EXAMPLE TEST QUESTIONS

Chapter 10

Multiple Choice

1. Under the equity method of accounting for investments, an investor recognizes its share of the earnings in the period in which the a. Investor sells the investmentb. Investee declares a dividendc. Investee pays a dividendd. Earnings are reported by the investee in its financial statements

Answer d

2. Pence Corporation, which accounts for its investments in the common stock of Walsh Company by the equity method, should ordinarily record a dividend received from Walsh asa. An addition to the carrying value of the investmentb. Dividend revenuec. A reduction of the carrying value of the investmentd. Revenue from affiliate

Answer c

3. On January 15, 2002, a corporation was granted a patent on a product. On January 2, 2010, to protect its patent, the corporation purchased a patent on a competing product the originally was issued on January 10, 2008. Because of its unique plant, the corporation does not feel the competing patent can be used in producing a product. The cost of the competing patent should be

a. Amortized over a maximum period of 17 yearsb. Amortized over a maximum period of 13 yearsc. Amortized over a maximum period of 9 yearsd. Expensed in 2010

Answer d

4. Pacer Company purchased 300 of the 1, 000 outstanding shares of Queen Company’s common stock for $80,000 on January 2, 2008. During 2009, Queen Company declared dividends of $8,000 and reported earnings for the year of $20,000.If Pacer Company uses the equity method of accounting for its investment in Queen Company, its Investment in Queen Company account at December 31, 2009 should be

a. $100, 000b. $88,000c. $83,600d. $80,000

Answer c

5. Refer to the facts in problem (4). If Pacer Company uses the lower of cost or market method of accounting for its investment in Queen Company, and the value of its investment hasn’t changed, its Investment in Queen Company account on December 31, 2009, should bea. $100, 000b. $88,000c. $80,000d. $73,600

Answer c

6. A large, publicly held company developed and registered a trademark during 2010. The cost of developing and registering the trademark should be accounted for bya. Charging it to an asset account that should not be amortizedb. Expensing it as incurredc. Amortizing it over 25 years if in accordance with management’s evaluationd. Amortizing it over its useful life or 17 years, whichever is shorter

Answer b

7. Goodwill should be written offa. As soon as possible against retrained earningsb. When there is evidence that its carrying value has been impaired c. By systematic charges against retained earnings over the period benefited, but not more

than 40 yearsd. By systematic charges to expense over the period benefited, but not more than 40 years

Answer b

8. A net unrealized loss on a company’s long-term portfolio of available for sale securities should be reflected in the current financial statements as a. An extraordinary item shown as a direct reduction from retained earningsb. A current loss resulting from holding marketable equity securitiesc. A footnote or parenthetical disclosure onlyd. A component of other comprehensive income

Answer d

9. Changes in the fair value of a long-term available for sale equity securities portfolio should be reported as a component of a. Other comprehensive incomeb. Noncurrent assets

c. Noncurrent liabilitiesd. Net income

Answer a

10. Cash dividends declared out of current earnings are distributed to an investor. How will the investor’s investment account be affected by those dividends under each of the following accounting methods?

Fair Value Method Equity Method a. Decrease No effectb. Decrease Decreasec. No effect Decreased. No effect No effect

Answer c

11. An activity that would be expensed currently as research and development costs is the a. Testing in search for or evaluation of product or process alternativesb. Adaptation of an existing capability to a particular requirement or customer’s need as a part

of continuing commercial activityc. Legal work in connection with patent applications or litigation, and the sale or licensing of

patentsd. Engineering follow-through in an early phase of commercial production

Answer a

12. Should the following fees associated with the registration of an internally developed patent be capitalized?

Registration Legal fees fees

a. Yes Yesb. Yes Noc. No Yesd. No No

Answer a

13. Which of the following assets acquired in 2010 are amortizable? Goodwill Trademarks

a. No Nob. No Yesc. Yes Nod. Yes No

Answer b

14. A purchased patent has a remaining life of 15 years. It should be a. Expensed in the year of acquisitionb. Amortized over 15 years regardless of its useful lifec. Amortized over its useful life if less than 15 yearsd. Amortized over 40 years

Answer c

15. Which of the following amounts incurred in connection with a trademark should be capitalized? Cost of a Registration Successful defense fees

a. Yes Nob. Yes Yes c. No Yesd. No No

Answer b

16. Zink Company owns 32% of Ace Company's outstanding voting stock. Zink Company normally should account for its investment in Ace Company using thea. Fair value method.b. Cost method.c. Consolidation procedure. d. Equity method.

