consolidate?

Cost Method Equity Method
Yes Yes
Yes No
No Yes
No No

Cost Method Equity Method
Yes Yes
A parent may use the cost method, the equity method, or any other method on its books to carry an investment in a subsidiary that it will consolidate. The method that is used on its books will affect the consolidating process, but the final consolidated financial statements will be the same regardless of the method the parent uses on its books.

169

Pride, Inc. owns 80% of Simba, Inc.'s outstanding common stock. Simba, in turn, owns 10% of Pride's outstanding common stock.
What percentage of the common stock cash dividends declared by the individual companies should be reported as dividends declared in the consolidated financial statements?

Dividends declared by Pride Dividends declared by Simba
90% 0%
90% 20%
100% 0%
100% 20%

Dividends declared by Pride Dividends declared by Simba
90% 0%
Subsidiary dividends are never considered part of consolidated dividends. They are either eliminated in the consolidation entries or allocated to reducing noncontrolling interests. In this problem, 80% of Simba's dividends will be eliminated as intercompany, and 20% will be allocated to reducing noncontrolling interest.
In addition, since 10% of the dividends of Pride never go outside the consolidated entity, they are not considered dividends of the consolidated entity either.

170

Which of the following statements about the differences between U.S. GAAP and IFRS in determining whether or not to consolidate an entity is/are correct?
I. IFRS guidelines for determining the eligibility of an entity to be consolidated are more principles-based than are U.S. GAAP guidelines.

II. In assessing an investor's level of ownership of an investee, both U.S. GAAP and IFRS consider outstanding securities that are exercisable or convertible into voting shares.

III. Under both U.S. GAAP and IFRS, there are circumstances under which a majority-owned subsidiary does not have to be consolidated.

A. I only.
B. I and II only.
C. I and III only.
D. I, II, and III.

C. I and III only.
Statement I and Statement III are correct; Statement II is not correct. Under IFRS, the guidelines for determining whether or not to consolidate an entity are more principles-based than are U.S. GAAP (Statement I). Under IFRS, the basic guideline is that an entity must be consolidated when another entity has the ability to govern the financial and operating policies of the entity to obtain benefits from it. U.S. GAAP has a specific two-tiered assessment process that must be followed to determine whether or not an entity should be consolidated. Under both U.S. GAAP and IFRS, there are circumstances under which a majority-owned subsidiary does not have to be consolidated (Statement III). U.S. GAAP does not require consolidation of a majority-owned subsidiary when the investor cannot exercise control of the subsidiary. IFRS does not require consolidation of a majority-owned subsidiary under certain conditions when the parent will be consolidated with a higher-level parent.

171

Which one of the following is not a characteristic of intercompany bonds?
A. Intercompany bonds may occur on the date of a business combination or subsequent to a business combination.
B. When bonds become intercompany, it is as though the bonds have been retired for consolidated purposes.
C. Intercompany bonds can result in the recognition of a gain or a loss for consolidating purposes.
D. When bonds become intercompany, they are written off of the books of the issuing affiliate and the investing affiliate.

D. When bonds become intercompany, they are written off of the books of the issuing affiliate and the investing affiliate.
The liability and investment related to intercompany bonds are eliminated only on the consolidating worksheet. They are not written off the books of either the issuing or the investing affiliate. From the perspective of the separate companies, the liability and investment related to the bonds continue to exist, but for consolidated purposes, they have been constructive retired.

172

An intercompany depreciable fixed asset transaction resulted in an intercompany gain. Which one of the following is least likely to be reflected in the consolidated financial statements prepared at the end of the period in which the intercompany transaction occurred?
A. Consolidated income will be less than the sum of the incomes of the separate companies being combined.
B. Consolidated assets will be less than the sum of the assets of the separate companies being combined.
C. Consolidated depreciation expense will be more than the sum depreciation expense of the separate companies being combined.
D. Consolidated accumulated depreciation will be more than the sum of accumulated depreciation of the separate companies being combined.

C. Consolidated depreciation expense will be more than the sum depreciation expense of the separate companies being combined.
Consolidated depreciation expense will be less, not more, than the sum of depreciation expense of the separate companies being combined. Because the intercompany transaction resulted in a gain, the buying affiliate will have the asset on its books with the intercompany gain included in its carrying value and will depreciate that value on its books. For consolidated purposes, that depreciation on the intercompany gain will be eliminated, resulting in less depreciation expense than the sum of the depreciation expense of the separate companies.

173

During 200X, Papa Company sold inventory, which cost it $18,000, to its subsidiary, Sonnyco, for $27,000. At the end of 200X, Sonnyco had $9,000 of the intercompany goods still on its books. The balance had been resold to unaffiliated customers for $24,000. Which one of the following is the amount of ending inventory that should be eliminated for consolidated statements?
A. $3,000
B. $6,000
C. $9,000
D. $15,000

A. $3,000
With a cost from non-affiliates of $18,000 and an intercompany selling price of $27,000, there is a $9,000 intercompany profit on the inventory transaction. Therefore, $9,000 profit/$27,000 cost to the buying affiliate results in a one third profit in ending inventory. Since the ending inventory at the buying affiliate's cost is $9,000, 1/3 x $9,000 = $3,000 is the intercompany profit in ending inventory and the amount that would have to be eliminated.

