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Flashcards in Investments Deck (93):
1

On April 1, North Company issued bonds in the market. Upon issue, South Company acquired 10% of North Company's issue. On November 30, South sold the North Company bonds in the market, and the bonds were acquired by East Company. On December 31, which one of the companies, if any, is an investor?

  1. North Company.
  2. South Company.
  3. East Company.
  4. None of the companies is an investor.

East Company.

Since East Company owns the bonds on December 31, it is the investor. North Company, the issuer of the bonds, is the investee. Since South Company did not issue the bonds and does not own the bonds on December 31, it is neither an investor nor an investee.

2

On April 1, North Company issued bonds in the market. Upon issue, South Company acquired 10% of North Company's issue. On November 30, South sold the North Company bonds in the market; the bonds were acquired by East Company. On December 31, which, if any, of the following companies is an investee?

  • North   
  • South   
  • East

  • North - YES   
  • South - NO   
  • East - NO

North is the investee because it issued the bonds, but neither South nor East are investees. Since East owns the bonds on December 31, it is the investor. Since South did not issue the bonds and does not own the bonds on December 31, it is neither an investor nor an investee.

3

Which one of the following is not considered an equity investment for investment accounting purposes?

  1. Common stock warrants.
  2. Preferred stock.
  3. Redeemable preferred stock.
  4. Common stock options.

Redeemable preferred stock.

Redeemable preferred stock is not considered an equity security for investment accounting purposes. Redeemable preferred stock, also known as callable preferred stock, may be reacquired by the issuing corporation under prescribed conditions.

4

In which one of the following cases would an investor be presumed to have significant influence over the investee?

  1. Investor acquires more than 50% of the investee's non-voting preferred stock.
  2. Investor acquires 10% of investee voting common stock.
  3. Investor acquires 40% of investee voting common stock, which it intends to hold for 60 days.
  4. Investor acquires 18% of investee voting common stock and is the primary buyer of the investee's output.

Investor acquires 18% of investee voting common stock and is the primary buyer of the investee's output.

Although the acquisition of 18% of an entity's voting common stock is less than the 20% normally required to presume significant influence over the investee, the fact that the investor has material transactions with the investee (together with the 18% ownership) is presumed to give the investor sufficient means for exercising significant influence.

5

In which one of the following circumstances would an investor most likely have control of an investee?

  1. The investor owns more than 50% of the voting common stock of an investee.
  2. The investor owns 100% of the non-voting preferred stock of an investee.
  3. The investor owns 90% of the voting common stock of a foreign investee on which the foreign government imposes significant financial and operating restrictions.
  4. The investor owns 100% of the voting common stock of a domestic investee that is in bankruptcy.

The investor owns more than 50% of the voting common stock of an investee.

When an investor owns more than 50% of the voting common stock of an investee, in the absence of constraining conditions (e.g., investee in bankruptcy), the investor has controlling interest in the investee.

6

In the absence of other relevant factors, what minimum level of voting ownership is considered to give an investor significant influence over an investee?

  1. 10%.
  2. 20%
  3. 50%
  4. 100%.

20%

The minimum level of voting ownership considered to give an investor significant influence over an investee is 20%. In the absence of other relevant factors, an investor is considered to have significant influence over an investee if it owns 20%-50% of the voting securities of the investee.

7

For accounting purposes, how many levels of influence, that an investor may have over an investee, are identified?

  1. One.
  2. Two.
  3. Three.
  4. Four

Three.

Accounting identifies three levels of influence that an investor may have over an investee. Those levels are:

  1. No significant influence 0-20%,
  2. Significant influence, but not control 21-50%, and
  3. Control 51-100%.

8

In year 1, a company reported in other comprehensive income an unrealized holding loss on an investment in available-for-sale securities. During year 2, these securities were sold at a loss equal to the unrealized loss previously recognized. The reclassification adjustment should include which of the following?

  1. The unrealized loss should be credited to the investment account.
  2. The unrealized loss should be credited to the other comprehensive income account.
  3. The unrealized loss should be debited to the other comprehensive income account.
  4. The unrealized loss should be credited to beginning retained earnings.

The unrealized loss should be credited to the other comprehensive income account.

The unrealized loss would be credited to the other comprehensive income account to reclassify the holding loss as a realized loss in the income statement for year 2. For purposes of illustration, assume the available for sale (AFS) securities were originally purchased for $5 and that the loss during year 1 was $1. The related entries would be:

Purchase:DR. AFS Securities$5

   CR. Cash$5

Year 1 End:DR. OCI (holding loss)$1

   CR. AFS Securities$1

Year 2:DR. Cash$4

   CR. AFS Securities$4

DR. Loss on AFS Securities$1(Income Statement)

   CR. OCI (holding loss)$1(B/S, Accumulated OCI)

The last entry (above) reclassifies the holding loss to recognize a realized loss on sale.

9

On January 10, 2005, Box, Inc. purchased marketable equity securities of Knox, Inc. and Scot, Inc. Box classified both securities as a noncurrent available-for-sale investments.

At December 31, 2005, the cost of each investment was greater than its fair market value. The loss on the Knox investment was considered permanent and that on Scot was considered temporary. How should Box report the effects of these investing activities in its 2005 Income Statement?

  • I. Excess of cost of Knox stock over its market value.
  • II. Excess of cost of Scot stock over its market value.
  1. An unrealized loss equal to I plus II.
  2. An unrealized loss equal to I only.
  3.  
  4. No Income Statement effect.

A realized loss equal to I only.

Permanent losses on securities available-for-sale (SAS) are recognized in earnings as if they were realized. This is an example of conservatism. If the market value is not expected to recover, a loss is probable and therefore should be recognized in earnings.

This is in contrast to the treatment for temporary losses, which for SAS, are treated as direct reductions to owners' equity. Thus, only the loss in I. (Knox) is recognized in earnings.

10

On January 1, 2004, Purl Corp. purchased, as a long-term investment, $500,000 face value Shaw, Inc. 8% bonds for $456,200. The bonds were purchased to yield 10% interest. Purl has the positive intent and ability to hold the bonds until maturity on January 1, 2010. The bonds pay interest annually on January 1, and Purl uses the interest method of amortization.

What amount (rounded to nearest $100) should Purl report on its December 31, 2005 Balance Sheet for this long-term investment?

  1. $468,000
  2. $466,200
  3. $461,800
  4. $456,200

$468,000

A held-to-maturity (HTM) investment purchased at a discount increases in value as maturity approaches, at which time the book value of the investment must be the face value of the investment. During the life of an HTM investment the investor carries and reports the investment at amortized cost.

The interest and amortization entries for the two years 2004 and 2005 lead to the correct ending balance at December 31, 2005 are:

December 31, 2004:

  • Dr. Interest receivable .08($500,000) $40,000
  • Dr. Investment in HTM bonds $5,620
    • Cr. Interest revenue .10($456,200) $45,620

December 31, 2005:

  • Dr. Interest receivable .08($500,000) $40,000
  • Dr. Investment in HTM bonds $6,182
    • Cr. Interest revenue .10($456,200 + $5,620) $46,182

Thus, the ending investment balance at December 31, 2005 is $456,200 + $5,620 + $6,182 = $468,002, or $468,000 (rounded to the nearest $100 as required by the problem).

11

For a marketable-equity securities portfolio classified as available-for-sale, which of the following amounts should be included in the period's net income?

  • I. Unrealized temporary losses during the period.
  • II. Realized gains during the period.
  • III. Changes in the valuation allowance during the period.

II ONLY.

On available-for-sale securities, only realized gains (from sale or reclassification) are recognized in the period.

These securities are not sold for the purpose of relatively quick sale. Rather, they are held for different purposes and may be held long-term. The unrealized changes in market value are recorded in owners' equity.

12

On January 2, 2004, Adam Co. purchased, as a long-term investment, 10,000 shares of Mill Corp.'s common stock for $40 a share.

On December 31, 2004, the market price of Mill's stock was $35 a share, reflecting a temporary decline in market price. On December 28, 2005, Adam sold 8,000 shares of Mill stock for $30 a share.

For the year ended December 31, 2005, Adam should report a loss on disposal of long-term investment of:

  1. $100,000
  2. $90,000
  3. $80,000
  4. $40,000

$80,000

The realized loss on the sale of available-for-sale securities is the decline in market value since the acquisition of the securities sold. The $80,000 loss equals 8,000($40-$30). The loss to the beginning of 2005 is unrealized and recorded in owners' equity.

13

Investments in AFS are reported on the balance sheet at?

  • Cost
  • Market value 
  • Lower of cost or market

 

Market Value (FMV)

Investments in available-for-sale securities are reported at market value under the fair value method ($28,000). The LCM method is no longer applicable to investments.

14

An investor purchased a bond as a long-term investment between interest dates at a premium. At the purchase date, the cash paid to the seller is:

  1. The same as the face amount of the bond.
  2. The same as the face amount of the bond plus accrued interest.
  3. More than the face amount of the bond.
  4. Less than the face amount of the bond.

More than the face amount of the bond.

