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Chapter 1

Introduction to Business Combinations and the Conceptual Framework

Multiple Choice
1. Stock given as consideration for a business combination is valued at
a. fair market value
b. par value
c. historical cost
d. None of the above

2. Which of the following situations best describes a business combination to be accounted for as a statutory merger?
a. Both companies in a combination continue to operate as separate, but related, legal entities.
b. Only one of the combining companies survives and the other loses its separate identity.
c. Two companies combine to form a new third company, and the original two companies are dissolved.
d. One company transfers assets to another company it has created.

3. A firm can use which method of financing for an acquisition structured as either an asset or stock acquisition?
a. Cash
b. Issuing Debt
c. Issuing Stock
d. All of the above

4. The objectives of FASB 141R (Business Combinations) and FASB 160 (NonControlling Interests in Consolidated Financial Statements) are as follows:
a. to improve the relevance, comparibility, and transparency of financial information related to business combinations.
b. to eliminate the amortization of Goodwill.
c. to facilitate the convergence project of the FASB and the International Accounting Standards Board.
d. a and b only

5. A business combination in which the boards of directors of the potential combining companies negotiate mutually agreeable terms is a(n)
a. agreeable combination.
b. friendly combination.
c. hostile combination.
d. unfriendly combination.

6. A merger between a supplier and a customer is a(n)
a. friendly combination.
b. horizontal combination.
c. unfriendly combination.
d. vertical combination.

7. When a business acquisition is financed using debt, the interest payments are tax deductible and create
a. operating synergy.
b. international synergy.
c. financial synergy.
d. diversification synergy.

8. The defense tactic that involves purchasing shares held by the would-be acquiring company at a price substantially in excess of their fair value is called
a. poison pill.
b. pac-man defense.
c. greenmail.
d. white knight.

9. The third period of business combinations started after World War II and is called
a. horizontal integration.
b. merger mania.
c. operating integration.
d. vertical integration.

10. A statutory ______________ results when one company acquires all the net assets of another company and the acquired company ceases to exist as a separate legal entity.
a. acquisition.
b. combination.
c. consolidation.
d. merger.

11. When a new corporation is formed to acquire two or more other corporations and the acquired corporations cease to exist as separate legal entities, the result is a statutory
a. acquisition.
b. combination.
c. consolidation.
d. merger.

12. The excess of the amount offered in an acquisition over the prior stock price of the acquired firm is the
a. bonus.
b. goodwill.
c. implied offering price.
d. takeover premium.

13. The difference between normal earnings and expected future earnings is
a. average earnings.
b. excess earnings.
c. ordinary earnings.
d. target earnings.

14. The first step in estimating goodwill in the excess earnings approach is to
a. determine normal earnings.
b. identify a normal rate of return for similar firms.
c. compute excess earnings.
d. estimate expected future earnings.

15. A potential offering price for a company is computed by adding the estimated goodwill to the
a. book value of the company’s net assets.
b. book value of the company’s net identifiable assets.
c. fair value of the company’s net assets.
d. fair value of the company’s net identifiable assets.

16. Estimated goodwill is determined by computing the present value of the
a. average earnings.
b. excess earnings.
c. expected future earnings.
d. normal earnings.

17. Which of the following statements would not be a valid or logical reason for entering into a business combination?
a. to increase market share.
b. to avoid becoming a takeover target.
c. to reduce risk by acquiring established product lines.
d. the operating costs of the combined entity would be more than the sum of the separate entities.

18. The parent company concept of consolidation represents the view that the primary purpose of consolidated financial statements is:
a. to provide information relevant to the controlling stockholders.
b. to represent the view that the affiliated companies are a separate, identifiable economic entity.
c. to emphasis control of the whole by a single management.
d. to include only a portion of the subsidiary’s assets, liabilities, revenues, expenses, gains, and losses.

19. Which of the following statements is correct?
a. Total elimination is consistent with the parent company concept.
b. Partial elimination is consistent with the economic unit concept.
c. Past accounting standards required the total elimination of unrealized intercompany profit in assets acquired from affiliated companies.
d. none of these.

20. Under the parent company concept, consolidated net income __________ the consolidated net income under the economic unit concept.
a. is the same as
b. is higher than
c. is lower than
d. can be higher or lower than

21. Under the economic unit concept, noncontrolling interest in net assets is treated as
a. a liability.
b. an asset.
c. stockholders’ equity.
d. an expense.

22. The parent company concept adjusts subsidiary net asset values for the
a. differences between cost and fair value.
b. differences between cost and book value.
c. total fair value implied by the price paid by the parent.
d. total cost implied by the price paid by the parent.

23. According to the economic unit concept, the primary purpose of consolidated financial statements is to provide information that is relevant to
a. majority stockholders.
b. minority stockholders.
c. creditors.
d. both majority and minority stockholders.

24. Which of the following statements is correct?
a. The economic unit concept suggests partial elimination of unrealized intercompany profits.
b. The parent company concept suggests partial elimination of unrealized intercompany profits.
c. The economic unit concept suggests no elimination of unrealized intercompany profits.
d. The parent company concept suggests total elimination of unrealized intercompany profits.

25. When following the parent company concept in the preparation of consolidated financial statements, noncontrolling interest in combined income is considered a(n)
a. prorated share of the combined income.
b. addition to combined income to arrive at consolidated net income.
c. expense deducted from combined income to arrive at consolidated net income.
d. deduction from current assets in the balance sheet.

26. When following the economic unit concept in the preparation of consolidated financial statements, the basis for valuing the noncontrolling interest in net assets is the
a. book values of subsidiary assets and liabilities.
b. fair values of subsidiary assets and liabilities.
c. general price level adjusted values of subsidiary assets and liabilities.
d. fair values of parent company assets and liabilities.

27. The view that consolidated financial statements represent those of a single economic entity with several classes of stockholder interest is consistent with the
a. parent company concept.
b. current practice concept.
c. historical cost company concept.
d. economic unit concept.

28. The view that the noncontrolling interest in income reflects the noncontrolling stockholders’ allocated share of consolidated income is consistent with the
a. economic unit concept.
b. parent company concept.
c. current practice concept.
d. historical cost company concept.

29. The view that only the parent company’s share of the unrealized intercompany profit recognized by the selling affiliate that remains in assets should be eliminated in the preparation of consolidated financial statements is consistent with the
a. economic unit concept.
b. current practice concept.
c. parent company concept.
d. historical cost company concept.

Problems

1-1 Perkins Company is considering the acquisition of Barkley, Inc. To assess the amount it might be willing to pay, Perkins makes the following computations and assumptions.
A. Barkley, Inc. has identifiable assets with a total fair value of $6,000,000 and liabilities of $3,700,000. The assets include office equipment with a fair value approximating book value, buildings with a fair value 25% higher than book value, and land with a fair value 50% higher than book value. The remaining lives of the assets are deemed to be approximately equal to those used by Barkley, Inc.
B. Barkley, Inc.’s pretax incomes for the years 2009 through 2011 were $470,000, $570,000, and $370,000, respectively. Perkins believes that an average of these earnings represents a fair estimate of annual earnings for the indefinite future. However, it may need to consider adjustments for the following items included in pretax earnings:

Depreciation on Buildings (each year) 380,000
Depreciation on Equipment (each year) 30,000
Extraordinary Loss (year 2011) 130,000
Salary Expense (each year) 170,000

C. The normal rate of return on net assets for the industry is 15%.

Required:
A. Assume that Perkins feels that it must earn a 20% return on its investment, and that goodwill is determined by capitalizing excess earnings. Based on these assumptions, calculate a reasonable offering price for Barkley, Inc. Indicate how much of the price consists of goodwill.
B. Assume that Perkins feels that it must earn a 15% return on its investment, but that average excess earnings are to be capitalized for five years only. Based on these assumptions, calculate a reasonable offering price for Barkley, Inc. Indicate how much of the price consists of goodwill.

1-2 Pierce Company is trying to decide whether to acquire Hager Inc. The following balance sheet for Hager Inc. provides information about book values. Estimated market values are also listed, based upon Pierce Company’s appraisals.

Hager Inc. Hager Inc.
Book Values Market Values

Current Assets $ 450,000 $ 450,000
Property, Plant & Equipment (net) 1,140,000 1,300,000
Total Assets $1,590,000 $1,750,000

Total Liabilities $700,000 $700,000
Common Stock, $10 par value 280,000
Retained Earnings 610,000
Total Liabilities and Equities $1,590,000

Pierce Company expects that Hager will earn approximately $290,000 per year in net income over the next five years. This income is higher than the 14% annual return on tangible assets considered to be the industry “norm.”

Required:
A. Compute an estimation of goodwill based on the information above that Pierce might be willing to pay (include in its purchase price), under each of the following additional assumptions:
(1) Pierce is willing to pay for excess earnings for an expected life of 4 years (undiscounted).
(2) Pierce is willing to pay for excess earnings for an expected life of 4 years, which should be capitalized at the industry normal rate of return.
(3) Excess earnings are expected to last indefinitely, but Pierce demands a higher rate of return of 20% because of the risk involved.
B. Determine the amount of goodwill to be recorded on the books if Pierce pays $1,300,000 cash and assumes Hager’s liabilities.

1-3 Pope Company acquired an 80% interest in the common stock of Simon Company for $1,540,000 on July 1, 2011. Simon Company’s stockholders’ equity on that date consisted of:

Common stock $800,000
Other contributed capital 400,000
Retained earnings 330,000

Required:
Compute the total noncontrolling interest to be reported in the consolidated balance sheet assuming the:
(1) parent company concept.
(2) economic unit concept.

1-4 The following balances were taken from the records of S Company:

Common stock (1/1/11 and 12/31/11) $720,000
Retained earnings 1/1/11 $160,000
Net income for 2011 180,000
Dividends declared in 2011 (40,000)
Retained earnings, 12/31/11 300,000
Total stockholders’ equity on 12/31/11 $1,020,000

P Company purchased 75% of S Company’s common stock on January 1, 2011 for $900,000. The difference between implied value and book value is attributable to assets with a remaining useful life on January 1, 2011 of ten years.

Required:

A. Compute the difference between cost/(implied) and book value applying:
1. Parent company theory.
2. Economic unit theory.

B. Assuming the economic unit theory:
1. Compute noncontrolling interest in consolidated income for 2011.
2. Compute noncontrolling interest in net assets on December 31, 2011.

Short Answer

1. Estimating the value of goodwill to be included in an offering price can be done under several alternative methods. The excess earnings approach is frequently used. Identify the steps used in this approach to estimate goodwill.

2. The two alternative views of consolidated financial statements are the parent company concept and the economic entity concept. Briefly explain the differences between the concepts.

Short Answer Questions in Textbook

1. Distinguish between internal and external expansion of a firm.

2. List four advantages of a business combination as compared to internal expansion.

3. What is the primary legal constraint on business combinations? Why does such a constraint exist?

4. Business combinations may be classified into three types based upon the relationships among the combining entities (e.g., combinations with suppliers, customers, competitors, etc.). Identify and define these types.

5. Distinguish among a statutory merger, a statutory consolidation, and a stock acquisition.

6. Define a tender offer and describe its use.

7. When stock is exchanged for stock in a business combination, how is the stock exchange ratio generally expressed?

8. Define some defensive measures used by target firms to avoid a takeover. Are these measures beneficial for shareholders?

9. Explain the potential advantages of a stock acquisition over an asset acquisition.

10. Explain the difference between an accretive and a dilutive acquisition.

11. Describe the difference between the economic entity concept and the parent company concept approaches to the reporting of subsidiary assets and liabilities in the consolidated financial statements on the date of the acquisition.

12. Contrast the consolidated effects of the parent company concept and the economic entity con-cept in terms of:
(a)The treatment of noncontrolling interests.
(b)The elimination of intercompany profits.
(c)The valuation of subsidiary net assets in the consolidated financial statements.
(d)The definition of consolidated net income.

13. Under the economic entity concept, the net as-sets of the subsidiary are included in the consolidated financial statements at the total fair value that is implied by the price paid by the parent company for its controlling interest. What practical or conceptual problems do you see in this approach to valuation?

14. Is the economic entity or the parent concept more consistent with the principles addressed in the FASB’s conceptual framework? Explain your answer.

15. How does the FASB’s conceptual framework influence the development of new standards?

16. What is the difference between net income, or earnings, and comprehensive income?

Business Ethics Questions from the Textbook

From 1999 to 2001, Tyco’s revenue grew approximately24% and it acquired over 700 companies. It was widely rumored that Tyco executives aggressively managed the performance of the companies that they acquired by suggesting that before the acquisition, they should accelerate the payment of liabilities, delay recording the collections of revenue, and increase the estimated amounts in reserve accounts.

1. What effect does each of the three items have on the reported net income of the acquired company before the acquisition and on the reported net income of the combined company in the first year of the acquisition and future years?

2. What effect does each of the three items have on the cash from operations of the acquired company before the acquisition and on the cash from operations of the combined company in the first year of the acquisition and future years?

3. If you are the manager of the acquired company, how do you respond to these suggestions?

4. Assume that all three items can be managed within the rules provided by GAAP but would be regarded by many as pushing the limits of GAAP.Is there an ethical issue? Describe your position as: (A) an accountant for the target company and (B) as an accountant for Tyco.

ANSWER KEY (Chapter 1)

Chapter 2

Accounting for Business Combinations

Multiple Choice

1. SFAS 141R requires that all business combinations be accounted for using
a. the pooling of interests method.
b. the acquisition method.
c. either the acquisition or the pooling of interests methods.
d. neither the acquisition nor the pooling of interests methods.

2. Under the acquisition method, if the fair values of identifiable net assets exceed the value implied by the purchase Pratt of the acquired company, the excess should be
a. accounted for as goodwill.
b. allocated to reduce current and long-lived assets.
c. allocated to reduce current assets and classify any remainder as an extraordinary gain.
d. allocated to reduce any previously recorded goodwill and classify any remainder as an ordinary gain.

3. In a period in which an impairment loss occurs, SFAS No. 142 requires each of the following note disclosures except
a. a description of the facts and circumstances leading to the impairment.
b. the amount of goodwill by reporting segment.
c. the method of determining the fair value of the reporting unit.
d. the amounts of any adjustments made to impairment estimates from earlier periods, if significant.

4. Once a reporting unit is determined to have a fair value below its carrying value, the goodwill impairment loss is computed by comparing the
a. fair value of the reporting unit and the fair value of the identifiable net assets.
b. carrying value of the goodwill to its implied fair value.
c. fair value of the reporting unit to its carrying amount (goodwill included).
d. carrying value of the reporting unit to the fair value of the identifiable net assets.

5. SFAS 141R requires that the acquirer disclose each of the following for each material business combination except the
a. name and a description of the acquiree.
b. percentage of voting equity instruments acquired.
c. fair value of the consideration transferred.
d. Each of the above is a required disclosure

6. In a leveraged buyout, the portion of the net assets of the new corporation provided by the management group is recorded at
a. appraisal value.
b. book value.
c. fair value.
d. lower of cost or market.

7. When the acquisition price of an acquired firm is less than the fair value of the identifiable net assets, all of the following are recorded at fair value except
a. Assumed liabilities.
b. Current assets.
c. Long-lived assets.
d. Each of the above is recorded at fair value.

8. Under SFAS 141R,
a. both direct and indirect costs are to be capitalized.
b. both direct and indirect costs are to be expensed.
c. direct costs are to be capitalized and indirect costs are to be expensed.
d. indirect costs are to be capitalized and direct costs are to be expensed.

9. A business combination is accounted for properly as an acquisition. Which of the following expenses related to effecting the business combination should enter into the determination of net income of the combined corporation for the period in which the expenses are incurred?

Security Overhead allocated
issue costs to the merger
a. Yes Yes
b. Yes No
c. No Yes
d. No No

10. In a business combination, which of the following costs are assigned to the valuation of the security?

Professional or Security
consulting fees issue costs
a. Yes Yes
b. Yes No
c. No Yes
d. No No

11. Par Company and Sub Company were combined in an acquisition transaction. Par was able to acquire Sub at a bargain Pratt. The sum of the fair values of identifiable assets acquired less the fair value of liabilities assumed exceeded the cost to Par. After eliminating previously recorded goodwill, there was still some “negative goodwill.” Proper accounting treatment by Par is to report the amount as
a. paid-in capital.
b. a deferred credit, which is amortized.
c. an ordinary gain.
d. an extraordinary gain.

12. With an acquisition, direct and indirect expenses are
a. expensed in the period incurred.
b. capitalized and amortized over a discretionary period.
c. considered a part of the total cost of the acquired company.
d. charged to retained earnings when incurred.

13. In a business combination accounted for as an acquisition, how should the excess of fair value of net assets acquired over the consideration paid be treated?
a. Amortized as a credit to income over a period not to exceed forty years.
b. Amortized as a charge to expense over a period not to exceed forty years.
c. Amortized directly to retained earnings over a period not to exceed forty years.
d. Recorded as an ordinary gain.

14. P Corporation issued 10,000 shares of common stock with a fair value of $25 per share for all the outstanding common stock of S Company in a business combination properly accounted for as an acquisition. The fair value of S Company’s net assets on that date was $220,000. P Company also agreed to issue an additional 2,000 shares of common stock with a fair value of $50,000 to the former stockholders of S Company as an earnings contingency. Assuming that the contingency is expected to be met, the $50,000 fair value of the additional shares to be issued should be treated as a(n)
a. decrease in noncurrent liabilities of S Company that were assumed by P Company.
b. decrease in consolidated retained earnings.
c. increase in consolidated goodwill.
d. decrease in consolidated other contributed capital.

15. On February 5, Pryor Corporation paid $1,600,000 for all the issued and outstanding common stock of Shaw, Inc., in a transaction properly accounted for as an acquisition. The book values and fair values of Shaw’s assets and liabilities on February 5 were as follows

Book Value Fair Value
Cash $ 160,000 $ 160,000
Receivables (net) 180,000 180,000
Inventory 315,000 300,000
Plant and equipment (net) 820,000 920,000
Liabilities (350,000) (350,000)
Net assets $1,125,000 $1,210,000

What is the amount of goodwill resulting from the business combination?
a. $-0-.
b. $475,000.
c. $85,000.
d. $390,000.

16. P Company purchased the net assets of S Company for $225,000. On the date of P’s purchase, S Company had no investments in marketable securities and $30,000 (book and fair value) of liabilities. The fair values of S Company’s assets, when acquired, were

Current assets $ 120,000
Noncurrent assets 180,000
Total $300,000

How should the $45,000 difference between the fair value of the net assets acquired ($270,000) and the consideration paid ($225,000) be accounted for by P Company?
a. The noncurrent assets should be recorded at $ 135,000.
b. The $45,000 difference should be credited to retained earnings.
c. The current assets should be recorded at $102,000, and the noncurrent assets should be recorded at $153,000.
d. An ordinary gain of $45,000 should be recorded.
17. If the value implied by the purchase price of an acquired company exceeds the fair values of identifiable net assets, the excess should be
a. allocated to reduce any previously recorded goodwill and classify any remainder as an ordinary gain.
b. allocated to reduce current and long-lived assets.
c. allocated to reduce long-lived assets.
d. accounted for as goodwill.

18. P Co. issued 5,000 shares of its common stock, valued at $200,000, to the former shareholders of S Company two years after S Company was acquired in an all-stock transaction. The additional shares were issued because P Company agreed to issue additional shares of common stock if the average post combination earnings over the next two years exceeded $500,000. P Company will treat the issuance of the additional shares as a (decrease in)
a. consolidated retained earnings.
b. consolidated goodwill.
c. consolidated paid-in capital.
d. non-current liabilities of S Company assumed by P Company.

19. In a business combination in which the total fair value of the identifiable assets acquired over liabilities assumed is greater than the consideration paid, the excess fair value is:
a. classified as an extraordinary gain.
b. allocated first to eliminate any previously recorded goodwill, and any remaining excess over the consideration paid is classified as an ordinary gain.
c. allocated first to reduce proportionately non-current assets then to non-monetary current assets, and any remaining excess over cost is classified as a deferred credit.
d. allocated first to reduce proportionately non-current, depreciable assets to zero, and any remaining excess over cost is classified as a deferred credit.

20. The first step in determining goodwill impairment involves comparing the
a. implied value of a reporting unit to its carrying amount (goodwill excluded).
b. fair value of a reporting unit to its carrying amount (goodwill excluded).
c. implied value of a reporting unit to its carrying amount (goodwill included).
d. fair value of a reporting unit to its carrying amount (goodwill included).

21. If an impairment loss is recorded on previously recognized goodwill due to the transitional goodwill impairment test, the loss should be treated as a(n):
a. loss from a change in accounting principles.
b. extraordinary loss
c. loss from continuing operations.
d. loss from discontinuing operations.

22. P Company acquires all of the voting stock of S Company for $930,000 cash. The book values of S Company’s assets are $800,000, but the fair values are $840,000 because land has a fair value above its book value. Goodwill from the combination is computed as:
a. $130,000.
b. $90,000.
c. $40,000.
d. $0.

23. Under SFAS 141R, what value of the assets and liabilities are reflected in the financial statements on the acquisition date of a business combination?
a. Carrying value
b. Fair value
c. Book value
d. Average value

Use the following information to answer questions 24 & 25.

Pratt Company issued 24,000 shares of its $20 par value common stock for the net assets of Sele Company in business combination under which Sele Company will be merged into Pratt Company. On the date of the combination, Pratt Company common stock had a fair value of $30 per share. Balance sheets for Pratt Company and Sele Company immediately prior to the combination were as follows:

Pratt Sele

Current Assets $1,314,000 $192,000
Plant and Equipment (net) 1,725,000 408,000
Total $3,039,000 $600,000

Liabilities $ 900,000 $150,000
Common Stock, $20 par value 1,650,000 240,000
Other Contributed Capital 218,000 60,000
Retained Earnings 271,000 150,000
Total $3,039,000 $600,000

24. If the business combination is treated as an acquisition and Sele Company’s net assets have a fair value of $686,400, Pratt Company’s balance sheet immediately after the combination will include goodwill of
a. $30,600.
b. $38,400.
c. $33,600.
d. $56,400.

25. If the business combination is treated as an acquisition and the fair value of Sele Company’s current assets is $270,000, its plant and equipment is $726,000, and its liabilities are $168,000, Pratt Company’s financial statements immediately after the combination will include
a. Negative goodwill of $108,000.
b. Plant and equipment of $2,133,000.
c. Plant and equipment of $2,343,000.
d. An ordinary gain of $108,000.

26. On May 1, 2011, the Phil Company paid $1,200,000 for 80% of the outstanding common stock of Sage Corporation in a transaction properly accounted for as an acquisition. The recorded assets and liabilities of Sage Corporation on May 1, 2011, follow:

Cash $100,000
Inventory 200,000
Property & equipment (Net of accumulated depreciation) 800,000
Liabilities (160,000)

On May 1, 2011, it was determined that the inventory of Sage had a fair value of $220,000 and the property and equipment (net) has a fair value of $1,200,000. What is the amount of goodwill resulting from the business combination?
a. $0.
b. $112,000.
c. $140,000.
d. $28,000.

Use the following information to answer questions 27 & 28.

Posch Company issued 12,000 shares of its $20 par value common stock for the net assets of Sato Company in a business combination under which Sato Company will be merged into Posch Company. On the date of the combination, Posch Company common stock had a fair value of $30 per share. Balance sheets for Posch Company and Sato Company immediately prior to the combination were as follows:

Posch Sato

Current Assets $ 657,000 $ 96,000
Plant and Equipment (net) 863,000 204,000
Total $1,520,000 $300,000

Liabilities $ 450,000 $ 75,000
Common Stock, $20 par value 825,000 120,000
Other Contributed Capital 109,000 30,000
Retained Earnings 136,000 75,000
Total $1,520,000 $300,000

27. If the business combination is treated as an acquisition and Sato Company’s net assets have a fair value of $343,200, Posch Company’s balance sheet immediately after the combination will include goodwill of
a. $15,300.
b. $19,200.
c. $16,800.
d. $28,200.

28. If the business combination is treated as an acquisition and the fair value of Sato Company’s current assets is $135,000, its plant and equipment is $363,000, and its liabilities are $84,000, Posch Company’s financial statements immediately after the combination will include
a. Negative goodwill of $54,000.
b. Plant and equipment of $1,226,000.
c. Plant and equipment of $1,172,000.
d. An extraordinary gain of $54,000.

29. Following its acquisition of the net assets of Sandy Company, Potter Company assigned goodwill of $60,000 to one of the reporting divisions. Information for this division follows:

Carrying Amount Fair Value
Cash $ 20,000 $20,000
Inventory 35,000 40,000
Equipment 125,000 160,000
Goodwill 60,000
Accounts Payable 30,000 30,000

Based on the preceding information, what amount of goodwill will be reported for this division if its fair value is determined to be $200,000?
a. $0
b. $60,000
c. $30,000
d. $10,000

30. The fair value of net identifiable assets exclusive of goodwill of a reporting unit of X Company is $300,000. On X Company’s books, the carrying value of this reporting unit’s net assets is $350,000, including $60,000 goodwill. If the fair value of the reporting unit is $335,000, what amount of goodwill impairment will be recognized for this unit?
a. $0
b. $10,000
c. $25,000
d. $35,000

31. The fair value of net identifiable assets of a reporting unit exclusive of goodwill of Y Company is $270,000. The carrying value of the reporting unit’s net assets on Y Company’s books is $320,000, including $50,000 goodwill. If the reported goodwill impairment for the unit is $10,000, what would be the fair value of the reporting unit?
a. $320,000
b. $310,000
c. $270,000
d. $290,000

32. Potter Corporation acquired Sims Company through an exchange of common shares. All of Sims’ assets and liabilities were immediately transferred to Potter. Potter Company’s common stock was trading at $20 per share at the time of exchange. The following selected information is also available:
Potter Company
Before Acquisition After Acquisition
Par value of shares outstanding $200,000 $250,000
Additional Paid in Capital 350,000 550,000

What number of shares was issued at the time of the exchange?
a. 5,000
b. 17,500
c. 12,500
d. 10,000

Problems

2-1 Balance sheet information for Seitz Corporation at January 1, 2011, is summarized as follows:
Current assets $ 920,000 Liabilities $ 1,200,000
Plant assets 1,800,000 Capital stock $10 par 800,000
Retained earnings 720,000
$2,720,000 $ 2,720,000

Seitz’s assets and liabilities are fairly valued except for plant assets that are undervalued by $200,000. On January 2, 2011, Pell Corporation issues 80,000 shares of its $10 par value common stock for all of Seitz’s net assets and Seitz is dissolved. Market quotations for the two stocks on this date are:

Pell common: $28
Seitz common: $19

Pell pays the following fees and costs in connection with the combination:

Finder’s fee $10,000
Costs of registering and issuing stock 5,000
Legal and accounting fees 6,000

Required:
A. Calculate Pell’s investment cost of Seitz Corporation.

B. Calculate any goodwill from the business combination.

2-2 Peterson Corporation purchased the net assets of Scarberry Corporation on January 2, 2011 for $560,000 and also paid $20,000 in direct acquisition costs. Scarberry’s balance sheet on January
1, 2011 was as follows:

Accounts receivable-net $ 180,000 Current liabilities $ 70,000
Inventory 360,000 Long term debt 160,000
Land 40,000 Common stock ($1 par) 20,000
Building-net 60,000 Paid-in capital 430,000
Equipment-net 80,000 Retained earnings 40,000
Total assets $ 720,000 Total liab. & equity $ 720,000

Fair values agree with book values except for inventory, land, and equipment, which have fair values of $400,000, $50,000 and $70,000, respectively. Scarberry has patent rights valued at $20,000.

Required:
A. Prepare Peterson’s general journal entry for the cash purchase of Scarberry’s net assets.

B. Assume Peterson Corporation purchased the net assets of Scarberry Corporation for $500,000 rather than $560,000, prepare the general journal entry.

2-3 Pyle Company acquired the assets (except cash) and assumed the liabilities of Sand Company on January 1, 2011, paying $2,600,000 cash. Immediately prior to the acquisition, Sand Company’s balance sheet was as follows:

BOOK VALUE FAIR VALUE
Accounts receivable (net) $ 240,000 $ 220,000
Inventory 290,000 320,000
Land 960,000 1,508,000
Buildings (net) 1,020,000 1,392,000
Total $2,510,000 $3,440,000

Accounts payable $ 270,000 $ 270,000
Note payable 600,000 600,000
Common stock, $5 par 420,000
Other contributed capital 640,000
Retained earnings 580,000
Total $2,510,000

Pyle Company agreed to pay Sand Company’s former stockholders $200,000 cash in 2012 if post- combination earnings of the combined company reached $1,000,000 during 2011.

Required:
A. Prepare the journal entry necessary for Pyle Company to record the acquisition on January 1, 2011. It is expected that the earnings target is likely to be met.

B. Prepare the journal entry necessary for Pyle Company in 2012 assuming the earnings contingency was not met.

2-4 Condensed balance sheets for Payne Company and Sigle Company on January 1, 2011 are as follows:

Payne Sigle
Current Assets $ 440,000 $200,000
Plant and Equipment (net) 1,080,000 340,000
Total Assets $1,520,000 $540,000

Total Liabilities $ 230,000 $ 80,000
Common Stock, $10 par value 840,000 240,000
Other Contributed Capital 300,000 130,000
Retained Earnings 150,000 90,000
Total Equities $1,520,000 $540,000

On January 1, 2011 the stockholders of Payne and Sigle agreed to a consolidation whereby a new corporation, Lawson Company, would be formed to consolidate Payne and Sigle. Lawson Company issued 70,000 shares of its $20 par value common stock for the net assets of Payne and Sigle. On the date of consolidation, the fair values of Payne’s and Sigle’s current assets and liabilities were equal to their book values. The fair value of plant and equipment for each company was: Payne, $1,270,000; Sigle, $360,000.
An investment banking house estimated that the fair value of Lawson Company’s common stock was $35 per share. Payne will incur $45,000 of direct acquisition costs and $15,000 in stock issue costs.

Required:
Prepare the journal entries to record the consolidation on the books of Lawson Company assuming that the consolidation is accounted for as an acquisition.

2-5 The stockholders’ equities of P Corporation and S Corporation were as follows on January 1, 2011:

P Corp. S Corp.
Common Stock, $1 par $1,000,000 $ 600,000
Other Contributed Capital 2,800,000 1,100,000
Retained Earnings 600,000 340,000
Total Stockholders’ Equity $4,400,000 $2,040,000

On January 2, 2011 P Corp. issued 100,000 of its shares with a market value of $14 per share in exchange for all of S’s shares, and S Corp. was dissolved. P Corp. paid $10,000 to register and issue the new common shares.

Required:
Prepare the stockholders’ equity section of P Corp. balance sheet after the business combination on January 2, 2011.

2-6 The managers of Petty Company own 10,000 of its 100,000 outstanding common shares. Swann Company is formed by the managers of Petty Company to take over Petty Company in a leveraged buyout. The managers contribute their shares in Petty Company and Swann Company then borrows $675,000 to purchase the remaining 90,000 shares of Petty Company for $600,000; the remaining $75,000 is used for working capital. Petty Company is then merged into Swann Company effective January 1, 2011. Data relevant to Petty Company immediately prior to the leveraged buyout follow:

Book Value Fair Value
Current Assets $ 90,000 $ 90,000
Plant Assets 255,000 525,000
Liabilities (45,000) (45,000)
Stockholders’ Equity $300,000 $570,000

Required:
A. Prepare journal entries on Swann Company’s books to reflect the effects of the leveraged buyout.
B. Determine the balance of each of the following immediately after the merger:
1. Current Assets
2. Plant Assets
3. Note Payable
4. Common Stock

2-7 On January 1, 2010, Presley Company acquired the net assets of Sill Company for $1,580,000 cash. The fair value of Sill’s identifiable net assets was $1,310,000 on his date. Presley Company decided to measure goodwill impairment using the present value of future cash flows to estimate the fair value of the reporting unit (Sill). The information for these subsequent years is as follows:

Carrying value of Fair Value
Present value Sill’s Identifiable Sill’s Identifiable
Year of Future Cash Flows Net Assets* Net Assets
2011 $1,400,000 $1,160,000 $1,190,000
2012 $1,400,000 $1,120,000 $1,210,000
* Identifiable net assets do not include goodwill.
Required:
A: For each year determine the amount of goodwill impairment, if any.
B: Prepare the journal entries needed each year to record the goodwill impairment (if any) on Presley’s books.

2-8 The following balance sheets were reported on January 1, 2011, for Piper Company and Sieler Company:

Piper Sieler
Cash $ 150,000 $ 30,000
Inventory 450,000 150,000
Equipment (net) 1,320,000 570,000
Total $1,920,000 $750,000

Total liabilities $ 450,000 $150,000
Common stock, $20 par value 600,000 300,000
Other contributed capital 375,000 105,000
Retained earnings 495,000 195,000
Total $1,920,000 $750,000

Required:
Appraisals reveal that the inventory has a fair value $180,000, and the equipment has a current value of $615,000. The book value and fair value of liabilities are the same. Assuming that Piper Company wishes to acquire Sieler for cash in an asset acquisition, determine the following cutoff amounts:
A. The purchase price above which Piper would record goodwill.
B. The purchase price at which Piper would record a $50,000 gain.
C. The purchase price below which Piper would obtain a “bargain.”
D. The purchase price at which Piper would record $75,000 of goodwill.

Short Answer

1. SFAS No. 142 requires that goodwill impairment be tested annually for each reporting unit. Discuss the necessary steps of the goodwill impairment test.

2. Briefly describe the different treatment under SFAS 141 vs. SFAS 141R for the following issues:
a. Business definition
b. Acquisitions costs
c. In-process R&D
d. Contingent consideration

Short Answer Questions from the Textbook

1. When contingent consideration in an acquisition is based on security prices, how should this contingency be reflected on the acquisition date? If the estimate changes during the measurement period, how is this handled? If the estimate changes after the end of the measurement period, how is this adjustment handled? Why?

2. What are pro forma financial statements? What is their purpose?

3. How would a company determine whether goodwill has been impaired?

4. AOL announced that because of an accounting change (FASB Statements Nos. 141R [ASC 805] and142 [ASC 350]), earnings would be increasing 2002, Veritas Software Corporation’s CFO resigned after claiming to have an MBA from Stanford University. On the other hand, Bausch & Lomb Inc.’s board re-fused the CEO’s offer to resign following a questionable claim to have an MBA. Suppose you have been retained by the board of a company where the CEO has ‘overstated’ credentials. This company has a code of ethics and conduct which over the next 25 years by $5.9 billion a year. What change(s) required by FASB (in SFAS Nos. 141Rand 142) resulted in an increase in AOL’s in-come? Would you expect this increase in earnings to have a positive impact on AOL’s stock price? Why or why not?

Business Ethics Question from Textbook
There have been several recent cases of a CEO or CFO resigning or being ousted for misrepresenting academic credentials. For instance, during February 2006,the CEO of RadioShack resigned by ‘mutual agreement’ for inflating his educational background. During states that the employee should always do “the right thing.”(a) What is the board of directors’ responsibility in such matters?(b) What arguments would you make to ask the CEO to resign? What damage might be caused if the decision is made to retain the current CEO?

ANSWER KEY (Chapter 2)

Chapter 3

Consolidated Financial Statements—Date of Acquisition

Multiple Choice

1. A majority-owned subsidiary that is in legal reorganization should normally be accounted for using
a. consolidated financial statements.
b. the equity method.
c. the market value method.
d. the cost method.

2. Under the acquisition method, indirect costs relating to acquisitions should be
a. included in the investment cost.
b. expensed as incurred.
c. deducted from other contributed capital.
d. none of these.

3. Eliminating entries are made to cancel the effects of intercompany transactions and are made on the
a. books of the parent company.
b. books of the subsidiary company.
c. workpaper only.
d. books of both the parent company and the subsidiary.

4. One reason a parent company may pay an amount less than the book value of the subsidiary’s stock acquired is
a. an undervaluation of the subsidiary’s assets.
b. the existence of unrecorded goodwill.
c. an overvaluation of the subsidiary’s liabilities.
d. none of these.

5. In a business combination accounted for as an acquisition, registration costs related to common stock issued by the parent company are
a. expensed as incurred.
b. deducted from other contributed capital.
c. included in the investment cost.
d. deducted from the investment cost.

6. On the consolidated balance sheet, consolidated stockholders’ equity is
a. equal to the sum of the parent and subsidiary stockholders’ equity.
b. greater than the parent’s stockholders’ equity.
c. less than the parent’s stockholders’ equity.
d. equal to the parent’s stockholders’ equity.

7. Majority-owned subsidiaries should be excluded from the consolidated statements when
a. control does not rest with the majority owner.
b. the subsidiary operates under governmentally imposed uncertainty.
c. a foreign subsidiary is domiciled in a country with foreign exchange restrictions or controls.
d. any of these circumstances exist.

8. Under the economic entity concept, consolidated financial statements are intended primarily for the benefit of the
a. stockholders of the parent company.
b. creditors of the parent company.
c. minority stockholders.
d. all of the above.

9. Reasons a parent company may pay more than book value for the subsidiary company’s stock include all of the following except
a. the fair value of one of the subsidiary’s assets may exceed its recorded value because of appreciation.
b. the existence of unrecorded goodwill.
c. liabilities may be overvalued.
d. stockholders’ equity may be undervalued.

10. What is the method of presentation required by SFAS 160 of “non-controlling interest” on a consolidated balance sheet?
a. As a deduction from goodwill from consolidation.
b. As a separate item within the long-term liabilities section.
c. As a part of stockholders’ equity.
d. As a separate item between liabilities and stockholders’ equity.

11. Which of the following is a limitation of consolidated financial statements?
a. Consolidated statements provide no benefit for the stockholders and creditors of the parent company.
b. Consolidated statements of highly diversified companies cannot be compared with industry standards.
c. Consolidated statements are beneficial only when the consolidated companies operate within the same industry.
d. Consolidated statements are beneficial only when the consolidated companies operate in different industries.

12. Pine Corp. owns 60% of Sage Corp.’s outstanding common stock. On May 1, 2011, Pine advanced Sage $90,000 in cash, which was still outstanding at December 31, 2011. What portion of this advance should be eliminated in the preparation of the December 31, 2011 consolidated balance sheet?
a. $90,000.
b. $54,000.
c. $36,000.
d. $-0-.

Use the following information for questions 13-15.

On January 1, 2011, Polk Company and Sigler Company had condensed balance sheets as follows:
Polk Sigler
Current assets $ 280,000 $ 80,000
Noncurrent assets _360,000 __160,000
Total assets $ 640,000 $240,000

Current liabilities $ 120,000 $ 40,000
Long-term debt 200,000 -0-
Stockholders’ equity __320,000 200,000
Total liabilities & stockholders’ equity $ 640,000 $240,000
On January 2, 2011 Polk borrowed $240,000 and used the proceeds to purchase 90% of the outstanding common stock of Sigler. This debt is payable in 10 equal annual principal payments, plus interest, starting December 30, 2011. Any difference between book value and the value implied by the purchase price relates to land.

On Polk’s January 2, 2011 consolidated balance sheet,

13. Noncurrent assets should be
a. $520,000.
b. $536,000.
c. $544,000.
d. $586,667.

14. Current liabilities should be
a. $200,000.
b. $184,000.
c. $160,000.
d. $120,000.

15. Noncurrent liabilities should be
a. $440,000.
b. $416,000.
c. $240,000.
d. $216,000.

16. A newly acquired subsidiary has pre-existing goodwill on its books. The parent company’s consolidated balance sheet will:
a. treat the goodwill the same as other intangible assets of the acquired company.
b. will always show the pre-existing goodwill of the subsidiary at its book value.
c. not show any value for the subsidiary’s pre-existing goodwill.
d. do an impairment test to see if any of it has been impaired.

17. The Difference between Implied and Book Value account is:
a. an account necessary for the preparation of consolidated working papers.
b. used in allocating the amounts paid for recorded balance sheet accounts that are different than
their fair values.
c. the excess implied value assigned to goodwill.
d. the unamortized excess that cannot be assigned to any related balance sheet accounts

18. The main evidence of control for purposes of consolidated financial statements involves
a. possessing majority ownership
b. having decision-making ability that is not shared with others.
c. being the sole shareholder
d. having the parent company and the subsidiary participating in the same industry.

19. In which of the following cases would consolidation be inappropriate?
a. The subsidiary is in bankruptcy.
b. Subsidiary’s operations are dissimilar from those of the parent.
c. The parent owns 90 percent of the subsidiary’s common stock, but all of the subsidiary’s nonvoting preferred stock is held by a single investor.
d. Subsidiary is foreign.

20. Princeton Company acquired 75 percent of the common stock of Sheffield Corporation on December 31, 2011. On the date of acquisition, Princeton held land with a book value of $150,000 and a fair value of $300,000; Sheffield held land with a book value of $100,000 and fair value of $500,000. What amount would land be reported in the consolidated balance sheet prepared immediately after the combination?
a. $650,000
b. $500,000
c. $550,000
d. $375,000

Use the following information to answer questions 21 – 23.

On January 1, 2011, Pena Company and Shelby Company had condensed balanced sheets as follows:

Pena Shelby

Current assets $ 210,000 $ 60,000
Noncurrent assets 270,000 120,000
Total assets $480,000 $180,000

Current liabilities $ 90,000 $ 30,000
Long-term debt 150,000 -0-
Stock holders’ equity 240,000 150,000
Total liabilities & stockholders’ equity $ 480,000 $ 180,000

On January 2, 2011 Pena borrowed $180,000 and used the proceeds to purchase 90% of the outstanding common stock of Shelby. This debt is payable in 10 equal annual principal payments, plus interest, starting December 30, 2011. Any difference between book value and the value implied by the purchase price relates to land.