174

ch one of the following kinds of eliminations, if any, will be required in every consolidating process?
Intercompany Receivables/Payables Intercompany Investment Intercompany Revenues/Expenses
Yes Yes Yes
Yes No Yes
No Yes No
Yes Yes No

No Yes No
An intercompany investment elimination will be required in every consolidating process (to eliminate the parent's investment against the subsidiary's shareholders' equity). Intercompany receivables/payables and intercompany revenues/expenses eliminations will not be required in every consolidating process. Those kinds of eliminations will be required only if the affiliated companies have engaged in intercompany transactions that resulted in such balances.

175

Penn, Inc., a manufacturing company, owns 75% of the common stock of Sell, Inc., an investment company. Sell owns 60% of the common stock of Vane, Inc., an insurance company.
In Penn's consolidated financial statements, should consolidation accounting or equity method accounting be used for Sell and Vane?

A. Consolidation used for Sell and equity method used for Vane.
B. Consolidation used for both Sell and Vane.
C. Equity method used for Sell and consolidation used for Vane.
D. Equity method used for both Sell and Vane.

B. Consolidation used for both Sell and Vane.
If one looked just at Penn's interest in Vane's result of 45% (75% x 60%), one might say that the equity method would be appropriate.
However, because Sell owns 60% of Vane, it controls Vane and would need to consolidate Vane. Because Penn owns 75% of Sell, it controls Vane and would need to consolidate Sell, which consolidated Vane. Thus, all three would be consolidated, making this response correct.

176

Sun Co. is a wholly owned subsidiary of Star Co. Both companies have separate general ledgers and prepare separate financial statements. Sun requires stand-alone financial statements. Which of the following statements is correct?
A. Consolidated financial statements should be prepared for both Star and Sun.
B. Consolidated financial statements should only be prepared by Star and not by Sun.
C. After consolidation, the accounts of both Star and Sun should be changed to reflect the consolidated totals for future ease in reporting.
D. After consolidation, the accounts of both Star and Sun should be combined together into one general ledger accounting system for future ease in reporting.

B. Consolidated financial statements should only be prepared by Star and not by Sun.

Consolidated statements should be prepared by Star, the parent, and not by Sun, the subsidiary. Star has an investment in and control of Sun, which is the basis for preparing consolidated statements; Sun does not have an investment in, or control of, Star. Thus, there is no basis for Sun to prepare consolidated statements.

177

The choice of methods that a parent uses on its books to account for its investment in a subsidiary will affect the:

Consolidating Process Consolidated Financial Statements
Yes Yes
Yes No
No Yes
No No

Consolidating Process Consolidated Financial Statements
Yes No
While the method a parent uses on its books to account for its investment in a subsidiary will affect the consolidating process, the choice of methods will not affect the final consolidated financial statements. The final consolidated financial statements will be the same regardless of the method used by the parent on its books; only the details of the process of developing those statements will be different. The primary difference will be in the nature of the investment eliminating entry on the worksheet.

178

An investor will report an investment in its financial statements using a different method than it uses to carry the investment on its books if its minimum ownership of the investee is:
A. 10+%.
B. 20+%.
C. 50+%.
D. 100%.

C. 50+%.
If an investor owns 50+% (up to and including 100%) of an investee, it will normally carry the investment on its books using the cost method, the equity method, or some other method, but it will report the investment in its financial statements as a consolidated subsidiary. The method used on the investor's books will be different than the method used to report the investment in financial statements.

179

Consolidated financial statements can be prepared for a business combination that was accounted for using which of the following accounting methods?
Acquisition Method Pooling of Interests Method
Yes Yes
Yes No
No Yes
No No

Acquisition Method Pooling of Interests Method
Yes Yes
Consolidated statements can be prepared when a business combination was accounted for using either the acquisition method or the pooling of interests method. Although the pooling of interests method can no longer be used (since June 30, 2001) to account for new business combinations, business combinations carried out under the pooling of interests method prior to that time still require the preparation of consolidated financial statements.

180

Which of the following statements, if any, concerning the preparation of consolidated financial statements is/are correct?

I. The consolidating process is carried out on the books of the parent entity.

II. The consolidated financial statements report two or more legal entities as though they are a single economic entity.

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

B. II only.
The consolidated financial statements report two or more legal entities (a parent and its subsidiary/ies) as though they are a single economic entity. Because the entities are under the common economic control of the parent's shareholders, GAAP requires that consolidated statements be the primary form of financial statement disclosure.

181

he results of the consolidating process are recorded in the books of the:
Parent Subsidiary
Yes Yes
Yes No
No Yes
No No

Parent Subsidiary
No No

The results of the consolidating process (adjustments, eliminations, etc.) are not recorded on either the books of the parent or of any subsidiary. The consolidating process takes place on worksheets and schedules, and the results are presented in the form of consolidated financial statements. Some of the worksheet and schedule data is carried forward from period end to period end to facilitate the recurring consolidating process.

