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True/False Questions

 

  1. Securities classified as held to maturity could be reported as either current or long-term on a classified balance sheet, depending upon their maturity dates.

 

Answer: True     Learning Objective: 1       Level of Learning: 1

 

  1. Both debt and equity securities can be categorized as trading securities.

 

Answer: True     Learning Objective: 3       Level of Learning: 1

 

  1. Both trading securities and securities available for sale are reported at their fair values.

 

Answer: True     Learning Objective: 3       Level of Learning: 1

 

  1. When a creditor’s receivable becomes impaired due to a troubled debt restructuring, the receivable is remeasured based on the discounted present value of currently expected cash flows at the loan’s original effective rate.

 

Answer: True     Learning Objective: Appendix       Level of Learning: 1

 

  1. All securities considered available for sale should be reported as current assets in a classified balance sheet.

 

Answer: False     Learning Objective: 2       Level of Learning: 1

 

  1. Purchases and sales of securities are always reported as investing activities on a statement of cash flows.

 

Answer: False     Learning Objective: 2       Level of Learning: 1

 

  1. All investments in debt securities whose fair values are not readily determinable are carried at historical cost.

 

Answer: False     Learning Objective: 1       Level of Learning: 1

 

  1. Net unrealized holding gains (losses) are reported on the income statement for trading securities.

 

Answer: True     Learning Objective: 3       Level of Learning: 1

 

  1. Routine transfers of debt and equity investments among the trading, available for sale, and held to maturity portfolios need not be disclosed in the financial statements.

 

Answer: False     Learning Objective: 3       Level of Learning: 2

 

  1. The equity method is in many ways a partial consolidation.

 

Answer: True     Learning Objective: 5       Level of Learning: 1

 

 

  1. Under the equity method of accounting for a stock investment, cash dividends received are considered a reduction of the investee’s net assets.

 

Answer: True     Learning Objective: 5       Level of Learning: 1

 

  1. When an equity method investment is sold, a gain or loss is recognized for the difference between its selling price and its cost.

 

Answer: False     Learning Objective: 5       Level of Learning: 1

 

 

Matching Pair Questions

 

Use the following to answer questions 13-22:

 

  • Indicate (by letter) the level of stock ownership that most frequently relates to each concept listed below.

 

Level of Stock Ownership:

  1. Less than 20%
  2. 20% — 50%
  3. More than 50%

Accounting/Reporting Concept:

  1. ____ The investor can significantly influence the investee’s operating and financial policies.
  2. ____ The reporting of the investment depends on the intent of management to hold or trade it.
  3. ____ The investment is reported at cost, adjusted for subsequent growth in the investee.
  4. ____ The investment is reported at fair value.
  5. ____ Financial statements are combined as if a single company.
  6. ____ The investor controls the investee.
  7. ____ Unrealized gains and losses are recorded at each reporting date.
  8. ____ The investee is a subsidiary of the investor.
  9. ____ Assets and liabilities of the investee are combined with those of investor for reporting purposes.
  10. ____ The investor does not include an investment account for the investee in the balance sheet.

 

Answer: 13-B; 14-A; 15-B; 16-A; 17-C; 18-C; 19-A; 20-C; 21-C; 22-C

 

 

Use the following to answer questions 23-32:

 

23-32.  Indicate (by letter) the way each of the investments listed below usually should be accounted for based on the information provided.

 

Reporting Category:

  1. Trading Securities
  2. Securities Held to Maturity
  3. Securities Available for Sale
  4. Equity Method
  5. Consolidation
  6. None of the above

Investments:

  1. ____ Accounts Receivable.
  2. ____ Treasury bonds held for short-term profit.
  3. ____ Common stock held for immediate resale.
  4. ____ 40% of the voting common stock of XYZ Company.
  5. ____ 85% of the voting common stock of ABC Corporation.
  6. ____ 25% of the voting common stock of DEF Corporation.
  7. ____ 50% of the voting common stock of JMG Corporation.
  8. ____ 18% of Griggs corporation; investor’s CEO on the board of directors of Griggs Corp; no  other investor owns more than 1%.
  9. ____ Corporate bonds to be held for full term of 10 years.

 

Answer: 23-C; 24-F; 25-A; 26-A; 27-D; 28-E; 29-D; 30-D; 31-D; 32-B

 

Use the following to answer questions 33-37:

 

33-37.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

  1. Change from the equity method
  2. Change to the equity method
  3. Dividends received
  4. Financial instrument
  5. Gross realized and unrealized holding gains and losses
  6. Securities available for sale
  7. Trading securities and securities available for sale
  8. Trading securities
  9. Unrealized gains
  10. Unrealized losses

Phrases:

  1. ____ Temporary decline in the fair value of an available for sale security.
  2. ____ Reported at fair value.
  3. ____ Changes in market value affect comprehensive income, but not net income.
  4. ____ Changes in market value affect net income.
  5. ____ Considered a reduction of investment account’s balance under the equity method.

 

Answer: 33-J; 34-G; 35-F; 36-H; 37-C

 

 

Use the following to answer questions 38-42:

 

38-42.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

  1. Change from the equity method
  2. Change to the equity method
  3. Dividends received
  4. Financial instrument
  5. Gross realized and unrealized holding gains and losses
  6. Securities available for sale
  7. Trading securities and securities available for sale securities
  8. Trading securities
  9. Unrealized gains
  10. Unrealized losses

Phrases:

  1. ____ Included in disclosure notes for each year presented.
  2. ____ Accounted for prospectively.
  3. ____ Accounted for retroactively.
  4. ____ Encompasses cash, equity securities, and debt securities
  5. ____ When related to trading securities, they increase net income.

 

Answer: 38-E; 39-A; 40-B; 41-D; 42-I

 

Use the following to answer questions 43-47:

 

Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

  1. Additional depreciation
  2. Amortization of purchased patent
  3. Consolidation
  4. Derivatives
  5. Equity method
  6. Extraordinary item
  7. Holding gains and losses
  8. Impairment of securities available for sale
  9. Losses of investee
  10. Securities held to maturity

Phrases:

  1. ____ Recognized only to the extent of carrying value under the equity method.
  2. ____ Reported on the income statement for trading securities.
  3. ____ Reduces investment account under the equity method due to change in intangible asset.
  4. ____ Requires positive intent and ability.
  5. ____ Requires recognition on the income statement if judged to be other than temporary.

 

Answer: 43-I; 44-G; 45-B; 46-J; 47-H

 

 

Use the following to answer questions 48-52:

 

48-52.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

  1. Additional depreciation
  2. Amortization of purchased patent
  3. Consolidation
  4. Derivatives
  5. Equity method
  6. Extraordinary item
  7. Holding gains and losses
  8. Impairment of securities available for sale
  9. Losses of investee
  10. Securities held to maturity

Phrases:

  1. ____ Results when fair value of investee’s assets exceeds carrying value.
  2. ____ Reported by investor, below income from continuing operations and in proportion to ownership interest in investee.
  3. ____ Used when investor can significantly influence investee.
  4. ____ Used when investor has effective control of investee.
  5. ____ Have value based on some other security or index.

 

Answer: 48-A; 49-F; 50-E; 51-C; 52-D

 

 

Multiple Choice Questions

 

  1. The investment category for which the investor’s «positive intent and ability to hold» is important is:
  2. A) Securities reported under the equity method.
  3. B) Trading securities.
  4. C) Securities classified as held to maturity.
  5. D) Securities available for sale.

 

Answer: C     Learning Objective: 1       Level of Learning: 1

 

  1. The fair value of debt securities not regularly traded can be reasonably approximated by:
  2. A) Calculating the discounted present value of the principal and interest payments.
  3. B) Determining the value using similar securities in the NASDAQ market.
  4. C) Using the relative fair value method.
  5. D) Calling a licensed and registered stockbroker.

 

Answer: A     Learning Objective: 2       Level of Learning: 1

 

 

  1. Securities that are purchased with the intent of selling them in the near future to take advantage of short-term price changes are classified as:
  2. A) Securities available for sale.
  3. B) Consolidating securities.
  4. C) Held-to-maturity securities.
  5. D) Trading securities.

 

Answer: D     Learning Objective: 3       Level of Learning: 1

 

  1. Both fair values and subsequent growth of the investee are irrelevant for investments in which of the following categories?
  2. A) Securities reported under the equity method.
  3. B) Trading securities.
  4. C) Held-to-maturity securities.
  5. D) Securities available for sale.

 

Answer: C     Learning Objective: 1       Level of Learning: 2

 

  1. All investments in debt and equity securities that don’t fit the definitions of the other reporting categories are classified as:
  2. A) Trading securities.
  3. B) Securities available for sale.
  4. C) Held-to-maturity securities.
  5. D) Consolidated securities.

 

Answer: B     Learning Objective: 2       Level of Learning: 1

 

  1. Investments in securities available for sale are reported at:
  2. A) Discounted present value.
  3. B) Lower of cost or market.
  4. C) Historical cost.
  5. D) Fair value on the reporting date.