On Pena’s January 2, 2011 consolidated balance sheet,

21. Noncurrent assets should be
a. $390,000.
b. $402,000.
c. $408,000.
d. $440,000.

22. Current liabilities should be
a. $150,000.
b. $138,000.
c. $120,000.
d. $90,000.

23. Noncurrent liabilities should be
a. $330,000.
b. $312,000.
c. $180,000.
d. $162,000.

24. On January 1, 2011, Primer Corporation acquired 80 percent of Sutter Corporation’s voting common stock.
Sutters’s buildings and equipment had a book value of $300,000 and a fair value of $350,000 at the time of
acquisition. At what amount will Sutter’s buildings and equipment will be reported in the consolidated
statements ?
a. $350,000
b. $340,000
c. $280,000
d. $300,000

Problems

3-1 On December 31, 2011, Page Company purchased 80% of the outstanding common stock of Snead Company for cash. At the time of acquisition, Snead Company’s balance sheet was as follows:

Current assets $ 1,680,000
Plant and equipment 1,580,000
Land 280,000
Total assets $3,540,000

Liabilities $ 1,320,000
Common stock, $10 par value 1,440,000
Other contributed capital 700,000
Retained earnings 240,000
Total $3,700,000
Treasury stock at cost, 5,000 shares 160,000
Total equities $3,540,000

Required:

Prepare the elimination entry(s) required for the preparation of a consolidated balance sheet workpaper on December 31, 2011, assuming the purchase price of the stock was $1,670,000. Any difference between the value implied by the purchase price of the investment and the book value of net assets acquired relates to subsidiary land.

3-2 P Company purchased 80% of the outstanding common stock of S Company on January 2, 2011, for $380,000. Balance sheets for P Company and S Company immediately after the stock acquisition were as follows:

P Company S Company
Current assets $ 166,000 $ 96,000
Investment in S Company 380,000 -0-
Plant and equipment (net) 560,000 224,000
Land 40,000 120,000
$1,146,000 $440,000

Current liabilities $ 120,000 $ 44,000
Long-term notes payable -0- 36,000
Common stock 480,000 160,000
Other contributed capital 244,000 64,000
Retained earnings 302,000 136,000
$1,146,000 $440,000

S Company owed P Company $16,000 on open account on the date of acquisition.

Required:

Prepare a consolidated balance sheet for P and S Companies on the date of acquisition. Any difference between the value implied by the purchase price of the investment and the book value of net assets acquired relates to subsidiary land. The book values of S Company’s other assets and liabilities are equal to their fair values.

3-3 P Company acquired 54,000 shares of the common stock of S Company on January 1, 2011, for $950,000 cash. The stockholders’ equity section of S Company’s balance sheet on that date was as follows:

Common stock, $10 par value $600,000
Other contributed capital 80,000
Retained earnings 320,000
Total $1,000,000

On the date of acquisition, S Company owed P Company $10,000 on open account.

Required:
Present, in general journal form, the elimination entries for the preparation of a consolidated balance sheet workpaper on January 1, 2011. The difference between the value implied by the purchase price of the investment and the book value of the net assets acquired relates to subsidiary land.

3-4 On January 2, 2011, Potter Company acquired 90% of the outstanding common stock of Smiley Company for $480,000 cash. Just before the acquisition, the balance sheets of the two companies were as follows:

Potter Smiley
Cash $ 650,000 $ 160,000
Accounts Receivable (net) 360,000 60,000
Inventory 290,000 140,000
Plant and Equipment (net) 970,000 240,000
Land 150,000 80,000
Total Assets $2,420,000 $680,000

Accounts Payable $ 260,000 $ 120,000
Mortgage Payable 180,000 100,000
Common Stock, $2 par value 1,000,000 170,000
Other Contributed Capital 520,000 50,000
Retained Earnings 460,000 240,000
Total Equities $2,420,000 $680,000

The fair values of Smiley’s assets and liabilities are equal to their book values with the exception of land.

Required:

A. Prepare the journal entry necessary to record the purchase of Smiley’s common stock.
B. Prepare a consolidated balance sheet at the date of acquisition.

3-5 P Corporation paid $420,000 for 70% of S Corporation’s $10 par common stock on December 31, 2011, when S Corporation’s stockholders’ equity was made up of $300,000 of Common Stock, $90,000 of Other Contributed Capital and $60,000 of Retained Earnings. S’s identifiable assets and liabilities reflected their fair values on December 31, 2011, except for S’s inventory which was undervalued by $60,000 and their land which was undervalued by $25,000. Balance sheets for P and S immediately after the business combination are presented in the partially completed work-paper below.

Eliminations
P S Debit Credit
Noncontrolling Interest Consolidated Balances
ASSETS
Cash $40,000 $30,000
Accounts
receivable-net 30,000 45,000
Inventories 185,000 165,000
Land 45,000 120,000
Plant assets-
net 480,000 240,000
Investment in
S Corp. 420,000
Difference between implied and book value
Goodwill
Total Assets $1,200,000 $600,000
EQUITIES
Current
liabilities $170,000 $150,000
Capital stock 600,000 300,000
Additional paid-in capital 150,000 90,000
Retained earnings 280,000 60,000
Noncontrolling interest
Total Equities $1,200,000 $600,000

Required:
Complete the consolidated balance sheet workpaper for P Corporation and Subsidiary.

3-6 Prepare in general journal form the workpaper entries to eliminate Porter Company’s investment in Sewell Company in the preparation of a consolidated balance sheet at the date of acquisition for each of the following independent cases:

Sewell Company Equity Balances
Cash Percent of Stock Owned Investment Cost Common Stock Other Contributed Capital Retained Earnings
a. 90 $675,000 $450,000 $180,000 $75,000
b. 80 318,000 620,000 140,000 20,000

Any difference between book value of net assets acquired and the value implied by the purchase price relates to subsidiary property, plant, and equipment except for case (b). In case (b) assume that all book values and fair values are the same.

3-7 On December 31, 2011, Pryor Company purchased a controlling interest in Shelby Company for $1,060,000. The consolidated balance sheet on December 31, 2011 reported noncontrolling interest in Shelby Company of $265,000.

On the date of acquisition, the stockholders’ equity section of Shelby Company’s balance sheet was as follows:

Common stock $520,000
Other contributed capital 380,000
Retained earnings 280,000
Total 1,180,000

Required:

A. Compute the noncontrolling interest percentage on December 31, 2011.
B. Prepare the investment elimination entry made to prepare a consolidated balance sheet workpaper. Any difference between book value and the value implied by the purchase price relates to subsidiary land.

3-8 On January 1, 2011, Primer Company issued 1,500 of its $20 par value common shares with a fair value of $50 per share in exchange for 2,000 outstanding common shares of Swartz Company in a purchase transaction. Registration costs amounted to $1,700 paid in cash. Just prior to the acquisition, the balance sheets of the two companies were as follows:

Primer Swartz

Cash $ 73,000 $13,000
Accounts Receivable (net) 95,000 19,000
Inventory 58,000 25,000
Plant and Equipment (net) 95,000 43,000
Land 26,000 20,000
Total Assets $ 347,000 $ 120,000

Accounts Payable $ 66,000 16,000
Notes Payable 82,000 21,000
Common Stock, $20 par value 100,000 40,000
Other Contributed Capital 60,000 24,000
Retained Earnings 39,000 19,000
Total Liabilities and Equities $ 347,000 $ 120,000

Any differences between the book value of equity and the value implied by the purchase price relates to Land.

Required:
A. Prepare the journal entry on Primer’s books to record the exchange of stock.
B. Prepare a Computation and Allocation Schedule for the Difference between book value and value implied by the purchase price.
C. Calculate the consolidated balance for each of the following accounts as of December 31, 2011:
1. Cash
2. Land
3. Common Stock
4. Other Contributed Capital

Short Answer

1. There are several reasons why a company would acquire a subsidiary’s voting common stock rather than its net assets. Identify at least two advantages to acquiring a controlling interest in the voting stock of another company rather than its assets.

2. A useful first step in the consolidating process is to prepare a Computation and Allocation of Difference (CAD) Schedule. Identify the steps involved in preparing the CAD schedule.

Short Answer Questions from the Textbook

1. What are the advantages of acquiring the majority of the voting stock of another company rather than acquiring all its voting stock?

2. What is the justification for preparing consolidated financial statements when, in fact, it is ap-parent that the consolidated group is not a legal entity?

3. Why is it often necessary to prepare separate financial statements for each legal entity in a consolidated group even though consolidated statements provide a better economic picture of the combined activities?

4. What aspects of control must exist before a subsidiary is consolidated?

5. Why are consolidated work papers used in pre-paring consolidated financial statements?

6. Define noncontrolling (minority) interest. List three methods that might be used for reporting the noncontrolling interest in a consolidated balance sheet, and state which is preferred under the SFAS No. 160[topic 810].

7. Give several reasons why a parent company would be willing to pay more than book value for subsidiary stock acquired.

8. What effect do subsidiary treasury stock holdings have at the time the subsidiary is acquired? How should the treasury stock be treated on consolidated work papers?

9. What effect does a noncontrolling interest have on the amount of intercompany receivables and payables eliminated on a consolidated balance sheet?

10 A.SFAS No. 109and SFAS No. 141R[ASC 740 and805] require that a deferred tax asset or liability be recognized for likely differences between the reported values and tax bases of assets and liabilities recognized in business combinations (for example, in exchanges that are nontaxable to the selling shareholders). Does this decision change the amount of consolidated net income reported in years subsequent to the business combination? Explain.

Business Ethics Question from the Textbook

Part I. You are working on the valuation of accounts receivable, and bad debt reserves for the current year’s annual report. The CFO stops by and asks you to reduce the reserve by enough to increase the current year’s EPS by 2 cents a share. The company’s policy has always been to use the previous year’s actual bad debt percentage adjusted for a specific economic index. The CFO’s suggested change would still be within acceptable GAAP. However, later, you learn that with the increased EPS, the CFO would qualify for a significant bonus. What do you do and why?

Part II. Consider the following: Accounting firm KPMG created tax shelters called BLIPS, FLIP, OPIS, and SOS that were based largely in the Cayman Islands and allowed wealthy clients (there were 186) to create $5 billion in losses, which were then deducted from their income for IRS tax purposes. BLIPS (Bond Linked Issue Premium Structures) had clients borrow from an offshore bank for purposes of purchasing currency. The client would then sell the currency back to the lender for a loss. However, the IRS contends the losses were phony and that there was never any risk to the client in the deals. The IRS has indicted eight former KPMG partners and an outside lawyer alleging that the transactions were shams, illegal methods for avoiding taxes. KPMG has agreed to pay a$456 million fine, no longer to do tax shelters, and to cooperate with the government in its prosecution of the nine individuals involved in the tax shelter scheme. Many argue that the courts have not always held that such tax avoidance schemes show criminal intent because the tax laws permit individuals to minimize taxes. However, the IRS argues that these shelters evidence intent because of the lack of risk.

Question
In this case, the IRS contends that the losses generated by the tax shelters were phony and that the clients never incurred any risk. Do tax avoidance schemes indicate criminal intent if the tax laws permit individuals to minimize taxes? Justify your answer.

ANSWER KEY (Chapter 3)

Chapter 4

Consolidated Financial Statements after Acquisition

1. An investor adjusts the investment account for the amortization of any difference between cost and book value under the
a. cost method.
b. complete equity method.
c. partial equity method.
d. complete and partial equity methods.

2. Under the partial equity method, the entry to eliminate subsidiary income and dividends includes a debit to
a. Dividend Income.
b. Dividends Declared – S Company.
c. Equity in Subsidiary Income.
d. Retained Earnings – S Company.

3. On the consolidated statement of cash flows, the parent’s acquisition of additional shares of the subsidiary’s stock directly from the subsidiary is reported as
a. an investing activity.
b. a financing activity.
c. an operating activity.
d. none of these.

4. Under the cost method, the workpaper entry to establish reciprocity
a. debits Retained Earnings – S Company.
b. credits Retained Earnings – S Company.
c. debits Retained Earnings – P Company.
d. credits Retained Earnings – P Company.

5. Under the cost method, the investment account is reduced when
a. there is a liquidating dividend.
b. the subsidiary declares a cash dividend.
c. the subsidiary incurs a net loss.
d. none of these.

6. The parent company records its share of a subsidiary’s income by
a. crediting Investment in S Company under the partial equity method.
b. crediting Equity in Subsidiary Income under both the cost and partial equity methods.
c. debiting Equity in Subsidiary Income under the cost method.
d. none of these.

7. In years subsequent to the year of acquisition, an entry to establish reciprocity is made under the
a. complete equity method.
b. cost method.
c. partial equity method.
d. complete and partial equity methods.

8. A parent company received dividends in excess of the parent company’s share of the subsidiary’s earnings subsequent to the date of the investment. How will the parent company’s investment account be affected by those dividends under each of the following accounting methods?

Cost Method Partial Equity Method
a. No effect No effect
b. Decrease No effect
c. No effect Decrease
d. Decrease Decrease

9. P Company purchased 80% of the outstanding common stock of S Company on May 1, 2011, for a cash payment of $1,272,000. S Company’s December 31, 2010 balance sheet reported common stock of $800,000 and retained earnings of $540,000. During the calendar year 2011, S Company earned $840,000 evenly throughout the year and declared a dividend of $300,000 on November 1. What is the amount needed to establish reciprocity under the cost method in the preparation of a consolidated workpaper on December 31, 2012?
a. $208,000
b. $260,000
c. $248,000
d. $432,000

10. P Company purchased 90% of the outstanding common stock of S Company on January 1, 1997. S Company’s stockholders’ equity at various dates was:
1/1/97 1/1/11 12/31/11
Common stock $400,000 $400,000 $400,000
Retained earnings 120,000 380,000 460,000
Total $520,000 $780,000 $860,000

The workpaper entry to establish reciprocity under the cost method in the preparation of a consolidated statements workpaper on December 31, 2011 should include a credit to P Company’s retained earnings of
a. $80,000.
b. $234,000.
c. $260,000.
d. $306,000.

11. Consolidated net income for a parent company and its partially owned subsidiary is best defined as the parent company’s
a. recorded net income.
b. recorded net income plus the subsidiary’s recorded net income.
c. recorded net income plus the its share of the subsidiary’s recorded net income.
d. income from independent operations plus subsidiary’s income resulting from transactions with outside parties.

12. In the preparation of a consolidated statements workpaper, dividend income recognized by a parent company for dividends distributed by its subsidiary is
a. included with parent company income from other sources to constitute consolidated net income.
b. assigned as a component of the noncontrolling interest.
c. allocated proportionately to consolidated net income and the noncontrolling interest.
d. eliminated.

13. In the preparation of a consolidated statement of cash flows using the indirect method of presenting cash flows from operating activities, the amount of the noncontrolling interest in consolidated income is
a. combined with the controlling interest in consolidated net income.
b. deducted from the controlling interest in consolidated net income.
c. reported as a significant noncash investing and financing activity in the notes.
d. reported as a component of cash flows from financing activities.

14. On October 1, 2011, Parr Company acquired for cash all of the voting common stock of Stein Company. The purchase price of Stein’s stock equaled the book value and fair value of Stein’s net assets. The separate net income for each company, excluding Parr’s share of income from Stein was as follows:
Parr Stein
Twelve months ended 12/31/11 $4,500,000 $2,700,000
Three months ended 12/31/11 495,000 450,000

During September, Stein paid $150,000 in dividends to its stockholders. For the year ended December 31, 2011, Parr issued parent company only financial statements. These statements are not considered those of the primary reporting entity. Under the partial equity method, what is the amount of net income reported in Parr’s income statement?
a. $7,200,000.
b. $4,650,000.
c. $4,950,000.
d. $1,800,000.

15. A parent company uses the partial equity method to account for an investment in common stock of its subsidiary. A portion of the dividends received this year were in excess of the parent company’s share of the subsidiary’s earnings subsequent to the date of the investment. The amount of dividend income that should be reported in the parent company’s separate income statement should be
a. zero.
b. the total amount of dividends received this year.
c. the portion of the dividends received this year that were in excess of the parent’s share of subsidiary’s earnings subsequent to the date of investment.
d. the portion of the dividends received this year that were NOT in excess of the parent’s share of subsidiary’s earnings subsequent to the date of investment.

16. Masters, Inc. owns 40% of Fields Corporation. During the year, Fields had net earnings of $200,000 and paid dividends of $50,000. Masters used the cost method of accounting. What effect would this have on the investment account, net earnings, and retained earnings, respectively?
a. understate, overstate, overstate.
b. overstate, understate, understate
c. overstate, overstate, overstate
d. understate, understate, understate

Use the following information in answering questions 17 and 18.

17. Prior Industries acquired a 70 percent interest in Stevenson Company by purchasing 14,000 of its 20,000 outstanding shares of common stock at book value of $210,000 on January 1, 2010. Stevenson reported net income in 2010 of $90,000 and in 2011 of $120,000 earned evenly throughout the respective years. Prior received $24,000 dividends from Stevenson in 2010 and $36,000 in 2011. Prior uses the equity method to record its investment.

Prior should record investment income from Stevenson during 2011 of:
a. $36,000
b. $120,000
c. $84,000
d. $48,000

18. The balance of Prior’s Investment in Stevenson account at December 31, 2011 is:
a. $210,000
b. $285,000
c. $297,000
d. $315,000

19. Parkview Company acquired a 90% interest in Sutherland Company on December 31, 2010, for $320,000. During 2011 Sutherland had a net income of $22,000 and paid a cash dividend of $7,000. Applying the cost method would give a debit balance in the Investment in Stock of Sutherland Company account at the end of 2011 of:
a. $335,000
b. $333,500
c. $313,700
d. $320,000

20. Hall, Inc., owns 40% of the outstanding stock of Gloom Company. During 2011, Hall received a $4,000 cash dividend from Gloom. What effect did this dividend have on Hall’s 2011 financial statements?
a. Increased total assets.
b. Decreased total assets.
c. Increased income.
d. Decreased investment account.

21. P Company purchased 80% of the outstanding common stock of S Company on May 1, 2011, for a cash payment of $318,000. S Company’s December 31, 2010 balance sheet reported common stock of $200,000 and retained earnings of $180,000. During the calendar year 2011, S Company earned $210,000 evenly throughout the year and declared a dividend of $75,000 on November 1. What is the amount needed to establish reciprocity under the cost method in the preparation of a consolidated workpaper on December 31, 2011?
a. $52,000
b. $65,000
c. $62,000
d. $108,000

22. P Company purchased 90% of the outstanding common stock of S Company on January 1, 1997. S Company’s stockholders’ equity at various dates was:
1/1/97 1/1/11 12/31/11
Common stock $200,000 $200,000 $200,000
Retained earnings 60,000 190,000 230,000
Total $260,000 $390,000 $430,000

The workpaper entry to establish reciprocity under the cost method in the preparation of a consolidated statements workpaper on December 31, 2011 should include a credit to P Company’s retained earnings of
a. $40,000.
b. $117,000.
c. $130,000.
d. $153,000.

Use the following information in answering questions 23 and 24.

23. Prior Industries acquired an 80 percent interest in Sanderson Company by purchasing 24,000 of its 30,000 outstanding shares of common stock at book value of $105,000 on January 1, 2010. Sanderson reported net income in 2010 of $45,000 and in 2011 of $60,000 earned evenly throughout the respective years. Prior received $12,000 dividends from Sanderson in 2010 and $18,000 in 2011. Prior uses the equity method to record its investment.

Prior should record investment income from Sanderson during 2011 of:
a. $18,000.
b. $60,000.
c. $48,000.
d. $33,600.

24. The balance of Prior’s Investment in Sanderson account at December 31, 2011 is:
a. $105,000.
b. $138,600.
c. $159,000.
d. $165,000.

25. Pendleton Company acquired a 70% interest in Sunflower Company on December 31, 2010, for $380,000. During 2011 Sunflower had a net income of $30,000 and paid a cash dividend of $10,000. Applying the cost method would give a debit balance in the Investment in Stock of Sunflower Company account at the end of 2011 of:
a. $400,000.
b. $394,000.
c. $373,000.
d. $380,000.

Use the following information to answer questions 26 and 27

On January 1, 2011, Rotor Corporation acquired 30 percent of Stator Company’s stock for $150,000. On the acquisition date, Stator reported net assets of $450,000 valued at historical cost and $500,000 stated at fair value. The difference was due to the increased value of buildings with a remaining life of 10 years. During 2011 Stator reported net income of $25,000 and paid dividends of $10,000. Rotor uses the equity method.

26. What will be the balance in the Investment account as of Dec 31, 2011?
a. $150,000
b. $157,500
c. $154,500
d. $153,000

27. What amount of investment income will be reported by Rotor for the year 2011?
a. $7,500
b. $6,000
c. $4,500
d. $25,000

28. On January 1, 2011, Potter Company purchased 25 % of Smith Company’s common stock; no goodwill resulted from the acquisition. Potter Company appropriately carries the investment using the equity method of accounting and the balance in Potter’s investment account was $190,000 on December 31, 2011. Smith reported net income of $120,000 for the year ended December 31, 2011 and paid dividends on its common stock totaling $48,000 during 2011. How much did Potter pay for its 25% interest in Smith?
a. $172,000
b. $202,000
c. $208,000
d. $232,000

Use the following information to answer questions 29 and 30.

29. On January 1, 2011, Paterson Company purchased 40% of Stratton Company’s 30,000 shares of voting common stock for a cash payment of $1,800,000 when 40% of the net book value of Stratton Company was $1,740,000. The payment in excess of the net book value was attributed to depreciable assets with a remaining useful life of six years. As a result of this transaction Paterson has the ability to exercise significant influence over Stratton Company’s operating and financial policies. Stratton’s net income for the ended December 31, 2011 was $600,000. During 2011, Stratton paid $325,000 in dividends to its shareholders. The income reported by Paterson for its investment in Stratton should be:
a. $120,000
b. $130,000
c. $230,000
d. $240,000

30. What is the ending balance in Paterson’s investment account as of December 31, 2011?
a. $1,800,000
b. $1,900,000
c. $1,910,000
d. $2,030,000
Problems

4-1 On January 1, 2011, Price Company purchased an 80% interest in the common stock of Stahl Company for $1,040,000, which was $60,000 greater than the book value of equity acquired. The difference between implied and book value relates to the subsidiary’s land.

The following information is from the consolidated retained earnings section of the consolidated statements workpaper for the year ended December 31, 2011:

STAHL CONSOLIDATED
COMPANY BALANCES
1/01/11 retained earnings $300,000 $1,400,000
Net income 220,000 680,000
Dividends declared (80,000) (140,000)
12/31/11 retained earnings $440,000 $1,940,000

Stahl’s stockholders’ equity includes only common stock and retained earnings.

Required:

A. Prepare the workpaper eliminating entries for a consolidated statements workpaper on December 31, 2011. Price uses the cost method.

B. Compute the total noncontrolling interest to be reported on the consolidated balance sheet on December 31, 2011.

4-2 On October 1, 2011, Packer Company purchased 90% of the common stock of Shipley Company for $290,000. Additional information for both companies for 2011 follows:

PACKER SHIPLEY
Common stock $300,000 $90,000
Other contributed capital 120,000 40,000
Retained Earnings, 1/1 240,000 50,000
Net Income 260,000 160,000
Dividends declared (10/31) 40,000 8,000

Any difference between implied and book value relates to Shipley’s land. Packer uses the cost method to record its investment in Shipley. Shipley Company’s income was earned evenly throughout the year.

Required:

A. Prepare the workpaper entries that would be made on a consolidated statements workpaper on December 31, 2011. Use the full year reporting alternative.

B. Calculate the controlling interest in consolidated net income for 2011.

4-3 On January 1, 2011, Pierce Company purchased 80% of the common stock of Stanley Company for $600,000. At that time, Stanley’s stockholders’ equity consisted of the following:

Common stock $220,000
Other contributed capital 90,000
Retained earnings 320,000

During 2011, Stanley distributed a dividend in the amount of $120,000 and at year-end reported a $320,000 net income. Any difference between implied and book value relates to subsidiary goodwill. Pierce Company uses the equity method to record its investment. No impairment of goodwill is observed in the first year.

Required:

A. Prepare on Pierce Company’s books journal entries to record the investment related activities for 2011.

B. Prepare the workpaper eliminating entries for a workpaper on December 31, 2011.

4-4 Pratt Company purchased 80% of the outstanding common stock of Selby Company on January 2, 2004, for $680,000. The composition of Selby Company’s stockholders’ equity on January 2, 2004, and December 31, 2011, was:
1/2/04 12/31/11
Common stock $540,000 $540,000
Other contributed capital 325,000 325,000
Retained earnings (deficit) (60,000) 295,000
Total stockholders’ equity $805,000 $1,160,000

During 2011, Selby Company earned $210,000 net income and declared a $60,000 dividend. Any difference between implied and book value relates to land. Pratt Company uses the cost method to record its investment in Selby Company.

Required:

A. Prepare any journal entries that Pratt Company would make on its books during 2011 to record the effects of its investment in Selby Company.

B. Prepare, in general journal form, all workpaper entries needed for the preparation of a consolidated statements workpaper on December 31, 2011.

4-5 P Company purchased 90% of the common stock of S Company on January 2, 2011 for $900,000. On that date, S Company’s stockholders’ equity was as follows:

Common stock, $20 par value $400,000
Other contributed capital 100,000
Retained earnings 450,000

During 2011, S Company earned $200,000 and declared a $100,000 dividend. P Company uses the partial equity method to record its investment in S Company. The difference between implied and book value relates to land.

Required:

Prepared, in general journal form, all eliminating entries for the preparation of a consolidated statements workpaper on December 31, 2011.

4-6 Pair Company acquired 80% of the outstanding common stock of Sax Company on January 2, 2010 for $675,000. At that time, Sax’s total stockholders’ equity amounted to $1,000,000. Sax Company reported net income and dividends for the last two years as follows:

2010 2011
Reported net income $45,000 $60,000
Dividends distributed 35,000 75,000

Required:

Prepare journal entries for Pair Company for 2010 and 2011 assuming Pair uses:
A. The cost method to record its investment
B. The complete equity method to record its investment. The difference between implied value and the book value of equity acquired was attributed solely to a building, with a 20-year expected life.

4-7 Pell Company purchased 90% of the stock of Silk Company on January 1, 2007, for $1,860,000, an amount equal to $60,000 in excess of the book value of equity acquired. All book values were equal to fair values at the time of purchase (i.e., any excess payment relates to subsidiary goodwill). On the date of purchase, Silk Company’s retained earnings balance was $200,000. The remainder of the stockholders’ equity consists of no-par common stock. During 2011, Silk Company declared dividends in the amount of $40,000, and reported net income of $160,000. The retained earnings balance of Silk Company on December 31, 2010 was $640,000. Pell Company uses the cost method to record its investment. No impairment of goodwill was recognized between the date of acquisition and December 31, 2011.

Required:

Prepare in general journal form the workpaper entries that would be made in the preparation of a consolidated statements workpaper on December 31, 2011.

4-8 On January 1, 2011, Pitt Company purchased 85% of the outstanding common stock of Small Company for $525,000. On that date, Small Company’s stockholders’ equity consisted of common stock, $150,000; other contributed capital, $60,000; and retained earnings, $210,000. Pitt Company paid more than the book value of net assets acquired because the recorded cost of Small Company’s land was significantly less than its fair value.

During 2011 Small Company earned $222,000 and declared and paid a $75,000 dividend. Pitt Company used the partial equity method to record its investment in Small Company.

Required:

A. Prepare the investment related entries on Pitt Company’s books for 2011.

B. Prepare the workpaper eliminating entries for a workpaper on December 31, 2011.

4-9

Picture Company purchased 40% of Stuffy Corporation on January 1, 2011 for $150,000. Stuffy Corporation’s balance sheet at the time of acquisition was as follows:

Cash $30,000 Current Liabilities $40,000
Accounts Receivable 120,000 Bonds Payable 200,000
Inventory 80,000 Common Stock 200,000
Land 150,000 Additional Paid in Capital 40,000
Buildings & Equipment 300,000 Retained Earnings 80,000
Less: Acc. Depreciation (120,000)

Total Assets $560,000
Total Liabilities and Equities $560,000

During 2011, Stuffy Corporation reported net income of $30,000 and paid dividends of $9,000. The fair values of Stuffy’s assets and liabilities were equal to their book values at the date of acquisition, with the exception of Building and Equipment, which had a fair value of $35,000 above book value. All buildings and equipment had a remaining useful life of five years at the time of the acquisition. The amount attributed to goodwill as a result of the acquisition in not impaired.

Required:

A. What amount of investment income will Picture record during 2011 under the equity method of accounting?

B. What amount of income will Picture record during 2011 under the cost method of accounting?

C. What will be the balance in the investment account on December 31, 2011 under the cost and equity method of accounting?

Short Answer

1. There are three levels of influence or control by an investor over an investee, which determine the appropriate accounting treatment. Identify and briefly describe the three levels and their accounting treatment.

2. Two methods are available to account for interim acquisitions of a subsidiary’s stock at the end of the first year. Describe the two methods of accounting for interim acquisitions.

Short Answer Questions from the Textbook

1. How should nonconsolidated subsidiaries be re-ported in consolidated financial statements?

2. How are liquidating dividends treated on the books of an investor, assuming the investor uses the cost method? Assuming the investor uses the equity method?

3. How are dividends declared and paid by a subsidiary during the year eliminated in the consolidated work papers under each method of ac-counting for investments?

4. How is the income reported by the subsidiary reflected on the books of the investor under each of the methods of accounting for investments?

5. Define: Consolidated net income; consolidated retained earnings.

6. At the date of an 80% acquisition, a subsidiary had common stock of $100,000 and retained earnings of $16,250. Seven years later, at December 31, 2010, the subsidiary’s retained earnings had increased to $461,430. What adjustment will be made on the consolidated work paper at December 31, 2011, to recognize the parent’s share of the cumulative undistributed profits (losses)of its subsidiary? Under which method(s) is this adjustment needed? Why?

7. On a consolidated work paper for a parent and its partially owned subsidiary, the noncontrolling interest column accumulates the non controlling interests’ share of several account balances. What are these accounts?

8. If a parent company elects to use the partial equity method rather than the cost method to record its investments in subsidiaries, what effect will this choice have on the consolidated financial statements? If the parent company elects the complete equity method?

9. Describe two methods for treating the preacquisition revenue and expense items of a subsidiary purchased during a fiscal period.

10. A principal limitation of consolidated financial statements is their lack of separate financial in-formation about the assets, liabilities, revenues, and expenses of the individual companies included in the consolidation. Identify some problems that the reader of consolidated financial statements would encounter as a result of this limitation.

11. In the preparation of a consolidated statement of cash flows, what adjustments are necessary because of the existence of a noncontrolling interest? (AICPA adapted)

12. What do potential voting rights refer to, and how do they affect the application of the equity method for investments under IFRS? Under U.S.GAAP? What is the term generally used for equity method investments under IFRS?

13B. Is the recognition of a deferred tax asset or deferred tax liability when allocating the difference between book value and the value implied by the purchase price affected by whether or not the affiliates file a consolidated income tax re-turn?

14B. What assumptions must be made about the realization of undistributed subsidiary income when the affiliates file separate income tax returns? Why? (Appendix)

15B. The FASB elected to require that deferred tax effects relating to unrealized intercompany profits be calculated based on the income tax paid by the selling affiliate rather than on the future tax benefit to the purchasing affiliate. Describe circumstances where the amounts calculated under these approaches would be different. (Appendix)

16B. Identify two types of temporary differences that may arise in the consolidated financial statements when the affiliates file separate income tax returns.

Business Ethics Question from the Textbook
On April 5, 2006, the New York State Attorney sued a New York online advertising firm for surreptitiously installing spyware advertising programs on consumers’ computers. The Attorney General claimed that con-sumers believed they were downloading free games or ‘browser’ enhancements. The company claimed that the spyware was identified as ‘advertising-supported’ and that the software is easy to remove and doesn’t collect personal data. Is there an ethical issue for the company? Comment on and justify your position.

ANSWER KEY (Chapter 4)

Chapter 5

Allocation and Depreciation of Differences Between Implied and Book Value

Multiple Choice

1. When the implied value exceeds the aggregate fair values of identifiable net assets, the residual difference is accounted for as
a. excess of implied over fair value.
b. a deferred credit.
c. difference between implied and fair value.
d. goodwill.

2. Long-term debt and other obligations of an acquired company should be valued for consolidation purposes at their
a. book value.
b. carrying value.
c. fair value.
d. face value.

3. On January 1, 2010, Lester Company purchased 70% of Stork Corporation’s $5 par common stock for $600,000. The book value of Stork net assets was $640,000 at that time. The fair value of Stork’s identifiable net assets were the same as their book value except for equipment that was $40,000 in excess of the book value. In the January 1, 2010, consolidated balance sheet, goodwill would be reported at
a. $152,000.
b. $177,143.
c. $80,000.
d. $0.

4. When the value implied by the purchase price of a subsidiary is in excess of the fair value of identifiable net assets, the workpaper entry to allocate the difference between implied and book value includes a
1. debit to Difference Between Implied and Book Value.
2. credit to Excess of Implied over Fair Value.
3. credit to Difference Between Implied and Book Value.
a. 1
b. 2
c. 3
d. Both 1 and 2

5. If the fair value of the subsidiary’s identifiable net assets exceeds both the book value and the value implied by the purchase price, the workpaper entry to eliminate the investment account
a. debits Excess of Fair Value over Implied Value.
b. debits Difference Between Implied and Fair Value.
c. debits Difference Between Implied and Book Value.
d. credits Difference Between Implied and Book Value.

6. The entry to amortize the amount of difference between implied and book value allocated to an unspecified intangible is recorded
1. on the subsidiary’s books.
2. on the parent’s books.
3. on the consolidated statements workpaper.
a. 1
b. 2
c. 3
d. Both 2 and 3

7. The excess of fair value over implied value must be allocated to reduce proportionally the fair values initially assigned to
a. current assets.
b. noncurrent assets.
c. both current and noncurrent assets.
d. none of the above.

8. The SEC requires the use of push down accounting when the ownership change is greater than
a. 50%
b. 80%
c. 90%
d. 95%

9. Under push down accounting, the workpaper entry to eliminate the investment account includes a
a. debit to Goodwill.
b. debit to Revaluation Capital.
c. credit to Revaluation Capital.
d. debit to Revaluation Assets.

10. In a business combination accounted for as an acquisition, how should the excess of fair value of identifiable net assets acquired over implied value be treated?
a. Amortized as a credit to income over a period not to exceed forty years.
b. Amortized as a charge to expense over a period not to exceed forty years.
c. Amortized directly to retained earnings over a period not to exceed forty years.
d. Recognized as an ordinary gain in the year of acquisition.

11. On November 30, 2010, Pulse Incorporated purchased for cash of $25 per share all 400,000 shares of the outstanding common stock of Surge Company. Surge ‘s balance sheet at November 30, 2010, showed a book value of $8,000,000. Additionally, the fair value of Surge’s property, plant, and equipment on November 30, 2010, was $1,200,000 in excess of its book value. What amount, if any, will be shown in the balance sheet caption “Goodwill” in the November 30, 2010, consolidated balance sheet of Pulse Incorporated, and its wholly owned subsidiary, Surge Company?
a. $0.
b. $800,000.
c. $1,200,000.
d. $2,000,000.

12. Goodwill represents the excess of the implied value of an acquired company over the
a. aggregate fair values of identifiable assets less liabilities assumed.
b. aggregate fair values of tangible assets less liabilities assumed.
c. aggregate fair values of intangible assets less liabilities assumed.
d. book value of an acquired company.

13. Scooter Company, a 70%-owned subsidiary of Pusher Corporation, reported net income of $240,000 and paid dividends totaling $90,000 during Year 3. Year 3 amortization of differences between current fair values and carrying amounts of Scooter’s identifiable net assets at the date of the business combination was $45,000. The noncontrolling interest in net income of Scooter for Year 3 was
a. $58,500.
b. $13,500.
c. $27,000.
d. $72,000.

14. Porter Company acquired an 80% interest in Strumble Company on January 1, 2010, for $270,000 cash when Strumble Company had common stock of $150,000 and retained earnings of $150,000. All excess was attributable to plant assets with a 10-year life. Strumble Company made $30,000 in 2010 and paid no dividends. Porter Company’s separate income in 2010 was $375,000. Controlling interest in consolidated net income for 2010 is:
a. $405,000.
b. $399,000.
c. $396,000.
d. $375,000.

15. In preparing consolidated working papers, beginning retained earnings of the parent company will be adjusted in years subsequent to acquisition with an elimination entry whenever:
a. a noncontrolling interest exists.
b. it does not reflect the equity method.
c. the cost method has been used only.
d. the complete equity method is in use.

16. Dividends declared by a subsidiary are eliminated against dividend income recorded by the parent under the
a. partial equity method.
b. equity method.
c. cost method.
d. equity and partial equity methods.

Use the following information to answer questions 17 through 20.

On January 1, 2010, Pandora Company purchased 75% of the common stock of Saturn Company. Separate balance sheet data for the companies at the combination date are given below:

Saturn Co. Saturn Co.
Pandora Co. Book Values Fair Values

Cash $ 18,000 $155,000 $155,000
Accounts receivable 108,000 20,000 20,000
Inventory 99,000 26,000 45,000
Land 60,000 24,000 45,000
Plant assets 525,000 225,000 300,000
Acc. depreciation (180,000) (45,000)
Investment in Saturn Co. 330,000
Total assets $960,000 $405,000 $565,000

Accounts payable $156,000 $105,000 $105,000
Capital stock 600,000 225,000
Retained earnings 204,000 75,000
Total liabilities & equities $960,000 $405,000

Determine below what the consolidated balance would be for each of the requested accounts on January 2, 2010.

17. What amount of inventory will be reported?
a. $125,000
b. $132,750
c. $139,250
d. $144,000

18. What amount of goodwill will be reported?
a. ($20,000)
b. ($25,000)
c. $25,000
d. $0

19. What is the amount of consolidated retained earnings?
a. $204,000
b. $209,250
c. $260,250
d. $279,000

20. What is the amount of total assets?
a. $921,000
b. $1,185,000
c. $1,525,000
d. $1,195,000

21. Sensible Company, a 70%-owned subsidiary of Proper Corporation, reported net income of $600,000 and paid dividends totaling $225,000 during Year 3. Year 3 amortization of differences between current fair values and carrying amounts of Sensible’s identifiable net assets at the date of the business combination was $112,500. The noncontrolling interest in consolidated net income of Sensible for Year 3 was
a. $146,250.
b. $33,750.
c. $67,500.
d. $180,000.

22. Primer Company acquired an 80% interest in SealCoat Company on January 1, 2010, for $450,000 cash when SealCoat Company had common stock of $250,000 and retained earnings of $250,000. All excess was attributable to plant assets with a 10-year life. SealCoat Company made $50,000 in 2010 and paid no dividends. Primer Company’s separate income in 2010 was $625,000. The controlling interest in consolidated net income for 2010 is:
a. $675,000.
b. $665,000.
c. $660,000.
d. $625,000.

Use the following information to answer questions 23 through 25.

On January 1, 2010, Poole Company purchased 75% of the common stock of Swimmer Company. Separate balance sheet data for the companies at the combination date are given below:

Swimmer Co. Swimmer Co.
Poole Co. Book Values Fair Values
Cash $ 24,000 $206,000 $206,000
Accounts receivable 144,000 26,000 26,000
Inventory 132,000 38,000 60,000
Land 78,000 32,000 60,000
Plant assets 700,000 300,000 350,000
Acc. depreciation (240,000) (60,000)
Investment in Swimmer Co. 440,000
Total assets $1,278,000 $542,000 $702,000

Accounts payable $206,000 $142,000 $142,000
Capital stock 800,000 300,000
Retained earnings 272,000 100,000
Total liabilities & equities $1,278,000 $542,000

Determine below what the consolidated balance would be for each of the requested accounts on January 2, 2010.

23. What amount of inventory will be reported?
a. $170,000.
b. $177,000.
c. $186,500.
d. $192,000.

24. What amount of goodwill will be reported?
a. $26,667.
b. $20,000.
c. $42,000.
d. $86,667.

25. What is the amount of total assets?
a. $1,626,667.
b. $1,566,667
c. $1,980,000.
d. $2,006,667.

Problems

5-1 Phillips Company purchased a 90% interest in Standards Corporation for $2,340,000 on January 1, 2010. Standards Corporation had $1,650,000 of common stock and $1,050,000 of retained earnings on that date.

The following values were determined for Standards Corporation on the date of purchase:

Book Value Fair Value
Inventory $240,000 $300,000
Land 2,400,000 2,700,000
Equipment 1,620,000 1,800,000

Required:
A. Prepare a computation and allocation schedule for the difference between the implied and book value in the consolidated statements workpaper.

B. Prepare the January 1, 2010, workpaper entries to eliminate the investment account and allocate the difference between implied and book value.

5-2 Pullman Corporation acquired a 90% interest in Sleeper Company for $6,500,000 on January 1 2010. At that time Sleeper Company had common stock of $4,500,000 and retained earnings of $1,800,000. The balance sheet information available for Sleeper Company on January 1, 2010, showed the following:

Book Value Fair Value
Inventory (FIFO) $1,300,000 $1,500,000
Equipment (net) 1,500,000 1,900,000
Land 3,000,000 3,000,000

The equipment had a remaining useful life of ten years. Sleeper Company reported $240,000 of net income in 2010 and declared $60,000 of dividends during the year.

Required:
Prepare the workpaper entries assuming the cost method is used, to eliminate dividends, eliminate the investment account, and to allocate and depreciate the difference between implied and book value for 2010.

5-3 On January 1, 2010, Preston Corporation acquired an 80% interest in Spiegel Company for $2,400,000. At that time Spiegel Company had common stock of $1,800,000 and retained earnings of $800,000. The book values of Spiegel Company’s assets and liabilities were equal to their fair values except for land and bonds payable. The land’s fair value was $120,000 and its book value was $100,000. The outstanding bonds were issued on January 1, 2005, at 9% and mature on January 1, 2015. The bond principal is $600,000 and the current yield rate on similar bonds is 8%.

Required:
Prepare the workpaper entries necessary on December 31, 2010, to allocate, amortize, and depreciate the difference between implied and book value.

Present Value
Present value of 1 of Annuity of 1
9%, 5 periods .64993 3.88965
8%, 5 periods .68058 3.99271

5-4 Pennington Corporation purchased 80% of the voting common stock of Stafford Corporation for $3,200,000 cash on January 1, 2010. On this date the book values and fair values of Stafford Corporation’s assets and liabilities were as follows:
Book Value Fair Value
Cash $ 70,000 $ 70,000
Receivables 240,000 240,000
Inventories 600,000 700,000
Other Current Assets 340,000 405,000
Land 600,000 720,000
Buildings – net 1,050,000 1,920,000
Equipment – net 850,000 750,000
$3,750,000 $4,805,000

Accounts Payable $ 250,000 $250,000
Other Liabilities 740,000 670,000
Capital Stock 2,400,000
Retained Earnings 360,000
$3,750,000

Required:
Prepare a schedule showing how the difference between Stafford Corporation’s implied value and the book value of the net assets acquired should be allocated.

