Week 7

Week 7
Lecture 1
Finance
Which one of the following is not necessarily a post-combination characteristic of a legal

acquisition?
A. The combining firms remain separate legal entities.
B. A parent-subsidiary relationship exists.
C. The acquiring firm owns 100% of the voting stock of the acquired firm.
D. The combining firms are under common economic control.
Correct!
The acquiring firm in a legal acquisition does not have to own 100% of the voting stock of the
acquired firm. In a legal acquisition, the acquiring firm need only acquire greater than 50%
(50% + 1 share) of the acquired firm to obtaining a controlling interest. Both firms continue to
exist and operate as separate legal entities, the acquiring firm as the parent and the acquired
firm as a subsidiary.
Under GAAP, which of the following can be issued as the primary form of public financial
statement disclosure for a parent and its subsidiaries?
Parent only Separate Parent and Subsidiary Consolidated
Statement Statements Statements
Yes Yes Yes
Yes No No
No Yes Yes
No No Yes
Correct!
Under GAAP, only consolidated financial statements may be issued as the primary form of
public disclosure for a parent and its subsidiaries. Parent only statements and separate parent
and subsidiary statements may not be issued in lieu of consolidated financial statements.
Penn, Inc., a manufacturing company, owns 75% of the common stock of Sell, Inc., an
investment company. Sell owns 60% of the common stock of Vane, Inc., an insurance
company.
In Penn's consolidated financial statements, should consolidation accounting or equity

method accounting be used for Sell and Vane?
A. Consolidation used for Sell and equity method used for Vane.
B. Consolidation used for both Sell and Vane.
C. Equity method used for Sell and consolidation used for Vane.
D. Equity method used for both Sell and Vane.
Correct!
If one looked just at Penn's interest in Vane's result of 45% (75% x 60%), one might say that
the equity method would be appropriate.
However, because Sell owns 60% of Vane, it controls Vane and would need to consolidate
Vane. Because Penn owns 75% of Sell, it controls Vane and would need to consolidate Sell,
which consolidated Vane. Thus, all three would be consolidated, making this response correct.
Aceco has significant investments in three separate entities. These investments are:
1. 40% ownership of the voting stock of Kapco.
2. 60% ownership of the voting stock of Placo.
3. 100% ownership of the voting stock of Simco
Which of Aceco's investments would be consolidated with Aceco in its consolidated financial
statements?
A. Simco only.
B. Placo and Simco.
C. Kapco, Placo, and Simco.
D. Kapco only.
Correct!
Since Aceco owns controlling interest in Placo (60%) and in Simco (100%), each would be
consolidated with Aceco. Kapco would not be consolidated, because Aceco does not have
controlling interest in Kapco. In Aceco's consolidated financial statements, Kapco would be
shown as an investment.
Consolidated financial statements are typically prepared when one company has a
controlling financial interest in another unless:
A. The subsidiary is a finance company.
B. The fiscal year-ends of the two companies are more than three months apart.
C. The subsidiary is in bankruptcy.
D. The two companies are in unrelated industries, such as manufacturing and real estate.
Correct!
Currently, the only reasons allowable for not consolidating a majority-owned subsidiary is
where control does not reside with the majority owner, making this the correct response.
Consolidated financial statements are based on the concept that:

A. In the preparation of financial statements, legal form takes precedence over economic
substance.
B. In the preparation of financial statements, economic substance takes precedence over legal
form.
C. Financial information should be presented separately for each legal entity.
D. Separate financial statements are more meaningful than consolidated financial statements.
Correct!
The preparation of consolidated financial statements is based on the concept that economic
substance takes precedence over legal form. In form, the corporations are separate legal
entities, but in substance, they are under the common economic control of the parent's
shareholders.
Which of the following information that exists at the date of an acquisition will be needed to
carry out the consolidating process?
I. Book values of a subsidiary's assets and liabilities.
II. Fair values of a subsidiary's assets and liabilities.
III. Parent's cost of its investment in the subsidiary.
A. I, II, and III.
B. I and II, only.
C. II and III, only.
D. III only.
Correct!
In order to prepare consolidated financial statements, the parent needs the book values and
fair values of a subsidiary's assets and liabilities at the date of the business combination as
well as the cost of its investment in the subsidiary.
The preparation of consolidated statements likely will require the following information
about the subsidiary's assets and liabilities at the date of acquisition:
Book Value Fair Value
Yes No
No Yes
Yes Yes
No No
Correct!
Both book values and fair values of a subsidiary's assets and liabilities will need to be
determined at the date of acquisition in order to prepare consolidated financial statements
after a business combination.
Consolidated financial statements can be prepared for a business combination that was
accounted for using which of the following accounting methods?
Acquisition Method Pooling of Interests Method
Yes Yes
Yes No
No Yes
No No
Correct!
Consolidated statements can be prepared when a business combination was accounted for
using either the acquisition method or the pooling of interests method. Although the pooling of
interests method can no longer be used (since June 30, 2001) to account for new business
combinations, business combinations carried out under the pooling of interests method prior to
that time still require the preparation of consolidated financial statements.
Following a business combination accomplished through a legal acquisition, transactions

between the affiliated entities can originate with the/a:
Parent Company Subsidiary Company
Yes Yes
Yes No
No Yes
No No
Correct!
Transactions between affiliated entities, called intercompany transactions, can originate with
either the parent company or a subsidiary company.
Which one of the following kinds of eliminations, if any, will be required in every
consolidating process?
Intercompany Intercompany Intercompany
Receivables/Payables Investment Revenues/Expenses
Yes Yes Yes
Yes No Yes
No Yes No
Yes Yes No
Correct!
An intercompany investment elimination will be required in every consolidating process (to