 

Answer: D     Learning Objective: 2       Level of Learning: 1

 

  1. The income statement reports changes in fair value for which type of securities?
  2. A) Securities reported under the equity method.
  3. B) Trading securities
  4. C) Held-to-maturity securities.
  5. D) Securities available for sale.

 

Answer: B     Learning Objective: 3       Level of Learning: 1

 

  1. The shareholders’ equity section of the balance sheet reflects changes in the fair value of securities for which type of securities?
  2. A) Securities available for sale.
  3. B) Trading securities.
  4. C) Consolidated securities.
  5. D) Held-to-maturity securities.

 

Answer: A     Learning Objective: 2       Level of Learning: 2

 

 

 

  1. Which category completely excludes equity securities?
  2. A) Securities available for sale.
  3. B) Consolidating securities.
  4. C) Held-to-maturity securities.
  5. D) Trading securities.

 

Answer: C     Learning Objective: 1       Level of Learning: 2

 

  1. The rules of FASB Statement No. 115, «Accounting for Certain Debt and Equity Securities,» generally apply when the percentage of ownership of another company is:
  2. A) Less than 20%.
  3. B) 20% to 50%.
  4. C) Over 50%.
  5. D) Exactly 100%.

 

Answer: A     Learning Objective: 2       Level of Learning: 2

 

  1. If the fair value of equity securities is not determinable and the equity method is not appropriate, the securities should be reported at:
  2. A) Amortized cost.
  3. B)
  4. C) Consolidated value.
  5. D) Net present value.

 

Answer: B     Learning Objective: 5       Level of Learning: 2

 

  1. When an investor uses the cost method to account for an investment in common stock, cash dividends are classified by the investor as:
  2. A) A return of capital.
  3. B) A loss.
  4. C) A deduction from the investment account.
  5. D) Dividend income.

 

Answer: D     Learning Objective: 2       Level of Learning: 2

 

  1. When an equity security is appropriately carried and reported using the cost method, a gain should be reported:
  2. A) When the fair market value of the security changes.
  3. B) When the present value of the security changes.
  4. C) Only when the Dow Jones Industrial Average increases at least 100 points.
  5. D) Only when the security is sold.

 

Answer: D     Learning Objective: 2       Level of Learning: 2

 

  1. Investments in securities to be held for an unspecified period of time are reported at:
  2. A) Historical cost.
  3. B) Present value.
  4. C) Lower of cost or market.
  5. D) Fair value.

 

Answer: D     Learning Objective: 2       Level of Learning: 2

 

 

 

  1. All investment securities are initially recorded at:
  2. A) Cost.
  3. B) Present value.
  4. C) Equity value.
  5. D) None of the above is correct.

 

Answer: A     Learning Objective: 2       Level of Learning: 1

 

  1. Unrealized holding gains and losses on securities available for sale would have the following effects on shareholders’ equity:
Gains Losses
A) Increase Increase
B) Decrease Decrease
C) Decrease Increase
D) Increase Decrease

 

Answer: D     Learning Objective: 2       Level of Learning: 2

 

  1. When an impairment of securities available for sale occurs for a reason that is judged to be «other than temporary,» the investment is written down to its fair market value and the amount of the write-down is:
  2. A) Recorded as a deferred credit.
  3. B) Included in income.
  4. C) Recorded as deferred asset.
  5. D) Treated as unrealized.

 

Answer: B     Learning Objective: 2       Level of Learning: 2

 

  1. Trading securities are most commonly found on the books of:
  2. A) Oil companies.
  3. B) Manufacturing companies.
  4. C)
  5. D) Foreign subsidiaries.

 

Answer: C     Learning Objective: 3       Level of Learning: 1

 

  1. For trading securities, unrealized holding gains and losses are included in earnings:
  2. A) Only at the end of the fiscal year.
  3. B) On each reporting date.
  4. C) Only when they exceed 10% of the underlying investment.
  5. D) Based on a vote of the board of directors.

 

Answer: B     Learning Objective: 3       Level of Learning: 1

 

  1. Holding gains and losses on trading securities are included in earnings because:
  2. A) They measure the success or failure of taking advantage of short-term price changes.
  3. B) The IRS mandates the inclusion.
  4. C) The SEC mandates the inclusion.
  5. D) They measure the book value of the securities on the balance sheet date.

 

Answer: A     Learning Objective: 3       Level of Learning: 2

 

 

 

  1. Trading securities, by definition, are properly classified on the balance sheet as:
  2. A)
  3. B)
  4. C) Current assets.
  5. D) Other assets.

 

Answer: C     Learning Objective: 3       Level of Learning: 1

 

  1. On the statement of cash flows, inflows and outflows of cash from buying and selling trading securities typically are considered:
  2. A) Investing activities.
  3. B) Operating activities.
  4. C) Financing activities.
  5. D) Noncash financing activities.

 

Answer: B     Learning Objective: 3       Level of Learning: 2

 

  1. On the statement of cash flows, inflows and outflows of cash from buying and selling available for sale securities are considered:
  2. A) Operating activities.
  3. B) Financing activities.
  4. C) Investing activities.
  5. D) Noncash financing activities.

 

Answer: C     Learning Objective: 2       Level of Learning: 2

 

  1. The equity method of accounting for investments in voting common stock is appropriate when:
  2. A) The investor can significantly influence the investee.
  3. B) The investor has voting control over the investee.
  4. C) The investor intends to vote the common stock.
  5. D) The investor is assured of a continued supply of a valuable raw material.

 

Answer: A     Learning Objective: 4       Level of Learning: 1

 

  1. Consolidated financial statements are prepared when one company has:
  2. A) Accounted for the investment using the equity method.
  3. B) Accounted for the investment using the cost method.
  4. C) Significant influence over another company.
  5. D) None of the above is correct.

 

Answer: D     Learning Objective: 4       Level of Learning: 1

 

  1. When using the equity method to account for an investment, cash dividends received by the investor from the investee should be recorded:
  2. A) As a reduction in the investment account.
  3. B) As an increase in the investment account.
  4. C) As dividend income.
  5. D) As a contra item to stockholders’ equity.

 

Answer: A     Learning Objective: 5       Level of Learning: 1

 

 

 

  1. When the equity method of accounting for investments is used by the investor, the investment account is increased when:
  2. A) A cash dividend is received from the investee.
  3. B) The investee reports a net income for the year.
  4. C) The investor records additional depreciation related to the investment.
  5. D) The investee reports a net loss for the year.

 

Answer: B     Learning Objective: 5       Level of Learning: 1

 

  1. When the equity method of accounting for investments is used by the investor, the amortization of additional depreciation due to differences between book values and fair values of investee assets on the date of acquisition:
  2. A) Reduces the investment account and increases investment revenue.
  3. B) Increases the investment account and increases investment revenue.
  4. C) Reduces the investment account and reduces investment revenue.
  5. D) Increases the investment account and reduces investment revenue.

 

Answer: C     Learning Objective: 6       Level of Learning: 2

 

  1. When the investor’s level of influence changes, it may be necessary to change from the equity method to another method.  When the level of ownership falls from a range of 20% to 50% to less than 20%, the equity method would be discontinued and the investment account balance would be carried over at:
  2. A) Amortized cost on the date of ownership change.
  3. B) Fair market value on the date of ownership change.
  4. C) Discounted present value on the date of ownership change.
  5. D) The current balance, and this balance would serve as the new «cost».

 

Answer: D     Learning Objective: 5       Level of Learning: 2

 

  1. When the investor’s level of influence changes, it may be necessary to change to the equity method from another method.  When the level of ownership rises from less than 20% to a range of 20% to 50%, the equity method would become appropriate and the investment account balance should be:
  2. A) Retroactively adjusted to the balance that would have existed if the equity method had been in effect for prior years.
  3. B) Carried over as is with no adjustment necessary.
  4. C) Carried over at fair market value on date of transfer.
  5. D) Adjusted to reflect amortized cost.

 

Answer: A     Learning Objective: 5       Level of Learning: 2

 

  1. What is the effect on a company’s cash flows and reported profit from using a particular method to account for an investment in another company?
Effect on Cash Flows Effect on Profit
A) Little, if any, effect Little, if any, effect
B) Significant effect Significant effect
C) Little, if any, effect Significant effect
D) Significant effect Little, if any, effect

 

Answer: C     Learning Objective: 2       Level of Learning: 2

 

 

  1. If Pop Company owns 15% of the common stock of Son Company, then Pop Company:
  2. A) Would record 15% of the net income of Son Company as investment income each year.
  3. B) Records dividends received from Son Company as investment revenue.
  4. C) Would increase its investment account by 15% of Son Company income each year.
  5. D) All of the above are correct.

 

Answer: B     Learning Objective: 4       Level of Learning: 2

 

  1. If Pop Company exercises significant influence over Son Company and owns 40% of its common stock, then Pop Company:
  2. A) Records dividends received from Son Company as investment revenue.
  3. B) Would increase its investment account when Son Company declares dividends.
  4. C) Would record 40% of the net income of Son Company as investment income each year.
  5. D) All of the above are correct.