182

On April 1, 2005, Dart Co. paid $620,000 for all the issued and outstanding common stock of Wall Corp. in a transaction properly accounted for as an acquisition.

The recorded assets and liabilities of Wall Corp.
on April 1, 2005 follow:

Cash $ 60,000
Inventory 180,000
Property and equipment (net of accumulated depreciation of $220,000) 320,000
Goodwill (net of accumulated amortization of $50,000) 100,000
Liabilities (120,000)
Net assets $540,000
========
On April 1, 2005, Wall's inventory had a fair value of $150,000, and the property and equipment (net) had a fair value of $380,000. What is the amount of goodwill resulting from the business combination?

A. $150,000
B. $120,000
C. $50,000
D. $20,000

A. $150,000
First the fair value of the identifiable net assets must be determined:
Cash $60,000
Inventory $150,000
P&E (net) $380,000
Liabilities ($120,000)
Net Assets $470,000
Once this has been determined it is a simple matter of subtracting this amount from the purchase price to determine the goodwill. ($620,000 - $470,000 = $150,000

Goodwill previously recognized by the acquired entity should not be recognized by the acquiring entity as an intangible asset.).

183

Under which of the following methods of carrying a subsidiary on its books, if any, will the carrying value of the investment normally change following a combination?
Cost Method Equity Method
Yes Yes
Yes No
No Yes
No No

If the parent uses the equity method to carry on its books the investment in a subsidiary, the carrying value of the investment will change as the equity of the subsidiary changes. However, if the parent uses the cost method, the carrying value on its books normally will not change.

184

A subsidiary, acquired for cash in a business combination, owned inventories with a market value different from the book value as of the date of combination. A consolidated balance sheet prepared immediately after the acquisition would include this difference as part of:
A. Deferred Credits
B. Goodwill
C. Inventories
D. Retained Earnings

C. Inventories
The difference between (fair) market value and book value of inventories would be recognized by adjusting inventories to fair value on the consolidated balance sheet.

185

Which of the following financial statements, if any, prepared by a parent immediately after a business combination is likely to be different from financial statements it prepares immediately before the business combination?
Balance Sheet Income Statement
Yes Yes
Yes No
No Yes
No No

Yes No
While a parent's balance sheet prepared immediately after a business combination will be different from its balance sheet prepared immediately before the business combination, the parent's income statement is not likely to be different than the consolidated income statement prepared immediately after the combination. As a result of the combination, the parent will have on its balance sheet an investment account (and probably other accounts/amounts) that it did not have before the combination, but the consolidated income statement prepared immediately after a business combination will likely be the same as the parent's pre-combination income statement.

186

On October 1, 2008, Potato Company acquired 100% of the voting stock of Spud Company in a legal acquisition. Potato chose to account for its investment in Spud on its books using the cost method. Spud had the following incomes and dividends for the periods shown:

10/1 - 12/31/08 1/1 - 12/31/09
Net Income $3,000 $15,000
Dividends Declared/Paid 1,000 3,000
In its December 31, 2009, consolidating process, which one of the following is the amount of the reciprocity entry Potato will make on the consolidating worksheet?

A. $2,000
B. $3,000
C. $14,000
D. $18,000

A. $2,000
The purpose of the reciprocity is to bring the investment account (on the worksheet) in balance with the subsidiary's retained earnings as of the beginning of the period being consolidated. Therefore, only the undistributed income of the subsidiary since the business combination up to the beginning of the period being consolidated (January 1, 2009) will be the reciprocity entry at the end of 2009.

The undistributed income from October 1 to December 31, 2008 (the beginning of 2009) is net income (+$3,000) less dividends declared and paid (-$1,000), or $2,000.

187

Assume that in acquiring a subsidiary, the parent determined there were several depreciable assets of the subsidiary that had a fair value less than book value. What effect will this fair value less than book value of the subsidiary's assets have on the following accounts in the preparation of consolidated statements?
Depreciable Assets Depreciation Expense
Increase Increase
Increase Decrease
Decrease Increase
Decrease Decrease

Depreciable Assets Depreciation Expense
Decrease Decrease

So, if FV

188

Parco owns 100% of its subsidiary, Subco, which it acquired at book value. It carries its investment in Subco on its books using the equity method of accounting. At the beginning of its 2009 fiscal year, the investment in Subco account was $552,000. During 2009, Subco reported the following:
Net Income $42,000
Dividends Declared/Paid 12,000
There were no other transactions between the firms in 2009.
In preparing its 2009 fiscal year consolidated statements, which one of the following is the amount of the investment eliminating entry that Parco will make as a result of its ownership of Subco?

A. $552,000
B. $582,000
C. $594,000
D. $606,000

A. $552,000
The amount of an investment eliminating entry is the balance in the investment account as of the beginning of the period being consolidated. In this case, that was $552,000. If the parent uses the equity method to account for its investment in the subsidiary, the entries it makes during the year are reversed so that the investment account has its beginning of the year balance.