eliminate the parent's investment against the subsidiary's shareholders' equity). Intercompany
receivables/payables and intercompany revenues/expenses eliminations will not be required in
every consolidating process. Those kinds of eliminations will be required only if the affiliated
companies have engaged in intercompany transactions that resulted in such balances.
Which one of the following kinds of accounts is least likely to be eliminated through an
eliminating entry on the consolidating worksheet?
A. Receivables.
B. Investment.
C. Goodwill.
D. Payables.
Correct!
Goodwill may be recognized by the entry that eliminates the parent's investment in the
subsidiary against the parent's share of the subsidiary's shareholders' equity, but goodwill will
not be eliminated through an eliminating entry.
Which one of the following circumstances will not impact directly the adjustments,
eliminations, or related amounts in the consolidating process?
A. Whether the parent company is a manufacturing firm or a service firm.
B. Whether the parent uses the cost or equity method to carry the investment in a subsidiary on
its books.
C. Whether the parent owns 100% or less than 100% of the subsidiary.
D. Whether transactions between the affiliated entities originate with the parent or with a
subsidiary.
Correct!
Whether the parent company is a manufacturing firm or a service firm (or other type of firm)
will not impact directly the adjustments, eliminations, or related amounts in the consolidating
process. Whatever the type of firm, the same kinds of adjustments, eliminations, and amounts
would have to be made in the consolidating process.
Which of the following statements, if any, concerning the preparation of consolidated
financial statements is/are correct?
I. The consolidating process is carried out on the books of the parent entity.
II. The consolidated financial statements report two or more legal entities as though they
are a single economic entity.
A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.
Correct!
The consolidated financial statements report two or more legal entities (a parent and its
subsidiary/ies) as though they are a single economic entity. Because the entities are under the
common economic control of the parent's shareholders, GAAP requires that consolidated
statements be the primary form of financial statement disclosure.
The results of the consolidating process are recorded in the books of the:
Parent Subsidiary
Yes Yes
Yes No
No Yes
No No
Correct!
The consolidating process takes place on worksheets and schedules, and the results are
presented in the form of consolidated financial statements. Some of the worksheet and
schedule data is carried forward from period end to period end to facilitate the recurring
consolidating process.
This question has been adapted from the original AICPA released question.
On April 1, 2005, Dart Co. paid $620,000 for all the issued and outstanding common stock
of Wall Corp. in a transaction properly accounted for as an acquisition.
The recorded assets and liabilities of Wall Corp.

on April 1, 2005 follow:
Cash $ 60,000
Inventory 180,000
Property and equipment (net of accumulated depreciation of $220,000) 320,000
Goodwill (net of accumulated amortization of $50,000) 100,000
Liabilities (120,000)
Net assets $540,000
========
On April 1, 2005, Wall's inventory had a fair value of $150,000, and the property and
equipment (net) had a fair value of $380,000. What is the amount of goodwill resulting
from the business combination?
A. $150,000
B. $120,000
C. $50,000
D. $20,000
Correct!
First the fair value of the identifiable net assets must be determined:
Cash $60,000
Inventory $150,000
P&E (net) $380,000
Liabilities ($120,000)
Net Assets $470,000
Once this has been determined it is a simple matter of subtracting this amount from the
purchase price to determine the goodwill. ($620,000 - $470,000 = $150,000 goodwill).
Penn Corp. paid $300,000 for the outstanding common stock of Star Co. At that time, Star
had the following condensed balance sheet:
Carrying amounts
Current assets $40,000
Plant and equipment, net 380,000
Liabilities 200,000
Stockholders' equity 220,000
The fair value of the plant and equipment was $60,000 more than its recorded carrying
amount. The fair values and carrying amounts were equal for all other assets and liabilities.
What amount of goodwill, related to Star's acquisition, should Penn report in its
consolidated balance sheet?
A. $20,000
B. $40,000
C. $60,000
D. $80,000
Correct!
In an acquisition business combination, all assets and liabilities are revalued to fair value. Any
excess of investment value over fair value of the revalued identifiable net assets is assigned to
goodwill.
Book value of net assets was $220,000. Plant and Equipment needed to be written up by
$60,000, making fair value of net assets $280,000. Since Penn paid $300,000 for Star, that
leaves $20,000 in goodwill ($300,000-$280,000). Thus, this is the correct response.
A subsidiary, acquired for cash in a business combination, owned inventories with a market
value different from the book value as of the date of combination. A consolidated balance
sheet prepared immediately after the acquisition would include this difference as part of:
A. Deferred Credits
B. Goodwill
C. Inventories
D. Retained Earnings
Correct!
The difference between (fair) market value and book value of inventories would be recognized
by adjusting inventories to fair value on the consolidated balance sheet.
Beni Corp. purchased 100% of Carr Corp.'s outstanding capital stock for $430,000 cash.
Immediately before the purchase, the balance sheets of both corporations reported the
following:
Beni Carr
Assets $2,000,000 $750,000
Liabilities $750,000 $400,000
Common stock 1,000,000 310,000
Retained earnings __250,000 __40,000
Liabilities and
$2,000,000 $750,000
stockholders' equity
On the date of purchase, the fair value of Carr's assets was $50,000 more than the
aggregate carrying amounts. In the consolidated balance sheet prepared immediately after
the purchase, the consolidated stockholders' equity should amount to:
A. $1,680,000
B. $1,650,000
C. $1,600,000
D. $1,250,000
Correct!
On the date of a business combination using acquisition accounting, the consolidated