The amount paid by buyer would have been more than the face amount of the bond because that amount would have included the amount of the premium and the amount of interest accrued since the last interest date.

15

On January 1 of the current year, Barton Co. paid $900,000 to purchase two-year, 8%, $1,000,000 face value bonds that were issued by another publicly-traded corporation. Barton plans to sell the bonds in the first quarter of the following year. The fair value of the bonds at the end of the current year was $1,020,000. At what amount should Barton report the bonds in its balance sheet at the end of the current year?

  1. $900,000
  2. $950,000
  3. $1,000,000
  4. $1,020,000

$1,020,000

For investments in debt securities other than those intended to be held to maturity, the fair value method is applied. $1,020,000 is the fair value of the investment in bonds and is the appropriate amount for reporting the investment.

16

On both December 31, 2003 and December 31, 2004, Kopp Co.'s only marketable equity security had the same market value, which was below cost.

Kopp considered the decline in value to be temporary in 2003 but other than temporary in 2004. At the end of both years, the security was classified as a noncurrent available-for-sale investment.

What should be the effects of the determination that the decline was other than temporary on Kopp's 2004 net noncurrent assets and net income?

  1. No effect on both net noncurrent assets and net income.
  2. No effect on net noncurrent assets and decrease in net income.
  3. Decrease in net noncurrent assets and no effect on net income.
  4. Decrease in both net noncurrent assets and net income.

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

A permanent decline in the value of an available-for-sale security is recognized as a loss in the Income Statement (whereas nonpermanent declines are treated as reductions in owners' equity).

The security did not change in value during 2004 because the market value had not changed, thus there is no further reduction in assets. The owners' equity account would be reclassified as a loss account; thus, only income is decreased.

17

Jent Corp. purchased bonds at a discount of $10,000. Jent classified the bonds as available-for-sale and subsequently sold them at a premium of $14,000. At the time of the sale, $2,000 of the discount had been amortized.

What amount should Jent report as gain on the sale of bonds?

  1. $12,000
  2. $22,000
  3. $24,000
  4. $26,000

$22,000

The book value at the date of sale was $8,000 below face value ($10,000 original discount-$2,000 amortization). The market value of the bonds at date of sale was $14,000 above face value ($14,000 premium). Thus, the difference between the price of the bonds at sale and the book value was $22,000 ($8,000 + $14,000). That difference is the gain on sale.

18

An investor purchased a bond classified as a held-to-maturity investment between interest dates at a discount.

At the purchase date, the carrying amount of the bond is more than the:

  • Cash paid to seller
  • Face amount of bond 

NO for BOTH.

When a bond is purchased at a discount, the price paid is less than face value. Any cash paid to the seller for accrued interest is debited to interest receivable, not to the bond investment. Thus, the carrying value is the portion of the total amount paid attributable to the total bond price, exclusive of accrued interest. 

The carrying value must be less than the cash paid to the seller, which includes accrued interest.

19

At the end of year one, Lane Co. held trading securities that cost $86,000 that had a year-end market value of $92,000. During year two, all of these securities were sold for $104,500. At the end of year two, Lane had acquired additional trading securities that cost $73,000 that had a year-end market value of $71,000. What is the impact of these stock activities on Lane's year two Income Statement?

  1. Loss of $2,000.
  2. Gain of $10,500.
  3. Gain of $16,500.
  4. Gain of $18,500

Gain of $10,500.

At the end of year one, Lane wrote the trading securities up to their fair value of $92,000. At sale, the gain recognized is, therefore, $104,500-$92,000=$12,500.

In addition, Lane had an unrealized holding loss of $73,000-$71,000=$2,000. 

Together, the net impact on Lane's Income Statement is $12,500-$2,000=$10,500 gain.

20

When the fair value of an investment in debt securities exceeds its carrying amount, how should each of the following assets be reported at the end of the year?

  • Held-to-maturity securities
  • Available-for-sale securities

  • Held-to-maturity securities - Carrying Amount
  • Available-for-sale securities - Fair Value

Securities classified as held-to-maturity are reported at amortized cost, which is the carrying amount of the securities. Further, securities classified as available-for-sale are reported at fair value.

21

In 2003, Lee Co. acquired, at a premium, Enfield, Inc. 10-year bonds as a held-to-maturity investment. At December 31, 2004, Enfield's bonds were quoted at a small discount.

Which of the following situations is the most likely cause of the decline in the bonds' market value?

  1. Enfield issued a stock dividend.
  2. Enfield is expected to call the bonds at a premium, which is less than Lee's carrying amount.
  3. Interest rates have declined since Lee purchased the bonds.
  4. Interest rates have increased since Lee purchased the bonds.

Interest rates have increased since Lee purchased the bonds.

Bond prices and interest rate changes are inversely related. When bond prices increase, the market value of fixed income investments, such as bonds decreases, because now there are better opportunities on the market.

22

Sun Corp. had investments in marketable equity securities costing $650,000. On June 30, 20x2, Sun decided to hold the investments indefinitely and, accordingly, reclassified them from held-for-trading to available-for-sale on that date. The investments' market value was $575,000 at December 31, 20x1, $530,000 at June 30, 20x2, and $490,000 at December 31, 20x2.

What amount should Sun report as net unrealized loss on noncurrent marketable equity securities in its 20x2 statement of stockholders' equity?

  1. $40,000
  2. $45,000
  3. $85,000
  4. $160,000

$40,000

The securities were classified as available-for-sale at June 30, 20x2. The decline in market value from that date to December 31, 20x2 is $40,000 ($530,000-$490,000).

That amount is reported in owners' equity because holding gains and losses on securities available-for-sale are not recognized in earnings.

23

The method of accounting for investments that does not give the investor significant influence over the investee is based on the investor's intent in making the investment. When investor intent changes, the classification of and accounting for the investment changes. When investments are transferred between classifications, which one of the following valuation basis is most likely to be used when recording the investment in the new classification?

  1. Historic cost.
  2. Amortized cost.
  3. Prior carrying value.
  4. Fair market value.

Fair market value is the valuation basis used when investments are transferred between classifications. Conceptually, the existing carrying value is written off and the current fair value is written on in the new classification, with any difference being an unrealized gain or loss.

24

Which, if any, of the following transfers between classifications of investments (which do not give the investor significant influence) are possible?

  • Held-to-maturity to held-for-trading   
  • Held-for-trading to held-to-maturity 

  • Held-to-maturity to held-for-trading - YES
  • Held-for-trading to held-to-maturity - YES

Both transfers from held-to-maturity to held-for-trading classifications and from held-for-trading to held-to-maturity classifications can occur in the accounting for investments where the investor does not have significant influence over the investee.

25

A marketable equity security is transferred from the held for trading portfolio to the available-for-sale portfolio. At the transfer date, the security's cost exceeds its market value.

What amount is used at the transfer date to record the security in the available-for-sale portfolio?

  1. Market value, regardless of whether the decline in market value below cost is considered permanent or temporary.
  2. Market value, only if the decline in market value below cost is considered permanent.
  3. Cost, if the decline in market value below cost is considered temporary.
  4. Cost, regardless of whether the decline in market value below cost is considered permanent or temporary.

Market value, regardless of whether the decline in market value below cost is considered permanent or temporary.

Reclassifications between the two investment categories are always recorded at market value. The reclassification is treated as if the security in the old classification was sold, and the security in the new classification was purchased.

Market value reflects a brand new valuation and is treated as original cost from then on for the purpose of the annual year-end revaluation adjustment.

26

In which of the following cases would an unrealized gain or loss on the transfer of an investment (which does not give the investor significant influence) from one classification to another classification not be recognized in current net income?

  1. Transfer from held-to-maturity to trading.
  2. Transfer from held-to-maturity to available-for-sale.
  3. Transfer from trading to held-to-maturity.
  4. Transfer from trading to available-for-sale.

Transfer from held-to-maturity to available-for-sale.

A transfer of an investment from held-to-maturity to available-for-sale would result in writing off the unamortized cost in the held-to-maturity classification and writing on the investment at fair value in the available-for-sale classification, with any difference being an unrealized gain or loss recognized in comprehensive income, not in current net income.

27

Which of the following are possible ways that gains or losses on changes in the fair value of investments in equity securities may be reported under IFRS requirements?

  • In profit/loss (Income Statement)
  • In other comprehensive income

  • In profit/loss (Income Statement) - YES
  • In other comprehensive income - YES

Under IFRS, changes in fair value may be reported in profit/loss or in other comprehensive income, depending on whether or not the investment is held for trading purposes or not. If an investment in equity securities is held-for-trading purposes (i.e., to make a profit on price appreciation), changes in fair value will be reported through profit/loss. If an investment in equity securities is not held-for-trading purposes, the investor may elect to report changes in fair value through other comprehensive income.

28

Which, if either, of the following statements concerning the transfer of investments between categories under IFRS No. 9 is/are correct?

I. Only investments in debt securities may be transferred between categories.

II. When investments are transferred between categories, financial statements of prior periods presented for comparative purposes must not be restated.