 

Answer: C     Learning Objective: 4       Level of Learning: 2

 

  1. Which of the following increases the investment account under the equity method of accounting?
  2. A) Decreasing the market price of the investee’s stock
  3. B) Dividends paid by the investee that were declared in the previous year
  4. C) Net loss of the investee company
  5. D) None of the above is correct.

 

Answer: D     Learning Objective: 5       Level of Learning: 1

Rationale: None of the transactions increase the owners’ equity of the investee.

 

  1. Which of the following investment securities held by Zoogle Inc. may be classified as held-to-maturity securities in its balance sheet?
  2. A) Long-term debenture bonds
  3. B) Common stock
  4. C) Callable preferred stock
  5. A) All of the above are correct.

 

Answer: A     Learning Objective: 1       Level of Learning: 1

 

  1. Which of the following investment securities held by Zoogle Inc. are not reported at fair value in its balance sheet?
  2. A) Common stock held as available for sale securities
  3. B) Debt securities held to maturity
  4. C) Preferred stock held as trading securities
  5. D) All of the above are reported at fair value.

 

Answer: B     Learning Objective: 1       Level of Learning: 1

 

 

  1. Assume that, on 1/1/06, Matsui Co. paid $1,200,000 for its investment in 60,000 shares of Yankee Inc.  Further, assume that Yankee has 200,000 total shares of stock issued.  The book value and fair value of Yankee’s identifiable net assets were both $4,000,000 at 1/1/06. The following information pertains to Yankee during 2006:

 

Net Income $200,000
Dividends declared and paid $60,000
Market price of common stock on 12/31/06 $22/share

 

What amount would Matsui report in its year-end 2006 balance sheet for its investment in Yankee?

  1. A) $1,320,000
  2. B) $1,260,000
  3. C) $1,242,000
  4. D) None of the above is correct.

 

Answer: C     Learning Objective: 5       Level of Learning: 3

Rationale: This is $1,200,000 + (30% x $200,000 net income) (30% x $60,000 dividends).

 

  1. Assume that, on 1/1/05, Sosa Enterprises paid $3,000,000 for its investment in 40,000 shares of Orioles Co.  Further, assume that Orioles has 120,000 total shares of stock issued, and estimates an 8 year remaining useful life and straight-line depreciation with no residual value for its depreciable assets.

 

The book value and fair value of Orioles’ identifiable net assets were $7,000,000 and $10,000,000, respectively, at 1/1/05. The difference between the fair value and book value of Orioles is attributable to $1,800,000 of goodwill and the remainder to depreciable equipment.

 

The following information pertains to Orioles during 2005:

 

Net Income $600,000
Dividends declared and paid $360,000
Market price of common stock on 12/31/06 $80/share

 

What amount would Sosa Enterprises report in its year-end 2005 balance sheet for its investment in Orioles Co.?

  1. A) $3,200,000
  2. B) $3,180,000
  3. C) $3,135,000
  4. D) $3,027,000

 

Answer: D     Learning Objective: 6       Level of Learning: 3

Rationale: This is $3,000,000 + (30% x $600,000 net income) (30% x $360,000 dividends) (30% x $1,200,000/8 yrs. of additional depreciation).

 

 

Use the following to answer questions 91-93:

 

Beresford Inc. purchased several investment securities during 2005, its first year of operations. The following information pertains to these securities.  The fluctuations in their fair values are not considered permanent.

 

Fair Value Fair Value Amortized Amortized
Held to Maturity Securities: 12/31/05 12/31/06 Cost 12/31/05 Cost 12/31/06
     ABC Co. Bonds $375,000 $400,000 $367,500 $360,000
Fair Value Fair Value
Trading Securities: 12/31/05 12/31/06 Cost
     DEF Co. Stock $48,000 $59,500 $66,000
     GEH Inc. Stock $47,000 $77,000 $39,000
     IJK Inc. Stock $44,000 $38,500 $32,900
Fair Value Fair Value
Available for Sale Securities: 12/31/05 12/31/06 Cost
     LMN Co. Stock $130,500 $150,400 $140,000

 

  1. What balance sheet amount would Beresford report for its total investment securities at 12/31/05?
  2. A) $637,000
  3. B) $644,500
  4. C) $645,400
  5. D) None of the above is correct.

 

Answer: A     Learning Objective: 1       Level of Learning: 3

Rationale: The held-to-maturity securities are reported at amortized cost, and the others are reported at fair value.

 

  1. What total holding gain would Beresford report in its 2006 income statement relative to its investment securities?
  2. A) $55,900
  3. B) $36,000
  4. C) $80,900
  5. D) $48,200

 

Answer: B     Learning Objective: 2       Level of Learning: 3

Rationale: This is the difference between the fair values of trading securities at 12/31/06 from 12/31/05.

 

  1. What holding gain would Beresford report in a special section of shareholders’ equity in its 12/31/06 balance sheet?
  2. A) $55,100
  3. B) $26,500
  4. C) $10,400
  5. D) None of the above is correct.

 

Answer: C     Learning Objective: 3       Level of Learning: 3

Rationale: This is the cumulative increase in fair value above cost for its available-for-sale securities.

 

 

  1. On January 1, 2006, Nana Company paid $100,000 for 8,000 shares of Papa Company common stock. These securities were classified as trading securities. The ownership in Papa Company is 10%. Papa reported net income of $52,000 for the year ended December 31, 2006. The fair value of the Papa stock on that date was $45 per share. What amount will be reported on the balance sheet of Nana Company for the investment in Papa at December 31, 2006?
  2. A) $284,400.
  3. B) $300,000.
  4. C) $315,600.
  5. D) $360,000.

 

Answer: D     Learning Objective: 3       Level of Learning: 3

Rationale:

8,000 x $45 = $360,000

Trading securities are reported at fair value.

 

  1. On January 1, 2006, Everglade Company purchased the following securities and properly accounted for them as securities available for sale:

 

Security Cost Market Value on 12/31/2006
ABC $40,000 $55,000
DEF 72,000   65,000
XYZ 16,000   20,000

 

All declines in value are considered temporary. What amount should the Everglade Company report relative to these securities in its 2006 income statement?

  1. A) $0.
  2. B) $19,000 unrealized gain.
  3. C) $12,000 net unrealized gain.
  4. D) $7,000 unrealized loss.

 

Answer: A     Learning Objective: 2       Level of Learning: 3

Rationale: Unrealized gains and losses on securities available for sale do not affect income.

 

  1. Goofy Inc. bought 15,000 shares of Crazy Co.’s stock for $150,000 on May 5, 2005, and classified the stock as available for sale. The market value of the stock declined to $118,000 by December 31, 2005. Goofy reclassified this investment as trading securities in December of 2006 when the market value had risen to $125,000. What effect on 2006 income should be reported by Goofy for the Crazy Co. shares?
  2. A) $0.
  3. B) $25,000 net loss.
  4. C) $7,000 net gain..
  5. D) $32,000 net loss.

 

Answer: B     Learning Objective: 3       Level of Learning: 3

Rationale: Unrealized loss of $32,000 recorded in an allowance during 2005, but not included in the income statement.  When the shares are reclassified in 2006, the $32,000 goes into the income statement.  In addition, $7,000 unrealized gain for 2006 goes directly to income.

 

 

  1. Boulter, Inc. began business on January 1, 2006. At the end of December 2006, Boulter had the following investments in equity securities:

 

Trading Available for Sale
Cost $60,000 $110,000
Market Value   54,000   107,500

 

All declines in value are deemed to be temporary in nature. How should the corresponding losses be reflected in the financial statements at December 31, 2006?

 

Income Separate Component of Shareholders’ Equity
A) $8,500 $  0
B) $  0 $8,500
C) $6,000 $  2,500
D) $  2,500 $6,000

 

Answer: C   Learning Objective: 2       Level of Learning: 3

Rationale:

Unrealized loss on trading securities is included in income: $60,000 $54,000 = $6,000

Unrealized loss on securities available for sale is reported as a separate component of shareholders’ equity: $110,000 $107,500 = $2,500

 

  1. Hobson Company bought the securities listed below during 2005. These securities were classified as trading securities. On its December 31, 2005, income statement Hobson reported a net unrealized loss of $13,000 on these securities. Pertinent data at the end of December 2006 are as follows:

 

Security Cost Fair Value
X $380,000 $352,000
Y 180,000 160,000
Z 420,000 414,000

 

What amount of loss on these securities should Hobson include in its income statement for the year ended December 31, 2006?

  1. A) $41,000.
  2. B) $54,000.
  3. C) $13,000.
  4. D) $

 

Answer: A     Learning Objective: 3       Level of Learning: 3

Rationale:

Security Cost 12/31/06 Value
X $380,000 $352,000
Y 180,000 160,000
Z   420,000   414,000
$980,000 $926,000
Total unrealized loss to date: $980,000 – $926,000 $54,000
Less unrealized loss recognized in 2005   13,000
Unrealized loss to report for 2006 $41,000
 

 

  1. Zwick Company bought 28,000 shares of the voting common stock of Handy Corporation in January 2006. In December, Hart announced $200,000 net income for 2006 and declared and paid a cash dividend of $2 per share on the 200,000 shares of outstanding common stock. Zwick Company’s dividend revenue from Handy Corporation in December 2006 would be:
  2. A) $
  3. B) $32,000.
  4. C) $56,000.
  5. D) None of the above is correct.