stockholders' equity will exactly equal the parent company stockholders' equity. This will
continue to be the case as long as the parent company uses a complete equity method of
accounting for the subsidiary.
A subsidiary, acquired for cash in a business combination, owned equipment with a market
value in excess of book value as of the date of combination. A consolidated balance sheet
prepared immediately after the acquisition would treat this excess as:
A. Goodwill
B. Plant and Equipment
C. Retained Earnings
D. Deferred Credits
Correct!
The excess of (fair) market value over book value of equipment would be recognized by
writing up plant and equipment to fair value on the consolidated balance sheet.
On November 30, 2004, Parlor, Inc. purchased for cash at $15 per share all 250,000 shares
of the outstanding common stock of Shaw Co.
On November 30, 2004, Shaw's balance sheet showed a carrying amount of net assets of
$3,000,000. On that date, the fair value of Shaw's property, plant, and equipment exceeded
its carrying amount by $400,000.
In its November 30, 2004, consolidated balance sheet, what amount should Parlor report as
goodwill?
A. $750,000
B. $400,000
C. $350,000
D. $0
Correct!
Goodwill is the difference between the purchase price of $3,750,000 (250,000 x $15.00) and
the fair value of the net assets ($3,000,000 + $400,000) or $350,000.
Under which of the following methods of carrying a subsidiary on its books, if any, will the
carrying value of the investment normally change following a combination?
Cost Method Equity Method
Yes Yes
Yes No
No Yes
No No
Correct!
If the parent uses the equity method to carry on its books the investment in a subsidiary, the
carrying value of the investment will change as the equity of the subsidiary changes. However,
if the parent uses the cost method, the carrying value on its books normally will not change.
A parent company may use which of the following methods to carry an investment in its
subsidiary on the parent's books?
Cost Method Equity Method
Yes Yes
Yes No
No Yes
No No
Correct!
A parent company may use the cost method or the equity method (or any variation thereof) to
carry an investment in a subsidiary on the parent's books. Since a subsidiary will be
consolidated with the parent (and possibly other subsidiaries) for reporting purposes, the
method the parent uses to carry the investment on its books will not impact the consolidated
statements. The consolidated statements will be the same regardless of the method the parent
uses on its books to carry a subsidiary; only the consolidating process will be different.
Which one of the following would be of concern in preparing consolidated financial

statements at the end of the operating period following a business combination that would
not be a concern in preparing financial statements immediately following a combination?
A. Whether or not there are intercompany accounts receivable/accounts payable.
B. Whether or not goodwill resulted from the business combination.
C. Whether the parent carries its investment in the subsidiary using the cost method or the
equity method.
D. Whether or not there is a noncontrolling interest in the subsidiary.
Correct!
Whether the parent carries its investment in the subsidiary using the cost method or the equity
method would be of concerning in preparing consolidated financial statements at the end of
the operating period following a business combination but would not be of concern in preparing
financial statements immediately following the combination. When consolidated financial
statements are prepared immediately following a combination, there has been no period over
which the parent has "carried" the investment on its books. Therefore, the method it WILL
(going forward) use is not of concern immediately after the combination.
Which of the following financial statements, if any, prepared by a parent immediately after
a business combination is likely to be different from financial statements it prepares
immediately before the business combination?
Balance Sheet Income Statement
Yes Yes
Yes No
No Yes
No No
Correct!
While a parent's balance sheet prepared immediately after a business combination will be
different from its balance sheet prepared immediately before the business combination, the
parent's income statement is not likely to be different than the consolidated income statement
prepared immediately after the combination. As a result of the combination, the parent will
have on its balance sheet an investment account (and probably other accounts/amounts) that
it did not have before the combination, but the consolidated income statement prepared
immediately after a business combination will likely be the same as the parent's pre-
combination income statement.
Which one of the following is not a characteristic of consolidated financial statements

prepared following an operating period that occurred after the date of a business
combination?
A. A full set of consolidated financial statements will be required.
B. The method used by the parent to carry on its books its investment in the subsidiary will
affect the consolidating process.
C. Intercompany transactions may have occurred since the business combination.
D. The method used by the parent to carry on its books its investment in the subsidiary will
affect the final consolidated financial statements.
Correct!
The method used by the parent to carry on its books its investment in the subsidiary will not
affect the final consolidated financial statements. The method used by the parent (cost, equity,
or other) will affect how the investment account has changed since the date of the investment
and, therefore, the investment elimination process but not the final consolidated financial
statements.
Which of the following financial statements, if any, prepared by a parent following an