 

 

I ONLY.

Statement I is correct; Statement II is not correct. Only investments in debt securities may be transferred between categories; equity securities may not be transferred between categories (Statement I). When investments are transferred between categories, financial statements of prior periods presented for comparative purposes must be restated (Statement II).

29

Which, if any, of the following transfers between categories is possible under IFRS No. 9 for investments in debt securities?

  • Amortized cost to fair value
  • Fair value to amortized cost

  • Amortized cost to fair value - YES
  • Fair value to amortized cost - YES

Under IFRS No. 9, investments in debt securities may be (1) transferred from amortized cost (when the investment originally meets both the business model test and the cash flow characteristic test) to fair value when the investment fails to continue to meet both the business model test and the cash flow characteristic test and (2) transferred from fair value to amortized cost when an investment that originally fails to meet both the business model test and the cash flow characteristic test subsequently meets both tests.

30

Inco, Inc., a U.S. entity, has elected to prepare financial statements in accordance with IFRS to provide to its foreign suppliers. Inco has the following information concerning an investment in the bonds of Tryco, Inc., as of December 31, 2011:

  • Par value $100,000
  • Original cost $108,000
  • Current premium $3,500
  • Fair value $105,000

Inco normally does not invest in debt but made this investment with the expectation that it could profit from short-term decreases in the market interest rate. Which one of the following is the amount at which Inco should report its investment in Tryco in its December 31, 2011 IFRS-based Statement of Financial Position?

  1. $100,000
  2. $103,500
  3. $105,000
  4. $108,000

$105,000

Under IFRS No. 9, investments in debt securities that are not made under an entity's business model plan to make and hold such investments solely to receive cash flow from interest and principal repayment should be reported at fair value. Thus, this investment should be reported at the fair value, $105,000.

31

Inco, Inc., a U.S. entity, has elected to prepare financial statements in accordance with IFRS to provide to its foreign suppliers. Inco has the following information concerning an investment in the bonds of Tryco, Inc., as of December 31, 2011:

  • Par value $100,000
  • Original cost $108,000
  • Current premium $3,500
  • Fair value $105,000

Inco's business model is to regularly invest in debt to receive the cash flow provided by interest and the repayment of principal on maturity. The bonds are not associated with any other asset or liability. Which one of the following is the amount at which Inco should report its investment in Tryco in its December 31, 2011 IFRS-based Statement of Financial Position?

  1. $100,000
  2. $103,500
  3. $105,000
  4. $108,000

$103,500

Under IFRS No. 9, investments in debt securities made under an entity's business model plan to make and hold such investments solely to receive cash from interest and principal repayment, and when there is no accounting mismatch, should be reported at amortized cost. Amortized cost is par value ($100,000) plus the unamortized premium ($3,500), or $100,000 + $3,500 = $103,500, the correct answer.

32

Which, if any, of the following characteristics concerning the categories of investments under IFRS No. 9 is/are correct?

  • I. There is a single category for debt investments and a single category for equity investments.
  • II. The business model test used in evaluating debt instruments for classification purposes is concerned with the investor's intent.

II ONLY.

Statement II is correct; Statement I is not correct. The business model test used in evaluating debt instruments for classification purposes is concerned with the investor's intent. Specifically, did the investor make the investment to collect cash flows from interest and return of principal, rather than to make a profit on sale of the investment (Statement II)? While there is a single category for equity investments (at fair value), there are two categories for debt investments (at amortized cost and at fair value) (Statement I).

33

Pear Co.'s Income Statement for the year ended December 31, 2004, as prepared by Pear's controller, reported income before taxes of $125,000. The auditor questioned the following amounts that had been included in income before taxes:

  • Equity in earnings of Cinn Co. $40,000
  • Dividends received from Cinn $8,000
  • Adjustments to profits of prior years for arithmetical errors in depreciation ($35,000)

Pear owns 40% of Cinn's common stock. Pear's December 31, 2004, Income Statement should report income before taxes of:

  1. $85,000
  2. $117,000
  3. $120,000
  4. $152,000

$152,000

  • Income before adjustment $125,000
  • Less dividends from Cinn ($8,000)
  • Plus adjustment for errors $35,000
  • Equals correct pretax income $152,000

Pear uses the equity method to account for its investment in Cinn. Thus, the equity in earnings of Cinn are properly included in Pear earnings.

However, the dividends are removed from income because under the equity method dividends reduce the investment account. They are not included in income. The error adjustments were subtracted from income but are actually prior period adjustments. These are adjustments to retained earnings and do not affect income. Thus, the adjustments are added back to income.

34

In its financial statements, Pulham Corp. uses the equity method of accounting for its 30% ownership of Angles Corp. At December 31, 2005, Pulham has a receivable from Angles.

How should the receivable be reported in Pulham's 2005 financial statements?

  1. None of the receivable should be reported, but the entire receivable should be offset against Angles' payable to Pulham.
  2. Seventy percent of the receivable should be separately reported, with the balance offset against 30% of Angles' payable to Pulham.
  3. The total receivable should be disclosed separately.
  4. The total receivable should be included as part of the investment in Angles without a separate disclosure.

The total receivable should be disclosed separately.

Although the equity method is often called a "one-line" consolidation, intercompany receivables remain separate from the investment account. Intercompany profit or loss is eliminated but that affects the income recognized by Pulham, not the receivable.

35

Green Corp. owns 30% of the outstanding common stock and 100% of the outstanding noncumulative nonvoting preferred stock of Axel Corp. Green's 30% ownership of common stock gives it significant influence over Axel. 

In 2004, Axel declared dividends of $100,000 on its common stock and $60,000 on its preferred stock. Green exercises significant influence over Axel's operations.

What amount of dividend revenue should Green report in its Income Statement for the year ended December 31, 2004?

  1. $0
  2. $30,000
  3. $60,000
  4. $90,000

$60,000

Only the dividends received on the preferred stock are recognized as revenue: $60,000 = 100% x ($60,000). The common stock investment is accounted for under the equity method, which treats all dividends received as a return of capital. Dividends reduce the investment account under this method.

36

When the equity method is used to account for investments in common stock, which one of the following affect(s) the investor's reported investment income?

  • A change in market value of investee's common stock
  • Cash dividends from investee 

NO and NO.

Under the equity method of accounting, changes in the market value of the investee's common stock are ignored. Further, cash dividends received by the investor from the investee are not recognized as investment income; rather they are recognized as a debit to cash and a reduction in (credit to) the investor's investment in investee account.

37

When the equity method is used to account for investments in common stock, which of the following affects the investor's reported investment income?

  • Goodwill amortization related to purchase    
  • Cash dividends from investee

NO and NO.

Under the equity method of accounting for an investment, neither amortization of goodwill nor dividends from the investee affect the investor's investment income. Goodwill resulting from an investment in another entity (i.e., the excess of the cost of the investment over the investor's share of the fair value of the investee's identifiable assets) is not amortized. Dividends from the investee are not recognized as income; rather, they reduce the investment account.

38

Peel Co. received a cash dividend from a common stock investment. Should Peel report an increase in the investment account if it accounts for the investment as held-for-trading or uses the equity method of accounting?

  • Held-for-trading
  • Equity method

  • Held-for-trading - NO
  • Equity method - NO

A dividend never increases the investment account under any accounting method.

Under the cost method, the dividend is recorded as revenue. Under the equity method, the dividend is recorded as a decrease in the investment account.

39

Pal Corp.'s 2004 dividend income included only part of the dividend received from its Ima Corp. investment. The balance of the dividend reduced Pal's carrying amount for its Ima investment. This reflects that Pal accounts for its Ima investment by the:

  1. Fair Value method, and only a portion of Ima's 2004 dividends represent earnings after Pal's acquisition.
  2. Fair Value method, and its carrying amount, exceeded the proportionate share of Ima's market value.
  3. Equity method, and Ima incurred a loss in 2004.
  4. Equity method, and its carrying amount exceeded the proportionate share of Ima's market value.

Fair Value method, and only a portion of Ima's 2004 dividends represent earnings after Pal's acquisition.

The portion of the dividend reducing the investment carrying value is a liquidating dividend. A liquidating dividend occurs when the investee pays more income than was earned during the period the investor owned the shares of the investee.

For example, assume that Pal held 1% of Ima's outstanding stock from January 1-December 31 of 2004 only. Ima earned $40,000 during 2004 but paid $50,000 in dividends ($10,000 coming from earnings before 2004). Pal would receive $500 dividends in total (1%), but only $400 are attributable to earnings during the period Pal was a shareholder. Thus, $100 of the dividend is attributable to income earned by Ima before Pal became an investor. From Pal's viewpoint, this is a return of a portion of Pal's investment, a liquidating dividend.

Under the cost method, liquidating dividends are treated as a reduction in the investment account whereas normal dividends are treated as income. The wording of the question implies that dividends are otherwise treated as income. Thus, the equity method could not be the method used by the firm.

Under the equity method, all dividends are treated as a reduction in the investment account. No dividends received are treated as income under the equity method.