5-5 Perez Corporation acquired a 75% interest in Schmidt Company on January 1, 2010, for $2,000,000. The book value and fair value of the assets and liabilities of Schmidt Company on that date were as follows:
Book Value Fair Value
Current Assets $ 600,000 $ 600,000
Property & Equipment (net) 1,400,000 1,800,000
Land 700,000 900,000
Deferred Charge 300,000 300,000
Total Assets $3,000,000 $3,600,000
Less Liabilities 600,000 600,000
Net Assets $2,400,000 $3,000,000

The property and equipment had a remaining life of 6 years on January 1, 2010, and the deferred charge was being amortized over a period of 5 years from that date. Common stock was $1,500,000 and retained earnings was $900,000 on January 1, 2010. Perez Company records its investment in Schmidt Company using the cost method.

Required:
Prepare, in general journal form, the December 31, 2010, workpaper entries necessary to:

A. Eliminate the investment account.
B. Allocate and amortize the difference between implied and book value.

5-6 On January 1, 2010, Page Company acquired an 80% interest in Schell Company for $3,600,000. On that date, Schell Company had retained earnings of $800,000 and common stock of $2,800,000. The book values of assets and liabilities were equal to fair values except for the following:

Book Value Fair Value
Inventory $ 50,000 $ 85,000
Equipment (net) 540,000 720,000
Land 300,000 660,000

The equipment had an estimated remaining useful life of 8 years. One-half of the inventory was sold in 2010 and the remaining half was sold in 2011. Schell Company reported net income of $240,000 in 2010 and $300,000 in 2011. No dividends were declared or paid in either year. Page Company uses the cost method to record its investment in Schell Company.

Required:
Prepare, in general journal form, the workpaper eliminating entries necessary in the consolidated statements workpaper for the year ending December 31, 2011.

5-7 Paddock Company acquired 90% of the stock of Spector Company for $6,300,000 on January 1, 2010. On this date, the fair value of the assets and liabilities of Spector Company was equal to their book value except for the inventory and equipment accounts. The inventory had a fair value of $2,300,000 and a book value of $1,900,000. The equipment had a fair value of $3,300,000 and a book value of $2,800,000.

The balances in Spector Company’s capital stock and retained earnings accounts on the date of acquisition were $3,700,000 and $1,900,000, respectively.

Required:
In general journal form, prepare the entries on Spector Company’s books to record the effect of the pushed down values implied by the acquisition of its stock by Paddock Company assuming that:

A values are allocated on the basis of the fair value of Spector Company as a whole imputed from the transaction.

B values are allocated on the basis of the proportional interest acquired by Paddock Company.

5-8 Pruitt Corporation acquired all of the voting stock of Soto Corporation on January 1, 2010, for $210,000 when Soto had common stock of $150,000 and retained earnings of $24,000. The excess of implied over book value was allocated $9,000 to inventories that were sold in 2010, $12,000 to equipment with a 4-year remaining useful life under the straight-line method, and the remainder to goodwill.

Financial statements for Pruitt and Soto Corporations at the end of the fiscal year ended December 31, 2011 (two years after acquisition), appear in the first two columns of the partially completed consolidated statements workpaper. Pruitt Corp. has accounted for its investment in Soto using the partial equity method of accounting.

Required:
Complete the consolidated statements workpaper for Pruitt Corporation and Soto Corporation for December 31, 2011.
Pruitt Corporation and Soto Corporation
Consolidated Statements Workpaper
at December 31, 2011

Eliminations
Pruitt Corp. Soto Corp. Debit Credit Consolidated Balances
INCOME STATEMENT
Sales 618,000 180,000
Equity from Subsidiary Income 36,000
Cost of Sales (450,000) (90,000)
Other Expenses (114,000) (54,000)
Net Income to Ret. Earn. 90,000 36,000
Pruitt Retained Earnings 1/1 72,000
Soto Retained Earnings 1/1 3,000
Add: Net Income 90,000 36,000
Less: Dividends (60,000) (12,000)
Retained Earnings 12/31 102,000 54,000
BALANCE SHEET
Cash 42,000 21,000
Inventories 63,000 45,000
Land 33,000 18,000
Equipment and Buildings-net 192,000 165,000
Investment in Soto Corp. 240,000

Total Assets 570,000 249,000
LIA & EQUITIES Liabilities 168,000 45,000
Common Stock 300,000 150,000
Retained Earnings 102,000 54,000
Total Equities 570,000 249,000

5-9 On January 1, 2010, Prescott Company acquired 80% of the outstanding capital stock of Sherlock Company for $570,000. On that date, the capital stock of Sherlock Company was $150,000 and its retained earnings were $450,000.

On the date of acquisition, the assets of Sherlock Company had the following values:

Fair Market
Book Value Value
Inventories $ 90,000 $165,000
Plant and equipment 150,000 180,000

All other assets and liabilities had book values approximately equal to their respective fair market values. The plant and equipment had a remaining useful life of 10 years from January 1, 2010, and Sherlock Company uses the FIFO inventory cost flow assumption.

Sherlock Company earned $180,000 in 2010 and paid dividends in that year of $90,000.
Prescott Company uses the complete equity method to account for its investment in S Company.

Required:

A. Prepare a computation and allocation schedule.
B. Prepare the balance sheet elimination entries as of December 31, 2010.
C. Compute the amount of equity in subsidiary income recorded on the books of Prescott Company on December 31, 2010.
D. Compute the balance in the investment account on December 31, 2010.

Short Answer

1. When the value implied by the acquisition price is below the fair value of the identifiable net assets the residual amount will be negative (bargain acquisition). Explain the difference in accounting for bargain acquisition between past accounting and proposed accounting requirements.

2. Push down accounting is an accounting method required for the subsidiary in some instances such as the banking industry. Briefly explain the concept of push down accounting.

Questions from the Textbook

1. Distinguish among the following concepts:(a)Difference between book value and the value implied by the purchase price.(b)Excess of implied value over fair value.(c)Excess of fair value over implied value.(d)Excess of book value over fair value.

2. In what account is the difference between book value and the value implied by the purchase
price recorded on the books of the investor? In what account is the “excess of implied over fair value” recorded?

3. How do you determine the amount of “the difference between book value and the value implied by the purchase price” to be allocated to a specific asset of a less than wholly owned subsidiary?

4. The parent company’s share of the fair value of the net assets of a subsidiary may exceed acquisition cost. How must this excess be treated in the preparation of consolidated financial statements?

5. What are the arguments for and against the alternatives for the handling of bargain acquisitions? Why are such acquisitions unlikely to occur with great frequency?

6. P Company acquired a 100% interest in S Company. On the date of acquisition the fair value of the assets and liabilities of S Company was equal to their book value except for land that had a fair value of $1,500,000 and a book value of $300,000.
At what amount should the land of S Company be included in the consolidated balance sheet?
At what amount should the land of S Company be included in the consolidated balance sheet if P Company acquired an80% interest in S Company rather than a 100%interest?

Business Ethics Question from the Textbook

Consider the following: Many years ago, a student in a consolidated financial statements class came to me and said that Grand Central (a multi-store grocery and variety chain in Salt Lake City and surrounding towns and cities) was going to be acquired and that I should try to buy the stock and make lots of money. I asked him how he knew and he told me that he worked part-time for Grand Central and heard that Fred Meyer was going to acquire it. I did not know whether the student worked in the accounting department at Grand Central or was a custodian at one of the stores. I thanked him for the information but did not buy the stock. Within a few weeks, the announcement was made that Fred Meyer was acquiring Grand Central and the stock price shot up, almost doubling. It was clear that I had missed an opportunity to make a lot of money … I don’t know to this day whether or not that would have been insider trading. How-ever, I have never gone home at night and asked my wife if the SEC called. From “Don’t go to jail and other good advice for accountants,” by Ron Mano, Accounting Today, October 25, 1999.
Question: Do you think this individual would have been guilty of insider trading if he had purchased the stock in Grand Central based on this advice? Why or why not? Are there ever instances where you think it would be wise to miss out on an opportunity to reap benefits simply because the behavior necessitated would have been in a gray ethical area, though not strictly illegal? Defend your position.

ANSWER KEY (Chapter 5)

Chapter 6

Elimination of Unrealized Profit on Intercompany Sales of Inventory

Multiple Choice

1. Sales from one subsidiary to another are called
a. downstream sales.
b. upstream sales.
c. intersubsidiary sales.
d. horizontal sales.

2. Noncontrolling interest in consolidated income is never affected by
a. upstream sales.
b. downstream sales.
c. horizontal sales.
d. Noncontrolling interest is affected by all sales.

3. Failure to eliminate intercompany sales would result in an overstatement of consolidated
a. net income.
b. gross profit.
c. cost of sales.
d. all of these.

4. Pratt Company owns 80% of Storey Company’s common stock. During 2011, Storey sold $400,000 of merchandise to Pratt. At December 31, 2011, one-fourth of the merchandise remained in Pratt’s inventory. In 2011, gross profit percentages were 25% for Pratt and 30% for Storey. The amount of unrealized intercompany profit that should be eliminated in the consolidated statements is
a. $80,000.
b. $24,000.
c. $30,000.
d. $25,000.

5. The noncontrolling interest’s share of the selling affiliate’s profit on intercompany sales is considered to be realized under
a. partial elimination.
b. total elimination.
c. 100% elimination.
d. both total and 100% elimination.

6. The workpaper entry in the year of sale to eliminate unrealized intercompany profit in ending inventory includes a
a. credit to Ending Inventory (Cost of Sales).
b. credit to Sales.
c. debit to Ending Inventory (Cost of Sales).
d. debit to Inventory – Balance Sheet.

7. Perez Company acquired an 80% interest in Seaman Company in 2010. In 2011 and 2012, Sutton reported net income of $400,000 and $480,000, respectively. During 2011, Seaman sold $80,000 of merchandise to Perez for a $20,000 profit. Perez sold the merchandise to outsiders during 2012 for $140,000. For consolidation purposes, what is the noncontrolling interest’s share of Seaman’s 2011 and 2012 net income?
a. $90,000 and $96,000.
b. $100,000 and $76,000.
c. $84,000 and $92,000.
d. $76,000 and $100,000.

8. A 90% owned subsidiary sold merchandise at a profit to its parent company near the end of 2010. Under the partial equity method, the workpaper entry in 2011 to recognize the intercompany profit in beginning inventory realized during 2011 includes a debit to
a. Retained Earnings – P.
b. Noncontrolling interest.
c. Cost of Sales.
d. both Retained Earnings – P and Noncontrolling Interest.

9. The noncontrolling interest in consolidated income when the selling affiliate is an 80% owned subsidiary is calculated by multiplying the noncontrolling minority ownership percentage by the subsidiary’s reported net income
a. plus unrealized profit in ending inventory less unrealized profit in beginning inventory.
b. plus realized profit in ending inventory less realized profit in beginning inventory.
c. less unrealized profit in ending inventory plus realized profit in beginning inventory.
d. less realized profit in ending inventory plus realized profit in beginning inventory.

10. In determining controlling interest in consolidated income in the consolidated financial statements, unrealized intercompany profit on inventory acquired by a parent from its subsidiary should:
a. not be eliminated.
b. be eliminated in full.
c. be eliminated to the extent of the parent company’s controlling interest in the subsidiary.
d. be eliminated to the extent of the noncontrolling interest in the subsidiary.

11. P Company sold merchandise costing $240,000 to S Company (90% owned) for $300,000. At the end of the current year, one-third of the merchandise remains in S Company’s inventory. Applying the lower-of- cost-or-market rule, S Company wrote this inventory down to $92,000. What amount of intercompany profit should be eliminated on the consolidated statements workpaper?
a. $20,000.
b. $18,000.
c. $12,000.
d. $10,800.

12. The material sale of inventory items by a parent company to an affiliated company:
a. enters the consolidated revenue computation only if the transfer was the result of arm’s length bargaining.
b. affects consolidated net income under a periodic inventory system but not under a perpetual inventory system.
c. does not result in consolidated income until the merchandise is sold to outside parties.
d. does not require a working paper adjustment if the merchandise was transferred at cost.

13. A parent company regularly sells merchandise to its 80%-owned subsidiary. Which of the following statements describes the computation of noncontrolling interest income?
a. the subsidiary’s net income times 20%.
b. (the subsidiary’s net income x 20%) + unrealized profits in the beginning inventory – unrealized profits in the ending inventory.
c. (the subsidiary’s net income + unrealized profits in the beginning inventory – unrealized profits in the ending inventory) × 20%.
d. (the subsidiary’s net income + unrealized profits in the ending inventory – unrealized profits in the beginning inventory) × 20%.

14. P Corporation acquired a 60% interest in S Corporation on January 1, 2011, at book value equal to fair value. During 2011, P sold merchandise that cost $135,000 to S for $189,000. One-third of this merchandise remained in S’s inventory at December 31, 2011. S reported net income of $120,000 for 2011. P’s income from S for 2011 is:
a. $36,000.
b. $50,400.
c. $54,000.
d. $61,200.

Use the following information for Questions 15 & 16:

P Company regularly sells merchandise to its 80%-owned subsidiary, S Corporation. In 2010, P sold merchandise that cost $240,000 to S for $300,000. Half of this merchandise remained in S’s December 31, 2010 inventory. During 2011, P sold merchandise that cost $375,000 to S for $468,000. Forty percent of this merchandise inventory remained in S’s December 31, 2011 inventory. Selected income statement information for the two affiliates for the year 2011 is as follows:

P _ S _
Sales Revenue $2,250,000 $1,125,000
Cost of Goods Sold 1,800,000 937,500
Gross profit $450,000 $187,500

15. Consolidated sales revenue for P and Subsidiary for 2011 are:
a. $2,907,000.
b. $3,000,000.
c. $3,205,500.
d. $3,375,000.

16. Consolidated cost of goods sold for P Company and Subsidiary for 2011 are:
a. $2,260,500.
b. $2,268,000.
c. $2,276,700.
d. $2,737,500.

Use the following information for Questions 17 & 18:

P Company owns an 80% interest in S Company. During 2011, S sells merchandise to P for $200,000 at a profit of $40,000. On December 31, 2011, 50% of this merchandise is included in P’s inventory. Income statements for P and S are summarized below:

P __ S __
Sales $1,200,000 $600,000
Cost of Sales (600,000) (400,000)
Operating Expenses (300,000) ( 80,000)
Net Income (2011) $300,000 $120,000

17. Controlling interest in consolidated net income for 2011 is:
a. $300,000.
b. $380,000.
c. $396,000.
d. $420,000.

18. Noncontrolling interest in income for 2011 is:
a. $4,000.
b. $19,200.
c. $20,000.
d. $24,000.

19. The amount of intercompany profit eliminated is the same under total elimination and partial elimination in the case of
1. upstream sales where the selling affiliate is a less than wholly owned subsidiary.
2. all downstream sales.
3. horizontal sales where the selling affiliate is a wholly owned subsidiary.
a. 1.
b. 2.
c. 3.
d. both 2 and 3.

20. Paige, Inc. owns 80% of Sigler, Inc. During 2011, Paige sold goods with a 40% gross profit to Sigler. Sigler sold all of these goods in 2011. For 2011 consolidated financial statements, how should the summation of Paige and Sigler income statement items be adjusted?
a. Sales and cost of goods sold should be reduced by the intercompany sales.
b. Sales and cost of goods sold should be reduced by 80% of the intercompany sales.
c. Net income should be reduced by 80% of the gross profit on intercompany sales.
d. No adjustment is necessary.

21. P Corporation acquired a 60% interest in S Corporation on January 1, 2011, at book value equal to fair value. During 2011, P sold merchandise that cost $225,000 to S for $315,000. One-third of this merchandise remained in S’s inventory at December 31, 2011. S reported net income of $200,000 for 2011. P’s income from S for 2011 is:
a. $60,000.
b. $90,000.
c. $120,000.
d. $102,000.

Use the following information for Questions 22 & 23:

P Company regularly sells merchandise to its 80%-owned subsidiary, S Corporation. In 2010, P sold merchandise that cost $192,000 to S for $240,000. Half of this merchandise remained in S’s December 31, 2010 inventory. During 2011, P sold merchandise that cost $300,000 to S for $375,000. Forty percent of this merchandise inventory remained in S’s December 31, 2011 inventory. Selected income statement information for the two affiliates for the year 2011 is as follows:

P _ S _
Sales Revenue $1,800,000 $900,000
Cost of Goods Sold 1,440,000 750,000
Gross profit $ 360,000 $150,000

22. Consolidated sales revenue for P and Subsidiary for 2011 are:
a. $2,325,000.
b. $2,400,000.
c. $2,565,000.
d. $2,700,000.

23. Consolidated cost of goods sold for P Company and Subsidiary for 2011 are:
a. $1,809,000.
b. $1,815,000.
c. $1,821,000.
d. $2,190,000.

Use the following information for Questions 24 & 25:

P Company owns an 80% interest in S Company. During 2011, S sells merchandise to P for $150,000 at a profit of $30,000. On December 31, 2011, 50% of this merchandise is included in P’s inventory. Income statements for P and S are summarized below:

P __ S __
Sales $900,000 $450,000
Cost of Sales (450,000) (300,000)
Operating Expenses (225,000) ( 60,000)
Net Income (2011) $225,000 $ 90,000

24. Controlling interest in consolidated net income for 2011 is:
a. $225,000.
b. $285,000.
c. $297,000.
d. $315,000.

25. Noncontrolling interest in income for 2011 is:
a. $3,000.
b. $14,400.
c. $15,000.
d. $18,000.

Problems

6-1 On January 1, 2011, Palmer Company purchased a 90% interest in Sauder Company for $2,800,000. At that time, Sauder had $1,840,000 of common stock and $360,000 of retained earnings. The difference between implied and book value was allocated to the following assets of Sauder Company:

Inventory $ 80,000
Plant and equipment (net) 240,000
Goodwill 591,111

The plant and equipment had a 10-year remaining useful life on January 1, 2011.

During 2011, Palmer sold merchandise to Sauder at a 20% markup above cost. At December 31, 2011, Sauder still had $180,000 of merchandise in its inventory that it had purchased from Palmer. In 2011, Palmer reported net income from independent operations of $1,600,000, while Sauder reported net income of $600,000.

Required:
A. Prepare the workpaper entry to allocate, amortize, and depreciate the difference between implied and book value for 2011.

B. Calculate controlling interest in consolidated net income for 2011.

6-2 Percy Company owns 80% of the common stock of Smyth Company. Percy sells merchandise to Smyth at 20% above cost. During 2011 and 2012, intercompany sales amounted to $1,080,000 and $1,200,000 respectively. At the end of 2011, Smyth had one-fifth of the goods purchased that year from Percy in its ending inventory. Smyth’s 2012 ending inventory contained one-fourth of that year’s purchases from Percy. There were no intercompany sales prior to 2011.

Percy reported net income from its own operations of $720,000 in 2011 and $760,000 in 2012. Smyth reported net income of $400,000 in 2011 and $460,000 in 2012. Neither company declared dividends in either year.

Required:

A. Prepare in general journal form all entries necessary on the consolidated statements workpapers to eliminate the effects of the intercompany sales for both 2011 and 2012.

B. Calculate controlling interest in consolidated net income for 2012.

6-3 Payton Company owns 90% of the common stock of Sanders Company. Sanders Company sells merchandise to Payton Company at 25% above cost. During 2010 and 2011 such sales amounted to $800,000 and $1,020,000, respectively. At the end of each year, Payton Company had in its inventory one-fourth of the amount of goods purchased from Sanders Company during that year. Payton Company reported income of $1,500,000 from its independent operations in 2010 and $1,720,000 in 2011. Sanders Company reported net income of $600,000 in each year and did not declare any dividends in either year. There were no intercompany sales prior to 2010.

Required:
A. Prepare, in general journal form, all entries necessary on the 2011 consolidated statements workpaper to eliminate the effects of intercompany sales.

B. Calculate the amount of noncontrolling interest to be deducted from consolidated income in the consolidated income statement in 2011.

C. Calculate controlling interest in consolidated net income for 2011.

6-4 Powers Company owns an 80% interest in Smiley Company and a 90% interest in Toro Company. During 2010 and 2011, intercompany sales of merchandise were made by all three companies. Total sales amounted to $2,400,000 in 2010, and $2,700,000 in 2011. The companies sold their merchandise at the following percentages above cost.
Powers 15%
Smiley 20%
Toro 25%

The amount of merchandise remaining in the 2011 beginning and ending inventories of the companies from these intercompany sales is shown below.

Merchandise Remaining in Beginning Inventory
Powers Smiley Toro Total
Sold by
Powers $225,000 $189,000 $414,000
Smiley $180,000 216,000 396,000
Toro 180,000 135,000 315,000

Merchandise Remaining in Ending Inventory
Powers Smiley Toro Total
Sold by
Powers $207,000 $138,000 $345,000
Smiley $144,000 198,000 342,000
Toro 195,000 150,000 345,000

Reported net incomes (from independent operations including sales to affiliates) of Powers, Smiley, and Toro for 2011 were $3,600,000, $1,500,000, and $2,400,000, respectively.

Required:
A. Calculate the amount noncontrolling interest to be deducted from consolidated income in the consolidated income statement for 2011.

B. Calculate the controlling interest in consolidated net income for 2011.

6-5 The following balances were taken from the records of S Company:
Common stock $2,500,000
Retained earnings, 1/1/11 $1,450,000
Net income for 2011 3,000,000
Dividends declared in 2011 (1,550,000)
Retained earnings, 12/31/11 2,900,000
Total stockholders’ equity, 12/31/11 $5,400,000

P Company owns 80% of the common stock of S Company. During 2011, P Company purchased merchandise from S Company for $4,000,000. S Company sells merchandise to P Company at cost plus 25% of cost. On December 31, 2011, merchandise purchased from S Company for $1,250,000 remains in the inventory of P Company. On January 1, 2011, P Company’s inventory contained merchandise purchased from S Company for $525,000. The affiliated companies file a consolidated income tax return. There was no difference between the implied value and the book value of net assets acquired.

Required:
A. Prepare all workpaper entries necessitated by the intercompany sales of merchandise.

B. Compute noncontrolling interest in consolidated income for 2011.

C. Compute noncontrolling interest in consolidated net assets on December 31, 2011.

6-6
P Corporation acquired 80% of S Corporation on January 1, 2011 for $240,000 cash when S’s stockholders’ equity consisted of $100,000 of Common Stock and $30,000 of Retained Earnings. The difference between the price paid by P and the underlying equity acquired in S was allocated solely to a patent amortized over 10 years.
P sold merchandise to S during the year in the amount of $30,000. $10,000 worth of inventory is still on hand at the end of the year with an unrealized profit of $4,000. The separate company statements for P and S appear in the first two columns of the partially completed consolidated workpaper.

Required:
Complete the consolidated workpaper for P and S for the year 2011.

P Corporation and Subsidiary
Consolidated Statements Workpaper
P S Eliminations Noncontrolling Consolidated
Corp. Corp. Dr. Cr. Interest Balances
Income Statement
Sales 200,000 150,000
Dividend Income 16,000
Cost of Sales (92,000) (47,000)
Other Expenses (23,000) (40,000)
Noncontrolling Interest in Income
Net Income 101,000 63,000
Retained Earnings Statement
Retained Earnings 1/1 110,000 30,000
Add: Net Income 101,000 63,000
Less: Dividends ( 30,000) (20,000)
Retained Earnings 12/31 181,000 73,000
Balance Sheet
Cash 20,000 19,000
Accounts Receivable-net 120,000 55,000
Inventories 140,000 80,000
Patent
Land 270,000 420,000
Equipment and Buildings-net 600,000 430,000
Investment in S Corporation 240,000
Total Assets 695,000 1,004,000
Equities
Accounts Payable 909,000 831,000
Common Stock 300,000 100,000
Retained Earnings 181,000 73,000
1/1 Noncontrolling Interest in Net Assets
12/31 Noncontrolling Interest in Net Assets
Total Equities 1,390,000 1,004,000
at December 31, 2011

6-7 On January 1, 2011, Porter Company purchased an 80% interest in the capital stock of Shilo Company for $3,400,000. At that time, Shilo Company had common stock of $2,200,000 and retained earnings of $620,000. Porter Company uses the cost method to record its investment in Shilo Company. Differences between the fair value and the book value of the identifiable assets of Shilo Company were as follows:

Fair Value in Excess of Book Value

Equipment $400,000
Land 200,000
Inventory 80,000

The book values of all other assets and liabilities of Shilo Company were equal to their fair values on January 1, 2011. The equipment had a remaining life of five years on January 1, 2011; the inventory was sold in 2011.

Shilo Company’s net income and dividends declared in 2011 were as follows:

Year 2011 Net Income of $400,000; Dividends Declared of $100,000

Required:

Prepare a consolidated statements workpaper for the year ended December 31, 2012 using the partially completed worksheet.

PORTER COMPANY AND SUBSIDIARY
Consolidated Statements Workpaper
For the Year Ended December 31, 2012
Porter Shilo Eliminations Noncontrolling Consolidated
Company Company Dr. Cr. Interest Balances
Income Statement
Sales 4,400,000 1,800,000
Dividend Income 192,000
Total Revenue 4,592,000 1,800,000
Cost of Goods Sold 3,600,000 800,000
Depreciation Expense 160,000 120,000
Other Expenses 240,000 200,000
Total Cost & Expenses 4,000,000 1,120,000
Net/Consolidated Income 592,000 680,000
Noncontrolling Interest in Income
Net Income to Retained Earnings 592,000 680,000
Retained Earnings Statement
1/1 Retained Earnings
Porter Company 2,000,000
Shilo Company 920,000
Net Income from above 592,000 680,000
Dividends Declared
Porter Company (360,000)
Shilo Company (240,000)
12/31 Retained Earnings to
Balance Sheet 2,232,000 1,360,000
Porter Shilo Eliminations Noncontrolling Consolidated
Company Company Dr. Cr. Interest Balances
Balance Sheet
Cash 280,000 260,000
Accounts Receivable 1,040,000 760,000
Inventory 960,000 700,000
Investment in Shilo Company 3,400,000
Difference between Implied and Book Value
Land 1,280,000
Plant and Equipment 1,440,000 1,120,000
Total Assets 7,120,000 4,120,000
Accounts Payable 528,000 440,000
Notes Payable 360,000 120,000
Common Stock:
Porter Company 4,000,000
Shilo Company 2,200,000
Retained Earnings from above 2,232,000 1,360,000
1/1 Noncontrolling Interest in Net Assets
12/31 Noncontrolling Interest in Net Assets
Total Liabilities & Equity 7,120,000 4,120,000
6-8 Pool Company owns a 90% interest in Slater Company. The consolidated income statement drafted by the controller of Pool Company appeared as follows:

Pool Company and Subsidiary
Consolidated Income Statement
for Year Ended December 31, 2011

Sales $13,800,000
Cost of Sales $9,000,000
Operating Expenses 1,800,000 10,800,000
Consolidated Income 3,000,000
Less Noncontrolling Interest in Consolidated Income 190,000
Controlling Interest in Consolidated Net Income $2,810,000

During your audit you discover that intercompany sales transactions were not reflected in the controller’s draft of the consolidated income statement. Information relating to intercompany sales and unrealized intercompany profit is as follows:

Selling Unsold at
Cost Price Year-End
2010 Sales—Slater to Pool $1,500,000 $1,800,000 1/4
2011 Sales—Pool to Slater 900,000 1,350,000 2/5

Required:
Prepare a corrected consolidated income statement for Pool Company and Slocum Company for the year ended December 31, 2011.

Short Answer

1. Past and proposed GAAP agree that unrealized intercompany profit should not be included in consolidated net income or assets. Briefly explain the preferred approach of eliminating intercompany profit.

2. Determination of the noncontrolling interest in consolidated net income differs depending on whether intercompany sales are downstream or upstream. Explain the difference in calculating noncontrolling interest for downstream and upstream sales.

Short Answer Questions from the Textbook

1. Does the elimination of the effects of intercompany sales of merchandise always affect the amount of reported consolidated net income? Explain.

2. Why is the gross profit on intercompany sales, rather than profit after deducting selling and administrative expenses, ordinarily eliminated from consolidated inventory balances?

3. P Company sells inventory costing $100,000 to its subsidiary, S Company, for $150,000. At the end of the current year, one-half of the goods re-mains in S Company’s inventory. Applying the lower of cost or market rule, S Company writes down this inventory to $60,000. What amount of intercompany profit should be eliminated on the consolidated statements workpaper?

4. Are the adjustments to the noncontrolling interest for the effects of intercompany profit eliminations illustrated in this text necessary for fair presentation in accordance with generally accepted accounting principles? Explain.

5. Why are adjustments made to the calculation of the noncontrolling interest for the effects of intercompany profit in upstream but not in down-stream sales?

6. What procedure is used in the consolidated statements workpaper to adjust the noncontrolling interest in consolidated net assets at the be-ginning of the year for the effects of intercompany profits?

7. What is the essential procedural difference between workpaper eliminating entries for unrealized intercompany profit made when the selling affiliate is a less than wholly owned subsidiary and those made when the selling affiliate is the parent company or a wholly owned subsidiary?

8. Define the controlling interest in consolidated net income using the t-account or analytical approach.

9. Why is it important to distinguish between up-stream and downstream sales in the analysis of intercompany profit eliminations?

ANSWER KEY (Chapter 6)

Chapter 7

Elimination of Unrealized Gains or Losses on Intercompany Sales of Property and Equipment

Multiple Choice

1. In the year a subsidiary sells land to its parent company at a gain, a workpaper entry is made debiting
1. Retained Earnings – P Company.
2. Retained Earnings – S Company.
3. Gain on Sale of Land.
a. 1
b. 2
c. 3
d. both 1 and 2.

2. In years subsequent to the year a 90% owned subsidiary sells equipment to its parent company at a gain, the noncontrolling interest in consolidated income is computed by multiplying the noncontrolling interest percentage by the subsidiary’s reported net income
a. minus the net amount of unrealized gain on the intercompany sale.
b. plus the net amount of unrealized gain on the intercompany sale.
c. minus intercompany gain considered realized in the current period.
d. plus intercompany gain considered realized in the current period.

3. Company S sells equipment to its parent company (P) at a gain. In years subsequent to the year of the intercompany sale, a workpaper entry is made under the cost method debiting
a. Retained Earnings – P.
b. Noncontrolling interest.
c. Equipment.
d. all of these.

4. Pinick Corp. owns 90% of the outstanding common stock of Shell Company. On December 31, 2011, Shell sold equipment to Pinick for an amount greater than the equipment’s book value but less than its original cost. The equipment should be reported on the December 31, 2011 consolidated balance sheet at
a. Pinick’s original cost less 90% of Shell’s recorded gain.
b. Pinick’s original cost less Shell’s recorded gain.
c. Shell’s original cost.
d. Pinick’s original cost.

5. Pratt Company owns 100% of Sage Corporation. On January 1, 2011 Pratt sold equipment to Sage at a gain. Pratt had owned the equipment for four years and used a ten-year straight-line rate with no residual value. Sage is using an eight-year straight-line rate with no residual value. In the consolidated income statement, Sage’s recorded depreciation expense on the equipment for 2011 will be reduced by
a. 10% of the gain on sale.
b. 12 1/2% of the gain on sale.
c. 80% of the gain on sale.
d. 100% of the gain on sale.

6. Pratt Corporation owns 100% of Stone Company’s common stock. On January 1, 2011, Pratt sold equipment with a book value of $210,000 to Stone for $300,000. Stone is depreciating the equipment over a ten-year life by the straight-line method. The net adjustments to compute 2011 and 2012 consolidated income would be an increase (decrease) of
2011 2012
a. ($90,000) $0
b. ($90,000) $9,000
c. ($81,000) $0
d. ($81,000) $9,000

7. In the year an 80% owned subsidiary sells equipment to its parent company at a gain, the noncontrolling interest in consolidated income is calculated by multiplying the noncontrolling interest percentage by the subsidiary’s reported net income
a. plus the intercompany gain considered realized in the current period.
b. plus the net amount of unrealized gain on the intercompany sale.
c. minus the net amount of unrealized gain on the intercompany sale.
d. minus the intercompany gain considered realized in the current period.

8. The amount of the adjustment to the noncontrolling interest in consolidated net assets is equal to the noncontrolling interest’s percentage of the
a. unrealized intercompany gain at the beginning of the period.
b. unrealized intercompany gain at the end of the period.
c. realized intercompany gain at the beginning of the period.
d. realized intercompany gain at the end of the period.

9. In January 2008, S Company, an 80% owned subsidiary of P Company, sold equipment to P Company for $1,980,000. S Company’s original cost for this equipment was $2,000,000 and had accumulated depreciation of $200,000. P Company continued to depreciate the equipment over its 9 year remaining life using the straight-line method. This equipment was sold to a third party on January 1, 2011 for $1,440,000. What amount of gain should P Company record on its books in 2011?
a. $60,000.
b. $120,000.
c. $240,000.
d. $360,000.

10. In years subsequent to the upstream intercompany sale of nondepreciable assets, the necessary consolidated workpaper entry under the cost method is to debit the
a. Noncontrolling interest and Retained Earnings (Parent) accounts, and credit the nondepreciable asset.
b. Retained Earnings (Parent) account and credit the nondepreciable asset.
c. Nondepreciable asset, and credit the Noncontrolling interest and Investment in Subsidiary accounts.
d. No entries are necessary.

11. When preparing consolidated financial statement workpapers, unrealized intercompany gains, as a result of equipment or inventory sales by affiliates, are allocated proportionately by percent of ownership between parent and subsidiary only when the selling affiliate is
a. the parent and the subsidiary is less than wholly owned.
b. a wholly owned subsidiary.
c. the subsidiary and the subsidiary is less than wholly owned.
d. the parent of a wholly owned subsidiary.

12. Gain or loss resulting from an intercompany sale of equipment between a parent and a subsidiary is
a. recognized in the consolidated statements in the year of the sale.
b. considered to be realized over the remaining useful life of the equipment as an adjustment to depreciation in the consolidated statements.
c. considered to be unrealized in the consolidated statements until the equipment is sold to a third party.
d. amortized over a period not less than 2 years and not greater than 40 years.

13. In 2011, P Company sells land to its 80% owned subsidiary, S Company, at a gain of $50,000. What is the effect of this sale of land on consolidated net income assuming S Company still owns the land at the end of the year?
a. consolidated net income will be the same as if the sale had not occurred.
b. consolidated net income will be $50,000 less than it would had the sale not occurred.
c. consolidated net income will be $40,000 less than it would had the sale not occurred.
d. consolidated net income will be $50,000 greater than it would had the sale not occurred.

14. Several years ago, P Company bought land from S Company, its 80% owned subsidiary, at a gain of $50,000 to S Company. The land is still owned by P Company. The consolidated working papers for this year will require:
a. no entry because the gain happened prior to this year.
b. a credit to land for $50,000.
c. a debit to P’s retained earnings for $50,000.
d. a debit to Noncontrolling interest for $50,000.

15. On January 1, 2010 S Corporation sold equipment that cost $120,000 and had a book value of $48,000 to P Corporation for $60,000. P Corporation owns 100% of S Corporation and the equipment has a 4-year remaining life. What is the effect of the sale on P Corporation’s Equity from Subsidiary Income account for 2011?
a. no effect
b. increase of $12,000.
c. decrease of $12,000.
d. increase of $3,000.

16. P Corporation acquired an 80% interest in S Corporation two years ago at an implied value equal to the book value of S. On January 2, 2011, S sold equipment with a five-year remaining life to P for a gain of $120,000. S reports net income of $600,000 for 2011 and pays dividends of $200,000. P’s Equity from Subsidiary Income for 2011 is:
a. $480,000.
b. $384,000.
c. $403,200.
d. $576,000

17. P Company purchased land from its 80% owned subsidiary at a cost of $100,000 greater than it subsidiary’s book value. Two years later P sold the land to an outside entity for $50,000 more than it’s cost. In its current year consolidated income statement P and its subsidiary should report a gain on the sale of land of:
a. $50,000.
b. $120,000.
c. $130,000.
d. $150,000.

18. On January 1, 2010, P Corporation sold equipment with a 3-year remaining life and a book value of $40,000 to its 70% owned subsidiary for a price of $46,000. In the consolidated workpapers for the year ended December 31, 2011, an elimination entry for this transaction will include a:
a. debit to Equipment for $6,000.
b. debit to Gain on Sale of Equipment for $6,000.
c. credit to Depreciation Expense for $6,000.
d. debit to Accumulated Depreciation for $4,000.

19. Parks Corporation owns 100% of Starr Company’s common stock. On January 1, 2011, Parks sold equipment with a book value of $350,000 to Starr for $500,000. Starr is depreciating the equipment over a ten-year life by the straight-line method. The net adjustments to compute 2011 and 2012 consolidated income would be an increase (decrease) of
2011 2012
a. ($150,000) $0
b. ($150,000) $15,000
c. ($135,000) $0
d. ($135,000) $15,000

20. In January 2008, S Company, an 80% owned subsidiary of P Company, sold equipment to P Company for $990,000. S Company’s original cost for this equipment was $1,000,000 and had accumulated depreciation of $100,000. P Company continued to depreciate the equipment over its 9 year remaining life using the straight-line method. This equipment was sold to a third party on January 1, 2011 for $720,000. What amount of gain should P Company record on its books in 2011?
a. $30,000.
b. $60,000.
c. $120,000.
d. $180,000.

21. P Corporation acquired an 80% interest in S Corporation two years ago at an implied value equal to the book value of S. On January 2, 2011, S sold equipment with a five-year remaining life to P for a gain of $180,000. S reports net income of $900,000 for 2011 and pays dividends of $300,000. P’s Equity from Subsidiary Income for 2011 is:
a. $720,000.
b. $576,000.
c. $604,800.
d. $864,000

22. P Company purchased land from its 80% owned subsidiary at a cost of $30,000 greater than it subsidiary’s book value. Two years later P sold the land to an outside entity for $15,000 more than it’s cost. In its current year consolidated income statement P and its subsidiary should report a gain on the sale of land of:
a. $15,000.
b. $36,000.
c. $39,000.
d. $45,000.

23. On January 1, 2010, P Corporation sold equipment with a 3-year remaining life and a book value of $100,000 to its 70% owned subsidiary for a price of $115,000. In the consolidated workpapers for the year ended December 31, 2011, an elimination entry for this transaction will include a:
a. debit to Equipment for $15,000.
b. debit to Gain on Sale of Equipment for $15,000.
c. credit to Depreciation Expense for $15,000.
d. debit to Accumulated Depreciation for $10,000.
Problems

7-1 Parker Company, a computer manufacturer, owns 90% of the outstanding stock of Santo Company. On January 1, 2011, Parker sold computers to Santo for $500,000. The computers, which are inventory to Parker, had a cost to Parker of $350,000. Santo Company estimated that the computers had a useful life of six years from the date of purchase.

Santo Company reported net income of $310,000, and Parker Company reported net income of $870,000 from its independent operations (including sales to affiliates) for the year ended December 31, 2011.

Required:
A. Prepare in general journal form the workpaper entries necessary because of the intercompany sales in the consolidated statements workpaper for both 2011 and 2012.

B. Calculate controlling interest in consolidated net income for 2011.

7-2 On January 1, 2008, Penny Company purchased a 90% interest in Stein Company for $800,000, the same as the book value on that date. On January 1, 2011, Stein sold new equipment to Penny for $16,000. The equipment cost $11,000 and had a five year estimated life as of January 1, 2011.

During 2012, Penny sold merchandise to Stein at 20% above cost in the amount (selling price) of $126,000. At the end of the year, Stein had one-third of this merchandise in its ending inventory. At the beginning of 2012, Stein had $48,000 of inventory purchased in 2011 from Penny

Required:
A. Prepare all workpaper entries necessary to eliminate the effects of the intercompany sales on the consolidated financial statements for 2012.

B. Calculate the amount of noncontrolling interest to be deducted from consolidated net income in the consolidated income statement for 2012. Stein Company reported $40,000 of net income in 2012.

7-3 Pringle Company owns 104,000 of the 130,000 shares outstanding of Seely Corporation. Seely Corporation sold equipment to Pringle Company on January 1, 2011 for $740,000. The equipment was originally purchased by Seely Corporation on January 1, 2010 for $1,280,000 and at that time its estimated depreciable life was 8 years. The equipment is estimated to have a remaining useful life of four years on January 1, 2011. Both companies use the straight-line method to depreciate equipment. In 2012 Pringle Company reported net income from its independent operations of $3,270,000, and Seely Corporation reported net income of $820,000 and declared dividends of $60,000. Pringle Company uses the cost method to record the investment in Seely Company.

Required:
A. Prepare, in general journal form, the workpaper entries relating to the intercompany sale of equipment that are necessary in the December 31, 2012 consolidated financial statements workpapers.

B. Calculate the amount of noncontrolling interest to be deducted from consolidated net income in the consolidated income statement for 2012.

C. Calculate controlling interest in consolidated net income for 2012.

7-4 P Company bought 60% of the common stock of S Company on January 1, 2011. On January 1, 2011 there was an intercompany sale of equipment at a gain of $63,000. The equipment had an estimated remaining life of six years. Net incomes of the two companies from their own operations (including sales to affiliates) were as follows:
2011 2012
P Company $280,000 $210,000
S Company 70,000 105,000

A. If S Company sold the equipment to P Company, fill in the following matrix:
2011 2012
Noncontrolling interest in consolidated net income

Controlling Interest in Consolidated net income

B. If P Company sold the equipment to S Company, fill in the following matrix:
2011 2012
Noncontrolling interest in consolidated net income

Controlling interest in consolidated net income

7-5 On January 1, 2011, Pinkel Company purchased equipment from its 80%-owned subsidiary for $2,400,000. On the date of the sale, the carrying value of the equipment on the books of the subsidiary company was $1,800,000. The equipment had a remaining useful life of six years on January 2011. On January 1, 2012, Pinkel Company sold the equipment to an outside party for $2,200,000.

Required:
A. Prepare, in general journal form, the entries necessary in 2011 and 2012 on the books of Pinkel Company to account for the purchase and sale of the equipment.

B. Determine the consolidated gain or loss on the sale of the equipment and prepare, in general journal form, the entry necessary on the December 31, 2012 consolidated statements workpaper to properly reflect this gain or loss.

7-6 P Corporation acquired 80% of the outstanding voting stock of S Corporation when the fair values equaled the book values.

On July 1, 2010, P sold land to S for $300,000. The land originally cost P $200,000. S recently resold the land on October 30, 2011 for $350,000.