Answer d

1. An investor purchased a bond as a long-term investment on January 1. Annual interest was received on December 31. The investor’s interest income for the year would be lowest if the bond was purchased ata. A discountb. A premiumc. Pard. Face value

Answer b

19. The theoretical justification for expensing research and development (R&D) cost as it is incurred is based on which of the following arguments?a. R&D costs provide no future benefits, thus it does not meet the definition of an assetb. R&D costs are incurred to generate current period revenue, thus the matching concept

requires that it be expensed as incurred.c. Whether R&D costs that have been incurred will provide future benefit is uncertain, thus it

does not meet the definition of an asset.

d. Since R&D costs have been incurred during the current period, they meet the definition of an expense.

Answer c

20. When a patent is successfully defended in court, the cost of the lawsuita. Should be expensed as incurred because it is a period cost.b. Should be added to the cost of the patent and depreciated over the remaining useful life of the

patent.c. Should be added to the cost of the patent which is then expensed as a period cost.d. Has already been expensed so there is no further action to take.

Answer b

21. Goodwill is an intangible asseta. That has a definite life and its cost should be amortized over its useful life.b. That is recorded when the company has projected earnings in excess of earnings expected for

an investment in a similar company in the same industry.c. That is reviewed for impairment when circumstances indicate that impairment may have

occurred. d. That is reviewed annually to determine whether impairment has occurred.

Answer d

22. A trading security is measured at fair value on the balance sheet date and reported asa. A current asset, and changes in fair value are reported in earnings as unrealized gains and

losses.b. A current asset, and changes in fair value are reported in earnings as realized gains and

losses.c. Either a current or noncurrent asset depending on whether they meet the definition of a

current asset.d. A current asset, and changes in fair value are reported in accumulated other comprehensive

income as unrealized gains and losses.

Answer a

23. Current accounting for an available-for-sale (AFS) security is consistent witha. The financial capital maintenance concept of income because AFS security unrealized gains

and losses are reported in earnings.b. The financial capital maintenance concept of income because AFS security unrealized gains

and losses are reports in other comprehensive income.c. The physical capital maintenance concept of income because AFS security unrealized gains

and losses are reported in earnings.

d. The physical capital maintenance concept of income because AFS security unrealized gains and losses are reported in other comprehensive income.

Answer d

24. The physical capital maintenance concept of income would require that an investment in the common stock of another entity bea. Reported in the balance sheet at historical cost and that only realized gains and losses be

reported in earnings.b. Reported in the balance sheet at historical cost and that unrealized gains and losses be

reported in earnings.c. Reported in the balance sheet at fair value and that unrealized gains and losses be reported in

earnings.d. Reported in the balance sheet at fair value and that unrealized gains and losses be reported in

other comprehensive income.

Answer d

25. The economic concept of income would require that an investment in the common stock of another entity bea. Reported in the balance sheet at historical cost and that only realized gains and losses be

reported in earnings.b. Reported in the balance sheet at historical cost and that unrealized gains and losses be

reported in earnings.c. Reported in the balance sheet at fair value and that unrealized gains and losses be reported in

earnings.d. Reported in the balance sheet at fair value and that unrealized gains and losses be reported in

other comprehensive income.

Answer c

26. Under the fair value option, an investment in the common stock of another entity will be

a. Reported as a current assetb. Reported as a noncurrent assetc. Reported as either a current or noncurrent asset depending on managerial intent.d. Reported as a current asset only if it was not previously reported as an equity method

investment.

Answer a

27. When a company reports goodwill in its balance sheet, we know thata. It was internally generated because the company has earnings in excess of those of other

companies in the industry.b. The company purchased it.

c. The company will be reporting amortization expense for the goodwill.d. The company will not be reporting an impairment loss for the goodwill.

Answer b

Essay

1. How are income and balance sheet values determined under the equity method?

Under the equity method, adjustments are made to the recorded cost of the investment to account for the profits and losses of the investee, and distributions of earnings. These adjustments are based on the investor’s percentage of ownership of the investee. For example, if the investee reports a profit, the investor will report as income its pro-rata ownership share of the investee profit and simultaneously increase the carrying value of the investment account by the same amount. Conversely, dividends received decrease in the carrying value of the investment account for the amount of the dividend received or receivable. Dividends are not reported as income because the investor reports the income of the investee as the investee earns it. In other words, under the equity method, dividends are viewed as distributions of accumulated earnings. Because the accumulation of earnings increases the investment account, the distribution of earnings decreases the investment account. Consequently, the investment account represents the investee’s equity in the investment.