operating period that occurred after a business combination, is likely to be different from
financial statements it prepares immediately before the business combination?
Balance Sheet Income Statement
Yes Yes
Yes No
No Yes
No No
Correct!
Both a parent's balance sheet and income statement prepared following an operating period
that occurred after a business combination are likely to be different from financial statements
it prepares immediately before the business combination. As a result of the combination, the
parent will have on its balance sheet an investment account (and probably other
accounts/amounts) that it did not have before the combination as well as the effects of post-
combination transactions on the assets, liabilities, and equities of the parent and its
subsidiaries. In addition, whereas the consolidated income statement prepared immediately
before (or immediately after) the combination will consist of only the parent's revenues and
expenses, an income statement prepared after an operating period will include the
subsidiaries' revenues and expenses as well as the result of post-combination transactions on
the revenues and expenses of the parent.
Which one of the following is not a characteristic associated with the reciprocity entry?
A. Adjusts the investment account to reflect changes in a subsidiary's retained earnings.
B. Is used when a parent uses the cost method to carry its investment in a subsidiary.
C. Is used in lieu of an investment elimination entry.
D. Is recorded only on the consolidating worksheet.
Correct!
A reciprocity entry is not used in lieu of an investment eliminating entry. Rather, a reciprocity
entry is used to bring the investment account, as brought onto the worksheet, in balance with
the subsidiary's retained earnings as of the beginning of the period so that the investment
eliminating entry can then be made.
On January 1, 20X1, Prim, Inc. acquired all the outstanding common shares of Scarp, Inc.
for cash equal to the book value of the stock. The carrying amount of Scarp's assets and
liabilities approximated their fair values, except that the carrying amount of its building
was more than fair value. In preparing Prim's 20X1 consolidated income statement, which
of the following adjustments would be made?
A. Depreciation expense would be decreased, and goodwill would be recognized.
B. Depreciation expense would be increased, and goodwill would be recognized.
C. Depreciation expense would be decreased, and no goodwill would be recognized.
D. Depreciation expense would be increased, and no goodwill would be recognized.
Correct!
Although the cost of the investment was equal to book values, the cost of the investment was
greater than the fair values, because the carrying amount of Scarp's building was more than
its fair value. For consolidated statement purposes, the building would be written down to its
lower fair value, and the excess of cost over fair values would be assigned to recognize
goodwill. Since for consolidated purposes the building has a lower fair value than its carrying
value, the depreciation expense taken on the carrying value would be greater than the
depreciation expense for consolidated purposes. Thus, depreciation expense would be
decreased in the consolidating process, and goodwill would be recognized.
If the parent uses the cost method to account for its investment in a subsidiary, the parent
will recognize:
A. the parent's share of the subsidiary's net income.
B. the parent's share of the subsidiary's dividends.
C. amortization of parent's excess cost of investment over the book value of the subsidiary.
D. the parent's share of the subsidiary's net loss.
Correct!
When a parent company uses the cost method to account for its investment in a subsidiary,
the parent will recognize its share of the subsidiary's dividends declared as income to the
parent.
When a parent company uses the cost method on its books to carry its investment in a
subsidiary, which one of the following will be recorded by the parent on its books?
A. Parent's share of subsidiary's net income/net loss.
B. Parent's amortization of goodwill resulting from excess investment cost over fair value of
subsidiary's net assets.
C. Parent's share of subsidiary's cash dividends declared.
D. Parent's depreciation of excess investment cost over book values of subsidiary's net assets.
Correct!
Under the cost method of carrying an investment in a subsidiary, the parent does recognize its
share of the subsidiary's dividends declared and, ultimately, the cash received in payment of
the dividend. The dividend income (CR.) so recognized by the parent would be eliminated in
the consolidating process against the retained earnings decrease (DR.) recognized by the
subsidiary.
On January 1, 20x6, Ritt Corp. purchased 80% of Shaw Corp.'s $10 par common stock for
$975,000. On this date, the carrying amount of Shaw's net assets was $1,000,000. The fair
values of Shaw's identifiable assets and liabilities were the same as their carrying amounts
except for plant assets (net), which were $100,000 in excess of the carrying amount. Those
plant assets had a 10-year remaining life, depreciated on a straight-line basis. The fair
value of the 20% noncontrolling interest in Shaw was properly determined to be $200,000
at that time. For the year ended December 31, 20x6, Shaw had a net income of $190,000
and paid cash dividends totaling $125,000. Which one of the following is the amount of
noncontrolling interest that should be reported in a consolidated balance sheet prepared
December 31, 2006?
A. $213,000
B. $235,000
C. $246,000
D. $248,000
Correct!
The noncontrolling interest on December 31, 2006, is 20% of the consolidated net assets
attributable to Shaw on that date. The consolidated net assets attributable to Shaw on
December 31, 2006, would include the book value of the net assets on the date of the
combination ($1,000,000), plus the write up of the plant assets to fair value ($100,000), plus
the goodwill at acquisition ($75,000), plus Shaw's net operating results for 2006 ($190,000),
less 20% of the worksheet depreciation taken on the write up of plant assets ($100,000/10
years =) $10,000 less the dividends paid by Shaw during 2006 ($125,000), or $1,175,000 at
acquisition plus ($190,000 - $10,000 - $125,000 =) $55,000 for 2006, or $1,230,000 x .20
noncontrolling interest = $246,000, the correct answer.
On January 1, 20x1 Ritt Corp. purchased 80% of Shaw Corp.'s $10 par common stock for
$975,000. Ritt's cost reflects an appropriate fair value measure for all of Shaw's
outstanding common stock. The original cost to the noncontrolling investors for the 20% of
Shaw's common stock not acquired by Ritt was $200,000. At the date of Ritt's purchase, the
carrying amount of Shaw's net assets was $1,000,000. The fair values of Shaw's identifiable
assets and liabilities were the same as their carrying amounts except for plant assets (net)
which were $100,000 in excess of the carrying amount. Which one of the following is the
amount of noncontrolling interest that should be reported in a consolidated balance sheet
prepared immediately following the business combination?
A. $125,000
B. $200,000
C. $220,000
D. $243,750
Correct!
Noncontrolling interest at the date of the business combination should be the noncontrolling
interest proportionate share of total fair value at that date, including goodwill. The total fair
value of Shaw (including goodwill) at the date Ritt acquired 80% of Shaw's common stock
would be $1,218,750 ($975,000/.80). The noncontrolling interest would be .20 x $1,218,750
= $243,705, the correct answer. The investment eliminating entry made immediately following
the business combination would be:
DR: (Various) Identifiable Net Assets $1,100,000
Goodwill 118,750
CR: Investment in Shaw $975,000
Noncontrolling Interest
243,750
(in Shaw)
On October 1, 2008, Potato Company acquired 100% of the voting stock of Spud Company
in a legal acquisition. Potato chose to account for its investment in Spud on its books using
the cost method. Spud had the following incomes and dividends for the periods shown:
10/1 - 12/31/08 1/1 - 12/31/09