On October 1, 2011, S Corporation sold equipment to P Corporation for $80,000. S originally paid $100,000 for this equipment and had accumulated depreciation of $40,000 thus far. The equipment has a five-year remaining life.

Required:
A. Complete the consolidated income statement for P Corporation and subsidiary for the year ended December 31, 2011.

P S Elimination Entries
Dr. Cr. Noncontrolling Interest Consolidated Balances
Sales 1,200,000 600,000
Dividend Income from S 80,000
Gain on Sale of
Equipment 20,000
Gain on Sale of Land 50,000
Cost of Sales (800,000) (300,000)
Depreciation Expense (160,000) (80,000)
Other Expenses (200,000) (160,000)
Noncontrolling Interest
in Income
Net Income 120,000 130,000

7-7 Pike Company owns 90% of the outstanding common stock of Sanka Company. On January 1, 2011, Sanka Company sold equipment to Pike Company for $300,000. Sanka Company had purchased the equipment for $450,000 on January 1, 2006 and has been depreciating it over a 10 year life by the straight-line method. The management of Pike Company estimated that the equipment had a remaining life of 5 years on January 1, 2011. In 2011, Pike Company reported $225,000 and Sanka Company reported $150,000 in net income from their independent operations.

Required:
A. Prepare in general journal form the workpaper entries relating to the intercompany sale of equipment that are necessary in the December 31, 2011 and 2012 consolidated statements workpapers. Pike Company uses the cost method to record its investment in Sanka Company.

B. Calculate equity in subsidiary income for 2011 and noncontrolling interest in net income for 2011.

7-8 On January 1, 2010, Peine Company acquired an 80% interest in the common stock of Stine Company on the open market for $3,000,000, the book value at that date.

On January 1, 2011, Peine Company purchased new equipment for $58,000 from Stine Company. The equipment cost $36,000 and had an estimated life of five years as of January 1, 2011.

During 2012, Peine Company had merchandise sales to Stine Company of $400,000; the merchandise was priced at 25% above Peine Company’s cost. Stine Company still owes Peine Company $70,000 on open account and has 20% of this merchandise in inventory at December 31, 2012. At the beginning of 2012, Stine Company had in inventory $100,000 of merchandise purchased in the previous period from Peine Company.

Required:
A. Prepare all workpaper entries necessary to eliminate the effects of the intercompany sales on the consolidated financial statements for the year ended December 31, 2012.

B. Assume that Stine Company reports net income of $160,000 for the year ended December 31, 2012. Calculate the amount of noncontrolling interest to be deducted from consolidated income in the consolidated income statement for the year ended December 31, 2012.

Short Answer

1. When there have been intercompany sales of depreciable property, workpaper entries are necessary to accomplish several financial reporting objectives. Identify three of these financial reporting objectives for depreciable property.

2. An eliminating entry is needed to adjust the consolidated financial statements when the purchasing affiliate sells a depreciable asset that was acquired from another affiliate. Describe the necessary eliminating entry.

Short Answer Questions from the Textbook

1. From a consolidated point of view, when should profit be recognized on intercompany sales of depreciable assets? Nondepreciable assets?

2. In what circumstances might a consolidated gain be recognized on the sale of assets to a nonaffiliate when the selling affiliate recognizes a loss?

3. What is the essential procedural difference between workpaper eliminating entries for un-realized intercompany profit when the selling affiliate is a less than wholly owned subsidiary and such entries when the selling affiliate is the parent company or a wholly owned subsidiary?

4. Define the controlling interest in consolidated net income using the t-account approach.

5. Why is it important to distinguish between up-stream and downstream sales in the analysis of intercompany profit eliminations?

6. In what period and in what manner should profits relating to the intercompany sale of depreciable property and equipment be recognized in the consolidated financial statements?

7. Define consolidated retained earnings using the analytical approach.

Business Ethics Question from the Textbook
Some people believe that the use of executive stock options is directly related to the increased number of earnings restatements. For each of the following items, discuss the potential ethical issues that might be related to earnings management within the firm.
1. Should stock options be expensed on the Income Statement?
2. Should the CEO or CFO be a past employee of the firm’s audit firm?
3. Should the firm’s audit committee be com-posed entirely of outside members and be solely responsible for hiring the firm’s auditors?

ANSWER KEY (Chapter 7)

Chapter 8

Changes in Ownership Interest

Multiple Choice

1. When the parent company sells a portion of its investment in a subsidiary, the workpaper entry to adjust for the current year’s income sold to noncontrolling stockholders includes a
a. debit to Subsidiary Income Sold.
b. debit to Equity in Subsidiary Income.
c. credit to Equity in Subsidiary Income.
d. credit to Subsidiary Income Sold.

2. A parent company may increase its ownership interest in a subsidiary by
a. buying additional subsidiary shares from third parties.
b. buying additional subsidiary shares from the subsidiary.
c. having the subsidiary purchase its shares from third parties.
d. all of these.

3. If a portion of an investment is sold, the value of the shares sold is determined by using the:
1. first-in, first-out method.
2. average cost method.
3. specific identification method.
a. 1
b. 2
c. 3
d. 1 and 3

4. If a parent company acquires additional shares of its subsidiary’s stock directly from the subsidiary for a price less than their book value:
1. total noncontrolling book value interest increases.
2. the controlling book value interest increases.
3. the controlling book value interest decreases.
a. 1
b. 2
c. 3
d. 1 and 3

5. If a subsidiary issues new shares of its stock to noncontrolling stockholders, the book value of the parent’s interest in the subsidiary may
a. increase.
b. decrease.
c. remain the same.
d. increase, decrease, or remain the same.

6. The purchase by a subsidiary of some of its shares from noncontrolling stockholders results in the parent company’s share of the subsidiary’s net assets
a. increasing.
b. decreasing.
c. remaining unchanged.
d. increasing, decreasing, or remaining unchanged.

7. The computation of noncontrolling interest in net assets is made by multiplying the noncontrolling interest percentage at the
a. beginning of the year times subsidiary stockholders’ equity amounts.
b. beginning of the year times consolidated stockholders’ equity amounts.
c. end of the year times subsidiary stockholders’ equity amounts.
d. end of the year times consolidated stockholders’ equity amounts.

8. Under the partial equity method, the workpaper entry that reverses the effect of subsidiary income for the year includes a:
1. credit to Equity in Subsidiary Income.
2. debit to Subsidiary Income Sold.
3. debit to Equity in Subsidiary Income.
a. 1
b. 2
c. 3
d. both 1 and 2

9. Polk Company owned 24,000 of the 30,000 outstanding common shares of Sloan Company on January 1, 2010. Polk’s shares were purchased at book value when the fair values of Sloan’s assets and liabilities were equal to their book values. The stockholders’ equity of Sloan Company on January 1, 2010, consisted of the following:
Common stock, $15 par value $ 450,000
Other contributed capital 337,500
Retained earnings 712,500
Total $1,500,000

Sloan Company sold 7,500 additional shares of common stock for $90 per share on January 2, 2010. If Polk Company purchased all 7,500 shares, the book entry to record the purchase should increase the Investment in Sloan Company account by
a. $562,500.
b. $590,625.
c. $675,000.
d. $150,000.
e. Some other account.

10. Polk Company owned 24,000 of the 30,000 outstanding common shares of Sloan Company on January 1, 2010. Polk’s shares were purchased at book value when the fair values of Sloan’s assets and liabilities were equal to their book values. The stockholders’ equity of Sloan Company on January 1, 2010, consisted of the following:
Common stock, $15 par value $ 450,000
Other contributed capital 337,500
Retained earnings 712,500
Total $1,500,000
Sloan Company sold 7,500 additional shares of common stock for $90 per share on January 2, 2010. If all 7,500 shares were sold to noncontrolling stockholders, the workpaper adjustment needed each time a workpaper is prepared should increase (decrease) the Investment in Sloan Company by
a. ($140,625).
b. $140,625.
c. ($112,500).
d. $192,000.
e. None of these.

11. On January 1, 2006, Parent Company purchased 32,000 of the 40,000 outstanding common shares of Sims Company for $1,520,000. On January 1, 2010, Parent Company sold 4,000 of its shares of Sims Company on the open market for $90 per share. Sims Company’s stockholders’ equity on January 1, 2006, and January 1, 2010, was as follows:
1/1/06 1/1/10
Common stock, $10 par value $400,000 $ 400,000
Other contributed capital 400,000 400,000
Retained earnings 800,000 1,400,000
$1,600,000 $2,200,000

The difference between implied and book value is assigned to Sims Company’s land. The amount of the gain on sale of the 4,000 shares that should be recorded on the books of Parent Company is
a. $68,000.
b. $170,000.
c. $96,000.
d. $200,000.
e. None of these.

12. On January 1, 2006, Patterson Corporation purchased 24,000 of the 30,000 outstanding common shares of Stewart Company for $1,140,000. On January 1, 2010, Patterson Corporation sold 3,000 of its shares of Stewart Company on the open market for $90 per share. Stewart Company’s stockholders’ equity on January 1, 2006, and January 1, 2010, was as follows:
1/1/06 1/1/10
Common stock, $10 par value $ 300,000 $ 300,000
Other contributed capital 300,000 300,000
Retained earnings 600,000 1,050,000
$1,200,000 $1,650,000

The difference between implied and book value is assigned to Stewart Company’s land. As a result of the sale, Patterson Corporation’s Investment in Stewart account should be credited for
a. $165,000.
b. $206,250.
c. $120,000.
d. $142,500.
e. None of these.

13. On January 1, 2006, Peterson Company purchased 16,000 of the 20,000 outstanding common shares of Swift Company for $760,000. On January 1, 2010, Peterson Company sold 2,000 of its shares of Swift Company on the open market for $90 per share. Swift Company’s stockholders’ equity on January 1, 2006, and January 1, 2010, was as follows:
1/1/06 1/1/10
Common stock, $10 par value $200,000 $ 200,000
Other contributed capital 200,000 200,000
Retained earnings 400,000 700,000
$800,000 $1,100,000

The difference between implied and book value is assigned to Swift Company’s land. Assuming no other equity transactions, the amount of the difference between implied and book value that would be added to land on a workpaper for the preparation of consolidated statements on December 31, 2010, would be
a. $120,000.
b. $115,000.
c. $105,000.
d. $84,000.
e. None of these.

14. On January 1 2010, Paulson Company purchased 75% of Shields Corporation for $500,000. Shields’ stockholders’ equity on that date was equal to $600,000 and Shields had 60,000 shares issued and outstanding on that date. Shields Corporation sold an additional 15,000 shares of previously unissued stock on December 31, 2010.

Assume that Paulson Company purchased the additional shares what would be their current percentage ownership on December 31, 2010?
a. 92%
b. 87%
c. 80%
d. 100%

15. On January 1 2010, Powder Mill Company purchased 75% of Selfine Company for $500,000. Selfine Company’s stockholders’ equity on that date was equal to $600,000 and Selfine Company had 60,000 shares issued and outstanding on that date. Selfine Company Corporation sold an additional 15,000 shares of previously unissued stock on December 31, 2010.

Assume Selfine Company sold the 15,000 shares to outside interests, Powder Mill Company’s percent ownership would be:
a. 33 1/3%
b. 60%
c. 75%
d. 80%

16. P Corporation purchased an 80% interest in S Corporation on January 1, 2010, at book value for $300,000. S’s net income for 2010 was $90,000 and no dividends were declared. On May 1, 2010, P reduced its interest in S by selling a 20% interest, or one-fourth of its investment for $90,000. What will be the Consolidated Gain on Sale and Subsidiary Income Sold for 2010?
Consolidated Gain on Sale Subsidiary Income Sold
a. $9,000 $6,000
b. $9,000 $15,000
c. $15,000 $6,000
d. $15,000 $15,000

17. P Corporation purchased an 80% interest in S Corporation on January 1, 2010, at book value for $300,000. S’s net income for 2010 was $90,000 and no dividends were declared. On May 1, 2010, P reduced its interest in S by selling a 20% interest, or one-fourth of its investment for $90,000. What would be the balance in the Investment of S Corporation account on December 31, 2010?
a. $300,000.
b. $225,000.
c. $279,000.
d. $261,000.

18. The purchase by a subsidiary of some of its shares from the noncontrolling stockholders results in an increase in the parent’s percentage interest in the subsidiary. The parent company’s share of the subsidiary’s net assets will increase if the shares are purchased:
a. at a price equal to book value.
b. at a price below book value.
c. at a price above book value.
d. will not show an increase.

Use the following information for Questions 19-21.

On January 1, 2006, Perk Company purchased 16,000 of the 20,000 outstanding common shares of Self Company for $760,000. On January 1, 2010, Perk Company sold 2,000 of its shares of Self Company on the open market for $90 per share. Self Company’s stockholders’ equity on January 1, 2006, and January 1, 2010, was as follows:
1/1/06 1/1/10
Common stock, $10 par value $ 200,000 $ 200,000
Other contributed capital 200,000 200,000
Retained earnings 400,000 700,000
$800,000 $1,100,000

The difference between implied and book value is assigned to Self Company’s land.

19. The amount of the gain on sale of the 2,000 shares that should be recorded on the books of Perk Company is
a. $34,000.
b. $85,000.
c. $48,000.
d. $100,000.
e. None of these.

20. As a result of the sale, Perk Company’s Investment in Self account should be credited for
a. $110,000.
b. $137,500.
c. $80,000.
d. $95,000.
e. None of these.

21. Assuming no other equity transactions, the amount of the difference between implied and book value that would be added to land on a work paper for the preparation of consolidated statements on December 31, 2010 would be
a. $120,000.
b. $115,000.
c. $105,000.
d. $84,000.

22. On January 1, 2010, P Corporation purchased 75% of S Corporation for $500,000. S’s stockholders’ equity on that date was equal to $600,000 and S had 40,000 shares issued and outstanding on that date. S Corporation sold an additional 8,000 shares of previously unissued stock on December 31, 2010.

Assume that P Corporation purchased the additional shares what would be their current percentage ownership on December 31, 2010?
a. 62 1/2%.
b. 75%
c. 79 1/6%
d. 100%

23. On January 1, 2010, P Corporation purchased 75% of S Corporation for $500,000. S’s stockholders’ equity on that date was equal to $600,000 and S had 40,000 shares issued and outstanding on that date. S Corporation sold an additional 8,000 shares of previously unissued stock on December 31, 2010.

Assume S sold the 8,000 shares to outside interests, P’s percent ownership would be:
a. 56 1/4%
b. 62 1/2%
c. 75%
d. 79 1/6%

Problems

8-1 Piper Company purchased Snead Company common stock through open-market purchases as follows:
Acquired
Date Shares Cost
1/1/09 1,500 $ 50,000
1/1/10 3,300 $ 90,000
1/1/11 6,600 $250,000

Snead Company had 12,000 shares of $20 par value common stock outstanding during the entire period. Snead had the following retained earnings balances on the relevant dates:

January 1, 2009 $ 90,000
January 1, 2010 30,000
January 1, 2011 150,000
December 31, 2011 300,000

Snead Company declared no dividends in 2009 or 2010 but did declare $60,000 of dividends in 2011. Any difference between cost and book value is assigned to subsidiary land. Piper uses the equity method to account for its investment in Snead.

Required:
A. Prepare the journal entries Piper Company will make during 2010 and 2011 to account for its investment in Snead Company.
B. Prepare workpaper eliminating entries necessary to prepare a consolidated statements workpaper on December 31, 2011.

8-2 On January 1, 2008, Patel Company acquired 90% of the common stock of Seng Company for $650,000. At that time, Seng had common stock ($5 par) of $500,000 and retained earnings of $200,000.

On January 1, 2010, Seng issued 20,000 shares of its unissued common stock, with a market value of $7 per share, to noncontrolling stockholders. Seng’s retained earnings balance on this date was $300,000. Any difference between cost and book value relates to Seng’s land. No dividends were declared in 2010.

Required:
A. Prepare the entry on Patel’s books to record the effect of the issuance assuming the cost method.
B. Prepare the elimination entries for the preparation of a consolidated statements workpaper on December 31, 2010 assuming the cost method.

8-3 Pratt Company purchased 40,000 shares of Silas Company’s common stock for $860,000 on January 1, 2010. At that time Silas Company had $500,000 of $10 par value common stock and $300,000 of retained earnings. Silas Company’s income earned and increase in retained earnings during 2010 and 2011 were:

2010 2011
Income earned $260,000 $360,000
Increase in Retained Earnings 200,000 300,000

Silas Company income is earned evenly throughout the year.

On September 1, 2011, Pratt Company sold on the open market, 12,000 shares of its Silas Company stock for $460,000. Any difference between cost and book value relates to Silas Company land. Pratt Company uses the cost method to account for its investment in Silas Company.

Required:
A. Compute Pratt Company’s reported gain (loss) on the sale.
B. Prepare all consolidated statements workpaper eliminating entries for a workpaper on December 31, 2011.

8-4 Pelky made the following purchases of Stark Company common stock:

Date Shares Cost
1/1/10 70,000 (70%) $1,000,000
1/1/11 10,000 (10%) 160,000

Stockholders’ equity information for Stark Company for 2010 and 2011 follows:

2010 2011
Common stock, $10 par value $1,000,000 $1,000,000

1/1 Retained earnings 300,000 380,000
Net income 110,000 140,000
Dividends declared, 12/15 (30,000) (40,000)
Retained earnings, 12/31 380,000 480,000
Total stockholders’ equity, 12/31 $1,380,000 $1,480,000

On July 1, 2011, Pelky sold 14,000 shares of Stark Company common stock on the open market for $22 per share. The shares sold were purchased on January 1, 2010. Stark notified Pelky that its net income for the first six months was $70,000. Any difference between cost and book value relates to subsidiary land. Pelky uses the cost method to account for its investment in Stark Company.

Required:
A. Prepare the journal entry made by Pelky to record the sale of the 14,000 shares on July 1, 2011.
B. Prepare the workpaper eliminating entries needed for a consolidated statements workpaper on December 31, 2011.
C. Compute the amount of noncontrolling interest that would be reported on the consolidated balance sheet on December 31, 2011.

8-5 P Company purchased 96,000 shares of the common stock of S Company for $1,200,000 on January 1, 2007, when S’s stockholders’ equity consisted of $5 par value, Common Stock at $600,000 and Retained Earnings of $800,000. The difference between cost and book value relates to goodwill.

On January 2, 2010, S Company purchased 20,000 of its own shares from noncontrolling interests for cash of $300,000 to be held as treasury stock. S Company’s retained earnings had increased to $1,000,000 by January 2, 2010. S Company uses the cost method in regards to its treasury stock and P Company uses the equity method to account for its investment in S Company.

Required:
Prepare all determinable workpaper entries for the preparation of consolidated statements on December 31, 2010.

8-6 Penner Company acquired 80% of the outstanding common stock of Solk Company on January 1, 2008, for $396,000. At the date of purchase, Solk Company had a balance in its $2 par value common stock account of $360,000 and retained earnings of $90,000. On January 1, 2010, Solk Company issued 45,000 shares of its previously unissued stock to noncontrolling stockholders for $3 per share. On this date, Solk Company had a retained earnings balance of $152,000. The difference between cost and book value relates to subsidiary land. No dividends were paid in 2010. Solk Company reported income of $30,000 in 2010.

Required:
A. Prepare the journal entry on Penner’s books to record the effect of the issuance assuming the equity method.
B. Prepare the eliminating entries needed for the preparation of a consolidated statements workpaper on December 31, 2010, assuming the equity method.

8-7 Petty Company acquired 85% of the common stock of Selmon Company in two separate cash transactions. The first purchase of 108,000 shares (60%) on January 1, 2009, cost $735,000. The second purchase, one year later, of 45,000 shares (25%) cost $330,000. Selmon Company’s stockholders’ equity was as follows:

December 31 December 31
2009 2010

Common Stock, $5 par $ 900,000 $ 900,000
Retained Earnings, 1/1 262,000 302,000
Net Income 69,000 90,000
Dividends Declared, 9/30 (30,000) (38,000)
Retained Earnings, 12/31 301,000 354,000
Total Stockholders’ Equity, 12/31 $1,201,000 $1,254,000

On April 1, 2010, after a significant rise in the market price of Selmon Company’s stock, Petty Company sold 32,400 of its Selmon Company shares for $390,000. Selmon Company notified Petty Company that its net income for the first three months was $22,000. The shares sold were identified as those obtained in the first purchase. Any difference between cost and book value relates to goodwill. Petty uses the partial equity method to account for its investment in Selmon Company.

Required:
A. Prepare the journal entries Petty Company will make on its books during 2009 and 2010 to account for its investment in Selmon Company.
B. Prepare the workpaper eliminating entries needed for a consolidated statements workpaper on December 31, 2010.

Short Answer
1. A parent’s ownership percentage in a subsidiary may change for several reasons. Identify three reasons the ownership percentage may change.

2. A parent company’s equity interest in a subsidiary may change as the result of the issuance of additional shares of stock by the subsidiary. Describe the affect on the parent’s investment account when the new shares are (a) purchased ratably by the parent and noncontrolling shareholders or (b) entirely by the noncontrolling shareholders.

Short Answer Question from the Textbook

1. Identify three types of transactions that result in a change in a parent company’s ownership interest in its subsidiary.

2. Why is the date of acquisition of subsidiary stock important under the purchase method?

3. When a parent company has obtained control of a subsidiary through several purchases and subsequently sells a portion of its shares in the subsidiary, how is the carrying value of the shares sold determined?

4. When a parent company that records its investment using the cost method during a fiscal year sells a portion of its investment, explain the correct accounting for any differences between selling price and recorded values.

5. ABC Corporation purchased 10,000 shares(80%) of EZ Company at $35 per share and sold them several years later for $35 per share. The consolidated income statement reports a loss on the sale of this investment. Explain.

6. Explain how a parent company that owns less than100% of a subsidiary can purchase an entire new is-sue of common stock directly from the subsidiary.

7. When a subsidiary issues additional shares of stock to noncontrolling stockholders and such issuance results in an increase in the book value of the parent’s share of the subsidiary’s equity, how should the increase be reflected in the financial statements? What if it results in a decrease?

8. P Company holds an 80% interest in S Company. Determine the effect (that is, increase, decrease, no change, not determinable) on both the total book value of the noncontrolling interest and the noncontrolling interest’s percentage of ownership in the net assets of S Company for each of the following situations:
a. P Company acquires additional shares directly from S Company at a price equal to the book value per share of the S Company stock immediately prior to the issuance.
b. S Company acquires its own shares on the open market. The cost of these shares is less than their book value.
c. Assume the same situation as in (b) except that the cost of the shares is greater than their book value.
d. P Company and a noncontrolling stockholder each acquire 100 shares directly from S Com-pany at a price below the book value per share.

Business Ethics Question from Textbook

During a recent review of the quarterly financial statements and supporting ledgers, you noticed several un-usual journal entries. While the dollar amounts of the journal entries were not large, there did not appear to be supporting documentation. You decide to bring the matter to the attention of your immediate supervisor. After you mentioned the issue, the supervisor calmly stated that the matter would be looked into and that you should not worry about it.1.You feel a bit uncomfortable about the situation. What is your responsibility and what action, if any, should you take?

ANSWER KEY (Chapter 8)

Chapter 9

Intercompany Bond Holdings and Miscellaneous Topics-Consolidated Financial Statements

Multiple Choice

1. Which of the following methods of allocating the gain or loss on an intercompany bond retirement is the soundest conceptually?
a. The gain (loss) is allocated to the company that issued the bonds.
b. The gain (loss) is allocated to the company that purchased the bonds.
c. The gain (loss) is allocated to the parent company.
d. The gain (loss) is allocated between the purchasing and issuing companies.

2. The constructive gain or loss on an intercompany bond retirement is recognized in the consolidated income statement _________ the recognition of the gain or loss on the individual companies’ books.
a. after
b. before
c. at the same time as
d. before or after

3. The constructive gain or loss to the purchasing company is the difference between the
a. book value of the bonds and their par value.
b. book value of the bonds and their purchase price.
c. cost of the bonds and their par value.
d. cost of the bonds and their purchase price.

4. The workpaper eliminating entry for a stock dividend declared by the subsidiary includes a
a. debit to Stock Dividends Declared – S Co.
b. debit to Noncontrolling interest.
c. credit to Stock Dividends Declared – S Co.
d. debit to Dividend Income.

5. The parent company records the receipt of shares from a subsidiary’s stock dividend as
a. dividend income.
b. a reduction of the investment account.
c. an increase in the investment account.
d. none of these.

6. If the book value of preferred stock is greater than its implied value, the difference is accounted for as an increase in
a. consolidated retained earnings.
b. consolidated net income.
c. other contributed capital.
d. investment in subsidiary preferred stock.

7. If a subsidiary has both common and preferred stock outstanding, a parent must own a controlling interest in
a. both the subsidiary’s common and preferred stock to justify consolidation.
b. the subsidiary’s common stock to justify consolidation.
c. the subsidiary’s common stock and at least 20% of the subsidiary’s preferred stock to justify consolidation.
d. the subsidiary’s common stock and more than 50% of the subsidiary’s preferred stock to justify consolidation.

Use the following information to answer Questions 8, 9, and 10.

Pollard Corporation owns 90% of the outstanding common stock of Steele Company. On January 1, 2008, Steele Company issued $500,000, 12%, ten-year bonds.

On January 1, 2010, Pollard Corporation paid $412,000 for Steele Company bonds with a par value of $400,000 and a carrying value of $393,600. Both companies use the straight-line method to amortize bond premiums and discounts. Pollard Corporation accounts for the investment using the cost method of accounting.

8. The total gain or loss on the constructive retirement of the debt to be reported in the 2010 consolidated income statement is
a. $12,000 loss.
b. $12,000 gain.
c. $18,400 loss.
d. $18,400 gain.
e. $6,400 loss.

9. Pollard Corporation would report a balance in the Investment in Steele Company Bonds account on December 31, 2010, of
a. $412,000.
b. $393,600.
c. $410,500.
d. $400,000.
e. none of these.

10. Compute the noncontrolling interest in the 2010 consolidated income assuming that Pollard Corporation reported a net income of $300,000 (includes dividend income from Steele Company). Steele Company reported net income of $180,000 and declared and paid cash dividends of $100,000.
a. $18,000
b. $17,440
c. $17,360
d. $18,560
e. none of these.

11. Sousa Corporation is an 80% owned subsidiary of Phillips Company. Sousa purchased bonds of Phillips Company for $103,000. Phillips Company reported the bond liability on the date of purchase at $100,000 less unamortized discount of $5,000. Assuming that the constructive gain or loss is material, the consolidated income statement should report an
a. ordinary loss of $8,000.
b. ordinary gain of $8,000.
c. extraordinary loss of $8,000 adjusted for income tax effects.
d. extraordinary gain of $8,000 adjusted for income tax effects.

12. From a consolidated entity point of view, the constructive gain or loss on the open market purchase of a parent company’s bonds by a subsidiary company is
a. considered realized at the date of the open market purchase.
b. realized in future periods through discount and premium amortization on the books of the individual companies.
c. realized only to the extent of the parent company’s interest in the subsidiary.
d. deferred and recognized in the consolidated income statement when the bonds are retired.

13. Stage Company is a 90% owned subsidiary of Princeton Company. On January 1, 2010, Stage Company purchased for $680,000 bonds of Princeton Company that had a carrying value of $725,000 (par value $700,000). The bonds mature on December 31, 2014. Both companies use the straight-line method of amortization and have a December 31 year-end. The increase in 2010 consolidated income (i.e., income before subtracting noncontrolling interest) is
a. $45,000.
b. $44,000.
c. $54,000.
d. $36,000.
e. $46,000.

Use the following information to answer Questions 14 and 15.

Parkes Company acquired 90% of Stanton Company’s common stock for $780,000 and 40% of its preferred stock for $180,000. On January 1, 2010, the date of acquisition, the companies reported the following account balances:
Parkes Company Stanton Company
Preferred stock, $100 par value $ 500,000 $ 360,000
Common stock, $10 par value 1,200,000 600,000
Other contributed capital 190,000 140,000
Retained earnings 210,000 110,000
Total stockholders’ equity $2,100,000 $1,200,000

The preferred stock is 10%, cumulative, nonparticipating, and has a liquidation value equal to 104% of par value. Dividends were not paid during 2009. During 2010, Stanton Company reported net income of $120,000 and declared and paid cash dividends in the amount of $70,000.

14. The difference between the implied value of the preferred stock and its book value is
a. $40,000.
b. $39,600.
c. $34,400.
d. $26,000.
e. 15,840.

15. Noncontrolling interest in the 2010 reported net income of Stanton Company is
a. $29,500.
b. $12,000.
c. $34,000.
d. $21,000.
e. $30,000.

16. Constructive gains and losses from intercompany bond transactions are:
a. treated as extraordinary items on the consolidated income statement
b. included as other revenues and expenses on the consolidated income statement.
c. excluded from the consolidated income statement until realized.
d. eliminated from the consolidated income statement.

17. Pittsford Company purchased bonds from Shay Company on the open market at a premium. Shay Company is a 100% owned subsidiary of Pittsford Company. Pittsford intends to hold the bonds until maturity. In a consolidated balance sheet, the difference between the bond carrying values in the two companies would be:
a. included as a decrease to retained earnings.
b. included as an increase to retained earnings.
c. reported as a deferred debit to be amortized over the remaining life of the bonds.
d. reported as a deferred credit to be amortized over the remaining life of the bonds.

18. On January 1, 2010, Plueger Company has $700,000 of 6%, 10-year bonds with an unamortized discount of $28,000. Steiner Company, an 80% subsidiary, purchased $350,000 of these bonds at 102. The gain or (loss) on the retirement of Plueger’s bonds is:
a. $14,000 loss.
b. $14,000 gain.
c. $21,000 loss.
d. $21,000 gain.

19. On a consolidated balance sheet, subsidiary preferred stock will be shown:
a. as part of consolidated stockholder’s equity.
b. combined with any preferred stock of the parent.
c. as part of the noncontrolling interest amount to the extent such balance represents preferred stock held by the parent.
d. as part of the noncontrolling interest amount to the extent such balance represents preferred stock held by outside interests.

20. Pettijohn Company has total stockholders’ equity of $2,000,000 consisting of $400,000 of $1 par value common stock, $400,000 of other contributed capital, and $1,200,000 of retained earnings. Pettijohn owns 80% of Spencer Company purchased at book value. Spencer has $800,000 of 5% cumulative preferred stock outstanding. Pettijohn acquired 40% of the preferred stock of Spencer for $200,000. After this transaction the balances in Pettijohn’s retained earnings and other contributed capital accounts are:
a. $1,200,000 and $400,000.
b. $1,200,000 and $520,000.
c. $1,320,000 and $400,000.
d. $1,080,000 and $400,000.

Use the following information to answer Questions 21-23.

Parkinson Company owns 90% of the outstanding common stock of Staggs Company. On January 1, 2008, Staggs Company issued $500,000, 12%, ten-year bonds.

On January 1, 2010, Parkinson Company paid $315,000 for Staggs Company bonds with a par value of $300,000 and a carrying value of $297,600. Both companies use the straight-line method to amortize bond premiums and discounts. Parkinson Company accounts for the investment using the cost method of accounting.

21. The total gain or loss on the constructive retirement of the debt to be reported in the 2010 consolidated income statement is
a. $15,000 loss.
b. $15,000 gain.
c. $17,400 loss.
d. $17,400 gain.
e. $ 2,400 loss.

22. Parkinson Company would report a balance in the Investment in Staggs Company Bonds account on December 31, 2010, of
a. $315,000.
b. $297,600.
c. $313,125.
d. $300,000
e. None of these.

23. Compute the noncontrolling interest in the 2010 consolidated income assuming that Parkinson Company reported a net income of $240,000 (includes dividend income from Staggs Company). Staggs Company reported net income of $150,000 and declared and paid cash dividends of $90,000.
a. $15,000.
b. $14,790.
c. $14,760.
d. $15,210.
e. None of these.

Use the following information to answer Questions 24 and 25.

Penner Company acquired 90% of Skulley Company’s common stock for $1,300,000 and 40% of its preferred stock for $300,000. On January 1, 2010, the date of acquisition, the companies reported the following account balances:
Penner Company Skulley Company
Preferred stock, $100 par value $ 800,000 $ 600,000
Common stock, $10 par value 2,000,000 1,000,000
Other contributed capital 320,000 230,000
Retained earnings 350,000 180,000
Total stockholders’ equity $3,470,000 $2,010,000

The preferred stock is 10%, cumulative, nonparticipating, and has a liquidation value equal to 102% of par value. Dividends were not paid during 2009. During 2010, Skulley Company reported net income of $200,000 and declared and paid cash dividends in the amount of $120,000.

24. The difference between the implied value of the preferred stock and its book value is
a. $60,000.
b. $78,000
c. $55,200.
d. $36,000.
e. none of these.

25. Noncontrolling interest in the 2010 reported net income of Skulley Company is
a. $50,000.
b. $20,000.
c. $80,000.
d. $56,000.
e. none of these.

Problems

9-1 On January 1, 2010, Page Company acquired an 80% interest in Sterling Company for $1,070,000. Sterling reported common stock of $1,000,000 and retained earnings of $400,000 on this date. Any difference between implied value and the book value interest acquired is attributable to land.

Other information available for Sterling Company is shown below:

Net Income Cash Dividends
2010 $130,000 $160,000

Page Company uses the cost method to account for its investment in Sterling Company.

Required:
A. Prepare the general journal entries for 2010 to record the receipt of the cash dividends.

B. Prepare in general journal form the workpaper entries necessary in the consolidated statements workpaper for the year end December 31, 2010.

9-2 Steinberger Company issued 10-year, 8% bonds with a par value of $1,000,000 on January 2, 2009, for $1,040,000. Interest is payable semiannually on June 30 and December 31. On December 31, 2010, Potts Company purchased $700,000 of Steinberger par value bonds for $670,000. Steinberger is an 80% owned subsidiary of Potts. Both companies use the straight-line method to amortize bond discounts and premiums. Steinberger declared cash dividends of $100,000 in 2010 and reported net income of $220,000 for the year.

Potts reported net income of $350,000 for 2010 and paid dividends of $160,000 during 2010.

Required:
A. Compute the total gain or loss on the constructive retirement of the debt.

B. Allocate the total gain or loss between Steinberger Company and Potts Company.

C. Compute the controlling interest in consolidated net income for 2010.

D. Prepare in general journal form the intercompany bond elimination entries for the consolidated statements workpaper prepared on December 31, 2010.

9-3 Prentice Company, who owns an 80% interest in Steffey Company, purchased $2,000,000 of Steffey’s 8% bonds at 106 on December 31, 2010. The bonds pay interest on January 1 and July 1 and mature on December 31, 2013. Prentice Company uses the cost method to account for its investment in Steffey. Selected balances from December 31, 2010 accounts of the two companies are as follows:

Prentice _____Steffey____

Investment in Steffey 8% bonds $2,120,000 $ —-
Bond discount —- 300,000
Interest payable —- 800,000
8% bonds payable —- 20,000,000
Interest expense —- 1,700,000
Gain or loss on constructive
retirement of bonds —- —-

Required:
Prepare in general journal form the workpaper eliminations related to the bonds to consolidated the financial statements of Prentice and its subsidiary for the year ended December 31, 2010 and 2011.

9-4 On January 1, 2010, Powell Company purchased 80% of the common stock of Southern Company for $400,000. Southern Company reported common stock of $200,000 ($10 par value), other contributed capital of $60,000, and retained earnings of $120,000 on this date. The difference between implied value and the book value interest acquired is attributable to the under-valuation of land held by Southern Company. Southern Company reported net income for 2010 of $100,000. During 2010 Southern Company declared and paid a 20% stock dividend and a $24,000 cash dividend. Southern Company stock had a market value of $30 per share on the date the stock dividend was declared. Powell Company uses the cost method to account for its investment in Southern Company.

Required:
A. Prepare the journal entries required in the books of Powell Company to account for the investment in Southern Company.

B. Prepare in general journal form the workpaper entries necessary in the consolidated statements workpaper for the year ended December 31, 2010.

C. Prepare the workpaper entry to establish reciprocity in the 2011 consolidated statements workpaper.

9-5 On January 1, 2010, Proctor Company acquired 90% of the common stock of Styles Company for $720,000 and 20% of the preferred stock for $70,000. On this date, Styles Company reported the following account balances:

Common stock ($10 par value) $600,000
Preferred stock ($100 par value, 8%,
cumulative, nonparticipating, liquidation
value equal to par value) 300,000
Other contributed capital – premium on
common stock 120,000
Retained earnings 80,000

Styles Company did not declare a cash dividend during 2009. Proctor Company uses the cost method.

Required:
A. During 2010 Styles Company reported net income of $360,000 and declared cash dividends of $160,000. Calculate the 2010 noncontrolling interest in net income and the amount of the cash dividends Proctor Company should have received during the year from each of the stock investments.

B. Prepare, in general journal form, the workpaper entries that would be made in the preparation of the December 31, 2010, consolidated statements workpaper. The difference between the implied value of the common stock and the book value interest acquired is attributable to an undervaluation in the land of Styles Company. Any difference between the implied value of the preferred stock and its book value is allocated to other contributed capital.

9-6 On January 1, 2010, Pippin Company acquired 80% of Skylark Company’s common stock for $210,000 and 70% of Skylark’s preferred stock for $80,000. Skylark Company reported the following stockholders’ equity on this date:

Preferred stock, 8%, Par value $20 $ 100,000
Common stock, Par value $50 200,000
Premium on common stock 30,000
Retained earnings 80,000
Total $410,000

The preferred stock is cumulative, nonparticipating, and callable at 104% of par value plus dividends in arrears. On January 1, 2010, dividends were in arrears for one year. Any difference between the implied value of the preferred stock and its book value interest is to be allocated to other contributed capital.

Changes in Skylark Company’s retained earnings during 2010 and 2011 were as follows:

January 1, 2010 Balance $ 80,000
2010 net income 20,000
2011 net income 16,000
2011 cash dividends (30,000)
December 31, 2011 Balance $ 86,000

Required:
A. Compute the difference between the implied value and book value interest acquired for the investment in preferred stock.

B. Compute the balance in the Investment in Preferred Stock account on December 31, 2011.

C. Compute the amount of Skylark Company’s net income that will be included in the controlling interest in consolidated net income for 2011.

9-7 On January 2, 2010, Preston, Inc. acquired an 80% interest in Simpson Corporation for $2,250,000. Simpson reported total stockholders’ equity of $2,500,000 on this date. An examination of Simpson’s books revealed that book value was equal to fair value for all assets and liabilities except for inventory, which was undervalued by $150,000. All of the undervalued inventory was sold during 2010.

Preston also purchased 30% of the $1,250,000 par value outstanding bonds of Simpson Corporation for $350,000 on January 2, 2010. The bonds mature in 10 years, carry an 11% annual interest rate payable on June 30 and December 31, and had a carrying value of $1,270,000 on the date of purchase. Both companies use the straight-line method to amortize bond discounts and premiums.

Preston reported net income of $750,000 for 2010 and paid dividends of $325,000 during 2010. Simpson Corporation reported net income of $800,000 for 2010 and paid dividends of $225,000 during the year.

Required:
Compute the following items at December 31, 2010.
1. Carrying value of the debt.
2. Interest revenue reported by Preston, Inc.
3. Interest expense reported by Simpson Corporation.
4. Balance in the Investment in Simpson Bonds account.
5. Controlling interest in consolidated net income for 2010 using the t-account approach.
6. Noncontrolling interest in consolidated income for 2010.

9-8 On January 2, 2010, Palmer Corporation purchased 80% of the outstanding common stock and 30% of the outstanding cumulative, nonparticipating, preferred stock of Sears Company for $800,000 and $140,000, respectively. At this date, Sears Company reported account balances of $800,000 in common stock, $400,000 in preferred stock and $200,000 in retained earnings. No other contributed capital accounts exist. The difference between implied and book value of the common stock is attributable to under- or overvalued land. Dividends on the 12% cumulative preferred stock (par $10) were not paid during 2009.

Palmer Sears
Corporation Company
1/2/2010 Retained Earnings $ 90,000 $200,000
2010 Reported Net Income 169,200 180,000
2010 Dividends Declared 50,000 100,000

Required:
A. Prepare the journal entries made by Palmer Corporation in 2010 to account for the investments assuming the partial equity method is used.
B. Compute the noncontrolling interest in Sears Company’s net income.
C. Prepare the 2010 workpaper entries related to the foregoing investments assuming the partial equity method is used to account for the investment.

Short Answer Questions from Textbook

1. Define “constructive retirement of debt.” How is the total constructive gain or loss computed?

2. The gain or loss on the constructive retirement of debt is recognized subsequently by the individual companies. Explain.

3. Allocating the gain or loss on constructive bond retirement between the purchasing and issuing companies is preferred conceptually. Describe how this allocation would be made.

4. Give the primary argument(s) in favor of assigning the total gain or loss on constructive bond retirement to the company that issued the bonds.

5. Under the allocation method followed in this text, how is the noncontrolling interest in consolidated income affected by intercompany bondholdings?

6. Investor Company purchased 70% of the$500,000 par value outstanding bonds of Investee Company, a 70% owned subsidiary. The bonds cost $338,000 and had a carrying value of$360,000 on the date of purchase. a.What portion of the gain or loss resulting from the constructive bond retirement should be allocated to Investor Company? b. What portion of the constructive gain or loss should be allocated to Investee Company?

7. An outside party issued a note to Affiliate X, who then sold the note to Affiliate Y. Y discounted the note at an unaffiliated bank, endorsing it with recourse. Which party is primarily liable and which party is contingently liable for the note?

8. Cash dividends are viewed as a distribution of the most recent earnings. How are stock dividends viewed?

9. Explain how the reciprocity calculation is modified in periods after the declaration of a stock dividend for firms using the cost method.

10. What journal entry, if any, would the parent company make to record the receipt of a stock dividend?

11. What effect does a stock dividend have on the consolidated statements work paper in the year of declaration? In subsequent periods?

12. How does the existence of preferred stock affect the calculation of noncontrolling interest?

13. Explain how to account for the difference between implied and book value interest of an in-vestment in preferred stock of a subsidiary.

14. What effect would cumulative preferred stock have on the allocation of a net loss to the common stockholders?

Business Ethics Question from the Textbook

The company that you work for is a subsidiary of a larger company. At the beginning of each year, the subsidiary prepares a budget for the year that includes a forecast of revenues for the coming year. The subsidiary sells a significant amount of inventory to the parent to be used in the manufacture of another product. The subsidiary’s revenues for the current year are short of the budgeted amount. An error in the books has misclassified an intercompany sale as an ordinary sale. The manager of the subsidiary asks you not to fix the error until after the books are closed. What is your responsibility? What action, if any, should you take? Why?