2. Discuss accounting for equity securities under the cost method.

Under the cost method an investment in equity securities is carried at its historical cost. Dividends received or receivable are reported as revenue. The cost method can be criticized because it does not measure current fair value. Historical cost provides information relevant for determining recovery when the securities are acquired. Current fair market value would provide a similar measure for the current accounting period. If the purpose of financial statements is to provide investors, creditors, and other users with information useful in assessing future cash flows, the current assessment of recoverable amounts (current market values) would be relevant. Even for those equity securities that are not actively traded, an estimate of current fair value may be more relevant than cost.

3. Discuss accounting for equity securities under the SFAS No. 115 now contained at FASB ASC 320.

Under the SFAS No. 115 fair value method, at acquisition, equity securities are classified as either trading or available-for-sale. Trading securities are defined as “securities that are bought and held principally for the purpose of selling them in the near term (thus held for only a short period of time).” Trading securities are actively and frequently bought and sold, generally with

the objective of generating profits from short-term price movements. Available-for-sale securities are those equity securities having readily determinable market prices that are not considered trading securities. All trading securities are classified as current assets. Available-for-sale securities are classified as current or long term depending on whether they meet the ARB No. 43 definition of current assets. Accordingly, these securities should be classified as current if they are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business or one year, whichever is longer. All other available-for-sale securities should be classified as long-term investments.

At each balance sheet date, current and long-term equity securities subject to the SFAS No. 115 provisions are reported at fair value. Unrealized holding gains and losses for available-for-sale securities are excluded from earnings. The cumulative unrealized holding gains and losses for these securities should be reported as a separate component of accumulated other comprehensive income. Dividend income for available-for-sale securities will continue to be included in earnings.

4. Summarize the accounting requirements for investments in equity securities. That is, what methods are available and when is each method appropriate?

The method of accounting for investments in equity securities is dependent on the percentage ownership. If an investor owns less than 20 percent of the outstanding shares of an investee the fair value method is to be used if fair value is readily available. If fair value is not determinable the cost method should be used. Additionally, the market value method may be used in certain circumstances as allowed by the industry practices exception. If an investor owns 20 to 50 percent of the outstanding shares the equity method is appropriate unless there is evidence the investor is not able to exercise significant influence over the investee. In such cases the fair value method is used. For investment in which the investor hold more than 50 percent of the outstanding shares of the investee, consolidate financial statements are prepared.

5. Discuss the use of the fair value option originally described in SFAS No. 159 now contained at FASB ASC 825-10.

SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” FASB ASC 825-10) permits companies to measure most financial assets and liabilities that are recognized in financial statements at fair value. Companies may not opt for fair value reporting for the following financial items: investments that must be consolidated, assets and obligations representing postretirement benefits, leases, demand deposits reported by banks, and financial instruments classified as components of stockholder’s equity. The objective of the fair value option is “to improve financial reporting by providing entities with an opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting.” However, since the pronouncement is not limited to related assets and liabilities, it is apparent that the FASB is attempting to broaden the use of fair value accounting to areas where it was not previously allowed, most notably to liabilities.

The election to opt for fair value reporting may be applied by instrument. It may be elected for a single eligible debt or equity security without electing it for other identical items. Moreover, the option need not be applied to all instruments issued or acquired in a single transaction. An exception to being able to apply by instrument is that when electing fair value for an investment that would otherwise be accounted for under the equity method, the investor must apply fair value to all financial interests in the same entity, including its eligible debt and equity instruments.

After making the fair value election, all subject items are reported in the balance sheet at fair value. Fair value is to be measured using exit prices on the balance sheet date. SFAS No. 159 defined fair value as the price that reporting entity would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants. All unrealized holding gains and losses are to be reported in earnings.

The reporting entity must separately disclose assets and liabilities pursuant to electing fair value in a manner that clearly separates them from the carrying values of other assets and liabilities, either parenthetically by a single line that includes both or on separate lines in the balance sheet. Moreover, if the fair value option is elected for available-for-sale and/or held-to-maturity securities when SFAS No. 159 (See FASB ASC 825-10) is adopted, they are to be reported as trading securities. The cumulative effect of the gains and losses for these securities is to be reported as an adjustment to retained earnings.