Net Income $3,000 $15,000
Dividends Declared/Paid 1,000 3,000
In its December 31, 2009, consolidating process, which one of the following is the amount
of the reciprocity entry Potato will make on the consolidating worksheet?
A. $2,000
B. $3,000
C. $14,000
D. $18,000
Correct!
The purpose of the reciprocity is to bring the investment account (on the worksheet) in
balance with the subsidiary's retained earnings as of the beginning of the period being
consolidated. Therefore, only the undistributed income of the subsidiary since the business
combination up to the beginning of the period being consolidated (January 1, 2009) will be the
reciprocity entry at the end of 2009. The undistributed income from October 1 to December
31, 2008 (the beginning of 2009) is net income (+$3,000) less dividends declared and paid (-
$1,000), or $2,000.
On January 1, 20x6 Ritt Corp. purchased 80% of Shaw Corp.'s $10 par common stock for
$975,000. On this date, the carrying amount of Shaw's net assets was $1,000,000. The fair
values of Shaw's identifiable assets and liabilities were the same as their carrying amounts
except for plant assets (net) which were $100,000 in excess of the carrying amount. Those
plant assets had a 10-year remaining life, depreciated on a straight-line basis. The fair
value of the 20% noncontrolling interest in Shaw was properly determined to be $200,000
at that time. For the year ended December 31, 20x6, Shaw had net income of $190,000 and
paid cash dividends totaling $125,000. Which one of the following is the amount of goodwill
that should be recognized as a result of the business combination?
A. $ 43,000
B. $ 75,000
C. $ 95,000
D. $175,000
Correct!
Goodwill is determined as the excess of investment value over the fair value of the subsidiary's
net assets. Investment value is the sum of the parent’s investment (which is the fair value of
consideration paid) + the fair value of any noncontrolling interest, which in this question is
$975,000 + $200,000 = $1,175,000. The fair value of Shaw's identifiable net assets is book
value $1,000,000 + write up in plant assets $100,000 = $1,100,000. Therefore, goodwill is
investment value $1,175,000 - fair value of identifiable assets $1,100,000 = $75,000, the
correct answer.
Parco owns 100% of its subsidiary, Subco, which it acquired at book value. It carries its
investment in Subco on its books using the equity method of accounting. At the beginning
of its 2009 fiscal year, the investment in Subco account was $552,000. During 2009, Subco
reported the following:
Net Income $42,000
Dividends Declared/Paid 12,000
There were no other transactions between the firms in 2009.
In preparing its 2009 fiscal year consolidated statements, which one of the following is the
amount of the investment eliminating entry that Parco will make as a result of its
ownership of Subco?
A. $552,000
B. $582,000
C. $594,000
D. $606,000
Correct!
The amount of an investment eliminating entry is the balance in the investment account as of
the beginning of the period being consolidated. In this case, that was $552,000. If the
parent uses the equity method to account for its investment in the subsidiary, the entries it
makes during the year are reversed so that the investment account has its beginning of the
year balance.
If a parent uses the equity method on its books to carry its investment in a subsidiary,
which one of the following current year entries (made by the parent) must be reversed on
the consolidating worksheet?
Income from Subsidiary Dividends from Subsidiary
Yes Yes
Yes No
No Yes
No No
Correct!
When a parent uses the equity method to account for its investment in a subsidiary, the parent
will recognize on its books during the year its share of the subsidiary's income (or loss) and its
share of dividends declared by the subsidiary. Therefore, in the consolidating process, those
entries (and any other equity-based entries made by the parent) must be reversed so that the
elements that make up those entries (revenues, expenses, etc.) can be individually recognized
on the consolidating worksheet and the consolidated financial statements.
Parco owns 100% of its subsidiary, Subco, which it acquired at book value. It carries its
investment in Subco on its books using the equity method of accounting. At the beginning
of its 2009 fiscal year, the investment in Subco account was $552,000. During 2009, Subco
reported the following:
Net Income $42,000
Dividends Declared/Paid 12,000
There were no other transactions between the firms in 2009.
In preparing its 2009 fiscal year consolidated statements, which one of the following is the
amount of investment that Parco will have to reverse for 2009 as a result of its ownership
of Subco?
A. $12,000
B. $30,000
C. $42,000
D. $54,000
Correct!
During 2009 Parco would recognize Subco's reported net income of $42,000 as equity
revenue; the entry would be: DR: Investment in Subco and CR: Equity Revenue. The $12,000
dividends would not be recognized as equity revenue but rather as a liquidation of part of
Parco's investment in Subco; the entry would be: DR: Dividends Receivable/Cash and CR:
Investment in Subco. Therefore, the net amount of investment to be reversed would be
$30,000, computed as +$42,000 - $12,000 = $30,000.
If a parent uses the equity method on its books to account for its investment in a
subsidiary, which one of the following will result in an increase in the investment account
on the parent's books?
Subsidiary Reports Income Subsidiary Declares Dividend
Yes Yes
Yes No
No Yes
No No
Correct!
Under the equity method, when a subsidiary reports income, the parent recognizes its share
as: DR: Investment and CR: Equity Income. Therefore, the subsidiary's reported income
increases the investment account. In addition, when a subsidiary declares a dividend, the
parent recognizes its share as: DR: Dividends Receivable/Cash and CR: Investment. Therefore,
the subsidiary's dividends do not increase the investment account but rather decrease the
investment account.
Assume that in acquiring a subsidiary, the parent determined that several depreciable
assets had a fair value greater than book value. If the parent accounts for its investment in
the subsidiary using the equity method, what effect will the amortization of the excess fair
value over the book value of the subsidiary's assets have on the following parent's
accounts?
Investment in Subsidiary Equity Revenue from Subsidiary
Increase Increase
Increase Decrease
Decrease Increase
Decrease Decrease
Correct!
When the fair value of a subsidiary's assets is greater than book value, it is as though the
parent paid more for the assets than the subsidiary paid for those assets. Using the equity
method of accounting for the investment, the parent must depreciate the excess of fair value
over book value. That equity entry would be: DR: Equity Revenue - to reduce it by the amount
of depreciation on the excess of fair value over book value, and CR: Investment in Subsidiary -
to offset a portion of the net income (or increase the amount of net loss) recognized from the
subsidiary. Thus, both accounts would be decreased.
On January 2 of the current year, Peace Co. paid $310,000 to purchase 75% of the voting
shares of Surge Co. Peace reported retained earnings of $80,000, and Surge reported
contributed capital of $300,000 and retained earnings of $100,000. The purchase
differential was attributed to depreciable assets with a remaining useful life of 10 years.
Peace used the equity method in accounting for its investment in Surge. Surge reported net
income of $20,000 and paid dividends of $8,000 during the current year. Peace reported
income, exclusive of its income from Surge, of $30,000 and paid dividends of $15,000
during the current year. What amount will Peace report as dividends declared and paid in
its current year's consolidated statement of retained earnings?
A. $8,000
B. $15,000
C. $21,000
D. $23,000
Correct!
This is the amount ($15,000) that Peace will report as dividends in its consolidated statement
of retained earnings. Only Peace's (the parent's) dividends paid of $15,000 are shown on the
Peace/Surge consolidated statement of retained earnings. The dividend paid by Surge to Peace
($8,000 x .75 = $6,000) will not show on the consolidated statement of retained earnings,
because it will be eliminated as intercompany dividend (you can't pay a dividend to yourself!).
The balance of Surge's dividend ($8,000 x .25 = $2,000) goes to the 25% minority
shareholders in Surge and reduces their claim to Surge's retained earnings, not Peace's
consolidated retained earnings.
The separate condensed balance sheets and income statements of Purl Corp. and its wholly-
owned subsidiary, Scott Corp., are as follows:
BALANCE SHEETS
December 31, 2005
Purl Scott
Assets
Current assets
Cash $80,000 $60,000
Accounts receivable (net) 140,000 25,000
Inventories 90,000 50,000
Total current assets 310,000 135,000
Property, plant, and equipment (net) 615,000 280,000
Investment in Scott (equity method) 400,000 -
Total assets $1,325,000 $415,000
Liabilities and stockholders' equity
Current liabilities
Accounts payable $160,000 $95,000
Accrued liabilities 110,000 30,000
Total current liabilities 270,000 125,000
Stockholders' equity common stock ($10 par) 300,000 50,000
Additional paid-in capital - 10,000
Retained earnings 755,000 230,000
Total stockholders' equity 1,055,000 290,000
Total liabilities and stockholders' equity $1,325,000 $415,000
INCOME STATEMENTS
For the year ended December 31, 2005
Purl Scott
Sales $2,000,000 $750,000
Cost of goods sold 1,540,000 500,000
Gross margin 460,000 250,000
Operating expenses 270,000 150,000
Operating income 190,000 100,000
Equity in earnings of Scott 70,000 -
Income before income taxes 260,000 100,000
Provisions for income taxes 60,000 30,000
Net income $200,000 $70,000
Additional information:
 On January 1, 2005, Purl purchased for $360,000 all of Scott's $10 par voting
common stock. On January 1, 2005, the fair value of Scott's assets and liabilities
equaled their carrying amount of $410,000 and $160,000, respectively, except that
the fair values of certain items identifiable in Scott's inventory were $10,000 more
than their carrying amounts. These items were still on hand on December 31, 2005.
Purl's policy is to amortize intangible assets over a 10-year period, unless a definite
life is ascertainable.
 During 2005, Purl and Scott paid cash dividends of $100,000 and $30,000,
respectively. For tax purposes, Purl receives the 100% exclusion for dividends
received from Scott.
 There were no intercompany transactions, except for Purl's receipt of dividends from
Scott and Purl's recording of its share of Scott's earnings.
 Both Purl and Scott paid income taxes at the rate of 30%.
In the December 31, 2005, consolidated financial statements of Purl and its subsidiary,
total assets should be:
A. $1,740,000
B. $1,450,000
C. $1,350,000
D. $1,325,000
Correct!
In adding the assets of Purl and Scott, the Investment in Scott account must be eliminated.
Otherwise, the amount will be double counted -once, as an Investment in Scott and a second
time as the individual assets of Scott. The elimination also needs to recognize fair value of
assets in excess of book value.
In this case, there is inventory ($10,000) that is still on hand and goodwill of $100,000. Thus,
net assets would be $1,740,000 - $400,000 + $10,000 + $100,000 = $1,450,000. Remember,
goodwill is not amortized.
Assume that in acquiring a subsidiary, the parent determined there were several
depreciable assets of the subsidiary that had a fair value less than book value. What effect
will this fair value less than book value of the subsidiary's assets have on the following
accounts in the preparation of consolidated statements?
Depreciable Assets Depreciation Expense
Increase Increase
Increase Decrease
Decrease Increase
Decrease Decrease
Correct!
Both accounts will be decreased. The investment eliminating entry on the consolidating
worksheet will write down (decreasing on the worksheet) the value of depreciable asset, from
book value to the lower fair value on the date of the combination. The decrease in depreciable
asset value recognized on the worksheet will mean that the depreciation expense on the
worksheet, brought on by the subsidiary, will overstate depreciation expense to the parent,
resulting in a reduction (decreasing) depreciation expense for consolidated statement
purposes.
Assume that in acquiring a subsidiary, the parent determined there were several
depreciable assets of the subsidiary that had a fair value greater than book value. What
effect will the excess fair value over book value of the subsidiary's assets have on the
following accounts in the preparation of consolidated statements?
Depreciable Assets Depreciation Expense
Increase Increase
Increase Decrease
Decrease Increase
Decrease Decrease
Correct!
The investment eliminating entry on the consolidating worksheet will write up (increasing on
the worksheet) the value of depreciable asset, from book value to fair value on the date of the
combination. The additional depreciable asset value recognized on the worksheet will then be
depreciated on the worksheet, resulting in additional (increasing) depreciation expense.
The separate condensed balance sheets and income statements of Purl Corp. and its wholly-
owned subsidiary, Scott Corp., are as follows:
BALANCE SHEETS
December 31, 2005
Purl Scott
Assets
Current assets
Cash $80,000 $60,000
Accounts receivable (net) 140,000 25,000
Inventories 90,000 50,000
Total current assets 310,000 135,000
Property, plant, and equipment (net) 615,000 280,000
Investment in Scott (equity method) 400,000 -
Total assets $1,325,000 $415,000
Liabilities and stockholders' equity