189

Parco owns 100% of its subsidiary, Subco, which it acquired at book value. It carries its investment in Subco on its books using the equity method of accounting. At the beginning of its 2009 fiscal year, the investment in Subco account was $552,000. During 2009, Subco reported the following:
Net Income $42,000
Dividends Declared/Paid 12,000
There were no other transactions between the firms in 2009.
In preparing its 2009 fiscal year consolidated statements, which one of the following is the amount of investment that Parco will have to reverse for 2009 as a result of its ownership of Subco?

A. $12,000
B. $30,000
C. $42,000
D. $54,000

B. $30,000
During 2009 Parco would recognize Subco's reported net income of $42,000 as equity revenue; the entry would be: DR: Investment in Subco and CR: Equity Revenue. The $12,000 dividends would not be recognized as equity revenue but rather as a liquidation of part of Parco's investment in Subco; the entry would be: DR: Dividends Receivable/Cash and CR: Investment in Subco. Therefore, the net amount of investment to be reversed would be $30,000, computed as +$42,000 - $12,000 = $30,000.

190

Assume that in acquiring a subsidiary, the parent determined that several depreciable assets had a fair value greater than book value. If the parent accounts for its investment in the subsidiary using the equity method, what effect will the amortization of the excess fair value over the book value of the subsidiary's assets have on the following parent's accounts?
Investment in Subsidiary Equity Revenue from Subsidiary
Increase Increase
Increase Decrease
Decrease Increase
Decrease Decrease

Decrease Decrease

When FV > BV, depr. assets increase, inv. decreases, and depr. expense increases, so revenue decreases.


When the fair value of a subsidiary's assets is greater than book value, it is as though the parent paid more for the assets than the subsidiary paid for those assets. Using the equity method of accounting for the investment, the parent must depreciate the excess of fair value over book value. That equity entry would be: DR: Equity Revenue - to reduce it by the amount of depreciation on the excess of fair value over book value, and CR: Investment in Subsidiary - to offset a portion of the net income (or increase the amount of net loss) recognized from the subsidiary. Thus, both accounts would be decreased.

191

On January 1, 20x1 Ritt Corp. purchased 80% of Shaw Corp.'s $10 par common stock for $975,000. Ritt's cost reflects an appropriate fair value measure for all of Shaw's outstanding common stock. The original cost to the noncontrolling investors for the 20% of Shaw's common stock not acquired by Ritt was $200,000. At the date of Ritt's purchase, the carrying amount of Shaw's net assets was $1,000,000. The fair values of Shaw's identifiable assets and liabilities were the same as their carrying amounts except for plant assets (net) which were $100,000 in excess of the carrying amount. Which one of the following is the amount of noncontrolling interest that should be reported in a consolidated balance sheet prepared immediately following the business combination?
A. $125,000
B. $200,000
C. $220,000
D. $243,750

D. $243,750
Noncontrolling interest at the date of the business combination should be the noncontrolling interest proportionate share of total fair value at that date, including goodwill. The total fair value of Shaw (including goodwill) at the date Ritt acquired 80% of Shaw's common stock would be $1,218,750 ($975,000/.80). The noncontrolling interest would be .20 x $1,218,750 = $243,750, the correct answer.

192

On January 1, 20x6, Ritt Corp. purchased 80% of Shaw Corp.'s $10 par common stock for $975,000, which included a control premium. On this date, the fair value of the noncontrolling interest was $200,000, giving Shaw a full fair value of $1,175,000. On the acquisition date the carrying amount of Shaw's net assets was $1,000,000. The fair values of Shaw's identifiable assets and liabilities were the same as their carrying amounts except for plant assets (net), which were $100,000 in excess of the carrying amount. Those plant assets had a 10-year remaining life, depreciated on a straight-line basis. Shaw had a net income of $190,000 and paid cash dividends totaling $125,000. Which one of the following is the amount of noncontrolling interest that should be reported in a consolidated balance sheet prepared December 31, 20x6?

A. $213,000
B. $235,000
C. $246,000
D. $248,000

C. $246,000
The noncontrolling interest on December 31, 20x6, is the noncontrolling interest (NCI) as of the acquisition date, plus the NCI share of Shaw's net income, less the NCI share of Shaw's dividends, less the NCI share of the depreciation of the plant asset revaluation. The consolidated net assets attributable to Shaw on January 1, 20x6, would include the book value of the net assets on the date of the combination ($1,000,000), plus the write up of the plant assets to fair value ($100,000), plus the goodwill at acquisition ($75,000) or $1,175,000 × 20% = $235,000. January 1, 20x6 NCI would be adjusted for Shaw's net operating results for 20x6 ($190,000), less 20% of the worksheet depreciation taken on the write up of plant assets ($100,000/10 years =) $10,000 less the dividends paid by Shaw during 20x6 ($125,000).
January 1, 20x6 NCI equity $235,000
+ 20x6 Net Income (190,000 × .2) 38,000
− 20x6 Dividends (125,000 × .2) (25,000)
− 20x6 Depreciation of plant assets (10,000 × .2) ( 2,000)
December 31, 20x6 NCI equity $246,000

193

Which of the following statements concerning contracts that are financial instruments is/are correct?
I. They result in the exchange of cash or ownership interest in an entity.