ANSWER KEY (Chapter 9)

Chapter 10

Insolvency – Liquidation and Reorganization

Multiple Choice

1. A corporation that is unable to pay its debts as they become due is:
a. bankrupt.
b. overdrawn.
c. insolvent.
d. liquidating.

2. When a business becomes insolvent, it generally has three possible courses of action. Which of the following is not one of the three possible courses of action?
a. The debtor and its creditors may enter into a contractual agreement, outside of formal bankruptcy proceedings.
b. The debtor continues operating the business in the normal course of the day-to-day operations.
c. The debtor or its creditors may file a bankruptcy petition, after which the debtor is liquidated under Chapter 7.
d. The debtor or its creditors may file a petition for reorganization under Chapter 11.

3. Assets transferred by the debtor to a creditor to settle a debt are transferred at:
a. book value of the debt.
b. book value of the transferred assets.
c. fair market value of the debt.
d. fair market value of the transferred assets.

4. A composition agreement is an agreement between the debtor and its creditors whereby the creditors agree to:
a. accept less than the full amount of their claims.
b. delay settlement of the claim until a latter date.
c. force the debtor into a liquidation.
d. accrue interest at a higher rate.

5. In a troubled debt restructuring involving a modification of terms, the debtor’s gain on restructuring:
a. will equal the creditor’s gain on restructuring.
b. will equal the creditor’s loss on restructuring.
c. may not equal the creditor’s gain on restructuring.
d. may not equal the creditor’s loss on restructuring.

6. A bankruptcy petition filed by a firm is a:
a. chapter petition.
b. involuntary petition.
c. voluntary petition.
d. chapter 11 petition.

7. When a bankruptcy court enters an “order for relief” it has:
a. accepted the petition.
b. dismissed the petition.
c. appointed a trustee.
d. started legal action against the debtor by its creditors.

8. An involuntary petition filed by a firm’s creditors whereby there are twelve or more creditors must be signed by at least:
a. two creditors.
b. three creditors.
c. five creditors.
d. six creditors.

9. The duties of the trustee include:
a. appointing creditors’ committees in liquidation cases.
b. approving all payments for debts incurred before the bankruptcy filing.
c. examining claims and disallowing any that are improper.
d. calling a meeting of the debtor’s creditors.

10. Which of the following items is not a specified priority for unsecured creditors in a bankruptcy petition?
a. Administration fees incurred in administering the bankrupt’s estate.
b. Unsecured claims for wages earned within 90 days and are less than $4,650 per employee.
c. Unsecured claims of governmental units for unpaid taxes.
d. Unsecured claims on credit card charges that do not exceed $3,000.

11. Which statement with respect to gains and losses on troubled debt restructuring is correct?
a. Creditors losses on restructuring are extraordinary.
b. Debtor’s gains and losses on asset transfers and debtor’s gains on restructuring are combined and treated as extraordinary.
c. Debtor gains and creditor losses on restructuring are extraordinary, if material in amount.
d. Debtor losses on asset transfers and debtor gains on restructuring are reported as a component of net income.

12. When fresh-start reporting is used according to Statement of Position (SOP) 90-7, the implication is that a new firm exists. Which of the following statements is not correct about fresh-start accounting?
a. Assets are reported at fair values.
b. Beginning retained earnings is reported at zero.
c. The fair value of the assets must be less than the post liabilities and allowed claims.
d. The original owners must own less than 50% of the voting stock after reorganization.

13. A Statement of Affairs is a report designed to show:
a. an estimated amount that would be received by each class of creditor’s claims in the event of liquidation.
b. a balance sheet prepared on the going-concern assumption.
c. assets and liabilities classified as current and noncurrent.
d. assets and liabilities reported at their current book values.

14. When a secured claim is not fully settled by the selling of the underlying collateral, the remaining portion:
a. of the claim cannot be collected by the creditor.
b. remains as a secured claim.
c. is classified as an unsecured priority claim.
d. is classified as an unsecured nonpriority claim.

15. Layne Corporation entered into a troubled debt restructuring agreement with their local bank. The bank agreed to accept land with a carrying amount of $360,000 and a fair value of $540,000 in exchange for a note with a carrying amount of $765,000. Ignoring income taxes, what amount should Layne report as a gain on its income statement?
a. $0.
b. $180,000.
c. $225,000.
d. $405,000.

16. The following information pertains to the transfer of real estate in regards to a troubled debt restructuring by Nen Co. to Baker Co. in full settlement of Nen’s liability to Baker:

Carrying amount of liability settled $450,000
Carrying amount of real estate transferred $300,000
Fair value of real estate transferred $330,000

What amount should Nen report as ordinary gain (loss) on transfer of real estate?
a. $(30,000).
b. $30,000.
c. $120,000.
d. $150,000.

17. The following information pertains to the transfer of real estate in regards to a troubled debt restructuring by Nen Co. to Baker Co. in full settlement of Nen’s liability to Baker:

Carrying amount of liability settled $450,000
Carrying amount of real estate transferred $300,000
Fair value of real estate transferred $330,000

What amount should Baker report as a gain or (loss) on restructuring?
a. $120,000 ordinary loss.
b. $120,000 extraordinary loss.
c. $150,000 ordinary loss.
d. $150,000 extraordinary loss.

18. Dobler Corporation was forced into bankruptcy and is in the process of liquidating assets and paying claims. Unsecured claims will be paid at the rate of thirty cents on the dollar. Carson holds a note receivable from Dobler for $75,000 collateralized by an asset with a book value of $50,000 and a liquidation value of $25,000. The amount to be realized by Carson on this note is:
a. $25,000.
b. $40,000.
c. $50,000.
d. $75,000.

19. Bad Company filed a voluntary bankruptcy petition, and the statement of affairs reflected the following amounts:
Estimated
Assets Book Value Current Value
Assets pledged with fully secured creditors $ 900,000 $ 1,110,000
Assets pledged partially secured creditors 540,000 360,000
Free assets 1,260,000 960,000
$2,700,000 $2,430,000
Liabilities
Liabilities with priority $ 210,000
Fully secured creditors 780,000
Partially secured creditors 600,000
Unsecured creditors 1,620,000
$3,210,000

Assume the assets are converted to cash at their estimated current values. What amount of cash will be available to pay unsecured nonpriority claims?

a. $720,000.
b. $840,000.
c. $960,000.
d. $1,080,000.

20. The final settlement with unsecured creditors is computed by dividing:
a. total net realizable value by total unsecured creditor claims.
b. net free assets by total secured creditor claims.
c. total net realizable value by total secured creditor claims.
d. net free assets by total unsecured creditor claims.

21. Dodge Corporation entered into a troubled debt restructuring agreement with their local bank. The bank agreed to accept land with a carrying value of $200,000 and a fair value of $300,000 in exchange for a note with a carrying amount of $425,000. Ignoring income taxes, what amount should Dodge report as a gain on its income statement?
a. $0.
b. $100,000.
c. $125,000.
d. $225,000.

22. The following information pertains to the transfer of real estate in regards to a troubled debt restructuring by Drier Co. to Cole Co. in full settlement of Drier’s liability to Cole:

Carrying amount of liability settled $375,000
Carrying amount of real estate transferred $250,000
Fair value of real estate transferred $275,000

What amount should Drier report as ordinary gain (loss) on transfer of real estate?
a. $(25,000).
b. $25,000.
c. $100,000.
d. $125,000.

23. The following information pertains to the transfer of real estate in regards to a troubled debt restructuring by Drier Co. to Cole Co. in full settlement of Drier’s liability to Cole:

Carrying amount of liability settled $375,000
Carrying amount of real estate transferred $250,000
Fair value of real estate transferred $275,000

What amount should Cole report as a gain or (loss) on restructuring?
a. $100,000 ordinary loss.
b. $100,000 extraordinary loss.
c. $125,000 ordinary loss.
d. $125,000 extraordinary loss.

24. Poor Company filed a voluntary bankruptcy petition, and the settlement of affairs reflected the following amounts:

Estimated
Assets Book Value Current Value
Assets pledged with fully secured creditors $ 450,000 $ 555,000
Assets pledged partially secured creditors 270,000 180,000
Free assets 630,000 480,000
$1,350,000 $1,215,000

Liabilities
Liabilities with priority $ 105,000
Fully secured creditors 390,000
Partially secured creditors 300,000
Unsecured creditors 810,000
$1,605,000

Assume the assets are converted to cash to their estimated current values. What amount of cash will be available to pay unsecured nonpriority claims?
a. $360,000.
b. $420,000.
c. $480,000.
d. $540,000.

25. Dooley Corporation was forced into bankruptcy and is in the process of liquidating assets and paying claims. Unsecured claims will be paid at the rate of thirty cents on the dollar. Cerner holds a note receivable from Dooley for $90,000 collateralized by an asset with a book value of $60,000 and a liquidation value of $30,000. The amount to be realized by Cerner on this note is:
a. $30,000.
b. $48,000.
c. $60,000.
d. $90,000.

Problems

10-1 On January 1, 2011, Bargain Mart owed City Bank $1,600,000, under an 8% note with three years remaining to maturity. Due to financial difficulties, Bargain Mart was unable to pay the previous year’s interest. City Bank agreed to settle Bargain Mart’s debt in exchange for land having a fair market value of $1,310,000. Bargain Mart purchased the land in 2003 for $1,000,000.

Required:
Prepare the journal entries to record the restructuring of the debt by Bargain Mart.

10-2 On January 1, 2010, Gannon, Inc. owed BancCorp $12 million on a 10% note due December 31, 2011. Interest was last paid on December 31, 2008. Gannon was experiencing severe financial difficulties and asked BancCorp to modify the terms of the debt agreement. After negotiation BancCorp agreed to:
– Forgive the interest accrued for the year just ended,
– Reduce the remaining two years interest payments to $900,000 each and delay the first payment until December 31, 2011, and
– Reduce the unpaid principal amount to $9,600,000.

Required:
Prepare the journal entries for Gannon, Inc. necessitated by the restructuring of the debt at (1) January 1, 2010, (2) December 31, 2011, and (3) December 31, 2012.

10-3 On January 2, 2011 Stevens, Inc. was indebted to First Bank under a $12 million, 10% unsecured note. The note was signed January 2, 2005, and was due December 31, 2014. Annual interest was last paid on December 31, 2009. Stevens negotiated a restructuring of the terms of the debt agreement due to financial difficulties.

Required:
Prepare all journal entries for Stevens, Inc. to record the restructuring and any remaining transactions relating to the debt under each independent assumption.
A. First Bank agreed to settle the debt in exchange for land which cost Stevens $8,500,000 and has a fair market value of $10,000,000.
B. First Bank agreed to (1) forgive the accrued interest from last year (2) reduce the remaining four interest payments to $600,000 each, and (3) reduce the principal to $9,000,000.

10-4 On December 31, 2011, Community Bank agreed to restructure a $900,000, 8% loan receivable from Neer Corporation because of Neer’s financial problems. At December 31 there was $36,000 of accrued interest for a six-month period. Terms of the restructuring agreement are as follows:
– Reduce the loan from $900,000 to $600,000;
– Extend the maturity date by 2 years from December 31, 2011 to December 31, 2013;
– Reduce the interest rate on the loan from 8% to 6%.

Present value assumptions:
Present value of $1 for 2 years at 6% = 0.8900
Present value of $1 for 2 years at 8% = 0.8573
Present value of an ordinary annuity of $1 for 2 years at 6% = 1.8334
Present value of an ordinary annuity of $1 for 2 years at 8% = 1.7833

Required:
Compute the gain or loss that will be reported by Community Bank.

10-5 Donnelly Corporation incurred major losses in 2010 and entered into voluntary Chapter 7 bankruptcy in the early part of 2011. By June 1, all assets were converted into cash, the secured creditors were paid, and $150,000 in cash was left to pay the remaining claims as follows.

Accounts payable $ 48,000
Claims prior to the trustee’s appointment 21,000
Property taxes payable 18,000
Wages payable (all under $4,650 per employee) 54,000
Unsecured note payable 60,000
Accrued interest on the note payable 6,000
Administrative expenses of the trustee 30,000
Total $237,000

Required:
Classify the claims by their Chapter 7 priority ranking, and analyze which amounts will be paid and which amounts will be written off.

10-6 Davis Corporation filed a petition under Chapter 7 of the U.S. Bankruptcy Act on June 30, 2011. Data relevant to its financial position as of this date are:
Estimated Net
Book Value Realizable Values
Cash $ 3,000 $ 3,000
Accounts receivable-net 72,000 48,000
Inventories 60,000 72,000
Equipment-net 165,000 87,000
Total assets $300,000 $210,000

Accounts payable $ 72,000
Rent payable 21,000
Wages payable 45,000
Note payable plus accrued interest 96,000
Capital stock 180,000
Retained earnings (deficit) (120,000)
Total liabilities and equity $300,000

Required:
A. Prepare a statement of affairs assuming that the note payable and interest are secured by
a mortgage on the equipment and that wages are less than $4,650 per employee.
B. Estimate the amount that will be paid to each class of claims if priority liquidation expenses including trustee fees are $24,000 and estimated net realizable values are actually realized.

10-7 The following data are taken from the statement of affairs of Mitchell Company.

Assets pledged with fully secured creditors
(Realizable value, $635,000) $800,000
Assets pledged with partially secured creditors
(realizable value, $300,000) 365,000
Free assets (Realizable value, $340,000) 535,000
Fully secured creditor claims 316,000
Partially secured creditor claims 400,000
Unsecured creditor claims with priority 100,000
General unsecured creditor claims 1,165,000

Required:
Compute the amount that will be paid to each class of creditor.

10-8 On February 1, 2011, Hilton Company filed a petition for reorganization under the bankruptcy statutes. The court approved the plan on September 1, 2011, including the following provisions:

1. Accrued expenses of $21,930, representing priority items, are to be paid in full.
2. Hilton Company is to exchange accounts receivable in the face amount of $138,000 and an allowance for uncollectible accounts of $29,200 for the full settlement of $198,600 owed on open account to one of its major unsecured creditors. The estimated fair value of the receivables is $104,000.
3. Unsecured creditors of open accounts amounting to $91,600 and paid 40 cents on the dollar in full settlement.
4. Hilton Company’s only other major unsecured creditor agreed to a five-year extension of the $500,000 principal owed him on a 10% note payable. Accrued interest on the note on September 1, 2011, amounts to $45,000, one-third of which is to be paid in cash and the remainder canceled. In addition, no interest is to be charged during the remaining five years to maturity of the note.

Required:
Prepare journal entries on the books of Hilton Company to give effect to the preceding provisions.

Short Answer

1. The Bankruptcy Reform Act assigns priorities to certain unsecured claims, and each rank must be satisfied in full before the next–lower rank is paid. Identify the five categories of unsecured creditor claims.

2. Creditors are classified by law as either secured or unsecured. Distinguish among fully secured, partially secured, and unsecured creditors.

Short Answer Questions from the Textbook

1. List the primary types of contractual agreements between a debtor company and its creditors and briefly explain what is involved in each of them.

2. Distinguish between a voluntary and involuntary bankruptcy petition.

3. Distinguish among fully secured, partially se-cured, and unsecured claims of creditors.

4. Five priority categories of unsecured claims must be paid before general unsecured creditors are paid. Briefly describe what makes up each category.

5. What are “dividends” in a bankruptcy proceeding?

6. For each of the following debt restructurings, indicate whether a gain is recognized and, if so, how the gain is measured and reported. (a)Transfer of assets by the debtor to the creditor.(b)Grant of an equity interest by the debtor to the creditor.(c)Modification of the terms of the payable.

7. What is the purpose of a Statement of Affairs?

8. One of the officers of a corporation that had just received a discharge in bankruptcy said, “Good, now we don’t owe anyone.” Is he correct?

9. What are the duties of a trustee in a liquidation proceeding?

10. What is the purpose of a combining work paper prepared by a trustee?

11. What is the purpose of a realization and liquidation account?

Business Ethics Question from Textbook

From an ethical perspective, some believe that it is never justifiable for an individual or business to declare bankruptcy. Others believe that some actions are appropriate only in extreme circumstances. Without question, as stated in the Journal of Accountancy, November 2005,page 51, “the ease with which debtors have been able to walk away from debt has frustrated creditors for years.”
1. Describe the differences between Chapter 7 (liquidations) and Chapter 11 (reorganizations)from an ethical standpoint. Who is most likely to be hurt by a Chapter 7 bankruptcy?
2. Discuss the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Do you believe the changes wrought by this act will serve to protect creditors?
3. The Protection Act of 2005 requires individuals, but not businesses, to undergo a “means” test before they can seek Chapter 7 relief. Do you believe this change should be applied to businesses as well? Why or why not?
4. Do you think that you would ever resort to filing for bankruptcy relief yourself? Why or why not?

ANSWER KEY (Chapter 10)

Chapter 11

International Financial Reporting Standards

Multiple Choice—Conceptual

1. The goals of the International Accounting Standards Committee include all of the following except
a. To improve international accounting.
b. To formulate a single set of auditing standards to be applied in all countries.
c. To promote global acceptance of its standards.
d. To harmonize accounting practices between countries.

2. Which of the following is true about the FASB after the mandatory adoption of IFRS by US companies?
a. The FASB will serve in an advisory capacity to the IASB.
b. The FASB will remain the designated standard-setter for US companies, but incorporate IFRS into US GAAP.
c. The role of the FASB post-IFRS adoption has not been determined.
d. The FASB will cease to exist.

3. Milestones in the transition plan for mandatory adoption of IFRS by US companies include all of the following except:
a. Improvements in accounting standards.
b. Limited early adoption of IFRS in an effort to enhance comparability for US investors
c. Mandatory use of IFRS by US entities.
d. All of the above are milestones in the transition plan for mandatory adoption of IFRS by US companies.

4. The roles of the IASC Foundation include
a. establishing global standards for financial reporting.
b. coordinating the filing requirements of stock exchange regulatory agencies.
c. financing IASB operations.
d. all of the above are roles of the IASC Foundation.

5. Which of the following statements is true regarding the IASC?
a. The IASC is a public-sector, not-for-profit organization.
b. The IASC is accountable to an international securities regulator.
c. The IASC is a stand-alone, private-sector organization.
d. The IASC funds the operations of the IASB through filing fees paid to national securities regulators.

6. . Concerns of the SEC with regard to the mandatory adoption of IFRS by US entities include all of the following except:
a. the extent to which the standard-setting process addresses emerging issues in a timely manner.
b. the security and stability of IASC funding.
c. the enhancement of IASB independence through a system of voluntary contributions from firms in the accounting profession.
d. the degree to which due process is integrated into the standard-setting process .

7. . Under the staged transition to mandatory adoption of IFRS being considered by the SEC,
a. large, accelerated filers would begin IFRS filings for fiscal years beginning on or after December 31, 2011.
b. non-accelerated filers would begin IFRS filings for fiscal years beginning on or after December 31, 2015.
c. large non-accelerated filers would have until fiscal years beginning on or after December 15, 2017 to adopt IFRS.
d. smaller reporting companies would begin IFRS filings for fiscal years beginning on or after December 15, 2016.
.
8. In order to complete its first IFRS filing, including three years of audited financial statements, according to the staged transition to mandatory adoption of IFRS considered by the SEC, a large accelerated filer would need to adopt IFRS beginning in fiscal year
a. 2011.
b. 2012.
c. 2013.
d. 2014.

9. Benefits of the FASB Accounting Standards Codification (ASC) include all of the following except
a. increases the independence of the FASB.
b. aids in the convergence of US GAAP with IFRS.
c. reduces time and effort required to research accounting issues.
d. clearly distinguishes between authoritative and non-authoritative guidance.

10. SFAS No.162, the Accounting Standards Codification, is directed to
a. auditors.
b. Boards of Directors.
c. securities regulators.
d. entities.

11. IFRS and US GAAP differ with regard to financial statement presentation in all of the following except
a. IFRS generally requires that assets be listed in order of increasing liquidity while US GAAP requires that assets be listed in order of decreasing liquidity.
b. US GAAP requires expenses to be listed by function while IFRS requires expenses to be listed by nature.
c. IFRS prohibits extraordinary items which are allowed by US GAAP.
d. IFRS requires two years of comparative income statements while under US GAAP, three years of income statements are required.

12. The major difference between IFRS and US GAAP in accounting for inventories is that
a. US GAAP prohibits the use of specific identification.
b. IFRS requires the use of the LIFO cost flow assumption.
c. US GAAP prohibits the use of the LIFO cost flow assumption
d. US GAAP allows the use of the LIFO cost flow assumption.

13. One difference between IFRS and GAAP in valuing inventories is that
a. IFRS, but not GAAP, allows reversals so that inventories written down under lower-of-cost-or-market can be written back up to the original cost .
b. GAAP defines market value as replacement cost where IFRS defines market as the selling price.
c. GAAP strictly adheres to the historical cost concept and does not allow for write-downs of inventory values while IFRS embraces fair value.
d. IFRS, but not GAAP, requires that inventories be valued at the lower of cost or market.

14. In accounting for research and development costs.
a. the general rule under both US GAAP and IFRS is that research and development costs should be expensed as incurred .
b. IFRS generally expenses all research and development costs while US GAAP expenses research costs as incurred but capitalizes development costs once technological and economic feasibility has been demonstrated.
c. US GAAP generally expenses all research and development costs while IFRS expenses research costs as incurred but capitalizes development costs once technological and economic feasibility has been demonstrated.
d. both US GAAP and IFRS expense research costs as incurred but capitalize development costs once technological and economic feasibility has been demonstrated.
.
15. Property, plant and equipment are valued at
a. historical cost under both IFRS and US GAAP.
b. historical cost or revalued amounts under both IFRS and US GAAP.
c. revalued amounts under IFRS.
d. historical cost under US GAAP while IFRS allows the assets to be valued at either historical cost or revalued amounts.

16. The amount of a long-lived asset impairment loss is generally determined by comparing
a. the asset’s carrying amount and its fair value under US GAAP.
b. the asset’s carrying amount and its discounted future cash flows less cost to sell under IFRS.
c. the asset’s carrying amount and its undiscounted future cash flows under US GAAP.
d. the asset’s carrying amount and its undiscounted future cash flows less disposal cost under IFRS.

17. In accounting for liabilities, IFRS interprets “probable” as
a. likely.
b. more likely than not.
c. somewhat possible.
d. possible and not remote.

18. Accounting under IFRS and US GAAP is similar for all of the following topics except
a. changes in estimates.
b. related party transactions.
c. research and development costs.
d. changes in methods.

Use the following information to answer the next three questions.

On January 1, 2010, AirFrance purchases an airplane for €14,400,000. The components of the airplane and their useful lives are as follows:

Component Cost Useful life
Frame €7,200,000 24 years
Engine 4,800,000 20 years
Other 2,400,000 10 years

AirFrance uses the straight-line method of depreciation. The asset is assumed to have no salvage value.

19. Under IFRS, the entry to record the acquisition of the airplane would include
a. a debit to Asset/ Airplane of €14,400,000.
b. a debit to Asset/ Airplane frame of €14,400,000.
c. a debit to Asset/ Airplane engine of €4,800,000.
d. cannot be determined from the information given.

20. Under US GAAP, the entry to record depreciation expense on the asset at December 31, 2011 will include
a. a credit to accumulated depreciation of €1,200,000.
b. a debit to depreciation expense of €1,440,000
c. a debit to depreciation expense of €800,000.
d. a credit to accumulated depreciation of €600,000.

21. Under IFRS, the entry to record depreciation expense on the asset at December 31, 2011 will include a credit to accumulated depreciation of
a. €1,440,000.
b. €1,200,000
c. €800,000.
d. €600,000.

22. Accounting terminology that differs between IFRS and US GAAP include all of the following except
a. the use by IFRS of “turnover” for revenue.
b. the use by IFRS of “share premium” for additional paid-in-capital.
c. the use by IFRS of “other capital reserves” for retained earnings.
d. the use by IFRS of “issued capital” for common stock.

23. New terminology introduced under the joint IFRS- US GAAP Customer Consideration (Allocation) Model includes all of the following except
a. revenue recognition voids.
b. contract rights.
c. net contract asset/ liability.
d. performance obligations.

24. Under IFRS, the criteria to determine whether a lease should be capitalized include
a. the present value of the minimum lease payments is 90% or more of the fair value of the asset at the inception of the lease.
b. the term of the lease is 75% or more of the economic life of the asset.
c. the term of the lease is equal to substantially all of the economic life of the asset.
d. the present value of the minimum lease payments is equal to substantially all of the fair value of the asset at the inception of the lease.

Use the following information to answer the next three questions.

Bellingham Electronics Inc. offers one model of laptop computer for £1000 and a two-year warranty for £250. The retailer, as part of a Boxing Day promotion, offers a limited-time offer for the laptop, including delivery and the two-year warranty for £1,180. The cost of the computer to Bellingham is £700. Any warranty repairs are assumed to be done ratably over time. Bellingham accounts for transactions using the customer consideration model.

In the first twelve months following the sale, Bellingham incurred £980 of costs servicing the computers under warranty.

25. Bellingham sells ten laptops to Bertram Inc. under the limited-time promotion. Upon delivery of the laptops to Bertram, Bellingham will recognize revenue of
a. £9,300.
b. £9,440
c. £10,000.
d. £11,800.

26. In the first twelve months following the sale, Bellingham would reduce the Contract liability – warranty account by
a. £784.
b. £980
c. £1,180.
d. £1,380.

27. In the first twelve months, Bellingham would record warranty expense of
a. £784.
b. £980
c. £1,180.
d. £1,380.

28. Significant differences between IFRS and Chinese GAAP include all of the following except
a. Chinese GAAP allows the use of LIFO while IFRS prohibits it.
b. Chinese GAAP has different related party disclosure requirements.
c. Chinese GAAP follows the cost principle while IFRS allows for revaluations and recoveries of impairment losses.
d. Chinese GAAP uses the equity method of accounting for jointly controlled entities while IFRS also allows proportionate consolidation.

29. All of the following are options for non-US companies who wish to list securities on a US exchange except
a. The company can use either IFRS or their local GAAP.
b. If a company uses their local GAAP they must reconcile net income and shareholders’ equity or fully disclose all financial information required of US companies.
c. If a company uses their local GAAP they must reconcile net income and shareholders’ equity and fully disclose all financial information required of US companies
d. The company must file a form 20-F with the SEC.

30. All of the following are true regarding American Depository Receipts (ADRs) except
a. Most ADRs are unsponsored, meaning that the DR bank creates a DR program without a formal agreement with the issuing non-US company.
b. An ADR is a derivative instrument traded in the US that usually represents a fixed number of publicly traded shares of a non-US company.
c. ADRs are denominated in US dollars.
d. A Level 1 sponsored ADR is the easiest way for a non-US company to access US markets.

Exercise from the Textbook

Exercise 11-1

Component Depreciation SMC Company purchases a building for $100,000. Included in this cost are $12,000 for electrical systems and $15,000 for the roof. The building is expected to have a 40 year useful life, but the electrical system will last for 20 years and the roof will last 15 years.

Required: Part A: Assuming that straight-line depreciation is used, compute depreciation expense assuming that U.S. GAAP is used.

Part B: Assuming that straight line depreciation is used, compute depreciation expense for year one assuming IFRS is used (assume component depreciation).

Problem from the Textbook

Problem 11-4

Prepare a statement of financial position using the proposed new format as described in the chapter.

Questions from the Textbook

1. As mentioned in Chapter 1, the project on business combinations was the first of several joint projects undertaken by the FASB and the IASB in their move to converge standards globally. Nonetheless, complete convergence has not yet occurred, and there are those who believe it to be a poor idea. Discuss the reasons for and against global convergence.

2. In recent months, virtually every topic that has come to the attention of the standard setters has been undertaken as a joint effort of the FASB and the IASB rather than as an individual effort by one of the two boards. List and discuss some of the joint projects that fall into this category.
3. What is the rationale for the harmonization of international accounting standards?

4. Why is the SEC, once so reluctant to accept IAS, now very willing to allow firms using IFRS to is-sue securities in the U.S. stock market without reconciling to U.S. GAAP?

5. Discuss the types of ADRs that non-U.S. companies might use to access the U.S. markets.

6. Describe the attitude of the FASB toward the IASB (International Accounting Standards Board).

7. How does the FASB view its role in the development of an international accounting system? Currently, two members of the IASB board were affiliated with the FASB. Comment on what effect this might have on the likelihood that the U.S. standard setters will accept the new IASB statements, if any?

8. List some of the major differences in accounting between IFRS and U.S. GAAP.

Business Ethics Question from the Textbook

A vice president of marketing for your company has been charged with embezzling nearly $100,000 from the company. The vice president allegedly submitted fraudulent vendor invoices in order to receive payments. As the vice president of marketing for the company, the vice president is authorized to approve the payment of invoices submitted by third-party vendors who did work for the company. After the activities were uncovered, the company responded by stating: “All employees are accountable to our ethics guidelines and procedures. We do not tolerate violations of our ethics policy and will consistently enforce these policies and procedures.”

1. How would you evaluate the internal controls of the company?

2. Do you think there are companies that develop comprehensive ethics and compliance pro-grams for mid- and lower-level employees and ignore upper-level executives and managers?

3. Is it an ethical issue if companies are not forth-coming concerning fraudulent activities of top executives in an effort to minimize negative publicity?

Answer Key (Chapter 11)

Chapter 12

Accounting for Foreign Currency Transactions And Hedging Foreign Exchange Risk

Multiple Choice

1. A discount or premium on a forward contract is deferred and included in the measurement of the related foreign currency transaction if the contract is classified as a:
a. hedge of a net investment in a foreign entity.
b. hedge of an exposed asset or liability position.
c. hedge of an identifiable foreign currency commitment.
d. contract acquired to speculate in the movement of exchange rates.

2. The discount or premium on a forward contract entered into as a hedge of an exposed asset or liability position should be:
a. included as a separate component of stockholders’ equity.
b. amortized over the life of the forward contract.
c. deferred and included in the measurement of related foreign currency transaction.
d. none of these.

3. An indirect exchange rate quotation is one in which the exchange rate is quoted:
a. in terms of how many units of the domestic currency can be converted into one unit of foreign currency.
b. for the immediate delivery of currencies exchanged.
c. in terms of how many units of the foreign currency can be converted into one unit of domestic currency.
d. for the future delivery of currencies exchanged.

4. A transaction gain is recorded when there is an:
a. importing transaction and the exchange rate increases.
b. exporting transaction and the exchange rate increases.
c. exporting transaction and the exchange rate decreases.
d. none of these.

5. During 2011, a U.S. company purchased inventory from a foreign supplier. The transaction was denominated in the local currency of the seller. The direct exchange rate increased from the date of the transaction to the balance sheet date. The exchange rate decreased from the balance sheet date to the settlement date in 2012. For the years 2011 and 2012, transaction gains or losses should be recognized as:
2011 2012
a. gain gain
b. gain loss
c. loss loss
d. loss gain

6. A transaction gain or loss is reported currently in the determination of income if the purpose of the forward contract is to:
a. hedge a net investment in a foreign entity.
b. hedge an identifiable foreign currency commitment.
c. speculate in foreign currency.
d. none of these.

7. On November 1, 2011, American Company sold inventory to a foreign customer. The account will be settled on March 1 with the receipt of $500,000 foreign currency units (FCU). On November 1, American also entered into a forward contract to hedge the exposed asset. The forward rate is $0.70 per unit of foreign currency. American has a December 31 fiscal year-end. Spot rates on relevant dates were:

Per Unit of
Date Foreign Currency
November 1 $0.73
December 31 0.71
March 1 0.74

The entry to record the forward contract is
a. FCU Receivable 350,000
Premium on Forward Contract 15,000
Dollars Payable 365,000

b. Dollars Receivable 365,000
Discount on Forward Contract 15,000
FCU Payable 350,000

c. FCU Receivable 365,000
Discount on Forward Contract 15,000
Dollars Payable 350,000

d. Dollars Receivable 350,000
Discount on Forward Contract 15,000
FCU Payable 365,000

8. On November 1, 2011, American Company sold inventory to a foreign customer. The account will be settled on March 1 with the receipt of $450,000 foreign currency units (FCU). On November 1, American also entered into a forward contract to hedge the exposed asset. The forward rate is $0.70 per unit of foreign currency. American has a December 31 fiscal year-end. Spot rates on relevant dates were:

Per Unit of
Date Foreign Currency
November 1 $0.73
December 31 0.71
March 1 0.74

What will be the adjusted balance in the Accounts Receivable account on December 31, and how much gain or loss was recorded as a result of the adjustment?

Receivable Balance Gain/Loss Recorded
a. $319,500 $9,000 gain
b. $319,500 $9,000 loss
c. $333,000 $4,500 gain
d. $333,000 $18,000 gain

9. A transaction gain or loss at the settlement date is:
a. a change in the exchange rate quoted by a foreign exchange trader.
b. synonymous with the translation of foreign currency financial statements into dollars.
c. the difference between the recorded dollar amount of an account receivable denominated in a foreign currency and the amount of dollars received.
d. the difference between the buying and selling rate quoted by a foreign exchange trader at the settlement date.

10. From the viewpoint of a U.S. company, a foreign currency transaction is a transaction:
a. measured in a foreign currency.
b. denominated in a foreign currency.
c. measured in U.S. currency.
d. denominated in U.S. currency.

11. The exchange rate quoted for future delivery of foreign currency is the definition of a(n):
a. direct exchange rate.
b. indirect exchange rate.
c. spot rate.
d. forward exchange rate.

12. A transaction loss would result from:
a. an increase in the exchange rate applicable to an asset denominated in a foreign currency.
b. a decrease in the exchange rate applicable to a liability denominated in a foreign currency.
c. the import of merchandise when the transaction is denominated in a foreign currency.
d. a decrease in the exchange rate applicable to an asset denominated in a foreign currency.

13. The forward exchange rate quoted for the remaining term of a forward contract is used to account for the contract when the forward contract:
a. extends beyond one year or the current operating cycle.
b. is a hedge of an identifiable foreign currency commitment.
c. is a hedge of an exposed net liability position.
d. was acquired to speculate in foreign currency.

14. A transaction gain or loss on a forward contract entered into as a hedge of an identifiable foreign currency commitment may be:
a. included as a separate item in the stockholders’ equity section of the balance sheet.
b. recognized currently in the determination of net income.
c. deferred and included in the measurement of the related foreign currency transaction.
d. none of these.

15. Craiger, Inc. a U.S. corporation, bought machine parts from Reinsch Company of Germany on March 1, 2011, for 70,000 marks, when the spot rate for marks was $0.5395. Craiger’s year-end was March 31, 2011, when the spot rate for marks was $0.5445. Craiger bought 70,000 marks and paid the invoice on April 20, 2011, when the spot rate was $0.5495. How much should be shown in Craiger’s income statements as foreign exchange (transaction) gain or loss for the years ended March 31, 2011 and 2012?

2011 2012
a. $0 $0
b. $0 $350 loss
c. $350 loss $0
d. $350 loss $350 loss

16. A forward exchange contract is transacted at a discount if the current forward rate is:
a. less than the expected spot rate.
b. more than the expected spot rate.
c. less than the current spot rate.
d. more than the current spot rate.

17. Stuart Corporation a U.S. company, contracted to purchase foreign goods. Payment in foreign currency was due one month after delivery. Between the delivery date and the time of payment, the exchange rate changed in Stuart’s favor. The resulting gain should be reported in the financial statements as a(n):
a. component of other comprehensive income.
b. component of income from continuing operations.
c. extraordinary income.
d. deferred income.

18. Jackson Paving Company purchased equipment for 350,000 British pounds from a supplier in London on July 7, 2011. Payment in British pounds is due on Sept. 7, 2011. The exchange rates to purchase one pound is as follows:
July 7 August 31, (year end) September 7
Spot-rate 2.08 2.05 2.04
30-day rate 2.07 2.03 —
60-day rate 2.06 1.99 —

On its August 31, 2011 income statement, what amount should Jackson Paving report as a foreign exchange transaction gain:
a. $14,000.
b. $7,000.
c. $10,500.
d. $0.

19. On September 1, 2011, Swash Plating Company entered into two forward exchange contracts to purchase 250,000 euros each in 90 days. The relevant exchange rates are as follows:

Forward Rate
Spot rate For Dec. 1, 2011
September 1, 2011 1.46 1.47
September 30, 2011 (year-end) 1.50 1.48

The first forward contract was to hedge a purchase of inventory on September 1, payable on December 1. On September 30, what amount of foreign currency transaction loss should Swash Plating report in income?
a. $0.
b. $2,500.
c. $5,000.
d. $10,000.

20. On September 1, 2011, Swash Plating Company entered into two forward exchange contracts to purchase 250,000 euros each in 90 days. The relevant exchange rates are as follows:

Forward Rate
Spot rate For Dec. 1, 2011
September 1, 2011 1.46 1.47
September 30, 2011 (year-end) 1.50 1.48

The second forward contract was strictly for speculation. On September 30, 2011, what amount of foreign currency transaction gain should Swash Plating report in income?
a. $0.
b. $2,500.
c. $5,000.
d. $10,000.

21. On November 1, 2011, Prism Company sold inventory to a foreign customer. The account will be settled on March 1 with the receipt of 250,000 foreign currency units (FCU). On November 1, Prism also entered into a forward contract to hedge the exposed asset. The forward rate is $0.90 per unit of foreign currency. Prism has a December 31 fiscal year-end. Spot rates on relevant dates were:

Per Unit of
Date Foreign Currency
November 1 $0.93
December 31 0.91
March 1 0.94

The entry to record the forward contract is
a. FCU Receivable 225,000
Premium on Forward Contract 7,500
Dollars Payable 232,500

b. Dollars Receivable 232,500
Discount on Forward Contract 7,500
FCU Payable 225,000

c. FCU Receivable 232,500
Discount on Forward Contract 7,500
Dollars Payable 225,000

d. Dollars Receivable 225,000
Discount on Forward Contract 7,500
FCU Payable 232,500

22. On November 1, 2011, National Company sold inventory to a foreign customer. The account will be settled on March 1 with the receipt of 200,000 foreign currency units (FCU). On November 1, National also entered into a forward contract to hedge the exposed asset. The forward rate is $0.80 per unit of foreign currency. National has a December 31 fiscal year-end. Spot rates on relevant dates were:

Per Unit of
Date Foreign Currency
November 1 $0.83
December 31 0.81
March 1 0.84

What will be the adjusted balance in the Accounts Receivable account on December 31, and how much gain or loss was recorded as a result of the adjustment?

Receivable Balance Gain/Loss Recorded
a. $170,000 $4,000 gain
b. $162,000 $4,000 loss
c. $168,000 $2,000 gain
d. $164,000 $2,000 loss

23. Caldron Company purchased equipment for 375,000 British pounds from a supplier in London on July 3, 2011. Payment in British pounds is due on Sept. 3, 2011. The exchange rates to purchase one pound is as follows:
July 3 August 31, (year end) September 3
Spot-rate 1.58 1.55 1.54
30-day rate 1.57 1.53 —
60-day rate 1.56 1.49 —

On its August 31, 2011, income statement, what amount should Caldron report as a foreign exchange transaction gain:
a. $18,750.
b. $3,750.
c. $11,250.
d. $0.

24. On April 1, 2011, Trent Company entered into two forward exchange contracts to purchase 300,000 euros each in 90 days. The relevant exchange rates are as follows:

Forward Rate
Spot rate For Aug. 1, 2011
April 1, 2011 1.16 1.17
April 30, 2011 (year-end) 1.20 1.18

The first forward contract was to hedge a purchase of inventory on April 1, payable on December 1. On April 30, what amount of foreign currency transaction loss should Trent report in income?
a. $0.
b. $3,000.
c. $9,000.
d. $12,000.

25. On April 1, 2011, Trent Company entered into two forward exchange contracts to purchase 300,000 euros each in 90 days. The relevant exchange rates are as follows:

Forward Rate
Spot rate For Aug. 1, 2011
April 1, 2011 1.16 1.17
April 30, 2011 (year-end) 1.20 1.18

The second forward contract was strictly for speculation. On April 30, 2011, what amount of foreign currency transaction gain should Trent report in income.
a. $0.
b. $3,000.
c. $9,000.
d. $12,000.

Problems

12-1 On November 1, 2010, Dorsey Company sold inventory to a company in England. The sale was for 600,000 British pounds and payment will be received on February 1, 2011. On November 1, Dorsey entered into a forward contract to sell 600,000 British pounds on February 1 at the forward rate of $1.65. Spot rates for the British pound are as follows:
November 1 $1.61
December 31 1.67
February 1 1.62

Dorsey has a December 31 fiscal year-end.

Required:
Compute each of the following:

1. The dollars to be received on February 1, 2011, from selling the 600,000 pounds to the exchange dealer.

2. The dollars that would have been received from the account receivable if Dorsey had not hedged the sale contract with the forward contract.

3. The discount or premium on the forward contract.

4. The transaction gain or loss on the exposed asset related to the sale in 2010 and 2011.

5. The transaction gain or loss on the forward contract in 2010 and 2011.

6. The amount of the discount or premium on the forward contract amortized in 2010 and 2011.

12-2 On December 1, 2010, Derrick Corporation agreed to purchase a machine to be manufactured by a company in Brazil. The purchase price is 1,150,000 Brazilian reals. To hedge against fluctuations in the exchange rate, Derrick entered into a forward contract on December 1 to buy 1,150,000 reals on April 1, the agreed date of machine delivery, for $0.375 per real. The following exchange rates were quoted:
Forward Rate
Date Spot Rate (Delivery on 4/1)
December 1 0.390 0.375
December 31 0.370 0.373
April 1 0.385 —

Required:
Prepare journal entries necessary for Derrick during 2010 and 2011 to account for the transactions described above.

12-3 Colony Corp., a U.S. corporation, entered into a contract on November 1, 2010, to sell two machines to Crown Company, for 95,000 foreign currency units (FCU). The machines were to be delivered and the amount collected on March 1, 2011.

In order to hedge its commitment, Colony entered into a forward contract for 95,000 FCU delivery on March 1, 2011. The forward contract met all conditions for hedging an identifiable foreign currency commitment.