Current liabilities
Accounts payable $160,000 $95,000
Accrued liabilities 110,000 30,000
Total current liabilities 270,000 125,000
Stockholders' equity common stock ($10 par) 300,000 50,000
Additional paid-in capital - 10,000
Retained earnings 755,000 230,000
Total stockholders' equity 1,055,000 290,000
Total liabilities and stockholders' equity $1,325,000 $415,000
INCOME STATEMENTS
For the year ended December 31, 2005
Purl Scott
Sales $2,000,000 $750,000
Cost of goods sold 1,540,000 500,000
Gross margin 460,000 250,000
Operating expenses 270,000 150,000
Operating income 190,000 100,000
Equity in earnings of Scott 70,000 -
Income before income taxes 260,000 100,000
Provisions for income taxes 60,000 30,000
Net income $200,000 $70,000
 On January 1, 2005, Purl purchased for $360,000 all of Scott's $10 par voting
common stock. On January 1, 2005, the fair value of Scott's assets and liabilities
equaled their carrying amount of $410,000 and $160,000, respectively, except that
the fair values of certain items identifiable in Scott's inventory were $10,000 more
than their carrying amounts. These items were still on hand on December 31, 2005.
Purl's policy is to amortize intangible assets over a 10-year period, unless a definite
life is ascertainable.
 During 2005, Purl and Scott paid cash dividends of $100,000 and $30,000,
respectively. For tax purposes, Purl receives the 100% exclusion for dividends
received from Scott.
 There were no intercompany transactions except for Purl's receipt of dividends from
Scott and Purl's recording of its share of Scott's earnings.
 Both Purl and Scott paid income taxes at the rate of 30%.
In the December 31, 2005, consolidated financial statements of Purl and its subsidiary,
total current assets should be:
A. $455,000
B. $445,000
C. $310,000
D. $135,000
Correct!
The assets of Purl and Scott need to be added together and any difference between book value
and fair value recognized.
The sum of the current assets is $445,000. However, in the investment eliminating entry,
inventory (still on hand) will be written up by $10,000 for consolidated purposes. This results
in a current asset total of $455,000.
Consolidated financial statements are based on the concept that:

A. In the preparation of financial statements, legal form takes precedence over economic
substance.
B. In the preparation of financial statements, economic substance takes precedence over legal
form.
C. Financial information should be presented separately for each legal entity.
D. Separate financial statements are more meaningful than consolidated financial statements.
Correct!
The preparation of consolidated financial statements is based on the concept that economic
substance takes precedence over legal form. In form, the corporations are separate legal
entities, but in substance, they are under the common economic control of the parent's
shareholders.
Which one of the following would be of concern in preparing consolidated financial

statements at the end of the operating period following a business combination that would
not be a concern in preparing financial statements immediately following a combination?
A. Whether or not there are intercompany accounts receivable/accounts payable.
B. Whether or not goodwill resulted from the business combination.
C. Whether the parent carries its investment in the subsidiary using the cost method or the
equity method.
D. Whether or not there is a noncontrolling interest in the subsidiary.
Correct!
Whether the parent carries its investment in the subsidiary using the cost method or the equity
method would be of concerning in preparing consolidated financial statements at the end of
the operating period following a business combination but would not be of concern in preparing
financial statements immediately following the combination. When consolidated financial
statements are prepared immediately following a combination, there has been no period over
which the parent has "carried" the investment on its books. Therefore, the method it WILL
(going forward) use is not of concern immediately after the combination.
This question has been adapted from the original AICPA released question.
On April 1, 2005, Dart Co. paid $620,000 for all the issued and outstanding common stock
of Wall Corp. in a transaction properly accounted for as an acquisition.
The recorded assets and liabilities of Wall Corp.
on April 1, 2005 follow:
Cash $ 60,000
Inventory 180,000
Property and equipment (net of accumulated depreciation of $220,000) 320,000
Goodwill (net of accumulated amortization of $50,000) 100,000
Liabilities (120,000)
Net assets $540,000
========
On April 1, 2005, Wall's inventory had a fair value of $150,000, and the property and
equipment (net) had a fair value of $380,000. What is the amount of goodwill resulting
from the business combination?
A. $150,000
B. $120,000
C. $50,000
D. $20,000
Correct!
First the fair value of the identifiable net assets must be determined:
Cash $60,000
Inventory $150,000
P&E (net) $380,000
Liabilities ($120,000)
Net Assets $470,000
Once this has been determined it is a simple matter of subtracting this amount from the
purchase price to determine the goodwill. ($620,000 - $470,000 = $150,000 goodwill).
Lecture 2
Which of the following kinds of transactions should be eliminated in the consolidating

process?
Parent to Subsidiary Subsidiary to Parent Subsidiary 1 Subsidiary 2

Yes Yes Yes
Yes Yes No
Yes No No
No Yes Yes
Correct!
All intercompany transactions (i.e., transactions between affiliated firms) must be eliminated in
the consolidating process, including not only transactions between a parent and its
subsidiaries, but also transactions between affiliated subsidiaries. The consolidated financial
statements must reflect accounts and amounts as though intercompany transactions never
occurred.
In the preparation of consolidated financial statement, which of the following sources of

transactions should be eliminated?
Transactions with Affiliates Transactions with Non-affiliates
Yes Yes
Yes No
No Yes
No No
Correct!
Transactions with affiliates (that are to be consolidated) will be eliminated in the preparation of
consolidated financial statements. Transactions with non-affiliates are not eliminated, because
those entities are not consolidated with the parent company.
During 2008, Popco acquired 80% of the voting stock of Sonco in a legal acquisition. Which
one of the following is least likely to be a type of intercompany balance that results from
transactions between Popco and Sonco during 2009?
A. Receivable.
B. Inventory.
C. Goodwill.
D. Revenue.
Correct!
Goodwill will occur on the date of a business combination as a result of the parent paying more
for its investment in a subsidiary than the fair value of identifiable net assets acquired.
Goodwill does not occur as a result of operating period transactions between a parent and its
subsidiaries.
Which one of the following is not a characteristic associated with intercompany

transactions?
A. Intercompany transactions must be eliminated in the consolidating process.
B. Gains and losses must be eliminated in the consolidating process.
C. Transactions that originate with a subsidiary must be eliminated in the consolidating process.
D. Transactions between two subsidiaries to be consolidated with the same parent do not need
to be eliminated.
Correct!
Intercompany transactions between two subsidiaries that will be consolidated with the same
parent do need to be eliminated. Intercompany transactions (i.e., transactions between
affiliated firms) must be eliminated regardless of whether the transactions are between the
parent and its subsidiaries or between two subsidiaries of the same parent. The consolidated
financial statements must reflect accounts and amounts as though intercompany transactions
never occurred.
Parco sells goods to its subsidiary, Subco, which in turn sells the goods to Noco, an
unaffiliated firm. Which of these transactions, if any, should be eliminated in the
consolidating process?
Parco to Subco Subco to Noco