40

Which of the following kinds of investments can result in the investor obtaining significant influence over an investee?

  • Equity investments
  • Debt investments 

  • Equity investments - YES
  • Debt investments - NO

An investment in equity securities of another entity gives the investor an ownership interest and, therefore, the ability to vote in corporate elections. An investment in the debt of another entity does not give the investor an ownership interest or the right to vote in corporate elections. An investment in the debt of another entity establishes a debtor-creditor relationship, not an ownership relationship.

41

When an investor owns 40% of the voting stock of an investee, and a standstill agreement is executed between the investor and the investee, which of the following is most likely to be used in accounting for the investment?

  1. Cost.
  2. Fair market value.
  3. The lower of cost or fair market value.
  4. Equity method of accounting.

Fair market value.

Even though the investor owns 40% of the voting stock of an investee, if a standstill agreement exists between the investor and the investee, the investor cannot exercise significant influence over the investee and likely would use fair value to carry and report the investment. A standstill agreement is a written agreement between two firms whereby certain actions between the firms are limited.

42

In which one of the following cases is an investor most likely to use the equity method to carry and report an investment in an investee?

  1. Investor owns 15% of the voting stock of the investee and has no other affiliation with the investee.
  2. Investor owns 40% of the voting stock of the investee, and the investee is in bankruptcy.
  3. Investor is a manufacturing firm that owns 25% of the voting stock of a consulting firm.
  4. Investor owns 30% of the voting stock of the investee but is unable to obtain representation on the investee's Board of Directors or obtain significant information from the investee.

Investor is a manufacturing firm that owns 25% of the voting stock of a consulting firm.

An investor that owns 25% of the voting stock of an investee, in the absence of evidence to the contrary, is presumed to be able to exercise significant influence over the investee. The fact that the investor and the investee are in different lines of business generally does not mitigate the influence the investor is able to exercise.

43

Larkin Co. has owned 25% of the common stock of Devon Co. for a number of years, and has the ability to exercise significant influence over Devon. The following information relates to Larkin's investment in Devon during the most recent year:

  • Carrying amount of Larkin's investment in Devon at the beginning of the year $200,000
  • Net income of Devon for the year $600,000
  • Total dividends paid to Devon's stockholders during the year $400,000

What is the carrying amount of Larkin's investment in Devon at year end?

  1. $100,000
  2. $200,000
  3. $250,000
  4. $350,000

$250,000

Larkin's investment in Devon at year end would be computed as the carrying amount of the investment at the beginning of the year ($200,000) + Larkin's share of Devon's reported net income for the year ($600,000 x .25 = $150,000)-Larkin's share of Devon's dividends paid during the year ($400,000 x .25 = $100,000), or $200,000 + $150,000 = $350,000-$100,000 = $250,000, the correct answer.

44

U.S. entities, Joco, Inc. and Vico, Inc., formed a corporate joint venture, JoViCo, Inc., with each holding a 50% ownership interest. Joco contributed $100,000 cash and equipment that had an original cost of $50,000, accumulated depreciation of $5,000, and a fair value of $48,000. At which one of the following amounts will Joco record its investment in the JoViCo joint venture?

  1. $150,000
  2. $148,000
  3. $145,000
  4. $72,500

$145,000

The investment of the equipment should be recorded at its carrying value ($50,000-$5,000 = $45,000). Therefore, the total investment should be recorded at $100,000 cash + $45,000 equipment = $145,000.

45

Which one of the following is least likely to be used to report an investment in a corporate joint venture?

  1. Equity method.
  2. Fair Value method.
  3. Consolidation basis.
  4. Partnership basis.

Fair Value method.

The fair value method is least likely to be used to report an investment in a corporate joint venture. Even though an investment in a joint venture is a financial asset, and financial assets generally are eligible to be reported at fair value at the election of the holder (investor), such an option is not likely to be available for joint ventures because (1) if the joint venture is to be consolidated, it is not eligible for fair value measurement and (2) even if it is not to be consolidated, the nature of joint ventures (e.g., not traded in a public market) makes it unlikely that a readily determinable fair value will be available.

The partnership basis will be used to report investments in joint ventures organized as partnership. In such a case, the investor/partner would accounting for its investment in the joint venture partnership using partnership accounting guidelines, with adjustments for certain intercompany items.

46

Jacko, Co., a 50% owner of Venture Co., a jointly controlled entity, contributed to Venture a nonmonetary asset with an original cost of $200,000, accumulated depreciation of $50,000, and a fair value of $180,000. Under IFRS, which one of the following is the amount of gain, if any, Jacko should recognize on its contribution to Venture Co.?

  1. $0 (no gain)
  2. $15,000
  3. $20,000
  4. $30,000

$15,000

A gain should be recognized by Jacko for the share of ownership held by others (50%) attributable to the excess of the fair value of the asset over its carrying value. The excess of fair value ($180,000) over carrying value ($200,000-$50,000 = $150,000) is $30,000 ($180,000- $150,000). Therefore, Jacko should recognize .50 x $30,000 = $15,000 as a gain.

47

On March 4, 2004, Evan Co. purchased 1,000 shares of LVC common stock at $80 per share.

On September 26, 2004, Evan received 1,000 stock rights to purchase an additional 1,000 shares at $90 per share. The stock rights had an expiration date of February 1, 2005. On September 30, 2004, LVC's common stock had a market value, exrights, of $95 per share and the stock rights had a market value of $5 each.

What amount should Evan report on its September 30, 2004, Balance Sheet for investment in stock rights?

  1. $4,000
  2. $5,000
  3. $10,000
  4. $15,000

 

$4,000

FMV Rights / (FMV Rights + FMV Stock) 

x

Cost of stock owned

The original stock investment cost is allocated to the stock and the rights based on their relative market values. Total market value of the stock is $95,000, and of the rights is $5,000. The original cost of the stock is $80,000.

Thus the investment in stock rights is reported at [$5,000/($5,000 + $95,000)] $80,000 = $4,000.

48

Plack Co. purchased 10,000 shares (2% ownership) of Ty Corp. on February 14, 2005. 
Plack received a stock dividend of 2,000 shares on April 30, 2005, when the market value per share was $35. Ty paid a cash dividend of $2 per share on December 15, 2005.

In its 2005 Income Statement, what amount should Plack report as dividend income?

  1. $20,000
  2. $24,000
  3. $90,000
  4. $94,000

$24,000

Because Plack Co. owns only 2% of Ty Corp. stock, it does not have significant influence over Ty and will not use the equity method to account for its investment. Plank's dividend will be determined by the number of shares of Ty that it owns multiplied by the amount of dividend per share. The calculation is:

  • 2/14 Purchase 10,000 shares
  • 4/30 Stock dividend 2,000 shares
  • 12/15 Total shares owned 12,000
  • Dividend rate $2
  • Total Dividend Income $24,000

49

Band Co. uses the equity method to account for its investment in Guard, Inc. common stock. How should Band record a 2% stock dividend received from Guard?

  1. As dividend revenue at Guard's carrying value of the stock.
  2. As dividend revenue at the market value of the stock.
  3. As a reduction in the total cost of Guard stock owned.
  4. As a memorandum entry, reducing the unit cost of all Guard stock owned.

As a memorandum entry, reducing the unit cost of all Guard stock owned.

Under any method used to account for an investment in common stock, the investor records a stock dividend received by a memorandum entry to increase the number of shares owned. Since the cost of the investment does not change, the per share cost of the stock decreases.

50

Stock dividends on common stock should be recorded at their fair market value by the investor when the related investment is accounted for under which of the following methods?

  • Cost
  • Equity

  • Cost - NO
  • Equity - NO

Stock dividends are not recognized in the accounts at receipt, at fair value or any other value. Rather, they reduce the cost per share under both methods. The original cost is spread over more shares.

The investor's percentage of the firm has not changed as a result of the stock dividend, but the investor has more shares (as do all investors). When the shares received as a dividend are sold, the reduction in cost basis increases the gain or reduces the loss.

51

Cobb Co. purchased 10,000 shares (2% ownership) of Roe Co. on February 12, 2004. Cobb received a stock dividend of 2,000 shares on March 31, 2004, when the carrying amount per share on Roe's books was $35 and the market value per share was $40. Roe paid a cash dividend of $1.50 per share on September 15, 2004.

In Cobb's Income Statement for the year ended October 31, 2004, what amount should Cobb report as dividend income?

  1. $98,000
  2. $88,000
  3. $18,000
  4. $15,000

$18,000

Cobb has 10,000 + 2,000 or 12,000 shares at the time of the dividend. The 2,000 shares were received from the stock dividend. Thus dividend income is 12,000($1.50) = $18,000. The stock dividend itself is not included in dividend income; rather decreases the cost per share of the investment. However, it does raise the number of shares which receive the cash dividend, which is recognized as income.

52

Bort Co. purchased 2,000 shares of Crel Co. common stock on March 5, 2004 for $72,000.