Selected exchange rates for FCU at various dates were as follows:

November 1, 2010 – Spot rate $1.3076
Forward rate for delivery on March 1, 2011 1.2980
December 31, 2010 – Spot rate 1.3060
Forward rate for delivery on March 1, 2011 1.3150
March 1, 2011 – Spot rate 1.2972

Required:
Prepare all journal entries relative to the above on the books of Colony Corp. on the following dates:
1. November 1, 2010.
2. Year-end adjustments on December 31, 2010.
3. March 1, 2011. (Include all adjustments related to the forward contract.)

12-4 On October 1, 2010, Nance Company purchased inventory from a foreign customer for 750,000 units of foreign currency (FCU) due on January 31, 2011. Simultaneously, Nance entered into a forward contract for 750,000 units of FC for delivery on January 31, 2011, at the forward rate of $0.75. Payment was made to the foreign customer on January 31, 2011. Spot rates on October 1, December 31, and January 31, were $0.72, $0.73, and $0.76, respectively. Nance amortizes all premiums and discounts on forward contracts and closes its books on December 31.

Required:

A. Prepare all journal entries relative to the above to be made by Nance on October 1, 2010.
B. Prepare all journal entries relative to the above to be made by Nance on December 31, 2010.
C. Compute the transaction gain or loss on the forward contract that would be recorded in 2011. Indicate clearly whether the amount is a gain or loss.

12-5 On October 1, 2010, Kline Company shipped equipment to a foreign customer for a foreign currency (FC) price of FC 3,000,000 due on January 31, 2011. All revenue realization criteria were satisfied and accordingly the sale was recorded by Kline Company on October 1. Simultaneously, Kline entered into a forward contract to sell 3,000,000 FCU on January 31, 2011 for $1,200,000. Payment was received from the foreign customer on January 31, 2011. Spot rates on October 1, December 31, and January 31 were $0.42, $0.425, and $0.435, respectively. Kline amortizes all premiums and discounts on forward contracts and closes its books on December 31.

Required:
Prepare all journal entries relative to the above to be made by Kline during 2010 and 2011.

12-6 On July 15, Worth, Inc. purchased 88,500,000 yen worth of parts from a Tokyo company paying 20% down, and the balance is due in 90 days. Interest is payable at a rate of 8% on the unpaid balance. The exchange rate on July 15, was $1.00 = 118 Japanese yen. On October 13, the exchange rate was $1.00 = 114 Japanese yen.

Required:
Prepare journal entries to record the purchase and payment of this foreign currency transaction in U.S. dollars.

12-7 On November 1, 2010, Bisk Corporation, a calendar-year U.S. Corporation, invested in a speculative contract to purchase 700,000 euros on January 31, 2011, from a German brokerage firm. Bisk agreed to buy 700,000 euros at a fixed price of $1.46 per euro. The brokerage firm agreed to send 700,000 euros to Bisk on January 31, 2011. The spot rates for euros are:

November 1, 2010 1 euro = 1.45
December 31, 2010 1 euro = 1.43
January 31, 2011 1 euro = 1.44
Required:
Prepare the journal entries that Bisk would record on November 1, December 31, and January 31.

12-8 Consider the following information:

1. On November 1, 2011, a U.S. firm contracts to sell equipment (with an asking price of 500,000 pesos) in Mexico. The firm will take delivery and will pay for the equipment on February 1, 2012.

2. On November 1, 2011, the company enters into a forward contract to sell 500,000 pesos for $0.0948 on February 1, 2012.

3. Spot rates and the forward rates for February 1, 2012, settlement were as follows (dollars per peso):

Forward Rate
Spot Rate for 2/1/12
November 1, 2011 $0.0954 $0.0948
Balance sheet date (12/31/11) 0.0949 0.0944
February 1, 2012 0.0947

4. On February 1, the equipment was sold for 500,000 pesos. The cost of the equipment was $20,000.

Required:
Prepare all journal entries needed on November 1, December 31, and February 1 to account for the forward contract, the firm commitment, and the transaction to sell the equipment.

Short Answer

1. Accounting for a foreign currency transaction involves the terms measured and denominated. Describe a foreign currency transaction and distinguish between the terms measured and denominated.
2. There are a number of business situations in which a firm may acquire a forward exchange contract. Identify three common situations in which a forward exchange contract can be used as a hedge.

Short Answer Questions from the Textbook

1. Define currency exchange rates and distinguish between “direct” and “indirect” quotations.

2. Explain why a firm is exposed to an added risk when it enters into a transaction that is to be settled in a foreign currency.

3. Name the three stages of concern to the accountant in accounting for import–export transactions. Briefly explain the accounting for each stage.

4. How should a transaction gain or loss be reported that is related to an unsettled receivable recorded when the firm’s inventory was exported?

5. A U.S. firm carried a receivable for 100,000 yen. Assuming that the direct exchange rate declined from $.009 at the date of the transaction to $.006at the balance sheet date, compute the transaction gain or loss. What balance would be reported for the receivable in the firm’s balance sheet?

6. Explain what is meant by the “two-transaction method” in recording exporting or importing trans-actions. What support is given for this method?

7. Describe a forward exchange contract.

8. Explain the effects on income from hedging a foreign currency exposed net asset position or net liability position.

9. What criteria must be satisfied for a foreign currency transaction to be considered a hedge of an identifiable foreign currency commitment?

10. The FASB classifies forward contracts as those acquired for the purpose of hedging and those acquired for the purpose of speculation. What main differences are there in accounting for these two classifications?

11. How are foreign currency exchange gains and losses from hedging a forecasted transaction handled?

12. What is a put option, and how might it be used to hedge a forecasted transaction?

13. Define a derivative instrument, and describe the keystones identified by the FASB for the ac-counting for such instruments.

14. Differentiate between forward-based derivatives and option-based derivatives.

15. List some of the criteria laid out by the FASB that are required for a gain or loss on forecasted trans-actions (a cash flow hedge) to be excluded from the income statement. If these criteria are satisfied, where are the gains or losses reported, and when (if ever) are they shown in the income statement? What is the rationale for this treatment?

Business Ethics Question from Textbook

Executive stock options (ESOs) are used to provide incentives for executives to improve company performance. ESOs are usually granted “at-the-money,” meaning that the exercise price of the options is set to equal the market price of the underlying stock on the grant date. Clearly, executives would prefer to be granted options when the stock price (and thus the exercise price) is at its lowest. Backdating options is the practice of choosing a past date when the market price was particularly low. Backdating has not, in the past, been illegal if no documents are forged, if communicated to the shareholders, and if properly reflected in earnings and in taxes.

1. Since backdating gives the executive an “instant” profit, why wouldn’t the firm simply grant an option with the exercise price lower than the cur-rent market price?

2. Suppose the executive was not involved in back-dating the ESOs. Does the executive face any ethical issues?

ANSWER KEY (Chapter 12)

Chapter 13

Translation of Financial Statements of Foreign Affiliates

Multiple Choice

1. When translating foreign currency financial statements for a company whose functional currency is the U.S. dollar, which of the following accounts is translated using historical exchange rates?

Notes Payable Equipment
a. Yes Yes
b. Yes No
c. No No
d. No Yes

2. Under the temporal method, monetary assets and liabilities are translated by using the exchange rate existing at the:
a. beginning of the current year.
b. date the transaction occurred.
c. balance sheet date.
d. None of these.

3. The process of translating the accounts of a foreign entity into its functional currency when they are stated in another currency is called:
a. verification.
b. translation.
c. remeasurement.
d. None of these.

4. Which of the following would be restated using the average exchange rate under the temporal method?
a. cost of goods sold
b. depreciation expense
c. amortization expense
d. None of these

5. Paid-in capital accounts are translated using the historical exchange rate under:
a. the current rate method only.
b. the temporal method only.
c. both the current rate and temporal methods.
d. neither the current rate nor temporal methods.

6. Which of the following would be restated using the current exchange rate under the temporal method?
a. Marketable securities carried at cost.
b. Inventory carried at market.
c. Common stock.
d. None of these.

7. The translation adjustment that results from translating the financial statements of a foreign subsidiary using the current rate method should be:
a. included as a separate item in the stockholders’ equity section of the balance sheet.
b. included in the determination of net income for the period it occurs.
c. deferred and amortized over a period not to exceed forty years.
d. deferred until a subsequent year when a loss occurs and offset against that loss.

8. Average exchange rates are used to translate certain items from foreign financial statements into U.S. dollars. Such averages are used in order to:
a. smooth out large translation gains and losses.
b. eliminate temporary fluctuation in exchange rates that may be reversed in the next fiscal period.
c. avoid using different exchange rates for some revenue and expense accounts.
d. approximate the exchange rate in effect when the items were recognized.

9. When the functional currency is identified as the U.S. dollar, land purchased by a foreign subsidiary after the controlling interest was acquired by the parent company should be translated using the:
a. historical rate in effect when the land was purchased.
b. current rate in effect at the balance sheet date.
c. forward rate.
d. average exchange rate for the current period.

10. The appropriate exchange rate for translating a plant asset in the balance sheet of a foreign subsidiary in which the functional currency is the U.S. dollar is the:
a. current exchange rate.
b. average exchange rate for the current year.
c. historical exchange rate in effect when the plant asset was acquired or the date of acquisition, whichever is later.
d. forward rate.

11. The following balance sheet accounts of a foreign subsidiary at December 31, 2011, have been translated into U.S. dollars as follows:
Translated at
Current Rates Historical Rates
Accounts receivable, current $ 600,000 $ 660,000
Accounts receivable, long-term 300,000 324,000
Inventories carried at market 180,000 198,000
Goodwill 190,000 220,000
$1,270,000 $1,402,000

What total should be included in the translated balance sheet at December 31, 2011, for the above items? Assume the U.S. dollar is the functional currency.
a. $1,270,000
b. $1,288,000
c. $1,300,000
d. $1,354,000

12. A foreign subsidiary’s functional currency is its local currency which has not experienced significant inflation. The weighted average exchange rate for the current year would be the appropriate exchange rate for translating

Wages expense Sales to customers
a. Yes Yes
b. Yes No
c. No No
d. No Yes

13. A wholly owned subsidiary of a U.S. parent company has certain expense accounts for the year ended December 31, 2011, stated in local currency units (LCU) as follows:
LCU
Depreciation of equipment (related assets
were purchased January 1, 2009) 375,000
Provision for doubtful accounts 250,000
Rent 625,000

The exchange rates at various dates are as follows:
Dollar equivalent
of 1 LCU
December 31, 2011 $0.50
Average for year ended December 31, 2011 0.55
January 1, 2009 0.40

Assume that the LCU is the subsidiary’s functional currency and that the charges to the expense accounts occurred approximately evenly during the year. What total dollar amount should be included in the translated income statement to reflect these expenses?

a. $687,500
b. $625,000
c. $550,000
d. $500,000

14. If the functional currency is determined to be the U.S. dollar and its financial statements are prepared in the local currency, SFAS 52, requires which of the following procedures to be followed?
a. Translate the financial statements into U.S. dollars using the current rate method.
b. Remeasure the financial statements into U.S. dollars using the temporal method.
c. Translate the financial statements into U.S. dollars using the temporal method.
d. Remeasure the financial statements into U.S. dollars using the current rate method.

15. P Company acquired 90% of the outstanding common stock of S Company which is a foreign company. The acquisition was accounted for using the purchase method. In preparing consolidated statements, the paid-in capital of S Company should be converted at the:
a. exchange rate effective when S Company was organized.
b. exchange rate effective on the date of purchase of the stock of S Company by P Company.
c. average exchange rate for the period S Company stock has been upheld by P Company.
d. current exchange rate.

16. In preparing consolidated financial statements of a U.S. parent company and a foreign subsidiary, the foreign subsidiary’s functional currency is the currency:
a. of the country the parent is located.
b. of the country the subsidiary is located.
c. in which the subsidiary primarily generates and spends cash.
d. in which the subsidiary maintains its accounting records.

17. Gains from remeasuring a foreign subsidiary’s financial statements from the local currency, which is not the functional currency, into the parent company’s currency should be reported as a(n):
a. other comprehensive income item.
b. extraordinary item (net of tax).
c. part of continuing operations.
d. deferred credit.

18. Assuming no significant inflation, gains resulting from the process of translating a foreign entity’s financial statements from the functional currency to U.S. dollars should be included as a(n):
a. other comprehensive income item.
b. extraordinary item (net of tax).
c. part of continuing operations.
d. deferred credit.

19. A foreign subsidiary’s functional currency is its local currency and inflation of over 100 percent has been experienced over a three-year period. For consolidation purposes, SFAS No. 52 requires the use of:
a. the current rate method only.
b. the temporal method only
c. both the current rate and temporal methods.
d. neither the current rate or the temporal method.

20. The objective of remeasurement is to:
a. produce the same results as if the books were maintained in the currency of the foreign entity’s largest customer.
b. produce the same results as if the books were maintained solely in the local currency.
c. produce the same results as if the books were maintained solely in the functional currency.
d. None of the above.

Problems

13-1 Ramsey, Inc. owns a company that operates in France. Account balances in francs for the subsidiary are shown below:

2011
January 1 December 31
Cash and Receivables 24,000 26,000
Supplies 1,000 500
Property, Plant, and Equipment 52,500 49,000
Accounts Payable (11,500) (5,500)
Long-term Notes Payable (19,000) (11,000)
Common Stock (30,000) (30,000)
Retained Earnings (17,000) (17,000)
Dividends-Declared & Paid on Dec 31 —- 3,000
Revenues —- (30,000)
Operating Expenses —- 15,000
Totals -0- -0

Exchange rates for 2011 were as follows:
January 1 $0.22
Average for the year 0.19
December 31 0.18

Revenues were earned and operating expenses, except for depreciation and supplies used, were incurred evenly throughout the year. No purchases of supplies or plant assets were made during the year.

Required:
A. Prepare a schedule to compute the translation adjustment for the year, assuming the subsidiary’s functional currency is the franc.

B. Prepare a schedule to compute the translation gain or loss, assuming the subsidiary’s functional currency is the U.S. dollar.

13-2 Sloop Sails Corporation, a U.S. company, operates a 100%-owned British subsidiary, Sewart Corporation. The U.S. dollar is the functional currency of the subsidiary. Financial statements for the subsidiary for the fiscal year-end December 31, 2011, are as follows:

Sewart Corporation
Income Statement
Pounds
Sales 650,000
Cost of Goods Sold
Beginning Inventory 310,000
Purchases 265,000
Goods Available For Sale 575,000
Less: Ending Inventory 285,000
Cost of Goods Sold 290,000
Depreciation 79,000
Selling and Admin. Expenses 155,000
Income Taxes 32,000 556,000
Net Income 94,000

Sewart Corporation
Partial Balance Sheet

Current Assets Current Liabilities
Cash 155,000 Notes Payable 78,000
Accts. Rec. 171,000 Accts. Payable 165,000
Inventories 285,000 Other Current Liab. 51,000
611,000 294,000
Long-term Liab. 250,000
(issued July 1, 2009)

Other Information:
1. Equipment costing 340,000 pounds was acquired July 1, 2009, and 38,000 was acquired June 30, 2011. Depreciation for the period was as follows:
Equipment – 2009 acquisitions 66,000
– 2011 acquisitions 6,000

2. The beginning inventory was acquired when the exchange rate was $1.77. The inventory is valued on a FIFO basis. Purchases and the ending inventory were acquired evenly throughout the period.

3. Dividends were paid by the subsidiary on June 30 amounting to 156,000 pounds.

4. Sales were made and all expenses were incurred uniformly throughout the year.

5. Exchange rates for the pound on various dates were:

July 1, 2009 $1.79
Jan. 1, 2011 1.75
June 30, 2011 1.74
Dec. 31, 2011 1.71
Average for 2011 1.73
13-2 (Continued)
Required:
A. Prepare a schedule to determine the translation gain or loss for 2010, assuming the net monetary liability position on January 1, 2011, was 180,000 pounds.

B. Compute the dollar amount that each of the following would be reported at in the 2011 financial statements:
1. Cost of Goods Sold.
2. Depreciation Expense.
3. Equipment.

13-3 Accounts are listed below for a foreign subsidiary that maintains its books in its local currency. The equity interest in the subsidiary was acquired in a purchase transaction. In the space provided, indicate the exchange rate that would be used to translate the accounts into dollars assuming the functional currency was identified (a) as the U.S. dollar and (b) as the foreign entity’s local currency. Use the following letters to identify the exchange rate:
H – Historical exchange rate
C – Current exchange rate
A – Average exchange rate for the current period

Exchange rate if the
functional currency is:
Account U.S. Dollar Local currency

1. Bonds Payable (issued 01/01/08) ___________ ______________
2. Office Supplies ___________ ______________
3. Dividends Declared ___________ ______________
4. Common Stock ___________ ______________
5. Additional Paid-In Capital ___________ ______________
6. Inventory Carried at Cost ___________ ______________
7. Short-term Notes Payable ___________ ______________
8. Accumulated Depreciation ___________ ______________
9. Cash ___________ ______________
10. Marketable Securities (carried
at market) ___________ ______________
11. Cost of Goods Sold ___________ ______________
12. Sales ___________ ______________
13. Accounts Receivable ___________ ______________
14. Depreciation Expense ___________ ______________
15. Income Tax Expense ___________ ______________

Use the following information to answer Problems 13-4 and 13-5.

On January 2, 2011, Promo Inc., a U.S. parent company, purchased a 100% interest in Spot Company, a subdivision located in Switzerland. The purchase method of accounting was used to account for the acquisition. The 2011 financial statements for Spot Company, the subsidiary, in Swiss francs were as follows:

Comparative Balance Sheets
Jan. 2 Dec. 31
Cash 15,000 33,000
Accounts receivable 45,000 49,500
Plant and equipment (net) (purchased 6/30/08) 75,000 67,500
Land (purchased 6/30/08) 45,000 45,000
Total 180,000 195,000

Accounts payable 13,500 18,000
Long-term notes payable (issued 6/30/08) 31,500 27,000
Common stock (issued 6/30/08) 90,000 90,000
Retained earnings 45,000 60,000
Total 180,000 195,000

Income Statement
Revenues 180,000
Operating expenses including depreciation
of 7,500 francs 135,000
Net income 45,000
Beginning retained earnings 45,000
90,000
Dividends declared and paid 30,000
Ending retained earnings 60,000

Sales were earned and operating expenses were incurred evenly during the year.

Exchange rates for the franc at various dates are:
January 2, 2011 0.8600
December 31, 2011 0.8830
Average for 2011 0.8715
December 10, 2011, dividend payment date 0.8810
June 30, 2008 0.8316

13-4 Use the above information to answer the following question:

Required:
Translate the year-end financial statements of Spot Company, the foreign subsidiary, using the temporal method. Round numbers to the nearest dollar.

13-5 Use the above information to answer the following question:

Required:
Prepare a schedule to compute the translation gain or loss for Spot Company, assuming the temporal method of translation. Round numbers to the nearest dollar.

13-6 Bass Corporation, a U.S. Company, formed a subsidiary with a new company in London on January 1, 2011, by investing 500,000 British pounds in exchange for all of the subsidiary’s common stock. The subsidiary purchased land for 100,000 pounds and a building for 300,000 pounds on July 1, 2011. The building is being depreciated over a 40-year life by the straight-line method. The inventory is valued on an average cost basis. The British pound is the subsidiary’s functional currency and its reporting currency and has not experienced any abnormal inflation. Exchange rates for the pound on various dates were:

January 1, 2011 1 pound = 1.81
July 1, 2011 1 pound = 1.86
December 31, 2011 1 pound = 1.83
2011 average rate 1 pound = 1.82

The subsidiary’s adjusted trial balance is presented below for the year ended December 31, 2011.

Debits In Pounds
Cash 200,000
Accounts receivable 60,000
Inventory 80,000
Land 100,000
Building 300,000
Depreciation expense 3,750
Cost of goods sold 213,750
Other expenses 90,000
Total debits 1,047,500

Credits
Accumulated depreciation 3,750
Accounts payable 84,000
Accrued liabilities 16,750
Common stock 500,000
Retained earnings – 0 –
Sales revenue 443,000
Total credits 1,047,500

Required: Prepare the subsidiary’s:
A. Translated workpapers (round to the nearest dollar)
B. Translated income statement
C. Translated balance sheet

13-7 Using the information provided in Problem 13-6, use the temporal method instead of the current rate method.

Required: Prepare the subsidiary’s:
A. Translated workpapers (round to the nearest dollar)
B. Translated income statement
C. Translated balance sheet

13-8

On January 1, 2011, Roswell Systems, a U.S.-based company, purchased a controlling interest in Swiss Management Consultants located in Zurich, Switzerland. The acquisition was treated as a purchase transaction. The 2011 financial statements stated in Swiss francs are given below.

SWISS MANAGEMENT CONSULTANTS
Comparative Balance Sheets
January 1 and December 31, 2011
Jan. 1 Dec. 31

Cash and Receivables 30,000 84,000
Net Property, Plant, and Equipment 60,000 56,000
Totals 90,000 140,000

Accounts and Notes Payable 45,000 50,000
Common Stock 30,000 30,000
Retained Earnings 15,000 60,000
Totals 90,000 140,000

SWISS MANAGEMENT CONSULTANTS
Consolidated Income and Retained Earnings Statement
For the Year Ended December 31, 2011

Revenues 112,000
Operating Expenses including depreciation of 5,000 francs 45,000
Net income 67,000
Dividends Declared and Paid 22,000
Increase in Retained Earnings 45,000

Direct exchange rates for Swiss franc are:

U.S. Dollars per Franc
January 1, 2011 $0.9987
December 31, 2011 0.9321
Average for 2011 0.9654
Dividend declaration and payment date 0.9810

Required:
A. Translate the year-end balance sheet and income statement of the foreign subsidiary using the current rate method of translation.
B. Prepare a schedule to verify the translation adjustment.

Short Answer
1. To accomplish the objectives of translation, two translation methods are used depending on the functional currency of the foreign entity. Describe the two translation methods.

2. The translation process can be done using either the current rate method or the temporal method. Explain under what circumstances each of the methods is appropriate.

Short Answer Questions from the Textbook

1. What requirements must be satisfied if a foreign subsidiary is to be consolidated?

2. What is meant by an entity’s functional currency and what are the economic indicators identified by the FASB to provide guidance in selecting the functional currency?

3. The __________is the functional currency of a foreign subsidiary with operations that are relatively self-contained and integrated within the country in which it is located. In such cases, the__________ method of translation would be used to translate the accounts into dollars.

4. The __________is the functional currency of a foreign subsidiary that is a direct and integral component or extension of a U.S. parent company. In such cases, the __________method of translation is used to translate (remeasure) the accounts into dollars.

5. Which method of translation is used to convert the financial statements when a foreign subsidiary operates in a highly inflationary economy?

6. Define remeasurement.

7. Under the current rate method, how are assets and liabilities that are stated in a foreign currency translated?

8. Under the current rate method, describe how the various balance sheet accounts are translated (including the equity accounts) and how this translation affects the computation of various ratios (such as debt to equity or the current ratio). In particular, discuss whether or not the ratios will change when computed in local currencies and compared to their calculations (after translation) using the parent’s currency.

9. What is the objective of the temporal method of translation?

10. Assuming that the temporal method is used, how are revenue and expense items in foreign currency financial statements converted?

11. A translation adjustment results from the process of translating financial statements of a foreign subsidiary from its functional currency into dollars. Where is the translation adjustment reported in the financial statements if the current rate method is used to translate the accounts?

Business Ethics Question from the Textbook

The Shady Tree Company is preparing to announce their quarterly earnings numbers. The company expectsto beat the analysts’ forecast of earnings by at least5cents a share. In anticipation of the increase instockvalue and before the release of the earnings numbers, the company issued stock options to the top executives in the firm, with the option price equal to today’s market price.
1. This type of executive stock option is often re-ferred to as “spring-loading.” Do you think this practice should be allowed? Does it provide in-formation about the integrity of the firm or is this just good business practice?
2. Do you think this practice violates the insider trading rules?

ANSWER KEY (Chapter 13)

Chapter 14

Reporting for Segments and for Interim Financial Periods

1. A component of an enterprise that may earn revenues and incur expenses, and about which management evaluates separate financial information in deciding how to allocate resources and assess performance is a(n)
a. identifiable segment.
b. operating segment.
c. reportable segment.
d. industry segment.

2. An entity is permitted to aggregate operating segments if the segments are similar regarding the
a. nature of the production processes.
b. types or class of customers.
c. methods used to distribute products or provide services.
d. all of these.

3. Which of the following is not a segment asset of an operating segment?
a. Assets used jointly by more than one segment.
b. Assets directly associated with a segment.
c. Assets maintained for general corporate purposes.
d. Assets used exclusively by a segment.

4. SFAS No. 131 requires the disclosure of information on an enterprise’s operations in different industries for
1. each annual period presented.
2. each interim period presented.
3. the current period only.
a. 1
b. 2
c. 3
d. both 1 and 2

5. Which of the following is not required to be disclosed by SFAS No. 131?
a. Information concerning the enterprise’s products.
b. Information related to an enterprise’s foreign operations.
c. Information related to an enterprise’s major suppliers.
d. All of the above are required disclosures.

6. To determine whether a substantial portion of a firm’s operations are explained by its segment information, the combined revenue from sales to unaffiliated customers of all reportable segments must constitute at least
a. 10% of the combined revenue of all operating segments.
b. 75% of the combined revenue of all operating segments.
c. 10% of the combined revenue from sales to unaffiliated customers of all operating segments.
d. 75% of the combined revenue from sales to unaffiliated customers of all operating segments.

7. A segment is considered to be significant if its
1. reported profit is at least 10% of the combined profit of all operating segments.
2. reported profit (loss) is at least 10% of the combined reported profit of all operating segments not reporting a loss.
3. reported profit (loss) is at least 10% of the combined reported loss of all operating segments that reported a loss.
a. 1
b. 2
c. 3
d. both 2 and 3

8. Which of the following disclosures is not required to be presented for a firm’s reportable segments?
a. Information about segment assets
b. Information about the bases for measurement
c. Reconciliation of segment amounts and consolidated amounts for revenue, profit or loss, assets, and other significant items.
d. All of these must be presented.

9. Current authoritative pronouncements require the disclosure of segment information when certain criteria are met. Which of the following reflects the type of firm and type of financial statement for which this disclosure is required?
a. Annual financial statements for publicly held companies.
b. Annual financial statements for both publicly held and nonpublicly held companies.
c. Annual and interim financial statements for publicly held companies.
d. Annual and interim financial statements for both publicly held and nonpublicly held companies.

10. An enterprise determines that it must report segment data in annual reports for the year ended December 31, 2011. Which of the following would not be an acceptable way of reporting segment information?
a. Within the body of the financial statements, with appropriate explanatory disclosures in the footnotes
b. Entirely in the footnotes to the financial statements.
c. As a special report issued separately from the financial statements.
d. In a separate schedule that is included as an integral part of the financial statements.

11. Selected data for a segment of a business enterprise are to be separately reported in accordance with SFAS No. 131 when the revenues of the segment is 10% or more of the combined
a. net income of all segments reporting profits.
b. external and internal revenue of all reportable segments.
c. external revenue of all reportable segments.
d. revenues of all segments reporting profits.

12. Long Corporation’s revenues for the year ended December 31, 2011, were as follows
Consolidated revenue per income statement $800,000
Intersegment sales 105,000
Intersegment transfers 35,000
Combined revenues of all operating segments $940,000

Long has a reportable segment if that segment’s revenues exceed
a. $80,000.
b. $90,500.
c. $94,000.
d. $14,000.

13. Revenue test
(dollars in thousands)
Wholesale Retail Finance
Segment Segment Segment
Sales to unaffiliated customers $3,600 $1,500 $-0-
Sales – intersegment 400 240 -0-
Loan interest income – intersegment -0- 120 900
Loan interest income – unaffiliated -0- 240 80
Income from equity method investees -0- 280 -0-

Determine the amount of revenue for each of the three segments that would be used to identify the reportable industry segments in accordance with the revenues test specified by SFAS 131.

Wholesale Retail Finance
a. $3,600 $1,500 $ -0-
b. 4,000 1,740 -0-
c. 4,000 1,980 980
d. 4,000 2,380 980

14. Which of the following is not part of the information about foreign operations that is required to be disclosed?
a. Revenues from external customers
b. Operating profit or loss, net income, or some other common measure of profitability
c. Capital expenditures
d. Long-lived assets

15. Eaton, Inc., discloses supplemental industry segment information. The following data are available for 2011.
Traceable
Segment Sales operating expenses
A $420,000 $255,000
B 480,000 300,000
C 300,000 165,000
$1,200,000 $720,000

Additional 2011 expenses, not included above, are as follows:

Indirect operating expenses $240,000
General corporate expenses 180,000

Appropriate common expenses are allocated to segments based on the ratio of a segment’s sales to total sales. What should be the operating profit for Segment C for 2011?
a. $135,000
b. $ 75,000
c. $ 105,000
d. $ 30,000

16. Gant Company has four manufacturing divisions, each of which has been determined to be a reportable segment. Common operating costs are appropriately allocated on the basis of each division’s sales in relation to Gant’s aggregate sales. Gant’s Delta division accounted for 40% of Gant’s total sales in 2011. For the year ended December 31, 2011, Delta had sales of $5,000,000 and traceable costs of $3,600,000. In 2011, Gant incurred operating costs of $350,000 that were not directly traceable to any of the divisions. In addition, Gant incurred interest expense of $360,000 in 2011. In reporting supplementary segment information, how much should be shown as Delta’s operating profit for 2011?
a. $1,400,000
b. $1,256,000
c. $1,260,000
d. $1,116,000

17. For external reporting purposes, it is appropriate to use estimated gross profit rates to determine the ending inventory value for

Interim Annual
Reporting Reporting
a. No No
b. No Yes
c. Yes No
d. Yes Yes

18. Inventory losses from market declines that are expected to be temporary
a. should be recognized in the interim period in which the decline occurs.
b. should be recognized in the last (fourth) quarter of the year in which the decline occurs.
c. should not be recognized.
d. none of these.

19. Gains and losses that arise in an interim period should be
a. recognized in the interim period in which they arise.
b. recognized in the last quarter of the year in which they arise.
c. allocated equally among the remaining interim periods.
d. deferred and included only in the annual income statement.

20. If a cumulative effect type accounting change is made during the first interim period of a year
a. no cumulative effect of the change should be included in net income of the period of change.
b. the cumulative effect of the change on retained earnings at the beginning of the year should be included in net income of the first interim period.
c. the cumulative effect of the change should be allocated to the current and remaining interim periods of the year.
d. none of these.

21. Which of the following does not have to be disclosed in interim reports?
a. Seasonal costs or expenses.
b. Significant changes in estimates.
c. Disposal of a segment of a business.
d. All of these must be disclosed.

22. For interim financial reporting, the effective tax rate should reflect

Anticipated Extraordinary
Tax Credits Items
a. Yes Yes
b. Yes No
c. No Yes
d. No No

23. Companies using the LIFO method may encounter a liquidation of base period inventories at an interim date that is expected to be replaced by the end of the year. In these cases, cost of goods sold should be charged with the
a. cost of the most recent purchases.
b. average cost of the liquidated LIFO base.
c. expected replacement cost of the liquidated LIFO base.
d. none of these.

24. In considering interim financial reporting, how did the Accounting Principles Board conclude that each reporting should be viewed?
a. As a “special” type of reporting that need not follow generally accepted accounting principles.
b. As useful only if activity is evenly spread throughout the year so that estimates are unnecessary.
c. As reporting for a basic accounting period.
d. As reporting for an integral part of an annual period.

25. When a company issues interim financial statements, extraordinary items should be
a. allocated to the current and remaining interim periods of the current year on a pro rata basis.
b. deferred and included only in the annual income statement.
c. included in the determination of net income in the interim period in which they occur.
d. charged or credited directly to retained earnings so that comparisons of interim results of operations will not be distorted.

26. If annual major repairs made in the first quarter and paid for in the second quarter clearly benefit the entire year, when should they be expensed?
a. An allocated portion in each of the last three quarters
b. An allocated portion in each quarter of the year
c. In full in the first quarter
d. In full in the second quarter

27. During the second quarter of 2011, Dodge Company sold a piece of equipment at a gain of $90,000. What portion of the gain should Dodge report in its income statement for the second quarter of 2011?
a. $90,000
b. $45,000
c. $30,000
d. $ -0-

28. In January 2011, Abel Company paid $200,000 in property taxes on its plant for the calendar year 2011. Also in January 2011, Abel estimated that its year-end bonuses to executives for 2011 would be $800,000. What is the amount of expenses related to these two items that should be reflected in Abel’s quarterly income statement for the three months ended June 30, 2011 (second quarter)?
a. $ -0-
b. $250,000
c. $ 50,000
d. $200,000

29. For interim financial reporting, a company’s income tax provision for the second quarter of 2011 should be determined using the
a. statutory tax rate for 2011.
b. effective tax rate expected to be applicable for the full year of 2011 as estimated at the end of the first quarter of 2011.
c. effective tax rate expected to be applicable for the full year of 2011 as estimated at the end of the second quarter of 2011.
d. effective tax rate expected to be applicable for the second quarter of 2011.

30. Which of the following reporting practices is permissible for interim financial reporting?
a. Use of the gross profit method for interim inventory pricing.
b. Use of the direct costing method for determining manufacturing inventories.
c. Deferral of unplanned variances under a standard cost system until year-end.
d. Deferral of inventory market declines until year-end.

31. Which of the following statements most accurately describes interim period tax expense?
a. The best estimate of the annual tax rate times the ordinary income (loss) for the quarter.
b. The best estimate of the annual tax rate times income (loss) for the year to date less tax expense (benefit) recognized in previous interim periods.
c. Average tax rate for each quarter, including the current quarter, times the current income (loss).
d. The previous year’s actual effective tax rate times the current quarter’s income.

32. The computation of a company’s third quarter provision for income taxes should be based upon earnings
a. for the quarter at an expected annual effective income tax rate.
b. for the quarter at the statutory rate.
c. to date at an expected annual effective income tax rate less prior quarters’ provisions.
d. to date at the statutory rate less prior quarters’ provisions.

33. Finney, a calendar year company, has the following income before income tax provision and estimated effective annual income tax rates for the first three quarters of 2011:

Income Before Estimated Effective
Income Tax Annual Tax Rate
Quarter Provision at the End of Quarter
First $120,000 25%
Second 160,000 25%
Third 200,000 30%

Finney’s income tax provision in its interim income statement for the third quarter should be
a. $74,000.
b. $60,000.
c. $50,000.
d. $144,000.

34. An inventory loss from a market price decline occurred in the first quarter. The loss was not expected to be restored in the fiscal year. However, in the third quarter the inventory had a market price recovery that exceeded the market decline that occurred in the first quarter. For interim reporting, the dollar amount of net inventory should
a. decrease in the first quarter by the amount of the market price decline and increase in the third quarter by the amount of the market price recovery.
b. decrease in the first quarter by the amount of the market price decline and increase in the third quarter by the amount of the decrease in the first quarter.
c. not be affected in the first quarter and increase in the third quarter by the amount of the market price recovery that exceeded the amount of the market price decline.
d. not be affected in either the first quarter or the third quarter.

35. Advertising costs may be accrued or deferred to provide an appropriate expense in each period for
Interim Annual
Reporting Reporting
a. Yes No
b. Yes Yes
c. No No
d. No Yes

Problems

14-1 The following information is available for Torrey Company for 2011:

a. In early April Torrey made major repairs to its equipment at a cost of $90,000. These repairs will benefit the remainder of 2011 operations.

b. At the end of May, Torrey sold machinery with a book value of $35,000 for $45,000.

c. An inventory loss of $60,000 from market decline occurred in July. In the fourth quarter the inventory had a market value recovery that exceeded the market decline by $30,000.

Required:
Compute the amount of expense/loss that would appear in Torrey Company’s June 30, September 30, and December 31, 2011, quarterly financial statements.

14-2 Stein Corporation’s operations involve three industry segments, X, Y, and Z. During 2011, the operating profit (loss) of each segment was:
Operating
Segment Profit (Loss)
X $ 600
Y 8,100
Z (6,300)

Required:
Determine which of the segments are reportable segments.

14-3 Bass Industries operates in four different industries. Information concerning the operations of these industries for the year 2011 is:

Revenue
Industry Operating Segment
Segment Total Intersegment Profit (Loss) Assets
A $ 24,000 $4,200 $ 2,700 $ 22,400
B 18,000 2,200 (2,000) 25,200
C 90,000 14,000 3,600 70,000
D 168,000 -0- 23,700 162,400
$300,000 $28,000 $280,000

Required:
Complete the following schedule to determine which of the above segments must be treated as reportable segments.
10% Test For
Segment Revenue Op. Profit (Loss) Segment Assets Reportable?
A

B

C

D

14-4 Logan Company prepares quarterly financial statements. The following information is available concerning calendar year 2011:

Estimated full-year earnings $3,000,000
Full-year permanent differences:
Penalty for pollution 150,000
Estimated dividend income exclusion 60,000
Actual pretax earnings, 1/1/11 to 3/31/11 480,000
Nominal income tax rate 40%

Required:
Compute the income tax provision for the first quarter of 2011.

14-5 XYZ Corporation has eight industry segments with sales, operating profit and loss, and identifiable assets at and for the year ended December 31, 2011, as follows:

Sales to Unaffiliated Customers Sales to Affiliated Customers Profit or (Loss) Segment
Assets
Steel $1,350,000 $150,000 $265,000 $2,250,000
Auto Parts 1,200,000 — 450,000 1,430,000
Coal Mine 600,000 450,000 (300,000) 1,200,000
Textiles 530,000 220,000 150,000 750,000
Paint 1,120,000 380,000 300,000 1,050,000
Lumber 710,000 — (75,000) 600,000
Leisure Time 690,000 — 110,000 450,000
Electronics 600,000 — 300,000 670,000
Total $6,800,000 $1,200,000 $1,200,000 $8,400,000

Required:
A. Identify the segments, which are reportable segments under one or more of the 10 percent revenue, operating profit, or assets tests.
B. After reportable segments are determined under the 10 percent tests, they must be reevaluated under a 75 percent revenue test before a final determination of reportable segments can be made. Under this 75 percent test, identify if any other segments may have to be reported.

14-6 Ace Company, which uses the FIFO inventory method, had 508,000 units in inventory at the beginning of the year at a FIFO cost per unit of $20. No purchases were made during the year. Quarterly sales information and end-of-quarter replacement cost figures follow:

End-of- Quarter
Quarter Unit Sales Replacement Cost
1 200,000 $17
2 60,000 18
3 85,000 13
4 61,000 18
The market decline in the first quarter was expected to be nontemporary. Declines in other quarters were expected to be permanent.

Required:
Determine cost of goods sold for the four quarters and verify the amounts by computing cost of goods sold using the lower-of-cost-or-market method applied on an annual basis.

14-7 Barr Company’s actual earnings for the first two quarters of 2011 and its estimate during each quarter of its annual earnings are:

Actual first-quarter earnings $ 800,000
Actual second-quarter earnings 1,020,000
First-quarter estimate of annual earnings 2,700,000
Second-quarter estimate of annual earnings 2,830,000

Barr Company estimated its permanent differences between accounting income and taxable income for 2011 as:

Environmental violation penalties $ 45,000
Dividend income exclusion 320,000

These estimates did not change during the second quarter. The combined state and federal tax rate for Barr Company for 2011 is 40%.

Required:
Prepare journal entries to record Barr Company’s provisions for income taxes for each of the first two quarters of 2011.

Short Answer
1. In SFAS No. 131, the FASB requires all public companies to report a variety of information for reportable segments. Define a reportable segment and identify the information to be reported for each reportable segment.

2. Publicly owned companies are usually required to file some type of quarterly (interim) report as part of the agreement with the stock exchanges that list their stock. Indicate two problems with interim reporting and GAAP’s position on this reporting.

Short Answer Questions from the Textbook

1. For what types of companies would segmented financial reports have the most significance? Why?

2. Why do financial statement users (financial analysts, for example) need information about seg- ments of a firm?

3. Define the following: (a)Operating segment.(b)Reportable segment.

4. Describe the guidelines to be used in determining (a) what constitutes an operating segment, and (b) whether a specific operating segment is a significant segment.

5. List the three major types of enterprise wide information disclosures required by SFAS No. 131[ASC 280], and explain how the firm’s designation of reportable segments affects these disclosures.

6. What segmental disclosures are required, if any, for interim reports?

7. What type of disclosure is required of a firm when the major portion of its operations takes place within a single reportable segment?

8. List the types of information that must be presented for each reportable segment of a com-pany under the rules of SFAS No. 131 [ASC 280].

9. Describe the methods that might be used to disclose reportable segment information.

10. What types of information must be disclosed about foreign operations under SFAS No. 131[ASC 280–10–50–40]?

11. How are foreign operations defined under SFASNo. 131 [ASC 280]?

12. If the operations of a firm in some foreign countries are grouped into geographic areas, what factors should be considered in forming the groups?

13. When must a firm present segmental disclosures for major customers? What is the reason for this requirement?

14. How are common costs distinguished from general corporate expenses for segmental purposes?

15. What is the purpose of interim financial reporting?

16. Some accountants hold the view that each interim period should stand alone as a basic ac-counting period, whereas others view each interim period as essentially an integral part of the annual period. Distinguish between these views.

17.Describe the basic procedure for computing in-come tax provisions for interim financial state-ments.

18.Describe how changes in estimates should be treated in interim financial statements.

19.What are the minimum disclosure requirements established ASC 270 for interim financial reports?

20.What is the general rule regarding the treatment of costs and expenses associated directly with revenues for interim reporting purposes?

Business Ethics Question from Textbook
SMC Inc. operates restaurants based on various themes, such as Mex-delight, Chinese for the Buffet, and Steak-it and Eat-it. The Steak-it and Eat-it restaurants have not been performing well recently, but SMC prefers not to disclose these details for fear that competitors might use the information to the detriment of SMC. The restaurants are located in various geographical locations, and management currently measures profits and losses and asset allocation by restaurant concept. How-ever, when preparing the segmental disclosures under SFAS No. 131 [ASC 280], the company reports the segment information by geographical location only. The company recently hired you to review the financial statements.
1.What disclosures should the company report for segment purposes?
2.The company’s CEO believed that the rules in SFAS No. 131 [ASC 280] are vague and that the company could easily support its decision to dis-close the segment data by geographic regions. What would you recommend to the CEO and how would you approach the issues?

ANSWER KEY (Chapter 14)

Chapter 15

Partnerships: Formation, Operation, and Ownership Changes

Multiple Choice

1. When a partner retires and withdraws assets in excess of his book value, the remaining partners absorb the excess
a. equally.
b. in their profit-sharing ratio.
c. based on their average capital balances.
d. based on their ending capital balances.