 

Answer: C     Learning Objective: 2       Level of Learning: 3

Rationale:

Ownership share = 28,000/200,000 = 14%, so neither the equity method nor consolidation is appropriate.

28,000 shares x $2.00 per share = $56,000

 

  1. On January 2, 2005, Howdy Doody Corporation purchased 12% of Ranger Corporation’s common stock for $50,000 and classified the investment as available for sale. Ranger’s net income for the years ended December 31, 2005 and 2006, were $10,000 and $50,000, respectively. During 2006, Ranger declared and paid a dividend of $60,000. There were no dividends in 2005. On December 31, 2005, the fair value of the Ranger stock owned by Howdy Doody had increased to $70,000. How much should Howdy Doody show on the 2006 income statement as income from this investment?
  2. A) $26,000.
  3. B) $  7,200.
  4. C) $20,000.
  5. D) $27,200.

 

Answer: B     Learning Objective: 2       Level of Learning: 3

Rationale:

Investment revenue from dividends:

$60,000 x 12% = $7,200

 

Any change in fair value during 2006 would be reflected in shareholders’ equity but would not affect net income.

 

  1. Anthers Inc. bought the following portfolio of trading securities near the end of 2006.

 

Security Cost Market Value 12/31/2006
A $80,000 $84,000
B 60,000 54,000
C 22,000 22,000

 

What amount will be reported on the balance sheet for this portfolio at December 31, 2006, and how will it be classified?

Amount Classification
A) $162,000 Investment
B) $162,000 Current Asset
C) $160,000 Investment
D) $160,000 Current Asset

 

Answer: D     Learning Objective: 3       Level of Learning: 3

Rationale: $84,000 + $54,000 + $22,000 = $160,000

 

 

  1. Jeremiah Corporation purchased securities during 2006 and classified them as securities available for sale:

 

Security Cost Fair Value,
12/31/2006
A $40,000 $49,000
B 70,000 66,000
C 28,000 39,000

 

All declines are considered to be temporary. How much gain will be reported by Jeremiah Corporation on the December 31, 2006, income statement relative to the portfolio?

  1. A) $0.
  2. B) $16,000.
  3. C) $20,000.
  4. D) None of the above is correct.

 

Answer: A     Learning Objective: 2       Level of Learning: 3

Rationale: Unrealized gains and losses are not included in earnings for securities available for sale.

 

  1. On January 1, 2006, Green Corporation purchased 20% of the outstanding voting common stock of Gold Company for $300,000. The book value of the acquired shares was $275,000. The excess of cost over book value is attributable to an intangible asset on Gold’s books that was undervalued and had a remaining useful life of five years. For the year ended December 31, 2003, White reported net income of $125,000 and paid cash dividends of $25,000. What is the carrying value of Green’s investment in Gold at December 31, 2006?
  2. A) $295,000.
  3. B) $300,000.
  4. C) $315,000.
  5. D) $320,000.

 

Answer: C     Learning Objective: 6       Level of Learning: 3

Rationale:

Cost $300,000
Share of NI: 20% x $125,000 $  25,000
Share of dividends: 20% x $25,000 (5,000 )
Amortization of intangible: ($300,000 – $275,000)/5   (5,000 )
Carrying value, 12/31/06 $315,000
 

 

 

 

  1. Hope Company bought 30% of Faith Corporation in 2006. During 2006, Faith reported net income in the amount of $4,000,000 and declared and paid dividends in the amount of $500,000. Hope mistakenly accounted for the investment using the cost method instead of the equity method. What effect would this error have on the investment account and net income, respectively, for 2006?
  2. A) Overstated by $1,050,000; understated by $1,050,000.
  3. B) Understated by $1,050,000; understated by $1,050,000.
  4. C) Overstated by $1,200,000; overstated by $1,200,000.
  5. D) Understated by $1,200,000; overstated by $1,050,000.

 

Answer: B     Learning Objective: 5       Level of Learning: 3

Rationale:

 

Net Income: Cost Method Equity Method
Investment 1,200,000
     Investment revenue 1,200,000
Dividends
Cash 150,000
     Investment revenue 150,000
Cash 150,000
     Investment 150,000

 

Net increase in investment of $1,200,000 $150,000 = $1,050,000 was not reported using the cost method.

 

Also, the reported investment revenue of $150,000 was $1,050,000 less than the $1,200,000 that should have also been reported.

 

  1. Sox Corporation purchased a 40% interest in Hack Corporation for $1,500,000 on Jan 1, 2006. On November 1, 2006, Hack declared and paid $1 million in dividends. On December 31, Hack reported a net loss of $6 million for the year. What amount of loss should Sox report on its income statement for 2006 relative to its investment in Hack?
  2. A) $1,100,000.
  3. B) $2,400,000.
  4. C) $1,500,000.
  5. D) $1,600,000.

 

Answer: A     Learning Objective: 5       Level of Learning: 3

Rationale:

Carrying value before net loss:

($1,500,000 (40% x $1,000,000) = $1,100,000

 

Sox’s share of net loss = $6 million x 40% = $2.4 million. Because the investment account cannot be reduced below zero, the loss reported in 2006 would be only $1,100,000.

 

 

  1. Jack Corporation purchased a 20% interest in Jill Corporation for $1,500,000 on January 1, 2006. Jack can significantly influence Jill. On December 10, 2006, Jill declared and paid $1 million in dividends. Jill reported a net loss of $6 million for the year. What amount of loss should Jack report on its income statement for 2006 relative to its investment in Jill?
  2. A) $1 000,000.
  3. B) $1,200,000.
  4. C) $1,400,000.
  5. D) $1,500,000.

 

Answer: B     Learning Objective: 4       Level of Learning: 3

Rationale:

Carrying value before net loss:

($1,500,000 (20% x $1,000,000) = $1,300,000

 

Jack’s share of net loss would be recognized in full: 20% x $6,000,000 = $1,200,000.

 

  1. Hawk Corporation purchased ten thousand shares of Diamond Corporation stock in 2003 for $50 per share and classified the investment as securities available for sale. Diamond’s market value was $60 per share on December 31, 2004, and $65 on December 31, 2005. During 2006, Hawk sold all of its Diamond stock at $70 per share. In its 2006 income statement, Hawk would report:
  2. A) A gain of $100,000.
  3. B) A gain of $150,000.
  4. C) A gain of $200,000
  5. D) A gain of $300,000.

 

Answer: C     Learning Objective: 2       Level of Learning: 3

Rationale:

In 2003-2005, Hawk accumulated an unrealized gain and fair value adjustment of ($65 50) x 10,000 = $150,000.  An additional increase of $50,000 occurred in 2006, so the total gain realized in the income statement would be $200,000.

 

  1. Dim Corporation purchased one thousand shares of Witt Corporation stock in 2003 for $800 per share and classified the investment as securities available for sale. Witt’s market value was $400 per share on December 31, 2004, and $300 on December 31, 2005. During 2006, Dim sold all of its Witt stock at $350 per share. For 2006, Dim would report:
  2. A) A realized gain of $50,000.
  3. B) A recognition of unrealized losses of $400,000.
  4. C) A loss on the sale of investments of $450,000.
  5. D) A trading gain of $50,000 and an unrealized loss of $500,000.

 

Answer: C     Learning Objective: 2       Level of Learning: 3

Rationale:

Cash 350,000
Loss on sale of investments 450,000
     Unrealized holding loss 500,000
     Investment in Witt 300,000

 

 

 

  1. Dicker Furriers purchased one thousand shares of Loose Corporation stock on January 10, 2005, for $800 per share and classified the investment as securities available for sale. Loose’s market value was $400 per share on December 31, 2005. As of December 31, 2006, Dicker still owned the Loose stock whose market value has declined to $100 per share. The decline is due to a reason that’s judged to be other than temporary. Dicker’s December 31, 2006, balance sheet and the 2006 income statement would show the following:
Unrealized loss on investments Investment in Loose stock Income statement loss on investments
A) 0 100,000 700,000
B) 700,000 100,000 300,000
C) 400,000 400,000 0
D) 0 100,000 300,000

 

Answer: A     Learning Objective: 2       Level of Learning: 3

Rationale:

12/31/05 Unrealized loss 400,000
       Investment in Loose 400,000
12/31/06 Loss due to impairment 700,000
       Unrealized loss 400,000
       Investment in Loose 300,000

 

  1. In 2004, Osgood Corporation purchased $4 million in ten-year municipal bonds at face value. On December 31, 2006, the bonds had a market value of $3,600,000 and Osgood reclassified the bonds from held to maturity to trading securities. Osgood’s December 31, 2006, balance sheet and the 2006 income statement would show the following:
Unrealized loss on investments Investment in municipal bonds Income statement loss on investments
A) 400,000 3,600,000 0
B) 0 3,600,000 400,000
C) (400,000) 4,000,000 400,000
D) 400,000 4,000,000 0

 

Answer: B     Learning Objective: 1       Level of Learning: 3

Rationale: The unrealized loss ($400,000) on transfer to new category of trading securities is included in income.