II. They impose on one entity a contractual obligation and grant another entity a contractual right.

III. They must be settled within one year or the operating cycle, whichever is longer.

A. I only.
B. II only.
C. I and II only.
D. I, II, and III.

C. I and II only.
Both Statements I and II are correct; Statement III is incorrect. Contracts that are financial instruments both result in the exchange of cash or an ownership interest (Statement I) and impose on one entity a contractual obligation and grant to another entity a contractual right (Statement II). Statement III is incorrect; contracts that are financial instruments do not have to be settled within one year or the operating cycle, whichever is longer.

194

Which of the following is the correct accounting measurement and treatment under IFRS for assets classified as "Loans and Receivables"?
A. Amortized cost, with interest and amortization recognized in current income.
B. Amortized cost, with interest and amortization recognized in other comprehensive income.
C. Fair value, with changes in fair value recognized in current income.
D. Fair value, with changes in fair value recognized in other comprehensive income.

A. Amortized cost, with interest and amortization recognized in current income.

Financial assets classified as "Loans and Receivables" are measured at amortized cost, with interest and amortization related to the instrument recognized in current income. This treatment is the same as the treatment under U.S. GAAP for investments held to maturity.

195

Which of the following describes an "accounting mismatch" as that expression is used in IFRS?
A. Debts don't equal credits.
B. Liabilities exceed assets.
C. Related assets and liabilities are valued using different measures.
D. The value of a hedging instrument does not equal the value of the hedged item.

An "accounting mismatch" refers to a circumstance where related assets and liabilities are valued using different measures.

196

Under IFRS, which one of the following instruments is most likely to be treated in its entirety as a financial liability?
A. Convertible debt.
B. Convertible preferred stock.
C. Redeemable preferred stock.
D. Common stock with a preemptive right.

C. Redeemable preferred stock.
Under IFRS, redeemable preferred stock would likely be treated in its entirety as a financial liability because the stock can be redeemed (repurchased) by the issuing corporation at its discretion. Since the preferred shares can be redeemed at the discretion of the issuing corporation, it is not treated as equity, but rather as a liability.

197

In the preparation of combined financial statements, would the following issues be treated in the same way as when preparing consolidated financial statements or in a different way?
Minority Interest Foreign Operations Different Fiscal Periods
Different Different Different
Different Same Same
Same Same Different
Same Same Same

Minority Interest Foreign Operations Different Fiscal Periods
Same Same Same
According to ASC 810, if problems associated with minority interest, foreign operations, different fiscal periods, or income taxes occur in the preparation of combined financial statements, they should be treated in the same manner as in the preparation of consolidated financial statements. Therefore, all three items should be treated in the same manner as in consolidated statements.

198

In measuring an impairment loss for a financial asset under U.S. GAAP and under IFRS, the carrying value of the financial asset would be compared to:

Under U.S. GAAP Under IFRS
Fair value Fair value
Fair value Recoverable amount
Recoverable amount Fair value
Recoverable amount Recoverable amount

Under U.S. GAAP Under IFRS
Fair value Recoverable amount
Under U.S. GAAP, an impairment loss on a financial asset is measured as the difference between the carrying value and the fair value of the asset; under IFRS, an impairment loss on a financial asset is measured as the difference between the carrying value and the recoverable amount of the asset.

199

When a concentration of credit risk must be disclosed and the exact amount is uncertain, which one of the following amounts must be disclosed?

A. Minimum amount at risk.
B. Current period average amount at risk.
C. Historic average amount at risk.
D. Maximum amount at risk.

D. Maximum amount at risk.

200

Nolan owns 100% of the capital stock of both Twill Corp. and Webb Corp.
Twill purchases merchandise inventory from Webb at 140% of Webb's cost. During 2004, merchandise that cost Webb $40,000 was sold to Twill. Twill sold all of this merchandise to unrelated customers for $81,200 during 2004. In preparing combined financial statements for 2004, Nolan's bookkeeper disregarded the common ownership of Twill and Webb.

By what amount was unadjusted revenue overstated in the combined income statement for 2004?

A. $16,000
B. $40,000
C. $56,000
D. $81,200

C. $56,000
Since all the goods have been sold outside the combined entity, income recognition is correct.
However, sales and cost of goods sold have been recorded at two different points (i.e., the sale from Webb to Twill and the sale from Twill to outsiders). To the combined entity, Webb's cost of merchandise (the original cost to the combined entity) is what is needed for cost of goods sold, and Twill's sales (the amount the merchandise was sold for outside the combined entity) is needed for sales.

This means that the sale from Webb to Twill and the cost of goods recorded by Twill need to be eliminated. That amount is $56,000 (computed as $40,000 cost to Webb x transfer price to Twill of 140% of cost = $56,000).