2. In a partnership, interest on capital investment is accounted for as a(n)
a. return on investment.
b. expense.
c. allocation of net income.
d. reduction of capital.

3. A partnership in which one or more of the partners are general partners and one or more are not is called a(n)
a. joint venture.
b. general partnership.
c. limited partnership.
d. unlimited partnership.

4. Which of the following is an advantage of a partnership?
a. mutual agency
b. limited life
c. unlimited liability
d. none of these

5. Bob and Fred form a partnership and agree to share profits in a 2 to 1 ratio. During the first year of operation, the partnership incurs a $20,000 loss. The partners should share the losses
a. based on their average capital balances.
b. in a 2 to 1 ratio.
c. equally.
d. based on their ending capital balances.

6. When the goodwill method is used to record the admission of a new partner, total partnership capital increases by an amount
a. equal to the new partner’s investment.
b. greater than the new partner’s investment.
c. less than the new partner’s investment.
d. that may be more or less than the new partner’s investment.

7. The bonus and goodwill methods of recording the admission of a new partner will produce the same result if the:
1. new partner’s profit-sharing ratio equals his capital interest
2. old partners’ profit-sharing ratio in the new partnership is the same relatively as it was in the old partnership.
a. 1
b. 2
c. both 1 and 2 are met.
d. none of these.

8. When the goodwill method is used and the book value acquired is less than the value of the assets invested, total implied capital is computed by
a. multiplying the new partner’s capital interest by the capital balances of existing partners.
b. dividing the total capital balances of existing partners by their collective capital interest.
c. dividing the new partner’s investment by his (her) capital interest.
d. dividing the new partner’s investment by the existing partners’ collective capital interest.

9. The partnership of Adams and Baker was formed on February 28, 2011. At that date the following assets were invested:
Adams Baker
Cash $ 120,000 $200,000
Merchandise -0- 320,000
Building -0- 840,000
Furniture and equipment 200,000 -0-

The building is subject to a mortgage loan of $280,000, which is to be assumed by the partnership. The partnership agreement provides that Adams and Baker share profits or losses 30% and 70%, respectively. Baker’s capital account at February 28, 2011, should be
a. $1,080,000.
b. $1,360,000.
c. $1,176,000.
d. $952,000.

10. The following balance sheet information is for the partnership of Abel, Ball, and Catt:

Cash $ 210,000 Liabilities $ 510,000
Other assets 1,500,000 Abel, Capital (40%) 300,000
Ball, Capital (40%) 480,000
Catt, Capital (20%) 420,000
$1,710,000 $1,710,000

Figures shown parenthetically reflect agreed profit and loss sharing percentages.
If the assets are fairly valued on the above balance sheet and the partnership wishes to admit Dent as a new 1/5 partner without recording goodwill or bonus, Dent should invest cash or other assets of
a. $427,500.
b. $240,000.
c. $300,000.
d. $342,000.

11. The following balance sheet information is for the partnership of Abel, Ball, and Catt:

Cash $ 210,000 Liabilities $ 510,000
Other assets 1,500,000 Abel, Capital (40%) 300,000
Ball, Capital (40%) 480,000
Catt, Capital (20%) 420,000
$1,710,000 $1,710,000

Figures shown parenthetically reflect agreed profit and loss sharing percentages.
If assets on the initial balance sheet are fairly valued, Abel and Ball consent and Dent pays Catt $225,000 for his interest; the revised capital balances of the partners would be
a. Abel, $315,000; Ball, $495,000; Dent, $450,000.
b. Abel, $315,000; Ball, $495,000; Dent, $420,000.
c. Abel, $300,000; Ball, $570,000; Dent, $450,000.
d. Abel, $300,000; Ball, $480,000; Dent, $420,000.

12. Linda desires to purchase a one-fourth capital and profit and loss interest in the partnership of Hank, Greg, and Jim. The three partners agree to sell Linda one-fourth of their respective capital and profit and loss interests in exchange for a total payment of $100,000. The payment is made directly to the individual partners. The capital accounts and the respective percentage interests in profits and losses immediately before the sale to Linda follow

Percentage
Capital Interests in
Accounts Profits and Losses
Hank $168,000 50%
Greg 104,000 35
Jim 48,000 15
Total $320,000

All other assets and liabilities are fairly valued and implied goodwill is to be recorded prior to the acquisition by Linda. Immediately after Linda’s acquisition, what should be the capital balances of Hank, Greg, and Jim, respectively?
a. $126,000; $78,000; $36,000
b. $156,000; $99,000; $45,000
c. $178,000; $111,000; $51,000
d. $208,000; $132,000; $60,000

13. At December 31, 2011, Barb and Kim are partners with capital balances of $250,000 and $150,000, and they share profits and losses in the ratio of 2:1, respectively. On this date, Jack invests $125,000 cash for a one-fifth interest in the capital and profit of the new partnership. The partners agree that the implied partnership goodwill is to be recorded simultaneously with the admission of Jack. The total implied goodwill of the firm is
a. $25,000.
b. $20,000.
c. $45,000.
d. $100,000.

14. Pete, Joe, and Ron are partners with capital balances of $135,000, $90,000, and $60,000, respectively. The partners share profits and losses equally. For an investment of $120,000 cash, Jerry is to be admitted as a partner with a one-fourth interest in capital and profits. Based on this information, the amount of Jerry’s investment can best be justified by which of the following?
a. Jerry will receive a bonus from the other partners upon his admission to the partnership.
b. Assets of the partnership were overvalued immediately prior to Jerry’s investment.
c. The book value of the partnership’s net assets were less than their fair value immediately prior to Jerry’s investment.
d. Jerry is apparently bringing goodwill into the partnership and his capital account will be credited for the appropriate amount.

15. The partnership of Amos, Cole, and Eddy had total capital of $570,000 on December 31, 2011 as follows:

Amos, Capital (30%) $180,000
Cole, Capital (45%) 255,000
Eddy, Capital (25%) 135,000
Total $570,000

Profit and loss sharing percentages are shown in parentheses. If Flynn purchases a 25 percent interest from each of the old partners for a total payment of $270,000 directly to the old partners
a. total partnership net assets can logically be revalued to $1,080,000 on the basis of the price paid by Flynn.
b. the payment of Flynn does not constitute a basis for revaluation of partnership net assets because the capital and income interests of the old partnership were not aligned.
c. total capital of the new partnership should be $760,000.
d. total capital of the new partnership will be $840,000 assuming no revaluation.

16. The partnership of Amos, Cole, and Eddy had total capital of $570,000 on December 31, 2011 as follows:

Amos, Capital (30%) $180,000
Cole, Capital (45%) 255,000
Eddy, Capital (25%) 135,000
Total $570,000

Profit and loss sharing percentages are shown in parentheses. Assume that Flynn became a partner by investing $150,000 in the Amos, Cole, and Eddy partnership for a 25 percent interest in capital and profits and that partnership net assets are not revalued. Flynn’s capital credit should be
a. $180,000.
b. $142,500.
c. $150,000.
d. $190,000.

17. The partnership of Amos, Cole, and Eddy had total capital of $570,000 on December 31, 2011 as follows:

Amos, Capital (30%) $180,000
Cole, Capital (45%) 255,000
Eddy, Capital (25%) 135,000
Total $570,000

Profit and loss sharing percentages are shown in parentheses.
Assume that Flynn became a partner by investing $100,000 in the Amos, Cole, and Eddy partnership for a 25 percent interest in the capital and profits, and the partnership assets are revalued. Under this assumption
a. Flynn’s capital credit will be $150,000.
b. Amos’s capital will be increased to $147,000.
c. total partnership capital after Flynn’s admission to the partnership will be $600,000.
d. net assets of the partnership will increase by $190,000, including Flynn’s interest.

18. In the absence of an agreement among the partners
a. interest is allowed on capital investments.
b. interest is charged on partners’ drawings.
c. interest is allowed on advances to the firm made by partners beyond agreed investments.
d. compensation is allowed partners for extra time devoted to the partnership.

19. The profit and loss sharing ratio should be
a. in the same ratio as the percentage interest owned by each partner.
b. based on relative effort contributed to the firm by the partners.
c. a weighted average of capital and effort contributions.
d. based on any formula that the partners choose.

20. The partnership agreement of Flynn, Gant, and Hill allows Gant a bonus of 10% of income after the bonus, salaries of $30,000 per partner and interest of 6% on average capital balances of $120,000, $150,000, and $180,000 for Flynn, Gant, and Hill, respectively. The amount of Gant’s bonus, assuming income before bonus, salaries, and interest of $315,000, is
a. $18,000.
b. $22,000.
c. $19,800.
d. $31,500.

21. Steve and Robby are partners operating an electronics repair shop. For 2011, net income was $50,000. Steve and Robby have salary allowances of $90,000 and $60,000, respectively, and remaining profits and losses are shared 4:6.
The division of profits would be:
a. $20,000 and $30,000
b. $50,000 and $-0-
c. $30,000 and $20,000
d. $25,000 and $25,000

22. Steve and Robby are partners operating an electronics repair shop. For 2011, net income was $50,000. Steve and Robby have salary allowances of $90,000 and $60,000, respectively, and remaining profits and losses are shared 4:6.
If their agreement specifies that salaries are allowed only to the extent of income, based on a prorata share of their salary allowances, the division of profits would be:
a. $20,000 and $30,000
b. $50,000 and $-0-
c. $30,000 and $20,000
d. $25,000 and $25,000

23. Carter, Wynn, and Norton are partners in a janitorial service. The business reported net income of $54,000 for 2011. The partnership agreement provides that profits and losses are to be divided equally after Wynn receives a $60,000 salary, Norton receives a $24,000 salary, and each partner receives 10% interest on his beginning capital balance. Beginning capital balances were $40,000 for Carter, $48,000 for Wynn, and $32,000 for Norton. Norton’s share of partnership income for 2011 is:
e. $68,800
f. $36,000
g. $31,200
h. $27,200

24. Bell and Carson are partners who share profits and losses 3:7. The capital accounts on January 1, 2011, are $120,000 and $160,000, respectively. Elston is to be admitted as a partner with a one-fourth interest in the capital and profits and losses by investing $80,000. Goodwill is not to be recorded. The capital balances after admission should be:
a. Bell, $117,000; Carson, $153,000; Elston, $90,000
b. Bell, $120,000; Carson, $160,000; Elston, $90,000
c. Bell, $123,000; Carson, $160,000; Elston, $80,000
i. Bell, $120,000; Carson, $167,000; Elston, $80,000

25. The balance sheet for the partnership of Nen, Pap, and Sup at January 1, 2011 follows. The partners share profits and losses in the ratio of 3:2:5, respectively.

Assets at cost $480,000

Liabilities $135,000
Nen, capital 75,000
Pap, capital 120,000
Sup, capital 150,000
$480,000

Nen is retiring from the partnership. By mutual agreement, the assets are to be adjusted to their fair value of $540,000 at January 1, 2011. Pap and Sup agree that the partnership will pay Nen $135,000 cash for his partnership interest. NO goodwill is to be recorded. What is the balance of Pap’s capital account after Nen’s retirement?
a. $138,000
b. $108,000
c. $120,000
d. $132,000

26. The following balance sheet information is for the partnership of Axe, Barr, and Cole:

Cash $ 210,000 Liabilities $ 510,000
Other assets 1,500,000 Axe, Capital (40%) 300,000
Barr, Capital (40%) 480,000
Cole, Capital (20%) 420,000
$1,710,000 $1,710,000

Figures shown parenthetically reflect agreed profit and loss sharing percentages.
If the assets are fairly valued on the above balance sheet and the partnership wishes to admit Dent as a new 1/5 partner without recording goodwill or bonus, Dent should invest cash or other assets of
a. $427,500.
b. $240,000.
c. $300,000.
d. $342,000.

27. Susan desires to purchase a one-fourth capital and profit and loss interest in the partnership of Tony, Mary, and Ron. The three partners agree to sell Susan one-fourth of their respective capital and profit and loss interests in exchange for a total payment of $125,000. The payment is made directly to the individual partners. The capital accounts and the respective percentage interests in profits and losses immediately before the sale to Susan follow

Percentage
Capital Interests in
Accounts Profits and Losses
Tony $210,000 50%
Mary 130,000 35
Ron 60,000 15
Total $400,000

All other assets and liabilities are fairly valued and implied goodwill is to be recorded prior to the acquisition by Susan. Immediately after Susan’s acquisition, what should be the capital balances of Tony, Mary, and Ron, respectively?
a. $157,500; $97,500; $45,000
b. $195,000; $123,750; $56,250
c. $222,500; $138,750; $63,750
d. $260,000; $165,000; $75,000

28. The partnership of Carr, Eddy, and Howe had total capital of $1,140,000 on December 31, 2011, as follows:

Carr, Capital (30%) $360,000
Eddy, Capital (45%) 510,000
Howe, Capital (25%) 270,000
Total $1,140,000

Profit and loss sharing percentages are shown in parentheses.
Assume that Klein became a partner by investing $300,000 in the Carr, Eddy, and Howe partnership for a 25 percent interest in capital and profits and that partnership net assets are not revalued. Klein’s capital credit should be
a. $360,000.
b. $285,000.
c. $300,000.
d. $380,000.

29. The partnership of Carr, Eddy, and Howe had total capital of $1,140,000 on December 31, 2011, as follows:

Carr, Capital (30%) $360,000
Eddy, Capital (45%) 510,000
Howe, Capital (25%) 270,000
Total $1,140,000

Profit and loss sharing percentages are shown in parentheses.
Assume that Klein became a partner by investing $300,000 in the Carr, Eddy, and Howe partnership for a 25 percent interest in the capital and profits, and the partnership assets are revalued. Under this assumption
a. Klein’s capital credit will be $300,000.
b. Carr’s capital will be increased to $394,000.
c. total partnership capital after Klein’s admission to the partnership will be $1,200,000.
d. net assets of the partnership will increase by $380,000 including Klein interest.

30. Newlin, Vick, and Morton are partners in a plumbing service. The business reported net income of $108,000 for 2011. The partnership agreement provides that profits and losses are to be divided equally after Vick receives a $60,000 salary, Morton receives a $24,000 salary, and each partner receives 10% interest on his beginning capital balance. Beginning capital balances were $40,000 for Newlin, $48,000 for Vick, and $32,000 for Morton. Vick’s share of partnership income for 2011 is:
a. $68,800.
b. $36,000.
c. $31,200.
d. $27,200.

Problems

15-1 Unruh, Grey, and Carter are partners with capital balances of $80,000, $200,000, and $120,000, respectively. Profits and losses are shared in a 3:2:1 ratio. Grey decided to withdraw and the partnership revalued its assets. The value of inventory was decreased by $20,000 and the value of land was increased by $50,000. Unruh and Carter then agreed to pay Grey $230,000 for his withdrawal from the partnership.

Required:
Prepare the journal entry to record Grey’s withdrawal under the
A. bonus method.
B. full goodwill method.

15-2 Dell and Gore are partners in an automobile repair business. Their respective capital balances are $425,000 and $275,000, and they share profits in a 3:2 ratio. Because of growth in their repair business, they decide to admit a new partner. Mann is admitted to the partnership, after which Dell, Gore, and Mann agree to share profits in a 3:2:1 ratio.

Required:
Prepare the necessary journal entries to record the admission of Mann in each of the following independent situations:

A. Mann invests $300,000 for a one-fourth capital interest, but will not accept a capital balance of less than his investment.

B. Mann invests $150,000 for a one-fifth capital interest. The partners agree that assets and the firm as a whole should be revalued.

C. Mann purchases a 20% capital interest from each partner. Dell receives $100,000 and Gore receives $50,000 directly from Mann.

15-3 Bryant, Milton, and Pine formed a partnership and agreed to share profits in a 3:1:2 ratio after recognition of 5% interest on average capital balances and monthly salary allowances of $3,750 to Milton and $3,000 to Pine. Average capital balances were as follows:

Bryant 300,000
Milton 240,000
Pine 180,000

Required:
Compute the net income (loss) allocated to each partner assuming the partnership incurred a $27,000 net loss.

15-4 Rice and Thome formed a partnership on January 2, 2011. Thome invested $120,000 in cash. Rice invested land valued at $30,000, which he had purchased for $20,000 in 2005. In addition, Rice possessed superior managerial skills and agreed to manage the firm. The partners agreed to the following profit and loss allocation formula:
a. Interest —8% on original capital investments.
b. Salary — $5,000 a month to Rice.
c. Bonus — Rice is to be allocated a bonus of 20% of net income after subtracting the bonus, interest, and salary.
d. Remaining profit is to be divided equally.

At the end of 2011 the partnership reported net income before interest, salaries, and bonus of $168,000.

Required:
Calculate the amount of bonus to be allocated to Rice.

15-5 Wynn and Yates are partners whose capital balances are $400,000 and $300,000 and who share profits 3:2. Due to a shortage of cash, Wynn and Yates agree to admit Zaun to the firm.

Required:
Prepare the journal entries required to record Zaun’s admission under each of the following assumptions:
(a) Zaun invests $200,000 for a 1/4 interest. The total firm capital is to be $900,000.
(b) Zaun invests $300,000 for a 1/4 interest. Goodwill is to be recorded.
(c) Zaun invests $150,000 for a 1/5 interest. Goodwill is to be recorded.
(d) Zaun purchases a 1/4 interest in the firm, with 1/4 of the capital of each old partner transferred to the account of the new partner. Zaun pays the partners cash of $250,000, which they divide between themselves.

15-6 The partners in the ABC partnership have capital balances as follows:
A. $70,000; B. $70,000 C. $105,000

Profits and losses are shared 30%, 20%, and 50%, respectively.

On this date, C withdraws and the partners agree to pay him $140,000 out of partnership cash.

Required:
A. Prepare journal entries to show three acceptable methods of recording the withdrawal. (Tangible assets are already stated at values approximating their fair market values.)

B. Which alternative would you recommend if you determined that the agreement to pay C $140,000 was not the result of arms length bargaining between C and the other partners? Why?

15-7 Agler, Bates and Colter are partners who share income in a 5:3:2 ratio. Colter, whose capital balance is $150,000, retires from the partnership.

Required:
Determine the amount paid to Colter under each of the following cases:

(1) $50,000 is debited to Agler capital account; the bonus approach is used.
(2) Goodwill of $60,000 is recorded; the partial goodwill approach is used.
(3) $66,000 is credited to Bates’ capital account; the total goodwill approach is used.

15-8 The partnership agreement of Stone, Miles, and Kiney provides for annual distribution of profit and loss in the following sequence:
– Miles, the managing partner, receives a bonus of 10% of net income.
– Each partner receives 5% interest on average capital investment.
– Residual profit or loss is to be divided 4:2:4.

Average capital investments for 2011 were:

Stone $270,000
Miles $180,000
Kiney $120,000

Required:
A. Prepare a schedule to allocate net income, assuming operations for the year resulted in:
1. Net income of $75,000.
2. Net income of $15,000.
3. Net loss of $30,000.

B. Prepare the journal entry to close the Income Summary account for each situation above.

Short Answer
1. The principal types of partnerships are general partnerships, limited partnerships, and joint ventures. Describe the characteristics of each type of partnership.
2. There are two methods of recording changes in the membership of a partnership – the bonus method and the goodwill method. Describe these two methods of recording changes in partnership membership.

Short Answer from the Textbook
1. Describe the tax treatment of partnership income.

2. Distinguish between a partner’s interest in capital and his interest in the partnership’s income and losses. Also, make a general distinction between a partner’s capital account and his drawing account.

3. Explain why a partnership is viewed in accounting as a “separate economic entity.”

4. What are some of the methods commonly used in allocating income and losses to the partners?

5. Explain the distinction between the terms “withdrawals” and “salaries.”

6. List some of the alternative methods of calculating a bonus that may appear in a partnership agreement.

7. What is meant by dissolution and what are its causes?

8. Discuss the methods used to record changes in partnership membership.

9. Differentiate between the admission of a new partner through assignment of an interest andthrough investment in the partnership.

10.Under what two conditions will the bonus and goodwill methods of recording the admission ofa partner yield the same result?

11.Describe the circumstances where neither the goodwill nor the bonus method should be used to record the admission of a new partner.

12.How might a partner withdrawing in violation of the partnership agreement and without the con-sent of the other partners be treated? What about a partner who is forced to withdraw?

Business Ethics Question from Textbook
Many companies with defined benefit plans are curtailing or eliminating the plans altogether. With a defined benefit plan, the company guarantees some set amount(or formula-determined payment) when the employee retires. Because most pension assets are invested in the stock market, whether a pension plan is fully funded of-ten depends on the strength of the stock market. Be-cause of this volatility, companies often find themselves unexpectedly in a position where they must either in-crease funding or disclose significant underfunding. Because of this, many companies simply reduce or eliminate the plan. Consider the pension plan of Golden Years Company (GYC). Historically, GYC has been a great company to work for, with strong employee benefits. GYC’s pension liability is approximately $15 million. However, recently the company has been experiencing minor financial troubles in a decreasing stock market and, consequently, announced the termination of the pension plan in an effort to save costs. However, the pension plan was fully funded by$9 million (the fair value of assets exceeded the expected liability).

1.How does the firm reconcile the trade-off between financial performance and the responsibility to its employees?

ANSWER KEY (Chapter 15)

Chapter 16

Partnership Liquidation

Multiple Choice

1. Which of the following statements is correct?
1. Personal creditors have first claim on partnership assets.
2. Partnership creditors have first claim on partnership assets.
3. Partnership creditors have first claim on personal assets.
a. 1
b. 2
c. 3
d. Both 2 and 3

2. The first step in the liquidation process is to
a. convert noncash assets into cash.
b. pay partnership creditors
c. compute any net income (loss) up to the date of dissolution.
d. allocate any gains or losses to the partners.

3. A schedule prepared each time cash is to be distributed is called a(n)
a. advance cash distribution schedule.
b. marshaling of assets schedule.
c. loss absorption potential schedule.
d. safe payment schedule.

4. An advance cash distribution plan is prepared
a. each time cash is distributed to partners in an installment liquidation.
b. each time a partnership asset is sold in an installment liquidation.
c. to determine the order and amount of cash each partner will receive as it becomes available for distribution.
d. none of these.

5. The first step in preparing an advance cash distribution plan is to
a. determine the order in which partners are to participate in cash distributions.
b. compute the amount of cash each partner is to receive as it becomes available for distribution.
c. allocate any gains (losses) to the partners in their profit-sharing ratio.
d. determine the net capital interest of each partner.

6. Offsetting a partner’s loan balance against his debit capital balance is referred to as the
a. marshaling of assets.
b. right of offset.
c. allocation of assets.
d. liquidation of assets.

7. If a partner with a debit capital balance during liquidation is personally solvent, the
a. partner must invest additional assets in the partnership.
b. partner’s debit balance will be allocated to the other partners.
c. other partners will give the partner enough cash to absorb the debit balance.
d. partnership will loan the partner enough cash to absorb the debit balance.

8. The following condensed balance sheet is presented for the partnership of Jim, Bill, and Fred who share profits and losses in the ratio of 4:3:3, respectively:

Cash $ 180,000
Other assets 1,940,000
Jim, receivable 60,000
$ 2,180,000

Accounts payable $ 480,000
Bill, loan 80,000
Jim, capital 720,000
Bill, capital 440,000
Fred, capital 460,000
$2,180,000

Assume that the assets and liabilities are fairly valued on the balance sheet and that the partnership decides to admit Tom as a new partner, with a 25% interest. No goodwill or bonus is to be recorded. How much should Tom contribute in cash or other assets?
a. $270,000
b. $405,000
c. $540,000
d. $520,000

9. The partnership of Joe, Al, and Mike shares profits and losses 60%, 30%, and 10%, respectively. On January 1, 2011, the partners voted to dissolve the partnership, at which time the assets, liabilities, and capital balances were as follows:

Assets Liabilities and Capital
Cash $ 400,000 Accounts Payable $ 580,000
Other Assets 1,200,000 Joe, Capital 440,000
Al, Capital 380,000
Mike, Capital 200,000
Total assets $1,600,000 Total liabilities $1,600,000

All of the partners are personally insolvent.

Assume that all noncash assets are sold for $840,000 and all available cash is distributed in final liquidation of the partnership. Cash should be distributed to the partners as follows
a. Joe, $744,000; Al, $372,000; Mike, $124,000.
b. Joe, $440,000; Al, $380,000; Mike, $200,000.
c. Joe, $224,000; Al, $272,000; Mike, $164,000.
d. Joe, $396,000; Al, $198,000; Mike, $66,000.

10. The partnership of Pratt, Ellis, and Mack share profits and losses in the ratio of 4:4:2, respectively. The partners voted to dissolve the partnership when its assets, liabilities, and capital were as follows:
Assets
Cash $ 250,000
Other assets 1,000,000
$1,250,000

Liabilities and Capital
Liabilities $ 200,000
Pratt, Capital 300,000
Ellis, Capital 350,000
Mack, Capital 400,000
$1,250,000

The partnership will be liquidated over a prolonged period of time. As cash is available, it will be distributed to the partners. The first sale of noncash assets having a book value of $600,000 realized $475,000. How much cash should be distributed to each partner after this sale?
a. Pratt, $90,000; Ellis, $140,000; Mack, $295,000
b. Pratt, $210,000; Ellis, $290,000; Mack, $145,000
c. Pratt, $290,000; Ellis, $210,000; Mack, $105,000
d. Pratt, $150,000; Ellis, $175,000; Mack, $200,000

11. In a partnership liquidation, the final cash distribution to the partners should be made in accordance with the:
a. partners’ profit and loss sharing ratio.
b. balances of the partners’ capital accounts.
c. ratio of the capital contributions by the partners.
d. ratio of capital contributions less withdrawals by the partners.

12. In an advance plan for installment distributions of cash to partners of a liquidating partnership, each partner’s loss absorption potential is computed by
a. dividing each partner’s capital account balance by the percentage of that partner’s capital account balance to total partners’ capital.
b. multiplying each partner’s capital account balance by the percentage of that partner’s capital account balance to total partners’ capital.
c. dividing the total of each partner’s capital account less receivables from the partner plus payables to the partner by the partner’s profit and loss percentage.
d. some other method.

13. Under the Uniform Partnership Act
a. partnership creditors have first claim (Rank I) against the assets of an insolvent partnership.
b. personal creditors of an individual partner have first claim (Rank I) against the personal assets of all partners.
c. partners with credit capital balances share (Rank I) the personal assets of an insolvent partner that has a debit capital balance with personal creditors of that partner.
d. personal creditors of the partners of an insolvent partnership share partnership assets on a pro rata basis (Rank I) with partnership creditors.

14. During the liquidation of the partnership of Karr, Rice, and Long. Karr accepts, in partial settlement of his interest, a machine with a cost to the partnership of $150,000, accumulated depreciation of $70,000, and a current fair value of $110,000. The partners share net income and loss equally. The net debit to Karr’s account (including any gain or loss on disposal of the machine) is
a. $90,000.
b. $100,000.
c. $110,000.
d. $150,000.

15. X, Y, and Z have capital balances of $90,000, $60,000, and $30,000, respectively. Profits are allocated 35% to X, 35% to Y, and 30% to Z. The partners have decided to dissolve and liquidate the partnership. After paying all creditors, the amount available for distribution is $60,000. X, Y, and Z are all personally solvent. Under the circumstances, Z will
a. receive $18,000.
b. receive $30,000.
c. personally have to contribute an additional $6,000.
d. personally have to contribute an additional $36,000.

16. The ABC partnership has the following capital accounts on its books at December 31, 2011:
Credit
A, Capital $400,000
B, Capital 240,000
C, Capital 80,000
All liabilities have been liquidated and the cash balance is zero. None of the partners have personal assets in excess of his personal liabilities. The partners share profits and losses in the ratio of 3:2:5. If the noncash assets are sold for $400,000, the partners should receive as a final payment:
a. A, $304,000; B, $176,000; C, $80,000
b. A, $256,000; B, $144,000; C, $-0-
c. A, $304,000; B, $176,000; C, $-0-
d. A, $120,000; B, $80,000; C, $200,000

17. The summarized balances of the accounts of MNO partnership on December 31, 2011, are as follows:

Assets Liabilities and Capital
Cash $ 15,000 Liabilities $ 15,000
Noncash 90,000 M, Capital 45,000
N, Capital 30,000
O, Capital 15,000
Total Assets $105,000 Total Equities $105,000

The agreed upon profit/loss ratio is 50:40:10, respectively. Using the information given above, which one of the following amounts, if any, is the loss absorption potential of partner N as of December 31, 2011?
a. $20,000
b. $35,000
c. $75,000
d. $120,000

18. Adamle, Boyer, and Clay are partners with a profit and loss ratio of 4:3:3. The partnership was liquidated and, prior to the liquidation process, the partnership balance sheet was as follows:

ADAMLE, BOYER, AND CLAY
Balance Sheet
January 1, 2011

Assets Liabilities and Equity
Cash $ 60,000 Adamle, Capital $216,000
Other assets 540,000 Boyer, Capital 240,000
Clay, Capital 144,000
Total Assets $600,000 Total Liabilities & Equities $600,000

After the partnership was liquidated and the cash was distributed, Boyer received $96,000 in cash in full settlement of his interest.

The liquidation loss must have been:
a. $360,000
b. $144,000
c. $504,000
d. $480,000

19. The partnership of Hall, Jones, and Otto has been dissolved and is in the process of liquidation. On July 1, 2011, just before the second cash distribution, the assets and equities of the partnership along with residual profit sharing ratios were as follows:

Assets Liabilities & Equities
Cash $ 200,000 Liabilities $ 150,000
Receivables-net 50,000 Hall, Capital 50% 100,000
Inventories 150,000 Jones, Capital 30% 175,000
Equipment-net 100,000 Otto, Capital 20% 75,000
Total assets $ 500,000 Total Lia & Equity 500,000

Assume that the available cash is distributed immediately, except for a $25,000 contingency fund that is withheld pending complete liquidation of the partnership. How much cash should be paid to each of the partners?

Hall Jones Otto
a. $87,500 $52,500 $35,000
b. 12,500 7,500 10,000
c. – 0 – 25,000 – 0 –
d. – 0 – 15,000 10,000

20. The partnership of Hall, Jones, and Otto has been dissolved and is in the process of liquidation. On July 1, 2011, just before the second cash distribution, the assets and equities of the partnership along with residual profit sharing ratios were as follows:

Assets Liabilities & Equities
Cash $ 200,000 Liabilities $ 150,000
Receivables-net 50,000 Hall, Capital 50% 100,000
Inventories 150,000 Jones, Capital 30% 175,000
Equipment-net 100,000 Otto, Capital 20% 75,000
Total assets $ 500,000 Total Lia & Equity 500,000

Assume that Hall takes equipment with a fair value of $40,000 and a book value of $50,000 in partial satisfaction of his equity in the partnership. If all the $200,000 cash is then distributed, the partners should receive:
Hall Jones Otto
a. $100,000 $60,000 $40,000
b. 25,000 15,000 10,000
c. – 0 45,000 5,000
d. – 0 50,000 – 0

21. The partnership of Starr, Foley, and Pele share profits and losses in the ratio of 4:4:2, respectively. The partners voted to dissolve the partnership when its assets, liabilities, and capital were as follows:

Assets Liabilities and Equity
Cash $150,000 Liabilities $120,000
Other assets 600,000 Starr, Capital 180,000
Foley, Capital 210,000
Pele, Capital 240,000
Total assets $750,000 Total Lia & Equity $750,000

The partnership will be liquidated over a prolonged period of time. As cash is available, it will be distributed to the partners. The first sale of noncash assets having a book value of $360,000 realized $285,000. How much cash should be distributed to each partner after this sale?
a. Starr, $54,000; Foley, $84,000; Pele, $177,000.
b. Starr, $174,000; Foley, $174,000; Pele, $87,000.
c. Starr, $126,000; Foley, $126,000; Pele, $63,000.
d. Starr, $90,000; Foley, $105,000; Pele, $120,000.

22. A, B, and C have capital balances of $90,000, $60,000, and $30,000, respectively. Profits are allocated 35% to A, 35% to B and 30% to C. The partners have decided to dissolve and liquidate the partnership. After paying all creditors the amount available for distribution is $60,000. A, B, and C are all personally solvent. Under the circumstances, C will
a. receive $18,000.
b. receive $30,000.
c. personally have to contribute an additional $6,000.
d. personally have to contribute an additional $36,000.

23. The ABC partnership has the following capital accounts on its books at December 31, 2011:

Credit
A, Capital $200,000
B, Capital 120,000
C, Capital 40,000

All liabilities have been liquidated and the cash balance is zero. None of the partners have personal assets in excess of his personal liabilities. The partners share profits and losses in the ratio of 3:2:5. If the noncash assets are sold for $150,000, the partners should receive as a final payment:
a. A, $152,000; B, $88,000 C, $40,000
b. A, $128,000; B, $72,000; C, $ – 0 –
c. A, $152,000; B, $88,000; C, $ – 0 –
d. A, $60,000; B, $40,000; C, $100,000

24. The summarized balances of the accounts of RST partnership on December 31, 2011, are as follows:
Assets Liabilities and Equity
Cash $ 30,000 Liabilities $ 30,000
Noncash 180,000 R, Capital 90,000
S, Capital 60,000
T, Capital 30,000
Total Assets $210,000 Total Lia & Equities $210,000

The agreed upon profit/loss ratio is 50:40:10, respectively. Using the information given above, which one of the following amounts, if any, is the loss absorption potential of partner S as of December 31, 2011?
a. $60,000
b. $70,000
c. $150,000
d. $240,000

25. The partnership of Hill, Kiner, and Polk has been dissolved and is in the process of liquidation. On July 1, 2011, just before the second cash distribution, the assets and equities of the partnership along with residual profit sharing ratios were as follows:
Assets Liabilities and Equity
Cash $ 80,000 Liabilities $ 60,000
Receivables-net 20,000 Hill, Capital 50% 40,000
Inventories 60,000 Kiner, Capital 30% 70,000
Equipment-net 40,000 Polk, Capital 20% 30,000
Total assets $200,000 Total Lia & Equity $200,000

Assume that the available cash is distributed immediately, except for a $10,000 contingency fund that is withheld pending complete liquidation of the partnership. How much cash should be paid to each of the partners?
Hill Kiner Polk
a. $35,000 $21,000 $14,000
b. $5,000 $3,000 $4,000
c. $0 $10,000 $0
d. $0 $6,000 $4,000

Problems

16-1 The NOR Partnership is being liquidated. A balance sheet prepared prior to liquidation is presented below:

Assets Liabilities & Equities
Cash $240,000 Liabilities $ 160,000
Other Assets 300,000 Reese, Loan 60,000
Nen, Capital 180,000
Ott, Capital 60,000
Reese, Capital 80,000
Total Assets $540,000 Total Equities $540,000

Nen, Ott, and Reese share profits and losses in a 40:40:20 ratio. All partners are personally insolvent.

Required:
A. Prepare the journal entries necessary to record the distribution of the available cash.

B. Prepare the journal entries necessary to record the completion of the liquidation process, assuming the other assets are sold for $120,000.

16-2 The trial balance for the ABC Partnership is as follows just before liquidation:

OTHER BALL ADLER BALL CARL
CASH ASSETS RECEIVABLE = LIABILITIES CAPITAL CAPITAL CAPITAL
180,000 625,000 90,000 150,000 420,000 270,000 180,000

Partners share profits a 50:30:20 ratio.

Required:
Prepare an advance cash distribution plan showing how available cash would be distributed.

16-3 Lewis, Nance, and Otis operate the LNO Partnership. The partnership agreement provides that the partners share profits in the ratio of 40:40:20, respectively. Unable to satisfy the firm’s debts, the partners decide to liquidate. Account balances just prior to the start of the liquidation process are as follows:
Debit Credit
Cash $ 90,000
Other Assets 330,000
Liabilities $165,000
Otis, Loan 36,000
Lewis, Capital 165,000
Nance, Capital 36,000
Otis, Capital 39,000
Otis, Drawing 21,000 _______
Totals $441,000 $441,000

During the first month of liquidation, other assets with a book value of $150,000 are sold for $165,000, and creditors are paid. In the following month unrecorded liabilities of $12,000 are discovered and assets carried on the books at a cost of $90,000 are sold for $36,000. During the third month the remaining other assets are sold for $42,000 and all available cash is distributed.

Required:
Prepare a schedule of partnership realization and liquidation. A safe distribution of cash is to be made at the end of the second and third months. The partners agreed to hold $30,000 in cash in reserve to provide for possible liquidation expenses and/or unrecorded liabilities. All of the partners are personally insolvent.

16-4 Due to the fact that the partnership had been unprofitable for the past several years, A, B, C, and D decided to liquidate their partnership. The partners share profits and losses in the ratio of 40:30:20:10, respectively. The following balance sheet was prepared immediately before the liquidation process began:

A B C D Partnership
Balance Sheet

Cash $ 100,000 Liabilities $250,000
Other Assets 350,000 A, Capital 55,000
B, Capital 60,000
C, Capital 50,000
D, Capital 35,000
Total Assets $450,000 Total Lia & Equities $450,000

The personal status of each partner is as follows:
Personal Personal
_Assets_ Liabilities
A $165,000 $ 120,000
B 100,000 140,000
C 180,000 160,000
D 60,000 70,000

The partnership’s other assets are sold for $100,000 cash. The partnership operates in a state which has adopted the Uniform Partnership Act.

Required:
A. Complete the following schedule of partnership realization and liquidation. Assume that a partner makes additional contributions to the partnership when appropriate based on their individual status.

OTHER CAPITAL
CASH ASSETS LIABILITIES __A__ __B__ __C__ __D__
$100,000 $350,000 $250,000 55,000 60,000 50,000 35,000

B. Complete the following schedule to show the total amount that will be paid to the personal creditors.

From Distribution Total Paid
Personal from to Personal
_Assets_ _Partnership_ _Creditors_
A
B
C
D

16-5 A trial balance for the DEF partnership just prior to liquidation is given below:

Debit Credit
Cash $ 75,000
Noncash Assets 750,000
Nonpartner Liabilities $240,000
Dugan, Loan 75,000
Dugan, Capital 225,000
Elston, Capital 153,000
Flynn, Capital 132,000
Totals $825,000 $825,000

The partners share income and loss on the following basis:
Dugan 50%
Elston 30%
Flynn 20%

Required:
Prepare an advance cash distribution plan for the partners.

16-6 David, Paul, and Burt are partners in a CPA firm sharing profits and losses in a ratio of 2:2:3, respectively. Immediately prior to liquidation, the following balance sheet was prepared:

Assets Liabilities & Equities
Cash $ 100,000 Liabilities $280,000
Noncash assets 580,000 David, Capital 160,000
Paul, Capital 160,000
_______ Burt, Capital 80,000
Total Assets $680,000 Total Liabilities & Equities $680,000

Required:
Assuming the noncash assets are sold for $300,000, determine the amount of cash to be distributed to each partner. Complete the worksheet and clearly indicate the amount of cash to be distributed to each partner in the spaces provided. No cash is available from any of the three partners.

A. Noncash David Paul Burt
Cash Assets Liabilities Capital Capital Capital
Beginning Bal. 100,000 580,000 280,000 160,000 160,000 80,000

16-7 Using the information from Problem 16-6, assume the noncash assets are sold for $160,000. Determine the amount of cash to be distributed to each partner assuming all partners are personally solvent.

16-8 The December 31, 2010, balance sheet of the Deng, Danielson, and Gibson partnership, along with the partners’ residual profit and loss sharing ratios, is summarized as follows:

Assets Liabilities & Equities
Cash $ 150,000 Accounts Payable $ 225,000
Receivables 300,000 Loan from Danielson 50,000
Inventories 375,000 Deng, Capital (20%) 250,000
Other Assets 475,000 Danielson, Capital (30%) 400,000
Gibson, Capital (50%) 375,000
Total Assets $1,300,000 Total Lia & Equities $1,300,000

The partners agree to liquidate their partnership as soon as possible after January 1, 2011 and to distribute all cash as it becomes available.

Required:
Prepare an advance cash distribution plan to show how cash will be distributed as it becomes available.

Section .01 Short Answer

1. The Uniform Partnership Act specifies specific steps in distributing available partnership assets in liquidation. Describe the steps used to distribute partnership assets during the liquidation process.

2. An advance cash distribution plan specifies the order in which each partner will receive cash and the dollar amount each will receive as it becomes available for distribution. Identify the four steps in the preparation of an advance cash distribution plan.

Short Answer Questions from the Textbook

1. Why are realization gains or losses allocated to partners in their profit and loss ratios?

2. In what manner should the final cash distribution be made in partnership liquidation?

3. Why does a debit balance in a partners’ capital account create problems in the UPA order of payment for a partnership liquidation?

4. Is it important to maintain separate accounts for a partner’s outstanding loan and capital ac-counts? Explain why or why not.

5. Discuss the possible outcomes in the situation where the equity interest of one partner is inadequate to absorb realization losses.

6. During a liquidation, at which point may cash be distributed to any of the partners?

7. What is “marshaling of assets”?

8. To what extent can personal creditors seek re-covery from partnership assets?

9. In an installment liquidation, why should the partners view each cash distribution as if it were the final distribution?

10. Discuss the three basic assumptions necessary for calculating a safe cash distribution. How is this safe cash distribution computed?

11. How are unexpected costs such as liquidation expenses, disposal costs, or unrecorded liabilities covered in the safe distribution schedule?

12. What is the objective of the procedures used for the preparation of an advance cash distribution plan?

13. What is the “loss absorption potential”?

14. In what order must partnership assets be distributed?

Business Ethics Question from the Textbook
You and two of your former college friends, Freeman and Oxyman, formed a partnership called FOB, which builds and installs fabricated swimming pools. The business has been operating for 15 years and has become one of the top swimming pool companies in the area. Typically, you have been providing the on-site estimates for the pools, while your partners do most of the onsite construction. While visiting one of the sites, you hear a conversation between one of your partners and a customer. Your partner is explaining that the cost will increase by $10,000 because of unexpected rock removal. You are a bit surprised by this, since you had tested the area for rocks. Later, back at the office, you review the core-sample results done on that job, which did not reveal any rock. You decide to talk to the partner when he returns to the office. When the partner returns to the office, he is arguing with someone from a local bank concerning an outstanding personal loan.
1.What do you see as your duty with respect to the partnership?

2.What should you do? Explain your reasoning.

ANSWER KEY (Chapter 16)

Chapter 17

Introduction to Fund Accounting

Multiple Choice

1. Governmental units include all of the following except
a. counties.
b. school districts.
c. industrial development districts.
d. voluntary health and welfare organizations.