6. Discuss accounting for investments in debt securities.

Investments in debt securities, such as bonds or government securities, for which the fair value option is not elected, are initially recorded at cost, including upfront cost to acquire the securities. Typically, the purchase price of a debt instrument differs from its face value. This difference reflects the fluctuations in market interest rates that have occurred since the time the debt instrument was initially offered for sale to the present. Thus, debt instruments are usually sold at a premium or discount.SFAS No. 115 required that at acquisition, individual investments in debt securities be classified as trading, available-for-sale, or held-to-maturity (See FASB 320-10-25-1). Those debt securities that are classified as trading or available-for-sale are to be treated in the same manner as equity securities that are similarly classified. That is, the fair value method described above for trading and available-for-sale equity securities also applies to trading and available-for-sale debt securities. Thus, the discussion that follows will be limited to those debt securities that are classified as held-to-maturity.Debt instruments must be classified as held-to-maturity “only if the reporting enterprise has the positive intent and ability to hold those securities to maturity.”Debt securities that are classified as held-to-maturity must be measured at amortized cost. When these debt securities are sold at a premium or discount, the total interest income to the investing enterprise over the life of the debt instrument from acquisition to maturity is affected by the amount of the premium or discount. Measurement at amortized cost means that the premium or discount is amortized each period to calculate interest income.

7. What is an intangible asset? How is the cost of an intangible asset amortized?

Intangibles are capital assets having no physical existence whose value depends on the rights and benefits that possession confers to the owner.Intangible assets derive their value from the special rights and privileges that they convey, and accounting for these assets involves the same problems as accounting for other long-term assets. Specifically, an initial carrying amount must be determined and then systematically and rationally allocated to the periods that receive benefit.Intangible assets other than goodwill are divided into two groups: those with indefinite lives and those with finite lives. An acquired intangible asset’s useful life is determined by reviewing various factors such as its expected use, related assets, legal regulatory or contractual provisions, the effects of obsolescence, and the level of required maintenance. If no legal, regulatory, contractual, or other factor limits an intangible asset’s useful life, it is considered to have an indefinite life. Intangible assets that are not amortized must be tested for impairment at least annually by comparing the fair values of those assets with their recorded amounts and/or amortized over their remaining useful lives. Intangible assets that have finite useful lives will continue to be amortized over their useful lives.

8. What is goodwill? How is goodwill written off under the provisions of SFAS No. 142 now FASB ASC 350?

Although goodwill may exist at any point in time, in practice goodwill is recognized for accounting purposes only when it is acquired through the purchase of an existing business. Only then is the value of goodwill readily determinable, because the purchase embodies an arm’s-length transaction wherein assets, often cash or marketable securities, are exchanged. The value of the assets exchanged indicates a total fair value for the business entity acquired. The excess of total fair value over the fair value of identifiable net assets is considered goodwill. This practice fulfills the stewardship function of accounting and facilitates the accountability of management to stockholders.SFAS No. 142 changes the accounting treatment for goodwill from an amortization period not to exceed forty years, to an approach that requires, at a minimum, annual testing for impairment. The goodwill impairment test is to be performed at the reporting unit level which is defined as an operating segment or one level below an operating segment (also known as a component).

Under the provisions of SFAS No. 142, the test for goodwill impairment is a two-step process that involves:

1. A comparison of the fair value of the reporting unit to its carrying value. In the event fair value exceeds carrying value, no further testing is required. However, if the carrying value of the reporting unit exceeds its fair value, step two is required.

2. A calculation of the implied fair value of goodwill by measuring the fair value of the net assets other than goodwill and subtracting this amount from the fair value of the reporting unit.

9. Define research and development. How are research and development costs recorded

Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service or new

process or technique or in bringing about a significant improvement to an existing product or process.

Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use. It includes the conceptual formulation, design and testing of product alternatives, construction of prototypes, and operation of pilot plants. It does not include routine or periodic alterations to existing products, production lines, manufacturing processes, and other ongoing operations even though these alterations may represent improvements and it does not include market research or market testing activities.FASB ASC 730 requires all research and development costs to be charged to expense as incurred.

10. How does IAS No 39 define fair value?

IASS No 39 defines fair value as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.