201

Nolan owns 100% of the capital stock of both Twill Corp. and Webb Corp. Twill purchases merchandise inventory from Webb at 140% of Webb's cost. During 2007, merchandise that cost Webb $40,000 was sold to Twill. Twill sold all of this merchandise to unrelated customers for $81,200 during 2007. In preparing combined financial statements for 2007, Nolan's bookkeeper disregarded the common ownership of Twill and Webb.
What amount should be eliminated from cost of goods sold in the combined income statement for 2007?

A. $56,000
B. $40,000
C. $24,000
D. $16,000

A. $56,000
The amount at which Webb sold the inventory to Twill ($40,000 x 1.40 = $56,000) will be the amount of cost of goods sold to Twill and should be eliminated in combining the financial statements of Webb and Twill. The cost of goods to Webb ($40,000) is the cost from an unrelated entity and should be the cost of goods sold for the combined entity. Since both the $40,000 cost of goods to Webb and the $56,000 cost of goods to Twill will be on the combining worksheet, the cost of goods to Twill (from Webb) must be eliminated, leaving only the $40,000 cost from a nonaffiliate.

202

Mr. Allen owns all of the common stock of Astro Company and 80% of the common stock of Bio Company. Astro owns the remaining 20% interest in Bio's common stock, for which it paid $8,000, and which it carries at cost, because there is no ready market for Bio's stock. The condensed balance sheets for Astro and Bio as of December 31, 2007, were:
Astro Bio
Assets $300,000 120,000
Liabilities $100,000 $60,000
Common Stock 50,000 40,000
Retained Earnings 150,000 20,000
Total $300,000 120,000
What amount should be reported as total owner's equity in a combined balance sheet for Astro and Bio as of December 31, 2007?
A. $260,000
B. $252,000
C. $212,000
D. $200,000

B. $252,000
The correct answer is Astro's equity of $200,000 plus Bio's equity of $60,000, less Astro's investment in Bio of $8,000, or $200,000 + $60,000 - $8,000 = $252,000. Astro's investment in Bio must be eliminated to prevent double counting of the $8,000 - once as an investment on Astro's books and again as net assets (to which the investment has a claim) on Bio's books.

203

Combined statements may be used to present the results of operations of:
Unconsolidated subsidiaries Companies under common management
Yes Yes
Yes No
No Yes
No No

Unconsolidated subsidiaries Companies under common management
Yes Yes
Combined financial statements are used when consolidated statements are not appropriate to accomplish much the same purpose. It is done when there is a non-consolidated sub or a group of companies owned by a common shareholder.

204

For financial accounting purposes, which one of the following is not a type of hedge carried out using derivatives?

A. Fair value.
B. Cash flow.
C. Speculative.
D. Foreign currency.

C. Speculative.
When derivatives are used for speculative purposes, the intent is not to hedge an existing position, because there is no existing position to hedge. Rather, when used for speculative purposes, the intent is to make a profit.

205

Which one of the following is not a financial instrument?

A. Cash.
B. Investment in another entity.
C. Derivative instruments.
D. All contracts.

D. All contracts.

Not all contracts are financial instruments. Only contracts that have certain features are financial instruments. Those features include: (1) they result in the exchange of cash or an ownership interest in an entity, and (2) both (a) impose on one entity a contractual obligation to deliver cash or another financial instrument and (b) convey to a second entity a contractual right to receive cash or another financial instrument. For example, a contract to exchange commodities would not be a financial instrument.

206

Exam Results
Question #1 (AICPA.101234FAR-SIM)
Which of the following is the correct accounting measurement and treatment under IFRS for assets classified as "Loans and Receivables"?
A. Amortized cost, with interest and amortization recognized in current income.
B. Amortized cost, with interest and amortization recognized in other comprehensive income.
C. Fair value, with changes in fair value recognized in current income.
D. Fair value, with changes in fair value recognized in other comprehensive income.

A. Amortized cost, with interest and amortization recognized in current income.
Financial assets classified as "Loans and Receivables" are measured at amortized cost, with interest and amortization related to the instrument recognized in current income. This treatment is the same as the treatment under U.S. GAAP for investments held to maturity.

207

Which of the following is a category of financial assets under IFRS for which there is not a comparable category under U.S. GAAP?
A. Instruments held available-for-sale.
B. Loans and receivables.
C. Instruments held to maturity.
D. Instruments for which changes in value are reported in profit/loss.

B. Loans and receivables.
U.S. GAAP does not have a category of financial assets for loans and receivables; IFRS does have such a category.

208

Where in its financial statements should a company disclose information about its concentration of credit risks?
A. No disclosure is required.
B. The notes to the financial statements.
C. Supplementary information to the financial statements.
D. Management's report to shareholders.

B. The notes to the financial statements.
An entity may make required disclosures about concentrations of credit risk in either the notes to the financial statements or in the body of the financial statements. Since "The body of the financial statements" is not a choice, the notes to the financial statements is the only correct choice.