2. Which type of fund entities are used to account for the activities of nonbusiness organizations that are similar to those of business enterprises?
a. Expendable fund entities
b. Proprietary fund entities
c. Budgetary fund entities
d. Restricted fund entities

3. When budgeted expenditures are enacted into law, they are referred to as
a. estimated expenditures.
b. encumbrances.
c. appropriations.
d. expenditures.

4. The term used to describe the application of accounting to expendable fund entities is the
a. accrual method.
b. cash method.
c. modified cash method.
d. modified accrual method.

5. The entry to close appropriations, expenditures, and encumbrances accounts includes a debit to
a. Appropriations.
b. Expenditures.
c. Encumbrances.
d. both Appropriations and Encumbrances.

6. The entry to record the receipt of office equipment previously encumbered includes a debit to
a. Office Equipment.
b. Encumbrances.
c. Reserve for Encumbrances.
d. both Office Equipment and Reserve for Encumbrances.

7. In accounting for and reporting inventory in the financial statements, the “Reserve for Inventory” account is used under
a. the consumption method.
b. the purchase method.
c. both the consumption and purchase methods.
d. none of these.

8. The two basic statements prepared for expendable fund entities are a balance sheet and a(n)
a. income statement.
b. statement of revenue.
c. statement of expenditures and encumbrances.
d. none of these.

9. If a credit was made to the fund balance in the process of recording a budget for a governmental unit, it can be assumed that
a. estimated expenses exceed actual revenues.
b. actual expenses exceed estimated expenses.
c. estimated revenues exceed appropriations.
d. appropriations exceed estimated revenues.

10. The “reserve for encumbrances—prior year” account represents amounts recorded by a governmental unit for
a. anticipated expenditures in the next year.
b. expenditures for which purchase orders were made in the prior year but disbursement will be in the current year.
c. excess expenditures in the prior year that will be offset against the current-year budgeted amounts.
d. unanticipated expenditures of the prior year that become evident in the current year.

11. Which of the following requires the use of the encumbrance system?
a. Capital projects fund
b. Debt service fund
c. Internal service fund
d. Enterprise fund

12. The following related entries were recorded in sequence in the general fund of a municipality:

1. Encumbrances 15,000
Reserve for Encumbrances 15,000

2. Reserve for Encumbrances 15,000
Encumbrances 15,000

3. Expenditures 15,350
Vouchers Payable 15,350

The sequence of entries indicates that
a. an adverse event was foreseen and a reserve of $15,000 was created; later the reserve was cancelled and a liability for the item was acknowledged.
b. an order was placed for goods or services estimated to cost $15,000; the actual cost was $15,350 for which a liability was acknowledged upon receipt.
c. encumbrances were anticipated but later failed to materialize and were reversed. A liability of $15,350 was incurred.
d. the first entry was erroneous and was reversed; a liability of $15,350 was acknowledged.

13. The reserve for encumbrances account is properly considered to be a
a. current liability if payable within a year; otherwise, long-term debt.
b. fixed liability.
c. floating debt.
d. reservation of the fund’s equity.

14. Customers’ meter deposits which cannot be spent for normal operating purposes would be classified as restricted cash in the balance sheet of which fund?
a. Internal Service
b. Trust
c. Agency
d. Enterprise

15. What journal entry should be made at the end of the fiscal year to close out encumbrances for which goods and services have not been received?
a. Debit reserve for encumbrance and credit encumbrances.
b. Debit reserve for encumbrances and credit fund balance.
c. Debit fund balance and credit encumbrances.
d. Debit encumbrances and credit reserve for encumbrances.

16. The GASB has the responsibility for establishing financial accounting standards for all of the following entities except:
a. state and local government entities.
b. veterans hospitals.
c. school districts.
d. civic organizations.

17. The expendable fund entity’s measurement focus is on:
a. the flow of current financial resources.
b. the flow of economic resources.
c. the flow of revenue, expenses, and net income.
d. none of the above.

18. Under GASB Statement No. 34, a government-wide financial statement should include a:
a. statement of revenues & expenses.
b. statement of activities.
c. statement of financial position.
d. notes to the financial statements.

19. In accounting for expendable fund entities, revenue is ordinarily not recognized until:
a. it can be objectively measured and it is available to finance expenditures of the current period.
b. a transaction has taken place and the earnings process is complete.
c. it has been received in cash.
d. none of the above.

20. The Expenditures account of a governmental unit is debited when:
a. the budget is recorded.
b. supplies are ordered.
c. supplies encumbered are received.
d. the supplies invoice is paid.

Problems

17-1 During 2011, the City of Paola was involved in the following transactions:

1. A budget consisting of estimated revenues of $1,500,000 and appropriations for expenditures of $1,550,000 was approved by the city council.

2. Statements of property tax assessments totaling $1,100,000 were mailed to property owners. Experience indicates that 2% of assessed taxes will be uncollectible.

3. Equipment costing $85,000 was purchased, and old equipment was sold for $15,000 at the end of its estimated useful life.

4. The city manager signed a contract to purchase a machine costing $25,000.

5. The city received a statement from the state indicating that the city’s portion of the state sales tax is $50,000.

6. The machine ordered in (4) above is delivered and accepted. The invoice in the amount of $26,000 was approved for payment.

Required:
Prepare the journal entries needed to account for the preceding transactions.

17-2 On December 31, 2011, the following account balances, among others, were included in the preclosing trial balance of the General Fund of the City of Ottawa.

Estimated Revenue $2,960,000
Expenditures 1,950,000
Encumbrances 530,000
Expenditures—2010 300,000
Reserve for Encumbrances (1) 830,000
Appropriations 2,850,000
Revenue 3,220,000
Reserve for Supplies Inventory (2) 600,000
Supplies Inventory 600,000
Unreserved Fund Balance 300,000

(1) The balance in this account was $270,000 on January 1, 2011. Purchase orders outstanding on December 2011 total $530,000.

(2) Supplies on hand on December 31, 2011, amount to $380,000.

Required:
1. What was the balance in the Unreserved Fund Balance account on December 31, 2010? What was the total Fund Balance on December 31, 2010?
2. Prepare the necessary adjusting and closing entries for the year ended December 31, 2011. Ottawa uses the purchase method to account for supplies.

17-3 The trial balance for the General Fund of the City of Girard as of December 31, 2010, is presented below:
CITY OF GIRARD
The General Fund
Adjusted Trial Balance
December 31, 2010

Debit Credit
Cash $216,000
Property Tax Receivable 31,000
Estimated Uncollectible Taxes $ 80,000
Due from Trust Fund 41,000
Vouchers Payable 55,000
Reserve for Encumbrances 20,000
Unreserved Fund Balance 205,000
$288,000 $288,000

Transactions for the year ended December 31, 2011 are summarized as follows:

1. The City Council adopted a budget for the year with estimated revenue of $720,000 and appropriations of $710,000.

2. Property taxes in the amount of $495,000 were levied for the current year. It is estimated that $20,000 of the taxes levied will prove to be uncollectible.

3. Proceeds from the sale of equipment in the amount of $32,000 were received by the General Fund. The equipment was purchased four years ago with resources of the General Fund at a cost of $200,000. On the date it was purchased, it was estimated that the equipment had a useful life of six years.

4. Licenses and fees in the amount of $90,000 were collected.

5. The total amount of encumbrances against fund resources for the year was $595,000.

6. Vouchers in the amount of $445,000 were authorized for payment. This was $11,000 less than the amount originally encumbered for these purchases.

7. An invoice in the amount of $19,000 was received for goods ordered in 2010. The invoice was approved for payment.

8. Property taxes in the amount of $425,000 were collected.

9. Vouchers in the amount of $385,000 were paid.

10. Forty-one thousand dollars was transferred to the General Fund from the Trust Fund.

11. The City Council authorized the write-off of $15,000 in uncollected property taxes.

Required:
1. Prepare entries, in general journal form, to record the transactions for the year ended December 31, 2011.
2. Prepare the necessary closing entries for the year ending December 31, 2011.

17-4 The following information regarding the fiscal year ended June 30, 2011, was drawn from the accounts and records of the Chase County general fund:

Revenues and other asset inflows:
Property taxes $6,000,000
Licenses and permits 750,000
State grants 150,000
Collection of interfund advance to other fund 80,000
Proceeds from sale of equipment 40,000

Expenditures and other asset outflows:
General government $2,250,000
Public safety 1,130,000
Judicial system 600,000
Health 900,000
Equipment purchases 370,000
Payment to debt service fund to cover future debt
service on general government bonds 570,000
Total fund balance, July 1, 2010 $1,200,000

Required:
Prepare a statement of revenues, expenditures, and changes in fund balance for the Chase County general fund for the year ended June 30, 2011.

17-5 The unadjusted trial balance for the general fund of the City of Iola at June 30, 2011, is as follows:

Debits
Cash $170,000
Due from agency fund 25,000
Encumbrances 120,000
Estimated revenues 800,000
Expenditures 610,000
Property taxes receivable 110,000

Credits
Allowance for uncollectible taxes 8,000
Appropriations 790,000
Unreserved fund balance 30,000
Reserve for encumbrances 60,000
Revenues 840,000
Vouchers payable 107,000

Supplies on hand at June 30, 2011, totaled $8,000. The $120,000 encumbrance relates to equipment ordered but not received by fiscal year-end.

Required:
Prepare a balance sheet for the general fund of the City of Iola at June 30, 2011.

17-6 At the beginning of 2011, the City of Wichita reported an Unreserved Fund Balance of $890,000 and a supplies inventory balance of $280,000. During the year, Wichita purchased $360,000 in supplies and used $350,000 worth. The city will report a reserve for supplies inventory.

Required:
a. Prepare the journal entries needed to account for the supplies under the consumption method.
b. Prepare the necessary journal entries under the purchases method.
c. What would the December 31, 2011, balance in the Unreserved Fund Balance be under the consumption method, assuming that the only transactions of the fund are those involving the supplies?

17-7 The following account balances, among others, were included in the preclosing trial balance of the General Fund of the City of Baxter on December 31, 2011.

Appropriations $2,350,000
Cash 180,000
Due from Other Funds 170,000
Due to Other Funds 70,000
Encumbrances 250,000
Estimated Revenue 2,480,000
Expenditures 2,010,000
Expenditures – 2010 200,000
Reserve for Encumbrances 250,000
Reserve for Encumbrances – 2010 210,000
Revenue 2,400,000
Taxes Receivable 400,000
Transfers from Other Funds 250,000
Transfers to Other Funds 350,000
Unreserved Fund Balance 280,000
Vouchers Payable 270,000

Required:
a. Prepare the necessary closing entries on December 31, 2011.
b. Calculate the amount of both the unreserved fund balance and the total fund balance in the balance sheet (1) on December 31, 2010, and (2) on December 31, 2011.

Short Answer
1. Fund entities may be classified as expendable fund entities, fiduciary fund entities, and proprietary fund entities. Distinguish among expendable, fiduciary, and proprietary fund entities.

2. Expendable fund entities prepare closing entries at the end of each period just as business enterprises do. Describe the necessary closing entries for expendable funds.

Short Answer Questions from the Textbook

1. What characteristics distinguish nonbusiness organizations from profit-oriented enterprises?

2. Define a fund as the term is applied in accounting for the activities of governmental units and other nonbusiness organizations.

3. What is the significance of the “unreserved fundbalance” of an expendable fund entity?

4. What are the major classifications of increases and decreases in expendable fund resources?

5. What are the revenue-recognition criteria for expendable fund entities? How do these criteria differ from revenue-recognition criteria for profit-oriented enterprises?

6. Expenditures may be classified by function, activity, object, or organizational unit. Give an ex-ample of each classification for a municipality. Which classification is the most appropriate for
external financial reporting?

7. Distinguish between an appropriation, an en-cumbrance, an expenditure, and a disbursement.

8. Distinguish between an expense and an expenditure.

9. Explain and justify the difference between the treatment of estimated uncollectible taxes in fund accounting and the treatment of estimated bad debts in commercial accounting.

10. Explain the purposes of encumbrance accounting. Might encumbrance accounting be used by commercial enterprises?

11. Is the year-end balance in the Reserve for En-cumbrances account a liability? Explain.

12. What columns would you suggest for a subsidiary ledger account in order that it might be a subsidiary not only to the “appropriations” control account but also the “encumbrances” and the “expenditures” control accounts?

13. Why is depreciation on fixed assets not recorded in the records of expendable fund entities?

14. How does the adoption of a budget for a general fund entity differ from the adoption of a budget by a commercial unit?

15. Describe the principal financial statements used to report on the activities and status of expendable fund entities.

16. Why may it be difficult or impossible for a governmental unit to determine the total cost of performing a particular activity or function?

Business Ethics Question from the Textbook

At State College, where football has long reigned asking and fans are near fanatical in their attendance, the frenzy for football tickets has recently reached an all-time high. With requests for home game tickets at an unprecedented level, prices on everything from parking passes to hotel rooms to home rentals have soared beyond belief. Parking passes were going for $500 on eBay, and hotel rates have doubled—and in some cases nearly tripled—reaching as high as $650 per night at some hotels.
1. What are the moral or ethical issues in charging what people will pay for rooms and tickets to at-tend a State College football game?
2. Why not let the economic forces of supply and demand determine prices in our capitalistic system?

ANSWER KEY (Chapter 17)

Chapter 18

Introduction to Accounting for State and Local Governmental Units

Multiple Choice

1. The highest level of priority of pronouncements that a government entity should look to for accounting and reporting guidance is
a. GASB Technical Bulletins.
b. GASB Concepts Statements.
c. AICPA Industry Accounting Guides.
d. GASB Statements.

2. Which of the following funds would account for operations that are financed and operated in a manner similar to private business enterprises?
a. Debt Service Fund
b. Enterprise Fund
c. Internal Service Fund
d. Special Revenue Fund

3. All of the following are Governmental (Expendable) Fund Entities except the
a. Capital Projects Fund.
b. Debt Service Fund.
c. Internal Service Fund.
d. Special Revenue Fund.

4. The activities of a municipal airport should be accounted for in the
a. General Fund.
b. Internal Service Fund.
c. Special Revenue Fund.
d. Enterprise Fund.

5. Fixed assets and noncurrent liabilities are accounted for in the records of
a. governmental funds
b. expendable funds
c. proprietary funds
d. both governmental and expendable funds.

6. The liability for general obligation long-term debt is reported in the
a. Debt Service Fund.
b. Capital Projects Fund.
c. Enterprise Fund.
d. none of these.

7. The activities of a central computer facility should be accounted for in the
a. General Fund.
b. Internal Service Fund.
c. Enterprise Fund.
d. Capital Projects Fund.

8. Internal Service Fund billings to government departments for services rendered is an example of interfund
a. reimbursements.
b. transfers.
c. services provided and used.
d. loans.

9. A nonrecurring contribution from the General Fund to the Enterprise Fund is an example of an interfund
a. reimbursement.
b. transfer.
c. services provided and used.
d. loan.

10. For state and local government units, the full accrual basis of accounting should be used for what type of fund?
a. Special revenue
b. General
c. Debt service
d. Internal service

11. Encumbrances would not appear in which fund?
a. General
b. Enterprise
c. Capital projects
d. Special revenue

12. Which type of fund can be either expendable or nonexpendable?
a. Debt service
b. Enterprise
c. Trust
d. Special revenues

13. Which of the following funds frequently does not have a fund balance?
a. General fund
b. Agency fund
c. Special revenue fund
d. Capital projects fund

14. A city should record depreciation as an expense in its
a. general fund and enterprise fund.
b. internal service fund and general fund.
c. enterprise fund and internal service fund.
d. enterprise fund and capital projects fund.

15. Part of the general obligation bond proceeds from a new issuance was used to pay for the cost of a new city hall as soon as construction was completed. The remainder of the proceeds was transferred to repay the debt. Entries are needed to record these transactions in the
a. general fund and capital projects fund.
b. general fund and debt-service fund.
c. trust fund and debt-service fund.
d. debt-service fund and capital projects fund.

16. One of the differences between accounting for a governmental unit and a commercial unit is that a governmental unit should
a. not record depreciation expense in any of its funds.
b. always establish and maintain complete self-balancing accounts for each fund.
c. use only the cash basis of accounting.
d. use only the modified accrual basis of accounting.

17. When a truck is received by a governmental unit, it should be recorded in the General Fund as a(n)
a. appropriation.
b. encumbrance.
c. expenditure.
d. fixed asset.

18. Which of the following should be accrued as revenues by the general fund of a local government?
a. Sales tax held by the state which will be remitted to the local government
b. Parking meter revenues
c. Sales tax collected by merchants
d. Income taxes currently due

19. Which of the following funds of a governmental unit recognizes revenues and expenditures under the same basis of accounting as the general fund?
a. Debt service
b. Enterprise
c. Internal service
d. Nonexpendable trust

20. Repayments from the funds responsible for a particular expenditure to the funds that initially paid for them are interfund
a. loans.
b. services provided and used.
c. transfers.
d. reimbursements.

21. It is proper to recognize revenues or expenditures resulting from which of the following classifications of interfund activity?
a. Interfund loans and interfund transfers
b. Interfund services provided/used and interfund reimbursements
c. Interfund reimbursements and interfund loans
d. Interfund services provided/used and interfund transfers

22. Revenues of a special revenue fund of a governmental unit should be recognized in the period in which the
a. revenues become available and measurable.
b. revenues become available and appropriated.
c. revenues are billable.
d. cash is received.

23. What is the underlying reason a governmental unit uses separate funds to account for its transactions?
a. Governmental units are so large that it would be unduly cumbersome to account for all transactions as a single unit.
b. Because of the diverse nature of the services offered and legal provisions regarding activities of a governmental unit, it is necessary to segregate activities by functional nature.
c. Generally accepted accounting principles require that nonbusiness entities report on a funds basis.
d. Many activities carried on by governmental units are shortlived and their inclusion in a general set of accounts could cause undue probability of error and omission.

24. Which of the following is not a budgetary account?
e. Appropriations
f. Estimated Revenues
g. Encumbrances
h. Reserve for Encumbrances

25. An interfund transfer should be reported in a governmental fund operating statement as a(n):
a. due from (to) other funds
b. other financing source (use)
c. revenue or expenditure
d. none of the above

Problems

18-1 During 2010, the City of Lebo started a street paving project. The project is being financed by the proceeds from the issue of five-year, 6% special assessment bonds payable at a face value of $3,000,000. The bonds were issued July 1, 2010 at their par value. One-fifth of the principal plus interest is payable on June 30 of each year beginning June 30, 2011. Property owners are assessed to provide the funds to pay the principal and interest on the debt.

The following transactions occurred during 2010 and 2011:

1. The bonds for the paving of the streets were issued.

2. The street paving was completed at a cost of $3,000,000.

3. Property owners were assessed and billed for the first installment of principal and interest on the special assessment debt.

4. Assessments for the first installment of principal and interest on the special assessment debt were collected. The June 30, 2011, payment of principal and interest was made.

Required:
Prepare all journal entries for the preceding transactions that are necessary for the City of Lebo assuming:
A. The City of Lebo has not obligated itself in any manner to the holders of the special assessment bonds.
B. The City of Lebo has made a commitment to the holders of the special assessment bonds to assure the full payment of principal and interest on the due dates.

18-2 The following activities and transactions are typical of those which may affect the various funds used by a municipal government.

Required:
Prepare journal entries to record each transaction and identify the fund in which each entry is recorded.
1. The Zola City Council passed a resolution approving a general operating budget of $6,800,000 for the fiscal year. Total revenues are estimated at $5,800,000.

2. The Zola City Council passed an ordinance providing a property tax levy of $3.50 per $100 of assessed valuation for the fiscal year. Total property valuation in Zola City is $320,000,000. Property is assessed at 30% of current property valuation. Property tax bills are mailed to property owners. An estimated 5% will be uncollectible.

3. Kansas City sold a general obligation term bond issue for $1,000,000 at 104 to a major brokerage firm. The stated interest rate is 10%. Construction of a new Municipal Courts Building will be financed by the bond issue proceeds.

4. The premium on bond sale in (3) above is transferred to the Debt Service Fund.

5. At the end of fiscal year, the Zola City Council approves the write-off of $55,000 of uncollected taxes because of inability to locate the property owners.

6. The Kansas City Municipal Courts Building (3 above) is completed. Contracts and expenses total $1,190,000, and all have been paid and recorded in the Capital Projects Fund. Prepare entries to close this project and record the completion of the project in all other funds and/or account groups affected. Any balance in the Capital Projects Fund is to be applied to payment of interest and principal of the bond issue.

7. On March 1, Webb City issued 10% serial bonds at par to finance streetlights in an area recently incorporated in the city limits. The face amount of the bonds is $900,000; interest is payable annually, and bonds are to be retired in equal amounts over 6 years from collections from assessments against property affected. In case of default by the property owners, the bond principal will be paid by the city.
a. Record the issuance of the bonds on March 1 of the current year.
b. Record the payment to bondholders on March 1 of the next year.

8. The street lighting project in (7) above was completed on September 30 at a total cost of $840,000. Record summary entries for expenditure transactions from March 1 – September 30, and on completion of the project.

18-3 Prepare entries, in general journal form, to record the following transactions in the proper fund(s) and/or account group(s). Designate the fund or account group in which each entry is recorded.

1. Bond proceeds of $2,000,000 were received to be used in constructing a new City Jail. An equal amount is contributed from general revenues.

2. Serial bonds in the amount of $300,000 matured. Interest of $75,000 was paid on these and other serial bonds outstanding.

3. Insurance proceeds amounting to $19,000 were received as a result of the accidental destruction of a garbage truck costing $33,000. Accumulated depreciation on the truck was $21,000.

4. The City Parks Endowment Fund transferred $160,000 in expendable funds to the City Parks Special Revenue Fund.

5. Proceeds of $21,000 were received from the sale of equipment which had been purchased from general revenues at a cost of $100,000. Accumulated depreciation on the equipment was $75,000.

6. The City Power Company (an enterprise fund) issued a bill for $400,000 for electricity provided to municipal government buildings.

7. The City Power Company transferred excess funds of $90,000 to the General Fund.

8. A central data processing center was established by a contribution of $400,000 from the General Fund, a long-term loan of $130,000 from the City Parks Special Revenue Fund, and general obligation bond proceeds of $180,000.

9. The Data Processing Fund billed the General Fund $20,000 and the City Parks Special Revenue Fund $8,500 for data processing services.

10. The City Power Company received $7,000 as customer deposits during the year. The monies are to be held in trust until customers request that their services be discontinued and final bills are collected.

11. In order to retire general obligation term bonds when they become due, it is determined that the Debt Service Fund will require annual contributions of $40,000 and earnings in the current year of $3,000.

18-4 The general fund trial balance for Shawnee City held the following balances at June 30, 2011, just before closing entries were made:

Unreserved Fund Balance $ 2,000
Estimated Revenues 33,000
Revenues 27,250
Appropriations 28,000
Expenditures 26,200
Expenditures-Prior Year 1,200
Encumbrances 3,000
Operating Transfers In 6,000
Reserve for Encumbrances 3,000
Reserve for Encumbrances – Prior Year 1,500

Required:
Prepare the necessary closing entries.

18-5 The following schedule of capital assets was prepared for Pratt County.

Government Activities Beg. Balance Additions Retirements Ending Balance
Total Capital Assets $850,000 250,000 (185,000) $915,000
Less: Accumulated ( 500,000) ( 50,000) 150,000 ( 400,000)
Depreciation
Net Capital Assets $350,000 $200,000 ( 35,000) $515,000

All capital asset acquisitions were made in the capital projects fund and paid in cash. An asset was sold by the general fund for $40,000 cash.

Required:
Determine how the above information will be reflected on each of the following statements for the year 2011.
A. The governmental funds’ statement of revenues, expenditures, and changes in fund balances. List the governmental fund and then list the dollar amount within the appropriate heading on the statement (such as Revenues, Expenditures, or Other Financing Sources (Uses)).
B. The government-wide statement of net assets.
C. The government-wide statement of activities.

18-6 The following events take place:
1. Interest payments in the amount of $20,000 that are the responsibility of the Debt Service Fund are paid by the General Fund.
2. The Internal Service Fund bills the Special Revenue Fund $25,000 for services performed.
3. The Special Revenue Fund transfers $10,000 to the Internal Service Fund as a temporary loan.
4. The General Fund transfers $150,000 to start an Internal Service Fund.

Required:
Identify the interfund activity as a loan, services provided and used, interfund transfer, or interfund reimbursement and prepare entries in general journal form to record the transactions on the records of the fund involved.

18-7 The following transactions take place:
1. On January 1, the city issued 9% general obligation bonds with a face value of $4,000,000 payable in 10 years to finance the construction of city offices. Total proceeds were $4,500,000.
2. On December 20, construction was completed and occupancy taken of the city offices. The full cost of $3,900,000 was paid to the contractor, and appropriate closing entries were made with regard to the project.
3. The General Fund repaid the Special Revenue Fund a loan of $15,000 plus $900 in interest on the loan.

Required:
Prepare entries in general journal form to record these transactions in the proper fund(s). Designate the fund in which each entry is recorded.

Short Answer
1. There are eleven categories of government fund entities that fall under three subheadings. Describe the subheadings of government fund entities.

2. GASB Statement No. 34 specifies how governments report capital assets and long-term obligations. Describe where capital assets and long-term obligations are reported in government financial statements.

Short Answer Questions from the Textbook

1. Eleven funds are recommended to account for the various activities and resources of a govern-mental unit. Identify these funds by title and type and briefly state (in two sentences or less) the basic purpose of each fund.

2. Why are governments required to prepare financial statements on a government-wide basis using full accrual accounting?

3. What is the difference between a governmental fund and a proprietary fund?

4. Are fiduciary funds governmental funds or proprietary funds? Explain.

5. A disbursement by the general fund to another fund may be recorded as a receivable, an expenditure, or a fund transfer. Explain the circum-stances that would result in each of these different treatments.

6. In what funds would you expect bonds payable to be included?

7. In what funds might property and other non financial resources be recorded?

8. Why are budgeted revenues and expenditures formally recorded in the records of the general fund but not in the records of a capital projects fund?

9. Are all major capital facilities acquisitions ac-counted for in a capital projects fund? Explain.

10. What exception to the normal expenditure recognition criteria is associated with debt ser-vice funds and what is the justification for this exception?

11. Identify and describe four types of interfund activities.

12. The following funds and account groups are recommended for use in accounting for state and municipal governmental financial operations:
A. General Fund.
B. Special Revenue Fund.
C. Debt Service Fund.
D. Capital Projects Fund.
E. Agency Fund.
F. Enterprise Fund.
G. Internal Service Fund.
H. Trust Fund.
I. Government-wide Statement of Activities.
J. Government-wide Statement of Net Assets.

Identify, by the letters given above, the funds and account groups in which each of the ac-count titles below might properly appear.
(1) Bonds Payable.
(2) Reserve for Encumbrances.
(3) Equipment.
(4) Appropriations.
(5) Estimated Revenue.
(6) Property Taxes Receivable.
(7) Construction Work in Progress.
(8) Accumulated Depreciation.
(9) Depreciation Expense.
(10)Required Earnings.

13. Describe some of the major reconciling items between a government fund and the government-wide financial statements.

Business Ethics Question from the Textbook

GASB 45requires that the expected future costs of retiree health costs be recognized in the current period. Prior to this, governments used a pay-as-you-go plan in which only the current year’s actual payments affected the financial statements. Suppose you are working for a government prior to the issuance of GASB 45. As part of the collective bar-gaining agreement, the government offers employees increased health benefits.
1. Prior to the issuance of GASB 45, what would be the impact on the government’s financial statements?
2. Under GASB 45, what are the financial statement implications?
3. Why might the current governmental leaders agree to offer such a benefit?4.What are the ethical issues involved in this decision?

ANSWER KEY (Chapter 18)

Chapter 19

Accounting for Nongovernment Nonbusiness Organizations: Colleges and Universities, Hospitals, and Other Healthcare Organizations

Multiple Choice

1. Special entities are not-for-profit organizations that are
a. government owned.
b. privately owned.
c. publicly owned.
d. either government owned or privately owned.

2. A municipality’s capital projects fund is similar to a university’s
a. renewals and replacements fund.
b. retirement of indebtedness fund.
c. investment in plant fund.
d. none of these.

3. Board designated funds should be accounted for as
a. restricted funds.
b. specific purpose funds.
c. unrestricted funds.
d. none of these.

4. For a university, the receipt of assets for operating activities that have external restrictions as to the purposes for which they can be used is recorded by crediting
a. Fund Balance-Restricted.
b. Contribution Revenue.
c. Deferred Revenue.
d. Net Assets Released.

5. Which of the following statements related to pledges is incorrect?
a. Pledges are signed commitments to contribute specific amounts of money on a future date or in installments.
b. Pledges are recorded as revenues when a promise to give is nonrevocable and unconditional.
c. Pledges are generally enforceable contracts.
d. All of these are correct.

6. When the donor has specified a particular date or event after which the principal of the Endowment Fund may be expended, the Endowment Fund is referred to as a(n)
a. pure endowment fund.
b. term endowment fund.
c. quasi endowment fund.
d. expendable endowment fund.

7. The basic financial statements for all NNOs include a
1. Balance sheet
2. Statement of activities
3. Statement of cash flows
a. 1 and 3
b. 2 and 3
c. 1 and 2
d. 1, 2, and 3

8. Revenues and expenses of hospitals are recorded in the accounts of the
a. Endowment Fund.
b. General Fund.
c. Plant Replacement Fund.
d. Specific Purpose Fund.

9. Investments are reported by NNOs at
a. cost.
b. fair value.
c. the lower of cost or fair value.
d. the higher of cost or fair value.

10. Resources of an unrestricted fund that are designated by the governing board for endowment purposes are accounted for in the unrestricted fund by all NNOs except
a. voluntary health and welfare organizations.
b. hospitals.
c. colleges and universities.
d. other NNOs.

11. In accounting for loan funds, revenue is recorded when the
a. contribution is received.
b. loan is made to students.
c. loan is repaid by students.
d. students graduate.

12. All of the following are a plant fund in colleges and universities except
a. unexpended plant fund.
b. funds for renewals and replacements.
c. investment in plant.
d. plant replacement and expansion fund.

13. Most property, plant and equipment transactions of hospitals are accounted for in the
a. fund for renewals and replacements.
b. general fund.
c. plant replacement and expansion fund.
d. unexpended plant fund.

14. All NNOs have current restricted funds and unrestricted funds except
a. colleges and universities
b. hospitals
c. VHWOs
d. ONNOs

15. Tuition waivers for which there is no intention of collection from the student should be classified by a college as:

Revenue Expenditures
a. No No
b. No Yes
c. Yes Yes
d. Yes No

16. Which of the following is used for current expenditures by a college?

Unrestricted Restricted
Current Funds Current Funds
a. No No
b. No Yes
c. Yes Yes
d. Yes No

17. Under Newman Hospital’s established rate structure, the hospital would have earned patient service revenue of $7,000,000 for the year ended December 31, 2011. However, Newman did not expect to collect this amount because of charity allowances of $1,000,000 and discounts of $500,000 to third party payers. In May 2011, Newman purchased bandages from Ace Supply Co. at a cost of $5,000. However, Ace notified Newman that the invoice was being cancelled and that the bandages were being donated to Newman.
For the year ended December 31, 2011, how much should Newman record as patient service revenue?
a. $7,000,000
b. $6,500,000
c. $6,000,000
d. $5,500,000

18. Under Newman Hospital’s established rate structure, the hospital would have earned patient service revenue of $7,000,000 for the year ended December 31, 2011. However, Newman did not expect to collect this amount because of charity allowances of $1,000,000 and discounts of $500,000 to third party payers. In May 2011, Newman purchased bandages from Ace Supply Co. at a cost of $5,000. However, Ace notified Newman that the invoice was being cancelled and that the bandages were being donated to Newman.
For the year ended December 31, 2011, Newman should record the donation of bandages as:
a. a $5,000 reduction in operating expenses.
b. nonoperating revenue of $5,000.
c. other operating revenue of $5,000.
d. a memorandum entry only.

19. The following funds were among those on Cole University’s books at April 30, 2011:
Funds to be used for acquisition of additional properties
for university purposes (unexpended at 4/30/11) $2,500,000
Funds set aside for debt service charges and for the
retirement of indebtedness on university properties 5,000,000
How much of the above-mentioned funds should be included in plant funds?
a. $0
b. $2,500,000
c. $5,000,000
d. $7,500,000

20. Which basis of accounting should a voluntary health and welfare organization use?
a. Cash basis for all funds
b. Modified accrual basis for all funds
c. Accrual basis for all funds
d. Accrual basis for some funds and modified accrual basis for other funds

21. Which one of the following statements is not required for NNOs?
a. statement of financial position
b. statement of cash flows
c. statement of changes in net assets
d. statement of activities

22. Admissions, counseling and registration are considered to be:
a. educational and general services.
b. auxiliary enterprises.
c. student services.
d. institutional support.

23. A good reason for NNOs to adopt fund accounting even though FASB standards do not require it is because:
a. the capital assets are significant.
b. the donated services are significant.
c. the program services are involved with more than one type of revenue.
d. restrictions are placed by donors in many cases.

24. Which of the following groups of not-for-profit entities must use fund accounting to be in conformity with GAAP?

Governmental Nongovernmental
a. Yes Yes
b. Yes No
c. No Yes
d. No No

25. GASB No. 35 allows public colleges and universities to:
a. apply guidance designed for special-purpose governments.
b. use FASB standards to permit consistent reporting.
c. optionally follow FASB standards.
d. none of the above is correct.

26. For the fall semester of 2011, Newton College assessed its students $5,000,000 for tuition and fees. The net amount realized was only $4,700,000 because of the following revenue reductions:
Refunds occasioned by class cancellations and student withdrawals $ 80,000
Tuition remissions granted to faculty members’ families 20,000
Scholarships and fellowships 200,000

How much should Newton College report for the period for unrestricted current funds revenues from tuition and fees?
a. $5,000,000
b. $4,900,000
c. $4,780,000
d. $4,700,000

27. During the years ending June 30, 2010, and June 30, 2011, Madison University conducted a cancer research project financed by a $3,000,000 gift from an alumnus. This entire amount was pledged by the donor on July 10, 2009, although he paid only $800,000 at that date. The gift was restricted to the financing of this particular research project. During the two-year research period, Madison related gift receipts and research expenditures were as follows:

Year Ended June 30
2010 2011
Gift receipts 1,100,000 1,200,000
Cancer research restricted expenditures 1,400,000 1,600,000

How much gift revenue should Madison University report in the temporarily restricted column of its statement of activities for the year ended June 30, 2011?
a. $3,000,000
b. $1,600,000
c. $1,200,000
d. $0

28. Bell Foundation, a voluntary health and welfare organization, supported by contributions from the general public, included the following costs in its statement of functional expenses for the year ended December 31, 2011.

Fund raising $1,000,000
Administrative 600,000
Research 200,000

Bell’s functional expenses for 2011 program services included
a. $200,000.
b. $600,000.
c. $1,000,000.
d. $1,800,000.

29. National Service Center is a voluntary welfare organization funded by contributions from the general public. During 2010 unrestricted pledges of $800,000 were received, half of which were payable in 2010 with the other half payable in 2011 for use in 2011. It was estimated that 10% of these pledges would be uncollectible. How much should National report as net contribution revenue for 2010 with respect to the pledges?
a. $800,000
b. $720,000
c. $360,000
d. $0

30. Cindy Duncan is a social worker on the staff of National Service Center, a voluntary welfare organization. She earns $42,000 annually for a normal workload of 2,000 hours. During 2011 she contributed an additional 800 hours of her time to National at no extra charge. How much should National record in 2011 as contributed service expense?
a. $0
b. $1,680
c. $8,400
d. $16,800

Problems

19-1 The following events affected the Burlington University Loan Fund:

1. $300,000 is received from a donor to establish a student loan fund. Loans will carry a 6% annual interest rate.

2. The Loan Fund loaned the $300,000 to students. Five percent of the loans are estimated to be uncollectible.

3. Loans of $50,000 were repaid with $3,000 of interest.

4. A $1,000 student loan was written off as uncollectible.

Required:
Prepare the journal entries necessary to record these transactions.

19-2 On October 10, 2010, a national voluntary health help foundation was the recipient of a telethon sponsored by a renowned celebrity. Phone donations totaling $8,500,000 were promised. Based on historical information, 15% of these pledges are expected to be uncollectible. Of these pledges, $7,100,000 were collected in 2011; the remainder were considered uncollectible.

Required:
Identify the proper fund and prepare the journal entries necessary in 2010 and 2011.

19-3 Prepare journal entries for the following transactions or events:

1. The board of trustees of Young College voted to designate $300,000 for expansion of the student union and $90,000 for future research projects.

2. In accordance with the requirements of a bond indenture, Young College transferred $85,000 of unrestricted funds for the accumulation of cash to retire the debt related to the construction of the Central Computer Building.

3. A governing board of a hospital designates $280,000 for the future expansion of the emergency care facilities.

4. A heart association receives pledges of $900,000 from the general public in connection with a telethon. It is estimated that 30% of the amounts pledged will not be collectible.

5. An ONNO receives the donated services of a CPA with a market value of $10,000.

6. On November 3, 2011, $75,000 was donated to a university for library acquisitions of which $50,000 was expended for this purpose during the remainder of the fiscal year.

7. On November 4, 2011, $15,000 was contributed to a voluntary health organization to be used to conduct CPR classes for the public. During the remainder of the current fiscal year $14,000 was expended for this purpose.

8. On November 5, 2011, $100,000 was contributed to a hospital for cancer research of which $90,000 was expended for this purpose during the remainder of the fiscal year.

19-4 An NNO obtained cash for the acquisition of property and equipment as follows:
Loan proceeds $200,000
Contributions $400,000

These funds are used to acquire land. In addition, $20,000 in principal and $2,000 in interest is paid on indebtedness relating to property and equipment. Depreciation on property and equipment for the year is $80,000.

Required:
Prepare all necessary entries in the affected funds of the NNO, assuming that the NNO is a:
a. Voluntary health and welfare organization.
b. University.
c. Hospital.

19-5

The following information was taken from the accounts and records of the NSP Foundation, a private, not-for-profit organization. All balances are as of June 30, 2011, unless otherwise noted.

Unrestricted Support – Contributions $250,000
Unrestricted Revenues – Investment Income 28,000
Temporarily Restricted Gain on Sale of Investments 13,000
Expenses – Scholarships 300,000
Expenses – Fund Raising 60,000
Expenses – Management and General 120,000
Restricted Support – Contributions 420,000
Restricted Revenues – Investment Income 30,000
Permanently Restricted Support – Contributions 50,000
Unrestricted Net Assets, July 1, 2010 250,000
Temporarily Restricted Net Assets, July 1, 2010 40,000
Permanently Restricted Net Assets, July 1, 2010 10,000

The unrestricted support from contributions was received in cash during the year. The expenses included $500,000 payable from donor-restricted resources.

Required:
Prepare NSP’s statement of activities for the fiscal year ended June 30, 2011.

19-6

Christy Hospital received money from a donor to set up an endowment fund. The following information pertains to this contribution:

2010
1. $3,000,000 was received to establish the fund. The requirements were
a. $150,000 of the endowment fund’s income must be used for research grants each year.
b. The remainder of income is under the discretion of the governing board.
c. The principal is expendable after the donor’s death. It shall be used to purchase equipment.
2. The cash received was invested in a number of securities.

2011
3. Dividends of $150,000 and interest of $400,000 were received.
4. The income was transferred to the appropriate funds.
5. Of the restricted income, only $100,000 was expended for its specified purpose during 2011.
6. The governing board specified that $300,000 of the income would be used for loans for deserving medical students.

2012
7. $250,000 was lent to medical students.
8. The donor died of cancer.

Required:
Set up headings for the following funds: Endowment, General, Specific Purpose, and Plant Replacement and Expansion. Prepare the entries necessary in each fund to record the events listed above.

19-7

The following events were recorded on the books of Denton Hospital for the year ended December 31, 2011.
1. Revenue from patient services totaled $12,000,000. The allowance for uncollectibles was established at $2,500,000. Of the $12,000,000 revenue, $4,500 was recognized under cost reimbursement agreements. This revenue is subject to audit and retroactive adjustment by third-party payors.
2. Patient service revenue is accounted for at established rates on the accrual basis.
3. Other operating revenue totaled $260,000, of which $120,000 was from specific purpose funds.
4. Denton received $310,000 in unrestricted gifts and bequests. They are recorded at fair market value when received.
5. Endowment funds earned $120,000 in unrestricted income.
6. Board designated funds earned $62,000 in income.
7. Denton’s operating expenses for the year amounted to $10,030,000. This included $380,000 in straight-line depreciation.

Required:
Prepare a statement of activities for Denton Hospital for the year ended December 31, 2011.

Short Answer
1. The fund structure and terminology differ among NNOS, but there are six funds commonly used. Identify the funds used by nongovernment nonbusiness organizations.

2. Contributions to NNOS include gifts of cash, pledges, donated services, and gifts of noncash assets. Explain how contributions are recorded by NNOS.

Short Answer Questions from the Textbook

1. What authoritative body(s) is (are) responsible for establishing financial accounting standards for NNOs?

2. Why do most NNOs use fund accounting?

3. NNOs distinguish between restricted and un restricted funds. Why is this distinction important?

4. What is the major difference in accounting for the general fund of a hospital and the unrestricted fund of other NNOs?

5. What is the major difference in accounting between conditional and unconditional pledges? Give an example of each.

6. What is the relationship (if any) between board-designated funds and nonmandatory transfers?

7. May board designated funds ever be accounted for in the unrestricted current fund? Explain.

8. When should an NNO record donated services in its accounting records?

9. The donated services of volunteer workers on fundraising campaigns are usually not given ac-counting recognition. Why?

10. Universities and hospitals often reduce their standard service charge to students or patients. How are these reductions reflected in the statements of revenue and expenses of these organizations? Explain.

11. What fund is used to account for the library books owned by a university? How should depreciation of the library books be reflected in the financial statements of the university?

12. In which fund of a hospital are medical equipment and related longterm obligations recorded? Would your answer be the same for a voluntary health and welfare organization? Explain.

13. What capital assets (if any) of ONNOs need not be depreciated?

14. Identify three different types of endowment funds and explain how they differ.

15. Distinguish an annuity fund from a life income fund.

ANSWER KEY (Chapter 19)