Bort received a $1,000 cash dividend on the Crel stock on July 15, 2004. Crel declared a 10% stock dividend on December 15, 2004, to stockholders of record as of December 31, 2004. The dividend was distributed on January 15, 2005. The market price of the stock was $38 on December 15, 2004, $40 on December 31, 2004, and $42 on January 15, 2005.

What amount should Bort record as dividend revenue for the year ended December 31, 2004?

  1. $1,000
  2. $8,600
  3. $9,000
  4. $9,400

$1,000

Only cash or property dividends are recognized as income to the recipient. Stock dividends are not recognized as revenue. Therefore dividend revenue is $1,000.

A stock dividend increases the number of shares for each investor, but not their percentage of the firm. After a 10% stock dividend, all investors hold 10% more stock but each share should be worth less (in theory).
GAAP does not record any value for a stock dividend received although the cost per share decreases and, thus, the gain per share on subsequent sale is increased.

53

Simpson Co. received dividends from its common stock investments during the year ended December 31, 2005 as follows:

  • A cash dividend of $8,000 from Wren Corp., in which Simpson owns a 2% interest.
  • A cash dividend of $45,000 from Brill Corp., in which Simpson owns a 30% interest. This investment is appropriately accounted for using the equity method.
  • A stock dividend of 500 shares from Paul Corp. was received on December 15, 2005, when the quoted market value of Paul's shares was $10 per share. Simpson owns less than 1% of Paul's common stock.

In Simpson's 2005 Income Statement, dividend revenue should be:

  1. $58,000
  2. $53,000
  3. $13,000
  4. $8,000

$8,000

Only the $8,000 dividend is included in dividend revenue. The dividend on the Brill stock is accounted for under the equity method, which treats all dividends as a reduction in the investment account. The stock dividend is not revenue. Rather it reduces the per share cost of the investment in Paul stock. No entry is recorded on receipt of a stock dividend.

54

Which, if either, of the following reasons for owning property can justify designating the property as investment property?

  • Holding to earning rental income   
  • Holding for capital appreciation 

  • Holding to earning rental income - YES
  • Holding for capital appreciation - YES

Holding building or land either to earn rental income or for capital appreciation can justify designating the property as investment property.

55

Which, if either, of the following statements concerning investment property is/are correct?

  • I. A part of a building may be investment property, while the other part is not investment property.
  • II. Property leased between affiliated entities cannot be reported as investment property in consolidated statements.

Both Statement I and statement II are correct.

It is correct that a part of a building may be investment property, while the other part is not investment property, if the two parts of property can be separately sold or rented and if the other requirements of investment property are met. It also is correct that property leased between affiliated entities cannot be reported as investment property in consolidated statements because, at the consolidated level, the leased property would be owner-occupied.

 

56

Which, if any, of the following statements concerning disclosures related to investment property is/are correct?

  • I. When the fair value method is used, the entity must disclose whether or not a qualified independent party provided valuations.
  • II. When the cost method is used, the entity must still disclose fair value of investment property.

Both Statement I and Statement II are correct.

When the fair value method is used to measure investment property, the entity must disclosed whether or not a qualified independent party provided valuations, (Statement I) and when the cost method is used to measure investment property, the entity must disclose fair value of investment property (Statement II).

57

Which of the following methods used to measure and report investment property will require disclosure of a reconciliation showing the causes of changes in the carrying amounts of investment property, between the beginning and end of a period?

  • Use of cost method   
  • Use of fair value method 

  • Use of cost method - YES  
  • Use of fair value method - YES

When either the cost method or the fair value method is used to measure investment property; the entity must provide a reconciliation showing the causes of changes in the carrying amounts of investment property between the beginning and end of a period.

58

If property is transferred from another category to investment property because of a change in use of the property, which of the following cases can result in the recognition of a gain or loss on the transfer?

  • I. Investment property is measured and reported at cost.
  • II. Investment property is measured and reported at fair value.

Statement II is correct, but statement I is not correct.

When property is transferred from another category into investment property measured at fair value, the old category will be based on cost and the new category (investment property) will be based on fair value. Any difference between the old cost-based carrying value and the new fair value will result in a gain or loss (statement II). When property is transferred from another category into investment property measured at cost, the cost-base carrying amount from the old category is the amount at which the asset is recorded in the new category and no gain or loss is recognized on the transfer (Statement I).

59

Which of the following is least likely to be investment property under IFRS?

  1. A vacant building listed with a broker as available for lease under an operating lease.
  2. A plot of vacant land held for long-term capital appreciation.
  3. A building under construction that is to be leased upon completion to another entity under an operating lease.
  4. A plot of vacant land that is for sale by a land developer.

A plot of vacant land that is for sale by a land developer.

A plot of vacant land that is for sale by a land developer would not qualify as investment property. The vacant land would constitute inventory to a land developer and, since it is not being held for capital appreciation, would not qualify as investment property.

60

On its December 31, year 1 balance sheet, the Noble Corporation reported the following as investments in long-term marketable equity securities:

  • Investment in long-term marketable equity securities at market $300,000

Less 

  • Adjustment to reflect decline in market value of marketable equity securities $28,000

At December 31, year 1, the market valuation of the portfolio was $298,000.  Noble does not elect to use the fair value option of reporting financial assets.  What should Noble report on its year 1 Statement of Income as a result of the increase in the market value of the investments in year 1?

  1. $0.
  2. Unrealized loss of $2,000.
  3. Realized gain of $26,000.
  4. Unrealized gain of $26,000.

$0.

No income results from an increase in market value of available-for-sale securities.  Since these equity securities were not purchased with the intent to sell them in the near term for a quick profit, they must be classified as available-for-sale securities.  Any unrealized gain or loss on such securities be recognized as “Other comprehensive income” and carried as a component of “Accumulated other comprehensive income” in the shareholder equity section (i.e., it is not recognized in net income).  When the market value increases, a decrease in the unrealized loss account will result.  Therefore, there will be no effect on the income statement.

Unrealized gains and losses on available-for-sale debt and equity securities are calculated in the same manner as those on trading securities.  These gains and losses, however, are not recognized in income of the period. Instead, the changes in fair value during a period (unrealized gains/losses) are reported as other comprehensive income, and the accumulated unrealized gain/loss on marketable securities account is presented as accumulated other comprehensive income in stockholders’ equity.

61

Cobb Co. purchased 10,000 shares (2% ownership) of Roe Co. on February 12, year 2.  Cobb received a stock dividend of 2,000 shares on March 31, year 2, when the carrying amount per share on Roe’s books was $35 and the market value per share was $40.  Roe paid a cash dividend of $1.50 per share on September 15, year 2.  In Cobb’s income statement for the year ended October 31, year 2, what amount should Cobb report as dividend income?

  1. $98,000
  2. $88,000
  3. $18,000
  4. $15,000

$18,000

No dividend revenue is recognized when an investor receives a proportional stock dividend, because the investor continues to own the same proportion of the investee as before the stock dividend. In addition the investee has not distributed any assets to the investor.  Therefore, Cobb’s dividend income includes only the cash dividend received [(10,000 + 2,000) × $1.50 = $18,000].

62

On January 2, year 1, Beal, Inc. acquired a $70,000 whole-life insurance policy on its president. The annual premium is $2,000.  The company is the owner and beneficiary.  Beal charged officer’s life insurance expense as follows:

  • Year 1 $2,000
  • Year 2 $1,800
  • Year 3 $1,500
  • Year 4 $1,100
  • Total $6,400

In Beal’s December 31, year 4 balance sheet, the investment in cash surrender value should be

  1. $0
  2. $1,600
  3. $6,400
  4. $8,000

$1,600

The cash surrender value (CSV) of a life insurance policy is considered an asset of the policy owner. Generally, part of each year’s insurance payment increases the CSV of the policy, so when the payment is made the asset account is debited for the amount of the increase, while the rest of the payment is recorded as insurance expense. Therefore, Beal’s cumulative journal entry for year 1- year 4 is

  • Insurance expense $6,400 (given) 
  • CSV $1,600 (plug) 
    •  Cash $8,000 (4 years × $2,000)

In the 12/31/Y4 balance sheet, the investment in CSV should be reported at $1,600.

63

On December 29, year 2, BJ Co. sold a marketable equity security that had been purchased on January 4, year 1. BJ owned no other marketable equity security. An unrealized loss was reported as components of “Other comprehensive income” and “Accumulated other comprehensive income” in the year 1 balance sheet. A realized gain was reported in the year 2 income statement. BJ Co. did not elect to use the fair value option in reporting financial assets.  Was the marketable equity security classified as a trading security and did its year 1 market price decline exceed its year 2 market price recovery?

  • Trading?
  • Year 1 market price decline exceeded year 2 market price recovery?