 

Use the following to answer questions 111-112:

 

At the start of the current year, SBC Corp. purchased 30% of Sky Tech Inc. for $45 million. At the time of purchase, the carrying value of Sky Tech’s net assets was $75 million. The fair market value of Sky Tech’s depreciable assets was $15 million in excess of their book value. For this year, Sky Tech reported a net income of $75 million and declared and paid $15 million in dividends.

 

 

  1. The amount of purchased goodwill is:
  2. A) $18 million.
  3. B) $30 million.
  4. C) $60 million.
  5. D) None of the above is correct.

 

Answer: A     Learning Objective: 6       Level of Learning: 3

Rationale: (in millions)

Cost $45
FMV: 30% x ($75 + $15) (27 )
Goodwill $ 18
 

 

  1. The total amount of additional depreciation to be recognized over the remaining life of the assets is:
  2. A) $4.5 million.
  3. B) $15 million.
  4. C) $27 million.
  5. D) None of the above is correct.

 

Answer: A     Learning Objective: 6       Level of Learning: 3

Rationale: (in millions)

FMV in excess of book value $15
Share of ownership 30 %
Additional depreciation, in total $  4.5
 

 

 

 

Problems

 

  1. Bentz Corporation bought and sold several securities during 2006. Listed below is a summary of the transactions:

 

February 17 Purchased $100,000 of U.S. Treasury 6% bonds, paying 102 plus
accrued interest of $1,000. The security is to be held for short-term profits.
April 10 Purchased 500 shares of Gauges Inc. common stock at $140 per
share. This security will be held for an unspecified period of time.
August 8 Sold 100 shares of Gauges Inc. for $150 per share.
October 5 Sold half of the U.S. Treasury bonds for 103 plus accrued interest
of $300.

 

Required:

Prepare the journal entries for the above transactions. Show calculations.

 

Answer:

Feb. 17 Investment in Treasury bonds 102,000
Interest receivable 1,000
        Cash 103,000
Apr. 10 Investment in Gauges, Inc. 70,000
        Cash 70,000
Aug. 8 Cash 15,000
        Investment in Gauges, Inc. 14,000
        Gain on sale of investments 1,000
Oct. 5 Cash 51,800
        Investment in Treasury 51,000
        Gain on sale of investments 500
        Interest earned 300

 

Learning Objective: 2       Level of Learning: 3

 

  1. Krogstad Corporation bought 1,000 shares of Cole Inc. for $90 per share plus a brokerage fee of $1,800. Three months later, the shares were sold for $110 per share. The brokerage fee on the sale was $2,200.

 

Required:

  • Prepare the appropriate journal entry to record the purchase of the stock.
  • Prepare the appropriate journal entry to record the sale of the stock.

 

Answer:

(1.) Investments 91,800
        Cash 91,800
(2.) Cash 107,800
        Investments 91,800
        Gain on sale of investments 16,000

 

Learning Objective: 2       Level of Learning: 3

 

 

  1. On March 17, 2006, Union Corporation purchased 5,000 shares of AZQ common stock as a long-term investment at $40 per share. On December 31, 2006, and December 31, 2007, the market value of the AZQ stock is $42 and $43, respectively.

 

Required:

  • What is the appropriate reporting category for this stock? Why?
  • Prepare the adjusting entry on December 31, 2006.
  • Prepare the adjusting entry on December 31, 2007.

 

Answer:

(1.) This investment should be accounted for as Available for Sale since it will be held for an unspecified period of time and doesn’t fit any other category.

 
(2.) 12/31/03 Investment in AZQ 10,000
          Unrealized holding gain on investments 10,000
(3.) 12/31/04 Investment in AZQ 5,000
          Unrealized holding gain on investments 5,000

 

Learning Objective: 2       Level of Learning: 3

 

  1. During 2006, Largent Enterprises purchased stock as follows:

 

May 17, Purchased 1,000 shares of Nugent common stock for $80 per share.

July 12, Purchased 400 shares of Alfredo common stock at $60 per share, plus a $600 brokerage commission.

 

At December 31, 2006, the market values of the securities were as follows:

 

Security Market Value per Share
Nugent $72
Alfredo $64

 

Required:

  • Prepare the journal entries to record the acquisition of the two investments.
  • Prepare any necessary adjusting entries assuming the stocks are both classified as available for sale securities.

 

Answer:

(1.) May 17 Investment in Nugent 80,000
     Cash 80,000
Jul. 12 Investment in Alfredo 24,600
     Cash 24,600
(2.) Dec. 31 Unrealized holding loss on investments 8,000
     Fair value adjustment in Nugent 8,000
Dec. 31 Fair value adjustment in Alfredo 1,000
     Unrealized holding gain on investments 1,000

 

($64 x 400) – $24,600 = $1,000

 

Learning Objective: 2       Level of Learning: 3

 

 

  1. FKG Inc. carries the following investments on its books at December 31, 2006, and December 31, 2007. All securities were purchased during 2006.

 

Trading Securities:
     Company Cost Value, Dec. 31, 2006 Value, Dec. 31, 2007
     A Company $25,000 $13,000 $20,000
     B Company $13,000 $20,000 $20,000
     C Company $35,000 $30,000 $25,000
Available for Sale Securities:
     Company Cost Value, Dec. 31, 2006 Value, Dec. 31, 2007
     X Company $210,000 $130,000 $50,000
     Y Company $ 50,000 $ 60,000 $70,000

 

Required:

  • Prepare the necessary journal entries for FKG on December 31, 2006, and December 31, 2007.
  • What net effect would the valuation of these stock investments have on 2006 net income? On 2007 net income?

 

Answer:

(1.)

2006:
Unrealized holding loss on investments 12,000
       Investment in A 12,000
Investment  in B 7,000
       Unrealized holding gain on investments 7,000
Unrealized holding loss on investments 5,000
       Investment In C 5,000
Unrealized holding loss on investments 80,000
       Investment in X 80,000
Investment in Y 10,000
       Unrealized holding gain on investments 10,000
2007:
Investment in A 7,000
       Unrealized holding gain on investments 7,000
NO ENTRY FOR B SHARES
Unrealized holding loss on investments 5,000
       Investment in C 5,000
Unrealized holding loss on investments 80,000
       Investment in X 80,000
Investment in Y 10,000
       Unrealized holding gain on investments 10,000

 

 

 

(2.)

2006:  Net Income would be reduced by $10,000 due to the net unrealized loss on trading securities on companies A, B, and C.

2007:  Net Income would be increased by $2,000 due to the net unrealized gain on trading securities on companies A,  B, and C.

The holding gains and losses on the securities available for sale are reported as a separate component of shareholders’ equity on the balance sheet and do not affect the income statement.

 

Learning Objective: 3       Level of Learning: 3

 

  1. On February 2, 2006, MBH Inc. acquired 30% of the voting common stock of Construction Corporation as a long-term investment. Data from Construction Corporation’s financial statements for the year ended December 31, 2006, include the following:

 

Net income      $150,000

Dividends paid   $75,000

 

Required:

Prepare any necessary journal entries for MBH at December 31, 2006, under the equity method of accounting for investments.

 

Answer:

Investment in MBH ($150,000 x 30%) 45,000
       Investment revenue 45,000
Cash ($75,000 x 30%) 22,500
       Investment in MBH 22,500

 

Learning Objective: 5       Level of Learning: 3

 

  1. On January 1, 2006, American Corporation purchased 25% of the outstanding voting shares of Short Supplies common stock for $210,000 cash. On that date, Short’s book value and fair value were both $420,000. The equity method is deemed appropriate for this investment. Short’s net income reported on December 31, 2006, was $80,000. During 2006, Short also paid cash dividends in the amount of $24,000.

 

Required:

            Compute the amount that would be reported for the investment on American Corporation’s financial statements at December 31, 2006.

 

Answer:

Investment in Short:
     Original Investment $210,000
     Share of net income — 25% of $80,000 20,000
     Less cash div. – 25% of $24,000 (6,000 )
     Balance, December 31, 2006 $224,000

 

Learning Objective: 5       Level of Learning: 3

 

 

  1. On January 1, 2006, American Corporation purchased 25% of the outstanding voting shares of Short Supplies common stock for $210,000 cash. On that date, Short’s book value and fair value were both $420,000. The equity method is deemed appropriate for this investment. Short’s net income reported on December 31, 2006, was $80,000. During 2006, Short also paid cash dividends in the amount of $24,000.

 

Required:

            Prepare the journal entries necessary to record the above information on American Corporation’s books during 2006.