209

On January 2, 20X8, Fiserveco acquired a five-year right to service mortgage contracts for which it paid $120,000. Fiserveco estimated that servicing and other fees would generate $400,000 over the five-year period. During 20X8, the contract generated $100,000 in revenues. Which one of the following is the amount, if any, that Fiserveco should recognize as an asset on January 2, 20X8?
A. $ -0-
B. $100,000
C. $120,000
D. $400,000

C. $120,000
Since Fiserveco acquired the servicing rights asset in the market, it should recognize a servicing asset at its fair value, which is the cost to Fiserveco in the market. Therefore, it should recognize an asset of $120,000 on January 2, 20X8.

210

Under which of the following conditions would a debtor be justified in writing off a recognized liability?
I. The debtor is relieved from being the primary obligator by the creditor.
II. The debtor is relieved from being the primary obligator by a court ruling.

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

C. Both I and II.
A debtor may write off a recognized liability if relieved from being the primary obligator by a court or if the debtor is relieved from being the primary obligator by the creditor (or if the debtor pays the creditor).

211

Servco, a loan servicing agency, paid $60,000 to acquire a three-year right to service $1,000,000 of Banco's loans. Servco will be entitled to a servicing fee of 1% of the interest and fees collected during the three-year period. Servco expects its servicing fees to be:
Year 20X1 $40,000
Year 20X2 $30,000
Year 20X3 $10,000
Which one of the following is the amount of gross profit after amortization of the servicing asset that Servco expects to earn over the three-year life of the service contract?

A. $ -0-
B. $10,000
C. $20,000
D. $80,000

C. $20,000
Over the three-year life of the contract, expected fees (revenues) are $80,000 ($40,000 + $30,000 + $10,000 = $80,000). Total amortization (expense) will be $60,000, the full cost of the servicing asset. Therefore, the expected gross profit is $80,000 - $60,000 = $20,000.

212

Which of the following conditions must be met for derecognition of a transferred financial asset to occur under IFRS?
I. The financial asset has been transferred outside the consolidated group of the transferor.

II. The transferor has transferred substantially all of the risks and rewards of ownership of the financial asset.

III. The contractual rights to the financial assets cash flows cannot be retained by the transferor, but must be transferred to the transferee.

A. I only.
B. II only.
C. Both I and II.
D. I, II, and III.

C. Both I and II.
IFRS has a two-step process in determining whether derecognition results from a transfer of assets. Both I and II are required to be met for derecognition to occur.

213

Under IFRS, which is true concerning servicing rights?
A. Servicing rights are a new separate asset, distinct from the transferred financial asset.
B. Servicing rights are financial assets that can be measured at amortized cost or fair value.
C. There is specific guidance for servicing rights, as financial assets, under IFRS.
D. Servicing rights retained in the transfer of a financial asset are considered to be a retained interest in the transferred asset, not a new separate asset, with value allocated as a portion of the carrying value of the entire financial asset before transfer.

D. Servicing rights retained in the transfer of a financial asset are considered to be a retained interest in the transferred asset, not a new separate asset, with value allocated as a portion of the carrying value of the entire financial asset before transfer.

214

Which one of the following is not associated with accounting for a transfer of a financial asset treated as a purchase by the transferee?
A. Measuring assets and liabilities at fair value.
B. Recognizing any gain or loss on the transfer in current income.
C. Recognizing the asset(s) obtained.
D. Recognizing the liability(ies) incurred.

B. Recognizing any gain or loss on the transfer in current income.
In a transfer of a financial asset treated as a purchase by the transferee, no gain or loss would be recognized by the transferee. The transferee is the recipient of the transferred asset. As such, assets and liabilities recognized by the transferee would be recorded at fair value.

215

On February 1, Rayco transferred a bond it owned with a maturity value of $50,000 to Dayco as security for a short-term loan from Dayco. By terms of the agreement, Dayco cannot resell or otherwise use the bond except as collateral for its loan to Rayco. Rayco defaulted on its repayment of the loan from Dayco on August 1 when the bond had a fair value of $48,000. On what date and in what amount should Dayco recognize the bonds on its books?
Recognize On Recognize
February 1 $50,000
February 1 $48,000
August 1 $50,000
August 1 $48,000

Recognize On Recognize
August 1 $48,000
Since the transfer of the bond is used only as security for the loan, and not as a sale of the bond, Dayco would not recognize the bond on its books at the time of the transfer. The bond would be recognized on Dayco's books on the date Rayco defaulted and at its fair value at that time.

216

The determination of the value or settlement amount of a derivative instrument involves a calculation, which uses
I. An underlying.
II. A notional amount.

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

C. Both I and II.
Both the underlying (e.g., price) and notional amount (e.g., quantity) are used in the determination of the value or settlement amount of a derivative instrument. Typically, the value is the result of multiplying the underlying by the notional amount.

Underlying = price of derivative
Notional amount = quantity of derivative

217

A derivative financial instrument is best described as:
A. Evidence of an ownership interest in an entity such as shares of common stock.
B. A contract that has its settlement value tied to an underlying notional amount.
C. A contract that conveys to a second entity a right to receive cash from a first entity.
D. A contract that conveys to a second entity a right to future collections on accounts receivable from a first entity.