  • Trading - NO
  • Year 1 market price decline exceeded year 2 market price recovery - NO

Unrealized losses on trading securities are reported in the income statement, while unrealized losses on available-for-sale securities are reported as “Other comprehensive income” and a reduction of accumulated other comprehensive income, a component of stockholders’ equity (bypassing the income statement). Thus, we know that the MES in this problem is classified as available-for-sale. A realized gain can be reported only if the security was sold for a price in excess of its carrying value before recognition of the unrealized loss (which equals cost). Therefore, the year 2 price recovery would exceed the year 1 price decline since the year 2 recovery would equal the year 1 decline plus the amount of the realized gain. The entry that would have been made upon sale of the securities is

  • Cash xxx 
    • Investment xxx
    • Other comprehensive income--Unrealized loss on AFS security xxx
    • Gain on sale of AFS security xxx

Note that the effect of the credit to other comprehensive income, etc., is to reverse the unrealized loss out of accumulated other comprehensive income.

64

Information pertaining to dividends from Wray Corp.’s common stock investments for the year ended December 31, year 2, follows:

  • On September 8, year 2, Wray received a $50,000 cash dividend from Seco, Inc., in which Wray owns a 30% interest.  A majority of Wray’s directors are also directors of Seco.  The equity method of accounting is used.
  • On October 15, year 2, Wray received a $6,000 liquidating dividend from King Co. Wray owns a 5% interest in King Co.
  • Wray owns a 2% interest in Bow Corp., which declared a $200,000 cash dividend on November 27, year 2, to stockholders of record on December 15, year 2, payable on January 5, year 3.

What amount should Wray report as dividend income in its income statement for the year ended December 31, year 2?

  1. $60,000
  2. $56,000
  3. $10,000
  4. $4,000

$4,000

The cash dividend from Seco ($50,000) is recorded as a reduction of the investment account, rather than as dividend revenue, because the equity method is used. The equity method is used because Wray’s ownership interest is greater than 20% and it can exercise significant influence over Seco. The liquidating dividend from King ($6,000) is also recorded as a reduction of the investment account because it is a return of, rather than a return on investment. Wray’s share of the Bow dividend (2% × $200,000 = $4,000) is recorded as dividend revenue in year 2 even though it is not received until year 3. Since the date of record was in year 2, Wray should accrue the revenue by debiting dividends receivable and crediting dividend revenue.

65

Anchor Co. owns 40% of Main Co.’s common stock outstanding and 75% of Main’s noncumulative preferred stock outstanding.  Anchor exercises significant influence over Main’s operations.  During the current period, Main declared dividends of $200,000 on its common stock and $100,000 on its noncumulative preferred stock.  Anchor does not elect the fair value option for reporting its investment in Main.  What amount of dividend income should Anchor report on its income statement for the current period related to its investment in Main?

  1. $75,000
  2. $80,000
  3. $120,000
  4. $225,000

$75,000

Assuming Anchor accounts for its investment in Main common stock using the equity method, Anchor would recognize investment income in the amount of 40% of Main’s income. Anchor’s 40% share of the dividends on common stock declared by Main would reduce Anchor’s investment account. In addition, Anchor would also recognize its proportionate share of preferred dividends from Main, $75,000 ($100,000 × 75%), as dividend income on the income statement. Therefore, this answer is correct.  Note that if Anchor elected the fair value option for reporting its financial assets, both the preferred and common stock dividends would be included as dividend income for the period. Anchor would recognize 40% of the common stock dividends declared by Main (40% × $200,000 = $80,000) plus 75% of the preferred stock dividends declared by Main (75% × $100,000 = $75,000) for a total of $155,000 ($80,000 + $75,000) dividend income.  Since this number is not one of the possible answers listed in the problem, Anchor must be using the equity method to account for its investment in the common stock of Main.

66

When an investor uses the cost adjusted for fair value method to account for investments in common stock held in either a trading or available-for-sale portfolio, cash dividends received by the investor from the investee should normally be recorded as

  1. Dividend income.
  2. An addition to the investor’s share of the investee’s profit.
  3. A deduction from the investor’s share of the investee’s profit.
  4. A deduction from the investment account.

Dividend income.

ASC Topic 320 does not change the method of recognition of cash dividends or interest income on debt and equity securities.  Thus, cash dividends or interest income should be included in the current period’s income.  The method of recognition for stock dividends is also not affected by ASC Topic 320; stock dividends should not be reflected in income.  Additional shares received from a stock dividend should be added to the original shares and the per share value should be calculated upon the original shares’ carrying value.  At the end of the period the carrying value of the stock is adjusted to the fair value, and any unrealized holding gain or loss is recorded.

67

Assume a company does not elect the fair value option for reporting financial assets. Realized gains from the sale of marketable debt securities should be included in net income of the period of sale when the marketable debt securities portfolio of which they are a part is classified as

  • Available-for-sale
  • Held-to-maturity

  • Available-for-sale - YES
  • Held-to-maturity - YES

Realized gains and losses shall be included in the determination of net income of the period in which they occur for both available-for-sale and held-to-maturity securities.

68

In its financial statements, Pulham Corp. uses the equity method of accounting for its 30% ownership of Angles Corp.  At December 31, year 2, Pulham has a receivable from Angles.  How should the receivable be reported in Pulham’s year 2 financial statements?

  1. None of the receivable should be reported, but the entire receivable should be offset against Angles’ payable to Pulham.
  2. Seventy percent of the receivable should be separately reported, with the balance offset against 30% of Angles’ payable to Pulham.
  3. The total amount of the receivable should be disclosed separately.
  4. The total receivable should be included as part of the investment in Angles, without separate disclosure.

The total amount of the receivable should be disclosed separately.

Under the equity method intercompany profits and losses are eliminated. However, receivables and payables are not eliminated as they are in the case of consolidated financial statements. On the December 31, year 2 balance sheet, Pulham should separately disclose the total amount of the receivable. Additionally, this receivable should be shown separately from other receivables.

69

On January 1, year 1, Grade Company paid $300,000 for 20,000 shares of Medium Company’s common stock which represents a 15% investment in Medium.  Grade does not have the ability to exercise significant influence over Medium. Medium declared and paid a dividend of $1 a share to its stockholders during year 1.  Medium reported net income of $260,000 for the year ended December 31, year 1, and had a market value of $300,000 at December 31, year 1. The balance in Grade’s balance sheet account “Investment in Medium Company” at December 31, year 1, should be

  1. $280,000
  2. $300,000
  3. $319,000
  4. $339,000

$300,000

Grade Company will account for this investment using the fair value method. This method is used because Grade owns less than 20% of Medium and cannot exercise significant influence over the company.

70

Zinc Company does not elect to use the fair value option for reporting financial assets.  An unrealized gain, net of tax, on Zinc’s held-to-maturity portfolio of marketable debt securities should be reflected in the current financial statements as

  1. An extraordinary item shown as a direct increase to retained earnings.
  2. A current gain resulting from holding marketable debt securities.
  3. A footnote or parenthetical disclosure only.
  4. A valuation allowance and included in the equity section of the statement of financial position.

A footnote or parenthetical disclosure only.

An unrealized gain on held-to-maturity securities is only disclosed in the notes to the financial statements. Gains are only reflected in the financial statements when they are realized (i.e., upon sale or for other than temporary declines in value). The year-end financial statements would present the held-to-maturity portfolio at cost. Parenthetical or footnote disclosure would indicate their market value.

71

On January 2 of the current year, Otto Co. purchased 40% of Penn Co.'s outstanding common stock. The carrying amount of Penn's depreciable assets was $1,000,000 on January 2. Penn's depreciable assets had an original useful life of 10 years, and a remaining useful life of five years. Otto recognized $8,000 amortization for the current year ending December 31 related to its investment in Penn due to the excess of fair value over book value on these assets. What was the fair value of Penn's depreciable assets on January 2 of the current year?

  1. $100,000
  2. $900,000
  3. $1,000,000
  4. $1,100,000

$1,100,000

Because Otto purchased 40% of Penn's common stock, Otto would recognize differences between the historical cost and fair value of the assets. The assets have a remaining useful life of 5 years. Otto would amortize the differential over that period. The current year amortization is $8,000 implying that the total difference related to Otto was $40,000 ($8,000 × 5 years). $40,000 represents 40% of the differential, implying the total differential is $100,000 ($40,000/0.40). The fair value of the assets is $1,100,000 ($1,000,000 + $100,000).

72

On January 1, year 2, Miller Company purchased 25% of Wall Corporation’s common stock; no goodwill resulted from the purchase.  Miller uses the equity method to account for this investment, and the balance in Miller’s investment account was $190,000 at December 31, year 2.  Wall reported net income of $120,000 for the year ended December 31, year 2 and paid common stock dividends totaling $48,000 during year 2.

How much did Miller pay for its 25% interest in Wall?

  1. $172,000
  2. $202,000
  3. $208,000
  4. $232,000

$172,000

he equity method is used to account for the investment, and no goodwill resulted from the acquisition. The solutions approach is to set up a T-account for the investment account remembering that under the equity method the investor debits the investment account for the cost of the investment and its share of the earnings of the investee and credits the account for its share of dividends paid by the investee.