 

Answer:

Jan. 1 Investment in Short 210,000
    Cash 210,000
Dec. 31 Investment in Short ($80,000 x 25%) 20,000
    Investment in revenue 20,000
Dec. 31 Cash ($24,000 x 25%) 6,000
    Investment in Short 6,000

 

Learning Objective: 5       Level of Learning: 3

 

  1. On July 1, 2006, Clearwater Inc. purchased 6,000 shares of the outstanding common stock of Mountain Corporation at a cost of $140,000. Mountain had 30,000 shares of outstanding common stock. Assume the book value and fair value of net assets is $650,000. Both companies have a January through December fiscal year. The following data pertain to Mountain Corporation during 2006:

 

Net Income, January 1 -June 30 $14,000
Net Income, July 1 — December 31 $18,000
Dividends declared and paid, Jan. 1 –June 30 $12,000
Dividends declared and paid, Jul. 1  Dec. 31 $12,000

 

Required:

  • Prepare the entry to record the original investment in Mountain.
  • Compute the goodwill (if any) on the acquisition.
  • Prepare the necessary entries (other than acquisition) for 2006 under the equity method.

 

Answer:

(1.) Investment in Mountain 140,000
   Cash 140,000
(2.) Purchase price 140,000
Fair value of assets purchased
($650,000 x 20%) 130,000
Goodwill purchased (difference) $10,000  
(3.) Cash ($12,000 x 20%) 2,400
   Investment in Mountain 2,400
Investment in Mountain ($18,000 x 20%) 3,600
   Investment revenue 3,600

 

Learning Objective: 6       Level of Learning: 3

 

 

  1. On July 1, 2006, Clearwater Inc. purchased 6,000 shares of the outstanding common stock of Mountain Corporation at a cost of $140,000. Mountain had 30,000 shares of outstanding common stock. The book value and fair value of net assets is $650,000. Both companies have a January through December fiscal year. The following data pertain to Mountain Corporation during 2006:

 

Net income, January 1 — June 30 $14,000
Net income, July 1 – December 31 $18,000
Dividends declared and paid, Jan. 1 — Jun .30 $12,000
Dividends declared and paid, Jul. 1 — Dec. 31 $12,000

 

Required:

  • Prepare the necessary entries for 2006 under the equity method (other than for the purchase).
  • Prepare any necessary entries for 2006 (other than for the purchase) that would be required under the cost method.

 

Answer:

(1.) Cash ($12,000 dividends x 20%) 2,400
   Investment in Mountain 2,400
Investment in Mountain ($18,000 NI x 20%) 3,600
   Investment revenue 3,600
(2.) Cash ($12,000 dividends x 20%) 2,400
   Dividend income 2,400

 

Learning Objective: 5       Level of Learning: 3

 

  1. Jackson Company engaged in the following investment transactions during the current year.

 

Feb 17 Purchased 500 shares of Medical Company common for $20 per
share plus a brokerage commission of $100.
These are trading securities.
April 1 Bought 30,000 of the 100,000 outstanding shares of Olde
Company for $300,000. Goodwill of $80,000 was included in the
price.
June 25 Received a $1.20 per share dividend on Medical Company stock.
June 30 Olde Company reported second quarter profits of $20,000.
Oct 1 Purchased 2,000 shares of Alpha Company for $15 per share plus
a brokerage fee of $400. These shares are classified as available
for sale.
Dec 31 Medical Co. shares are selling for $25 and Alpha stock is selling
for $12.

 

Required:

            Prepare the appropriate journal entries to record the transactions for the year including year-end adjustments. Show calculations.

 

 

Answer:

Feb. 17 Investment in Medical [$500 x $20) + $100] 10,100
   Cash 10,100
Apr. 1 Investment in Olde 300,000
   Cash 300,000
Jun. 25 Cash (500 x $1.20) 600
   Investment revenue 600
Jun. 30 Investment in Olde ($20,000 x 30%) 6,000
   Investment revenue 6,000
Oct. 1 Investment in Alpha [(2,000 x $15) + $400] 30,400
   Cash 30,400
Dec. 31 Investment in Medical [500 x $25) — $10,100] 2,400
   Unrealized holding gain on investments 2,400
Dec. 31 Unrealized holding loss on investments 6,400
    Fair value adjustment in Alpha [(2,000 x $12) —  $30,400] 6,400

 

Learning Objective: 2       Level of Learning: 3

 

  1. On March 1, 2006, Navy Corporation used excess cash to purchase $100,000 of U.S. Treasury bonds that were selling for 103 plus accrued interest. The appropriate interest rate is 6%. Interest on these bonds is payable on January 1 and July 1 of each year.

 

Required:

  • Prepare the appropriate journal entries to record the transactions for the year, including any year-end adjustments. Show calculations, rounded to the nearest dollar.
  • Assuming that these Treasury bonds were acquired as trading securities, explain whether any premium or discount should be amortized.

 

Answer:

(1.) Mar. 1 Interest receivable ($100,000 x 6% x 2/12) 1,000
Investment in Treasury bonds ($100,000 x 103%) 103,000
       Cash 104,000
Jul. 1 Cash ($100,000 x6% x 6/12) 3,000
       Interest revenue 2,000
       Interest receivable 1,000
Dec. 31 Interest receivable 3,000
       Interest revenue 3,000
(2.) Premiums or discounts are not amortized on trading securities.

 

Learning Objective: 3       Level of Learning: 3

 

 

  1. On January 1, 2006, Wildcat Company purchased $93,000 of 10% bonds at face value. The bonds are to be held to maturity. The bonds pay interest semiannually on January 1, and July 1.

 

Required:

  • Prepare the appropriate journal entry to record the acquisition of the bonds.
  • Record the first two interest payments (ignore year-end accruals).

 

Answer:

(1.) 01/1/06 Investment in bonds 93,000
           Cash 93,000
(2.) 07/1/06 Cash ($93,000 x 10% x 6/12) 4,650
            Interest revenue 4,650
01/1/07 Cash 4,650
            Interest revenue 4,650

 

Learning Objective: 1       Level of Learning: 3

 

  1. On January 1, 2006, Hoosier Company purchased $930,000 of 10% bonds at face value. The bond market value was $980,000 on December 31, 2006.

 

Required:

            Prepare the appropriate journal entry on December 31, 2006, to properly value the bonds assuming the bonds are classified as (ignore premium or discount amortization):

  • Trading securities.
  • Securities available for sale.
  • Held-to-maturity securities.

 

Answer:

(1.) Investment in bonds ($980,000 — $930,000) 50,000
     Unrealized holding gain on investments 50,000
(2.) Same as above.
(3.) Changes in FMV of held-to-maturity securities are ignored.

 

Learning Objective: 1       Level of Learning: 3

 

 

  1. On January 1, 2006, Bactin Corporation acquired 10% of Oakton Company for $100,000. On that date, the book value and fair value of Oakton’s net assets was $900,000. Any difference between cost and book value is attributable to goodwill.  In 2006, Oakton reported net income of $60,000 and paid dividends of $30,000.  On January 1, 2007, Bactin Corporation bought another 10% of Oakton for $100,000. The value of net assets was $900,000. In 2007, Oakton reported net income of $80,000 and paid dividends of $40,000.

 

Required:

            Prepare all journal entries for Bactin for 2006 and 2007, assuming no change in market value of the Oakton stock during that time period.

 

Answer:

1/1/06 Investment in Oakton 100,000
       Cash 100,000
12/31/06 Cash ($30,000 x 10%) 3,000
       Investment revenue 3,000
1/1/07 Investment in Oakton 100,000
       Cash 100,000
Investment in Oakton 3,000
       Retained earnings** 3,000
12/31/07 Cash ($40,000 x 20%) 8,000
       Investment in Oakton 8,000
12/31/07 Investment in Oakton ($80,000 x 20%) 16,000
       Investment revenue 16,000

 

To adjust retained earnings due to change to equity method:

10% x $60,000 NI — 10% x $30,000 dividends

 

Learning Objective: 6       Level of Learning: 3

 

  1. The following transactions occurred during the year for XYZ Corporation:
  • During the year, trading securities were purchased for $250,000.
  • During the year, securities available for sale were purchased for $80,000.
  • During the year, trading securities that cost $100,000 at the beginning of the year were sold for $125,000 cash.
  • At the end of the year, the trading securities portfolio has an aggregate market value of $142,000 and an aggregate cost of $150,000.

 

Required:

            Indicate how each of these transactions would affect the statement of cash flows for a corporation. Assume the statement of cash flows is prepared using the indirect method. Each transaction is assumed to be independent of the other transactions.

 

 

Answer:

  • The $250,000 cash payment for trading securities will be reflected as an increase in the balance of trading securities and deducted from net income in arriving at cash flows from operations.
  • The $80,000 will be shown as an investing cash outflow.
  • The $25,000 gain will be included in net income, the $100,000 decrease in trading securities will be added to net income in arriving at cash flows from operations.
  • The $8,000 unrealized loss will be added from net income in arriving at cash flows from operations.