B. A contract that has its settlement value tied to an underlying notional amount.

A contract that has it settlement value tied to an underlying notional amount best describes a derivative financial instrument. The value or settlement amount of a derivative is the amount determined by the multiplication (or other arithmetical calculation) of a notional amount and an underlying. Simply put, a derivative instrument is a special class of financial instrument which derives its value from the value of some other financial instrument or variable.

218

Which of the following statements, if either, concerning accounting for derivative financial instruments is/are correct?
I. Derivative instruments can be used only for hedging purposes.

II. Derivative instruments can be used only to hedge fair value.

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

D. Neither I nor II.
Neither Statement I nor Statement II is correct. Derivative instruments can be used not only for hedging purposes (Statement I), but also for speculative purposes. In addition, derivative instruments can be used not only to hedge fair value (Statement II), but also to hedge cash flows.

219

Which of the following concepts is not part of the definition of a derivative under IFRS?
A. The instrument has one or more underlyings.
B. The instrument requires little or no initial net investment.
C. The instrument permits net settlement.
D. The instrument has a notional amount.

D. The instrument has a notional amount.
The definition of a derivative under IFRS does not include the concept of notional amount. GAAP has both an underlying and a notional amount.

220

Which of the following statements, if either, concerning differences between U.S. GAAP and IFRS in accounting for hedges is/are correct?
I. IFRS permits hedging a forecasted business combination that is subject to foreign exchange risk; U.S. GAAP does not permit hedging in that case.

II. IFRS permits hedging part of the life of a hedged item; U.S. GAAP does not permit hedging of part of the life of a hedged item.

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

C. Both I and II.
Both Statement I and Statement II are correct. IFRS permits (1) hedging a forecasted business combination that is subject to foreign exchange risk, and (2) hedging part of the life of a hedged item. U.S. GAAP does not permit hedging in either case.

221

Which one of the following is not a characteristic of a cash flow hedge?

A. Can be used to hedge the risk of variability in cash flow of a forecasted transaction.
B. Measures the hedged item using the present value of expected cash flows.
C. The derivative used as the hedging instrument is measured at fair value.
D. All difference between the change in value of the hedged item and the change in value of the hedging instrument is recognized in current income.

D. All difference between the change in value of the hedged item and the change in value of the hedging instrument is recognized in current income.

To the extent that the hedge works, that amount is recognized in OCI, not NI.

222

Derivatives used for hedging purposes that require disclosure of reclassifications of accumulated other comprehensive income are most likely related to which of the following hedging purposes, if any?
I. Fair value hedges.

II. Cash flow hedges.

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

B. II only.

When derivatives are used as cash flow hedges, an amount of G/L can be deferred in OCI and subsequently become part of AOCI.

Amounts of AOCI (on the hedging instrument) will be reclassified to income when the hedged item affects income.

223

On October 1, 2008, Buyco entered into a legally enforceable contract to acquire raw material inventory in 180 days for $20,000. In order to mitigate the risk of a change in the value of the raw materials, Buyco also entered into a qualified 180-day forward contract to hedge the fair value of the raw materials. At December 31, 2008, the value of the raw materials had decreased by $500, and the fair value of the futures contract had increased by $480. On March 29, 2009, the date the raw materials were delivered to Buyco, they had a fair value of $19,300, and the forward contract had a fair value of $700. Which one of the following is the amount of net gain or loss that would be recognized on the raw materials and related forward contract by Buyco in its 2008 net income?

A. $500
B. $480
C. $20
D. $ -0-

C. $20
Because Buyco entered into the forward contract (hedging instrument) to hedge the risk of change in the fair value of the raw materials (hedged item), the change in fair value of the forward contract during 2008 offsets the change in the fair value of the raw materials. Specifically, the decrease in the value of the raw materials, $500, was offset by the increase in the value of the forward contract of $480, so the net loss recognized in 2008 was $500 - $480 = $20, which is the correct answer.

Decrease in value in raw materials - increase in value of forward contract = net loss

224

If a firm used a derivative to hedge the risk of exchange rate changes between the time a liability is recorded and the time it is settled in a foreign currency, which one of the following is being hedged?
A. Unrecognized firm commitment.
B. Forecasted transaction.
C. Recognized liability.
D. Net investment in a foreign entity.

C. Recognized liability.
A foreign currency hedge of a recognized liability hedges the risk of exchange rate changes on the cash flow (or fair value) of a liability between the time it is recorded (recognized) and the time it is settled in a foreign currency.

225

Which one of the following is not a characteristic of a foreign currency hedge?
A. Hedges the risk due to change in foreign currency exchange rates.
B. Can hedge net investments in a foreign entity.
C. Are all treated as fair value hedges.
D. Can be used to hedge forecasted intercompany transactions.

C. Are all treated as fair value hedges.

All foreign currency hedges are not treated as fair value hedges. While foreign currency hedges of unrecognized firm commitments, investments in available-for-sale securities, and net investments in foreign operations are treated as fair value hedges,

foreign currency hedges of forecasted transactions are treated as cash flow hedges,

and foreign currency hedges of recognized assets or liabilities may be treated either as fair value hedges or cash flow hedges, depending on management's designation.