The initial cost (purchase price) of $172,000 is computed by solving the following equation for X:

  • Beg. balance (cost)+Earnings−Dividends=End balance
  • X + $30,000 − $12,000 = $190,000
  • X = $172,000

73

On January 2, year 1, Winn Company purchased as a long-term investment 5,000 shares of Pyle Corp. common stock for $70 per share, which represents a 1% interest.  On December 31, year 1, the market price of the stock was $75 per share.  On December 18, year 2, Winn needed additional cash for operations and sold all 5,000 shares of Pyle stock for $100 per share. Winn’s income tax rate was 40% for year 2.  For the year ended December 31, year 2, Winn should include in its income from continuing operations a realized gain on disposal of long-term investment of

  1. $0
  2. $90,000
  3. $125,000
  4. $150,000

$150,000

Since these equity securities were not purchased with the intent to sell them in the near term for a quick profit, they must be classified as available-for-sale securities. A realized gain on the disposal of such securities equals the excess of the proceeds (5,000 × $100 = $500,000) over the carrying value before recognition of any unrealized gains or losses (which equals cost) of the investment [5,000 × ($75 − $5) = $350,000]. Therefore, the gain is $150,000 ($500,000 − $350,000). Note that the tax rate (40%) is not used; components of income from continuing operations are reported gross with income tax expense deducted from the total income from continuing operations.

74

When a firm elects not to bifurcate a hybrid financial instrument, how should changes in fair value be recognized?

  1. As other comprehensive income.
  2. On a prospective basis in the current year earnings and future year’s earnings.
  3. As a prior period adjustment with restatement of previous years’ financial statements.
  4. As a cumulative effect adjustment to the beginning balance of retained earnings for the period.

On a prospective basis in the current year earnings and future year’s earnings.

The difference between the total carrying amount of the components of the bifurcated hybrid financial instruments and the fair value of the combined hybrid instruments should be recognized in earnings for the period.

75

An investor uses the equity method to account for an investment in common stock.  Assuming the fair value option of reporting financial assets is not elected, after the date of acquisition, the investment account of the investor would

  1. Not be affected by its share of the earnings or losses of the investee.
  2. Not be affected by its share of the earnings of the investee, but would be decreased by its share of the losses of the investee.
  3. Be increased by its share of the earnings of the investee, but would not be affected by its share of the losses of the investee.
  4. Be increased by its share of the earnings of the investee, and decreased by its share of the losses of the investee.

Be increased by its share of the earnings of the investee, and decreased by its share of the losses of the investee.

When an entity uses the equity method to account for an investment in another entity’s stock, the investment is recorded at cost on the date of acquisition. As the investee reports income or losses, the investor will recognize its percentage of ownership share of that income or loss by increasing or decreasing the investment account.

76

On January 1, year 1, Ball, Inc. purchased a $1,000,000 ordinary life insurance policy on its president.  The policy year and Ball’s accounting year coincide.  Additional data are available for the year ended December 31, year 3.

  • Cash surrender value, 1/1/Y3 $43,500
  • Cash surrender value, 12/31/Y3 $54,000
  • Annual advance premium paid 1/1/Y3 $20,000
  • Dividend received 7/1/Y3 $3,000

Ball, Inc. is the beneficiary under the life insurance policy.  How much should Ball report as life insurance expense for year 3?

  1. $6,500
  2. $9,500
  3. $17,000
  4. $20,000

$6,500

 

The cash surrender value (CSV) of the policy, which is an asset of the company, increased by $10,500 during year 3 ($54,000 − $43,500). Therefore, part of the premium paid is not expense, but a payment to increase the CSV.  The journal entry when the premium is paid is

  • Cash surrender value $10,500 
  • Insurance expense $9,500 
    •  Cash $20,000

The dividend received from the policy ($3,000) is not a dividend earned from a separate investment.  The dividend is received only because the company owns the insurance policy.  This related item should be offset against insurance expense.  When the cash is received, the entry is

  • Cash3,000
    •  Insurance expense3,000

Therefore, year 3 insurance expense is $6,500 ($9,500 − $3,000).

77

A marketable equity security is transferred from the available-for-sale portfolio to the trading securities portfolio. At the transfer date, the security’s cost exceeds its market value.  What amount is used at the transfer date to record the security in the trading portfolio?

  1. Market value, regardless of whether the decline in market value below cost is considered permanent or temporary.
  2. Market value, only if the decline in market value below cost is considered permanent.
  3. Cost, if the decline in market value below cost is considered temporary.
  4. Cost, regardless of whether the decline in market value below cost is considered permanent or temporary.

Market value, regardless of whether the decline in market value below cost is considered permanent or temporary.

A transfer of any marketable equity security from one category to another should be made at the security’s market value. The carrying value of the available-for-sale security would already have been at market value and, in this type of transfer, any unrealized holding gain or loss carried in "Accumulated other comprehensive income" at the date of the transfer would be recognized in earnings immediately.

78

Beach Co. determined that the decline in the fair value (FV) of an investment was below the amortized cost and permanent in nature.  The investment was classified as available-for-sale on Beach’s books.  Beach Co. does not elect the fair value option to account for these securities. The controller would properly record the decrease in FV by including it in which of the following?

  1. Other comprehensive income section of the income statement only.
  2. Earnings section of the income statement and writing down the cost basis to FV.
  3. Extraordinary items section of the income statement and writing down the cost basis to FV.
  4. Other comprehensive income section of the income statement, and writing down the cost basis to FV.

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

An available-for-sale security is valued at fair value at the balance sheet date, and any temporary decline in value is recorded in other comprehensive income for the period. However, because the decline was permanent (not temporary in nature), the available-for-sale security should be written down to fair value, and the amount of the write-down should be recorded in the income statement as a loss. Therefore, this answer is correct. The new cost basis would not be changed for subsequent recoveries in fair value; however, subsequent increases in the fair value of the available-for-sale security would be included in other comprehensive income in the year of the increase.

NOTE: This answer assumes the fair value option is not elected.

79

A short-term marketable debt security was purchased on September 1, year 1, between interest dates. The next interest payment date was February 1, year 2.  On the balance sheet at December 31, year 1, the debt security should be carried at

  1. Market value plus the accrued interest paid.
  2. Market value.
  3. Cost plus the accrued interest paid.
  4. Cost.

Market value.

A short-term marketable debt security would be carried in a trading portfolio. Securities in trading portfolios are carried at market value.

80

Taft Corp. uses the equity method to account for its 25% investment in Flame, Inc.  During year 2, Taft received dividends of $30,000 from Flame and recorded $180,000 as its equity in the earnings of Flame. Additional information follows:

  • All the undistributed earnings of Flame will be distributed as dividends in future periods.
  • The dividends received from Flame are eligible for the 80% dividends received deduction.
  • There are no other temporary differences.
  • Enacted income tax rates are 30% for year 2 and thereafter.

In its December 31, year 2 balance sheet, what amount should Taft report for deferred income tax liability?

  1. $9,000
  2. $10,800
  3. $45,000
  4. $54,000

$9,000

The deferred income tax liability is the result of the undistributed earnings of an equity investee, which are expected to be distributed as dividends in future periods.  For accounting purposes, investment revenue is $180,000, while for tax purposes, dividend revenue is $30,000, which will be partially offset by the 80% dividends received deduction.  Because of this deduction, the difference ($180,000 − $30,000 = $150,000) is partially a permanent difference (80% × $150,000 = $120,000) and partially a temporary difference (20% × $150,000 = $30,000 which will be taxable in future years).  This future taxable amount will be taxed at 30%, resulting in a deferred tax liability of $9,000 (30% × $30,000).

81

Assume the fair value option is not elected for reporting financial assets.  When an investor uses the equity method to account for investments in common stock, the investment account will be increased when the investor recognizes

  1. A proportionate interest in the net income of the investee.
  2. A cash dividend received from the investee.
  3. Periodic amortization of intangibles with definite lives related to the purchase.
  4. Depreciation related to the excess of market value over book value of the investee’s depreciable assets at the date of purchase by the investor.

A proportionate interest in the net income of the investee.

Under the equity method, an investor initially records an investment in stock at cost, and then adjusts the carrying amount of the investment to recognize the investor’s share of the earnings and losses of the investee subsequent to acquisition. When the investee reports periodic net income, the investor makes the following entry to record its share of earnings:

  • Investment in stock of investee xx 
    • Income from investment xx

82

During year 1, Wall Co. purchased 2,000 shares of Hemp Corp. common stock for $31,500 and properly classified the investment as available-for-sale.  The market value of this investment was $29,500 at December 31, year 1.  Wall did not elect to use the fair value option for reporting financial assets. Wall sold all of the Hemp common stock for $14 per share on December 15, year 2, incurring $1,400 in brokerage commissions and taxes.  On the sale, Wall should report a realized loss of

  1. $4,900
  2. $3,500
  3. $2,900
  4. $1,500

$4,900

A realized loss on the disposal of available-for-sale securities is the excess of the carrying value (before recognition of any unrealized gain or loss) of the investment ($31,500) over the net proceeds from the sale [(2,000 × $14) − $1,400 = $26,600].  Therefore, the loss is $4,900 ($31,500 − $26,600).  Changes in the market value of the MES before sale do not affect the computation of the realized loss. For example, at 12/31/Y1, the market value of the MES was below its cost, which required the security to be written down to $29,500 and a $2,000 unrealized loss to be recognized as other comprehensive income and included in accumulated other comprehensive income in the balance sheet.  However, the netting of these figures yields the equivalent of the investment’s original cost ($29,500 + $2,000 = $31,500). Upon sale of the investment in year 2, the $2,000 loss would be reversed out of “Accumulated other comprehensive income” by reporting the $2,000 as a reclassification adjustment that would increase “Other comprehensive income.”