 

Learning Objective: 3       Level of Learning: 3

 

Use the following to answer questions 129-130:

 

In its 2005 annual report to shareholders, Kraut Inc. included the following disclosure regarding its available for sale investments in securities:

 

December 31
2005 2004 2003
In thousands
Accumulated other comprehensive income
Unrealized gains (losses) on securities:
   Balance at beginning of year………………….  — (7,533 ) (6,862 )
   Unrealized gains (losses) for the year……… 1,509   (3,564 )   (671 )
   Unrealized losses recognized …………………  —      11,097      —
Balance at end of year……………………………. 1,509        —    (7,533 )

 

Required:

 

  1. Prepare the journal entry (in thousands) that Kraut made at the end of 2005 to record the information disclosed above.

 

Answer:

Investments in securities   1,509

Unrealized gain on investments     1,509

 

Learning Objective: 2       Level of Learning: 3

 

  1. In 2004, Kraut made two adjustments to its available for sale investments.

 

Required:

Briefly explain the adjustments and why they occurred.

 

Answer:

The first entry was to record the additional unrealized loss $3,564 thousand that Kraut had incurred from holding these securities.  This raised the accumulated holding loss to 11,097 thousand on these investments.  The second adjustment indicates the recognition (realization) of that accumulated loss.  This occurred because Kraut either wrote off the investment or sold it at the end of the year.

 

Learning Objective: 2       Level of Learning: 3

 

 

Use the following to answer questions 131-133:

 

Arctic Cat Inc., the snowmobile manufacturer, reported the following in its 2005 annual report to shareholders:

 

NOTE B  —  SHORT-TERM INVESTMENTS

 

Short-term investments consist primarily of a diversified portfolio of municipal bonds and money market funds and are classified as follows at March 31:

 

2005 2004
Trading securities $64,433,000 $55,282,000
Available-for-sale debt securities  3,196,000 7,113,000
$67,629,000 $62,395,000
 

 

Trading securities consists of $54,608,000 and $41,707,000 invested in various money market funds at March 31, 2005 and 2004, respectively, while the remainder of trading securities and available-for-sale securities consists primarily of A-rated or higher municipal bond investments. The amortized cost and fair value of debt securities classified as available-for-sale was $3,105,000 and $3,196,000, at March 31, 2005. The unrealized gain on available-for-sale debt securities is reported, net of tax, as a separate component of shareholders’ equity.

 

Arctic Cat Inc.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

Years Ended March 31,

 

Accumulated Other Comprehensive Income:

 

2004:
Unrealized loss on securities available-
       for-sale, net of tax $(154,000)
2005:
Unrealized loss on securities available-
      for-sale, net of tax  (140,000)

 

2005 2004
Cash flows from
investing activities:
   Sale and maturity of
   available-for-sale securities 3,703,000 1,729,000

 

In its 2004 annual report, Arctic Cat disclosed that «The contractual maturities of available-for-sale debt securities at March 31, 2004, are $3,573,000 within one year and $3,340,000 from one year through five years.»

 

 

  1. Required:

How much did Arctic Cat actually receive from the sale of available-for-sale securities during 2005?

 

Answer:

$130,000 (i.e., $3,703,000 cash flow — $3,573,000 maturity).

 

Learning Objective: 2       Level of Learning: 3

 

  1. Required:

Based on the data provided above, what gain or loss did Arctic actually realize from selling available-for-sale securities during 2005?  Assume a 30% tax rate.

 

Answer:

$9,800 loss, net of tax savings

The investment, measured at fair value, declined $3,917,000 (from $7,113,000 to $3,196,000) during the year.  Of this reduction, $3,573,000 was the maturity of certain of the securities.  Also, there was an additional unrealized loss (decline in value of the securities) of $140,000 after tax ($200,000 before a 30% tax of $60,000).  Thus, the fair value of the assets sold was $144,000 (i.e., $3,917,000 — $3,573,000 — $200,000).  Because the cash flow from the sales was $130,000 (i.e., $3,703,000 cash flow — $3,573,000 maturity), there was a loss before taxes of $14,000 realized on the sale.  This generates a tax savings of $4,200 (30% of $14,000).  Thus, the loss on the sale was $9,800, net of tax savings.

 

Learning Objective: 2       Level of Learning: 3

 

  1. Required:

Assuming Arctic’s effective tax rate is 30%, what gain or loss would be realized if the available for sale securities on Arctic Cat’s 3/31/05 balance sheet were sold immediately for their fair value?  Show the journal entry for such a sale.

 

Answer:

Arctic would report a $63,700 gain, net of $27,300 in taxes.  This is the difference between the amortized cost of the investments ($3,105,000) and their fair value ($3,196,000), or $91,000, taxed at 30%.  The transaction would be recorded as follows:

 

Cash 3,196,000
   Available for Sale Debt Securities 3,196,000
Unrealized gain (net) 63,700
   Realized gain (net) on sale of securities 63,700

 

Learning Objective: 2       Level of Learning: 3

 

 

Use the following to answer questions 134-135:

 

Fragrance International, a large perfume manufacturer, reported the following in its 2005 annual report to shareholders:

 

ACCUMULATED OTHER COMPREHENSIVE INCOME

 

The components of accumulated other comprehensive income (loss) («OCI») included in the accompanying consolidated balance sheets consist of the following:

 

YEAR ENDED JUNE 30
2005    2004   2003  
(IN MILLIONS)
Net unrealized investment gains, beginning
  of year ……………………………………………….  $  2.9 $ 13.9 $ 6.1
Unrealized investment gains (losses)   ………..  (5.0 )  (18.3 ) 13.0
Provision for deferred income taxes…………… 2.0   7.3   (5.2) )
Net unrealized investment gains (losses),
  end of year …………………………………………. (0.1 ) 2.9    13.9
       

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

YEAR ENDED JUNE 30
2005   2004   2003
(IN MILLIONS)
CASH FLOWS FROM INVESTING ACTIVITIES
  Capital expenditures . …………………………………………………………….. (203.2 )  (192.2 )  (180.9 )
  Acquisition of businesses, net of
    acquired cash ……………………………………………………………..    (18.5 )   (16.0 )   (180.5 )
  Purchases of long-term investments ……………………………………………………………..  —   —  (15.9 )
  Proceeds from disposition of long-term
    investments . ……………………………………………………………..  4.7        1.9        3.0  
NET CASH FLOWS USED FOR
        INVESTING ACTIVITIES …………………………………………………………….. (217.0 ) (206.3 )  (374.3 )
     

 

Investments sold during 2005 originally cost $3.0 million and were unchanged in value from the date of purchase to the date of sale.

 

  1. Required:

 

What was the realized gain or loss on the sale of available-for-sale securities in 2005? Assume a 40% tax rate.

 

Answer: $1.7 million gain before taxes ($4.7 proceeds — $3.0 securities).  Taxes would be $0.68 million ($1.7 million x .4 tax rate).  Thus, the after-tax gain would be $1.02 million.

 

Learning Objective: 2       Level of Learning: 3

 

 

  1. Required:

Assuming a constant tax rate of 40%, what was the pre-tax accumulated unrealized gain or loss on available-for-sale securities at 7/1/04?

 

Answer: $4.833 million unrealized gain.  At a 40% tax rate, the after-tax unrealized gain is 60% of the total.  Therefore, $2.9 million is 60% of the total.  Total is $2.9/.6 = $4.833 million.

 

Learning Objective: 2       Level of Learning: 3

 

  1. Required:

 

What was the adjusting journal entry that Fragrance International recorded at 6/30/05 to bring the available-for-sale securities held to fair value?

 

Answer:

Unrealized investment loss 5.0 million
          Available for sale securities 3.0 million
          Deferred income taxes 2.0 million

 

Learning Objective: 2       Level of Learning: 3

 

  1. On July 1, 2006, Silverwood Company purchased for cash 35% of the voting common stock of Yellowstone Corporation. Both companies have a December 31 fiscal year-end. Yellowstone Corporation, which is publicly traded on an organized stock exchange, reported its net income for the year to Silverwood and paid a dividend to Silverwood during the year.

 

Required:

            How should Silverwood report the above information in its year-end income statement and balance sheet? Discuss the rationale for your answer.

 

Answer: The Silverwood Company should follow the equity method of accounting for this investment. Because Silverwood owns 35% of the voting stock of Yellowstone, the presumption of significant influence exists. 35 % of Yellowstone’s net income would be added to Silverwood’s Investment account balance. Adjustments would also be made, if appropriate, to reflect additional depreciation. The investment account’s adjusted balance would be reported as a long-term investment in the asset section of the balance sheet. 35% of Yellowstone’s net income, minus any additional depreciation, would be reflected in Silverwood’s income statement. Since the equity method is appropriate for this investment, the dividends would not be included in income.

 

Learning Objective: 5       Level of Learning: 2

 

 

  1. LaBelle Corporation owns a $6 million whole life insurance policy on the life of its CEO, naming LaBelle as beneficiary. The annual premiums are $95,000 and are payable at the beginning of each year. The cash surrender value of the policy was $56,000 at the beginning of 2006.

 

Required:

  • Prepare the appropriate 2006 journal entry to record insurance expense and the increase in the investment, assuming the cash surrender value of the policy increased according to the contract to $70,000.
  • The CEO died at the end of 2006. Prepare the appropriate journal entry.

 

Answer:

1) Insurance expense (difference) 81,000
Cash surrender value of life insurance ($70,000 – 56,000) 14,000
   Cash (2006 premium) 95,000
2) Cash (death benefit) 6,000,000
   Cash surrender value of life insurance (account balance) 70,000
   Gain on life insurance settlement (to balance) 5,930,000

 

Learning Objective: Appendix       Level of Learning: 3

 

  1. Guido Properties owes First State Bank $60 million under a 7% note with two years remaining to maturity. Due to financial difficulties of Guido, the previous year’s interest ($4.2 million) was not received. The bank agrees to settle the note receivable and accrued interest receivable in exchange for land having a fair market value of $44 million.

 

Required:  Compute the loss on troubled debt restructuring that the bank would record.

 

Answer: $20.2 million

 

Land 44.0 million
Loss on troubled debt restructuring 20.2 million
   Accrued interest receivable (7% x $60 million) 4.2 million
   Note receivable 60.0 million

 

Learning Objective: Appendix       Level of Learning: 3

 

 

Essay

 

Instructions:

 

The following answers point out the key phrases that should appear in students’ answers.  They are not intended to be examples of complete student responses. It might be helpful to provide detailed instructions to students on how brief or in-depth you want their answers to be.

 

  1. Previously, marketable equity securities were reported using a technique referred to as «lower of cost or market.» The current accounting standard requires fair value reporting for trading securities and securities available for sale. Some accountants believe that the FASB was inconsistent when Statement No. 115 was released requiring changes in the value of trading securities to be reported on the income statement and balance sheet, while changes in the value of securities available for sale are reported only on the balance sheet.

 

Required:

            Evaluate the rationale for these two diverse reporting requirements for equity securities. What arguments could be made to support each treatment?

 

Answer: When securities are actively managed, as trading securities are, with the express intent of profiting from short-term price changes, the gains and losses that result from holding securities during market price changes are appropriate measures of success or lack of success in that endeavor. On the other hand, securities available for sale are held for reasons other than profiting from short-term price changes so holding gains and losses are appropriately included in income only when realized upon sale of the investment. Also, unrealized gains and losses prior to sale may cancel one another out.

 

Learning Objective: 3       Level of Learning: 2

 

  1. Jaycom Enterprises has invested its excess cash in the stock of several different companies and desires to maximize income over the short-run. Jaycom is unsure about the appropriate investment policy and thus reporting practice to follow.

 

Required:

            What classification procedure and subsequent classification could Jaycom follow in order to meet its objective?  How will Jaycom justify its choice to their auditors?

 

Answer: If Jaycom classifies the securities as available for sale, none of the market value changes would be reflected in net income, while all market value changes would be reflected in net income if Jaycom classifies these securities as trading. This demonstrates how some FASB pronouncements can potentially be used to manipulate earnings. To maximize income the company could classify securities that have decreased in value as available for sale while classifying as trading securities those that have increased in value. One way to justify this would be to argue that securities that were increasing in value could be sold at any time. The managers could also argue that they held declining securities indefinitely or until they felt the decline was over. However, appropriate accounting procedures require that an investor assign a reporting classification to each security at acquisition, with the classification chosen based on the company’s intent at that time. Reasons for transfers between classifications must be explained in footnote disclosures.

 

Learning Objective: 2       Level of Learning: 2

 

 

  1. Newjohn Company owns stock in several affiliated companies. Investments in  of these affiliates are accounted for using the cost method while some are accounted for using the equity method.

 

Required:

            What factors determine which method should be used?

What events are recorded when the equity method is used?

What events are recorded when the cost method is used?

 

Answer:

In order to use the equity method, Newjohn must be able to exercise significant influence over the affiliated company. If the ownership is less than 20%, then the lack of significant influence would generally be presumed and the cost method would be appropriate. If Newjohn can control the investee, generally represented by an ownership interest greater than 50%, then consolidation would be appropriate.

 

The acquisition of the subsidiary is recorded the same way under both the cost and the equity methods. Under the cost method, dividends are recorded as revenue by the parent.

 

The equity method requires that a proportionate share of dividends and reported earnings be recorded as adjustments to respectively decrease and increase the investment account, with the proportion of reported revenue included in net income of the parent. Differences between the price paid for the investment and the underlying book value must be analyzed and amortized, if appropriate.

 

Learning Objective: 4       Level of Learning: 2

 

  1. From time to time, debt and equity securities must be reclassified when conditions and circumstances surrounding the investment change.

 

Required:

            Describe the general accounting procedures for reclassifying securities from one category to another- held to maturity, available for sale, or trading.

 

Answer: When a security is reclassified between two categories, the security is transferred at fair value on the date of transfer. Any unrealized holding gain or loss at reclassification should be accounted for in a manner consistent with the classification into which the security is being transferred. Reclassifications are quite unusual, so when they occur, footnote disclosures should describe the circumstances that resulted in the transfer.

 

Learning Objective: 1       Level of Learning: 2

 

 

  1. Discuss the following questions.

 

Required:

            What securities must be classified within one of the three categories of held to maturity, available for sale, and trading? (Do not describe how to determine how securities are classified among these three categories.)  Identify the four primary recording activities related to investments in securities.

 

Answer:

The three categories listed apply to all investments in debt securities and investments in equity securities with a readily determinable fair value that are not accounted for under the equity method or using consolidation procedures. In other words, equity securities where the investor owns less than 20% of the voting stock are included in one of these three categories.  Held to maturity securities must be debt securities.  Trading and available for sale securities may be debt or equity securities.

The four major recording activities are:

  • recording the purchase;
  • recording changes in value of the securities;
  • recording interest and dividends; and
  • recording the sale of securities

 

Learning Objective: 5       Level of Learning: 2

 

  1. When an investor owns 20% to 50% of the voting stock of an investee company, the investor is presumed to exercise significant influence over the investee unless there is evidence to the contrary.

 

Required:

            What factors could be evidence of significant influence?

What factors could be evidence of lack of significant influence?

 

Answer:

Some factors indicating significant influence:

  • Representation on the board of directors.
  • Material intercompany transactions.
  • Participation in the policy setting process of the company.

 

Some factors indicating lack of significant influence:

  • Investor tries and fails to obtain representation on the board of investee.
  • Majority ownership is concentrated among a small group of investors.
  • Investor is unable to obtain the information necessary to apply the equity method.

 

Learning Objective: 4       Level of Learning: 2

 

 

  1. Many corporations own more than 50% of the voting stock in other corporations. Sometimes these affiliated companies operate within the same industry, and many times the companies are in unrelated industries.

 

Required:

            What is the significance of owning more than 50% of the voting common stock of another company?

 

Answer: When a firm owns more than 50% of the voting stock in another corporation, then consolidation procedures are required. Owning more than 50% of an investee company ensures, in most cases, that the parent company has control of the management decisions of the subsidiary by holding over half of the votes at stockholder meetings. Control involves the presence of two essential characteristics: (1) ability to guide the subsidiary’s ongoing activities and (2) ability to derive benefit from that power. This usually means that the corporation can choose several board members and can control policy making.

 

Learning Objective: 4       Level of Learning: 2

 

  1. In its 2001 annual report to shareholders, Maytag Corporation included the following disclosures in its income statement and related footnotes:

 

CONSOLIDATED STATEMENTS OF INCOME

 

Year Ended December 31
2001 2000 1999
(In thousands)
Loss on securities…………… (7,230) (17,600) —

 

Special Charges and Loss on Securities

           

            During the fourth quarter of 2001, the Company recorded special charges and loss on securities totaling $17.0 million, or $13.5 million after-tax. Special charges of $9.8 million, or $6.2 million after-tax, were associated with a salaried workforce reduction of approximately 250 employees. Cash expenditures for 2001 related to this charge were $3.7 million. Loss on securities of $7.2 million resulted from the write-down of the remaining investment in a privately held Internet-related company.

 

During the fourth quarter of 2000, the Company recorded special charges and loss on securities totaling $57.5 million, or $36.5 million after-tax. Special charges of $39.9 million, or $25.3 million after-tax, were associated with terminated product initiatives, asset write-downs and executive severance costs related to management changes. Loss on securities of $17.6 million, or $11.2 million after-tax, resulted from a lower market valuation of securities of TurboChef Technologies, Inc. and investments in privately held Internet-related Companies ….. The loss on securities charge of $17.6 million was non-cash.

 

Required:

Discuss the possible rationale behind the losses on securities reported by Maytag in 2000 and 2001.

 

 

Answer: As indicated in the footnote, Maytag held investments in securities of TurboChef Technologies.  These may have been treated as trading securities, in which case reductions in their values would have been recorded as a loss against income in 2000.  Alternatively, this loss could result from permanent impairments in value, even if these were not treated by Maytag as trading securities.  In addition, Maytag had investments in privately held Internet-related companies.  The portion of the 2000 and 2001 losses on securities related to these investments seem to have resulted from permanent impairments.  Note that the footnote disclosure indicates these were non-cash losses, thereby ruling out these losses having occurred as a result of Maytag selling the securities at a loss.

 

Learning Objective: 3       Level of Learning: 3

 

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