83

On July 1, year 2, Denver Corp. purchased 3,000 shares of Eagle Co.’s 10,000 outstanding shares of common stock for $20 per share.  On December 15, year 2, Eagle paid $40,000 in dividends to its common stockholders. Eagle’s net income for the year ended December 31, year 2, was $120,000, earned evenly throughout the year.  Denver uses the equity method to account for its shares in Eagle. In its year 2 income statement, what amount of income from this investment should Denver report?

  1. $36,000
  2. $18,000
  3. $12,000
  4. $ 6,000

$18,000

This investment should be accounted for using the equity method since Denver owns a 30% interest (3,000 of 10,000 shares), which implies that Denver has significant influence over Eagle.  Since Eagle’s $120,000 net income was earned evenly throughout year 2, it can be assumed that Eagle’s net income since Denver’s July 1 purchases was $60,000 (6/12 × $120,000).  Denver’s share of Eagle’s earnings (30% × $60,000 = $18,000) would be recognized as investment revenue under the equity method. The dividends received by Denver (30% × $40,000 = $12,000) do not affect investment revenue using the equity method; they are recorded as a reduction of the investment account.

84

At year-end, Rim Co. held several investments with the intent of selling them in the near term. The investments consisted of $100,000, 8%, five-year bonds, purchased for $92,000, and equity securities purchased for $35,000.  At year-end, the bonds were selling on the open market for $105,000 and the equity securities had a market value of $50,000. What amount should Rim report as trading securities in its year­-end balance sheet?

  1. $50,000
  2. $127,000
  3. $142,000
  4. $155,000

$155,000

Both securities are trading securities and both should be valued at market value, or $155,000 ($105,000 + $50,000).

85

Green Corp. owns 30% of the outstanding common stock and 100% of the outstanding noncumulative nonvoting preferred stock of Axel Corp. In year 2, Axel declared dividends of $100,000 on its common stock and $60,000 on its preferred stock.  Green exercises significant influence over Axel’s operations.  Green uses the equity method to account for its investment in Axel.  What amount of dividend revenue should Green report in its income statement for the year ended December 31, year 2?

  1. $0
  2. $30,000
  3. $60,000
  4. $90,000

$60,000

The preferred dividends received by Green (100% × $60,000 = $60,000) are reported as dividend revenue in year 2. The common dividends received (30% × $100,000 = $30,000) are not reported as dividend revenue. Because the equity method is used (due to 30% ownership and significant influence), the common dividends received are recorded as a reduction of the investment account rather than as dividend revenue.

86

87

An investor uses the equity method to account for investments in common stock and does not elect to use the fair value option for reporting financial assets.  The purchase price implies a fair value of the investee’s depreciable assets in excess of the investee’s net asset carrying values. The investor’s amortization of the excess

  1. Decreases the investment account.
  2. Decreases the goodwill account.
  3. Increases the investment revenue account.
  4. Does not affect the investment account.

Decreases the investment account.

The difference between the cost of the investment and the carrying value of the net assets is known as the differential, which is periodically amortized to reduce the amount of the investment in the investee company.

88

Park Co. uses the equity method to account for its January 1, year 2 purchase of Tun Inc.’s common stock. On January 1, year 2, the fair values of Tun’s FIFO inventory and land exceeded their carrying amounts. How do these excesses of fair values over carrying amounts affect Park’s reported equity in Tun’s year 2 earnings?

  • Inventory excess
  • Land excess

  • Inventory excess - Decrease
  • Land excess - No Effect

When the equity method is used, the investor should amortize any portion of the excess of fair values over carrying amounts (differential) that relates to depreciable or amortizable assets held by the investee. Amortization of the differential results in a reduction of the investment account and a reduction in the equity of the investee’s earnings. Inventory is a depreciable asset. Therefore, amortization of the portion of the differential that relates to inventory would decrease Park’s reported equity in Tun’s earnings. Land is not a depreciable asset, so there would be no amortization of the differential related to land, and therefore no effect on Park’s reported equity.

89

On January 2 of the current year, LTTI Co. entered into a three-year, noncancellable contract to buy up to 1 million units of a product each year at $.10 per unit with a minimum annual guarantee purchase of 200,000 units.  At year-end, LTTI had only purchased 80,000 units and decided to cancel sales of the product.  What amount should LTTI report as a loss related to the purchase commitment as of December 31 of the current year?

  1. $0
  2. $8,000
  3. $12,000
  4. $52,000

$52,000

The cancellation of a firm purchase commitment to purchase goods results in an ineffective hedge and requires recognition of the total liability when the contract is canceled. Because LTTI purchased 80,000 units during year 1, it is liable for purchasing an additional 120,000 units in year 1, as well as 200,000 units in each of the next two years {[120,000 (for year 1) + 400,000 (for years 2 and 3)] × $0.10 per unit = $52,000}.

90

On January 1, year 2, Justo purchases 30,000 shares of the 100,000 outstanding shares of stock in Bonita Corp. for $5 per share.  During the year, Bonita Corporation has $20,000 of net income and pays $4,000 in dividends.  On December 31, year 2, the value of a share of Bonita Corporation stock is $6 per share. Assuming Justo uses the equity method of accounting for Bonita stock, what is the amount shown for Investment in Bonita on the December 31, year 2 balance sheet?

  1. $150,000
  2. $156,000
  3. $154,800
  4. $180,000

$154,800

If Justo accounts for the investment using ASC Topic 323 and the equity method of accounting, Justo will initially record the investment at cost. If Bonita Corporation has net income for the year, Justo will include its proportionate share of income as an increase in the investment account. Also, Justo will reduce the investment account for its share of the dividend. Therefore, at December 31, year 2, Justo will have $154,800 in its Investment in Bonita account [$150,000 + (30% × 20,000) − (30% × $4,000) = $154,800].

91

On April 1, Year 2, Calico Corp. purchases 10,000 shares of stock in Linwood Corporation for $60 per share, representing 5% of the outstanding shares of Linwood. Calico classifies the investment as an available-for-­sale security. During Year 2, Linwood pays a dividend of $.30 per share. On December 31, Year 2, the Linwood shares are valued at $62 per share. Calico elects to use the fair value option for reporting its investment in Linwood.  What is the amount that Calico will record as unrealized gain on the securities in its Year 2 income statement?

  1. $0
  2. $3,000
  3. $20,000
  4. $17,000

$20,000

The $3,000 (30 cents per share × 10,000 shares) is reported as dividend income on the income statement. Per ASC Topic 825, if the fair value option is elected, the difference between the fair value at December 31, Year 2 of $620,000 and the purchased price of $600,000 ($20,000) is an unrealized gain and is reported on the income statement.

92

Clara Corp. does not elect to use the fair value option to report financial assets.  For marketable debt securities included in Clara’s held-to-maturity portfolio, which of the following amounts should be included in the period’s net income?

  •  I.Unrealized temporary losses during the period.
  •  II.Gains on securities sold during the period.
  •  III.Permanent decline in value.

  • I.Unrealized temporary losses during the period. - NO
  •  II.Gains on securities sold during the period. - YES
  •  III.Permanent decline in value. - YES

II and III should be reported on the income statement. Unrealized gains and losses on held-to-maturity securities are not reported. Gains on securities sold should always be included as realized gains in the income statement of the applicable period. A permanent decline in value requires that the impaired security be written down to fair value. The amount of such a write-down is included in earnings as a realized loss.

93

Gil Co. began operations on January 3, year 1.  The following information was extracted from Gil Co.’s December 31, year 1 balance sheet:

  • Noncurrent assets: 
    • Long-term investments in marketable equity securities $96,450
  • Stockholders’ equity: 
  • Accumulated other comprehensive income: 
    • Net unrealized loss on investments in marketable equity securities (less tax benefit of 4,800) ($15,000)

Gil Co. did not elect to use the fair value option for reporting financial assets. Historical cost of the long-term investments in marketable equity securities was

  1. $63,595
  2. $76,650
  3. $96,450
  4. $116,250

$116,250

Since these equity securities were not purchased with the intent to sell them in the near term for a quick profit, they must be classified as available-for-sale securities. Unrealized gains and losses on available-for-sale marketable equity securities (MES) are reported as “Other comprehensive income” under one of three alternatives and as “Accumulated other comprehensive income,” a direct reduction of stockholders’ equity.  Thus, these MES must have been reduced by the amount of unrealized loss; the amount of the unrealized loss is the loss net of tax ($15,000) plus the tax benefit ($4,800) or $19,800.

The historical cost of the MES is $116,250 ($96,450 + $19,800).