Yes Yes
Yes No
No Yes
No No
Correct!
The transaction between Parco and Subco should be eliminated, because they are affiliated
entities, but the transaction between Subco and Noco should not be eliminated, because Noco
is not affiliated with Subco (or Parco).
If on the date of consolidation a 70% owned subsidiary has $50,000 in interest payable due
to its parent, the amount that should be eliminated is:
A. $- 0 -
B. $15,000
C. $35,000
D. $50,000
Correct!
The amount of intercompany payables to be eliminated is $50,000, the full amount of

intercompany payables (and receivables on the parent's books). Since $50,000 is the amount
that is intercompany, that amount must be eliminated in the consolidating process.
On December 31, 2005, Grey, Inc. owned 90% of Winn Corp., a consolidated subsidiary,
and 20% of Carr Corp., an investee in which Grey cannot exercise significant influence. On
the same date, Grey had receivables of $300,000 from Winn and $200,000 from Carr.
In its December 31, 2005, consolidated balance sheet, Grey should report accounts
receivable from affiliates of:
A. $500,000
B. $340,000
C. $230,000
D. $200,000
Correct!
A 90% owned subsidiary will be consolidated, and any intercompany receivables such as these
are eliminated from both parties' books in the consolidating process.
Therefore, the $300,000 receivable from Winn will not appear on the consolidated balance
sheet at all. The $200,000 from Carr is a receivable from an affiliate (20% owned) and will
need to be reported as such.
Bell, Inc. owns 60% of Dart Corporation's common stock. On December 31, 20X6, Dart is
indebted to Bell for a $200,000 cash advance. In preparing the consolidated balance sheet
on that date, what amount of the advance should be eliminated?
A. $-0-
B. $80,000
C. $120,000
D. $200,000
Correct!
The amount to be eliminated is $200,000, which is the full amount of the intercompany
receivable-payable resulting from the cash advance.
Selected information from the separate and consolidated balance sheets and income
statements of Pare, Inc. and its subsidiary, Shel Co., as of December 31, 20x4, and for the
year then ended is as follows:
__Pare__ __Shel__ Consolidated
Balance sheet accounts
Accounts receivables $52,000 $38,000 $78,000
Inventory 60,000 50,000 104,000
Income statement accounts
Revenues $400,000 $280,000 $616,000
Cost of goods sold 300,000 220,000 462,000
Gross profits $100,000 $60,000 $154,000
======== ======== ========
Additional Information: During 20x4, Pare sold goods to Shel at the same markup on cost
that Pare uses for all sales.
On December 31, 20x4, what was the amount of Shel's payable to Pare from intercompany
sales?
A. $6,000
B. $12,000
C. $58,000
D. $64,000
Correct!
The intercompany payable from Shel to Pare is $12,000. Although the (intercompany)
payables are not given in the facts, the accounts receivable are given. The payable to Pare
that would be shown on Shel's books is also a receivable on Pare's books. Since intercompany
receivables/payables are eliminated, the difference between the sum of the accounts
receivables on the separate sets of books ($52,000 + $38,000 = $90,000) and the amount
shown on the consolidated balances sheet ($78,000) is the amount of intercompany
receivables/payables that was eliminated in the consolidating process. Thus, $90,000 -
$78,000 = $12,000 is the amount of Shel's payable to Pare from intercompany sales and was
eliminated in getting the consolidated accounts receivable of $78,000 ($52,000 + $38,000 -
$12,000 = $78,000).
Pride, Inc. owns 80% of Simba, Inc.'s outstanding common stock. Simba, in turn, owns
10% of Pride's outstanding common stock.
What percentage of the common stock cash dividends declared by the individual companies
should be reported as dividends declared in the consolidated financial statements?
Dividends declared by Pride Dividends declared by Simba

90% 0%
90% 20%
100% 0%
100% 20%
Correct!
Subsidiary dividends are never considered part of consolidated dividends. They are either
eliminated in the consolidation entries or allocated to reducing noncontrolling interests. In this
problem, 80% of Simba's dividends will be eliminated as intercompany, and 20% will be
allocated to reducing noncontrolling interest.
In addition, since 10% of the dividends of Pride never go outside the consolidated entity, they
are not considered dividends of the consolidated entity either.
Rowe Inc. owns 80% of Cowan Co.'s outstanding capital stock. On November 1, Rowe
advanced $100,000 in cash to Cowan. What amount should be reported related to the
advance in Rowe's consolidated balance sheet as of December 31?
A. $-0-
B. $20,000
C. $80,000
D. $100,000
Correct!
All intercompany receivables and payables should be eliminated in the preparation of a

consolidated balance sheet so that no intercompany receivables/payables are reported. In this
question, an eliminating entry should be made that eliminates (credits) Rowe's receivable from
Cowan against (debits) Cowan's payable to Rowe, both for $100,000. Since the
receivable/payable is between the affiliated entities, 100% (not 80%) of the intercompany
amount should be eliminated.
Cobb, Inc., has current receivables from affiliated companies on December 31, 20x5, as
follows:
 A $75,000 cash advance to Hill Corporation. Cobb owned 30% of the voting stock of
Hill and accounts for the investment by the equity method.
 A receivable of $260,000 from Vick Corporation for administrative and selling
services. Vick is 100% owned by Cobb and is included in Cobb's consolidated
financial statements.
 A receivable of $200,000 from Ward Corporation for merchandise sales on credit.
Ward is 40% owned by Cobb, which can exercise significant influence over Ward.
In the current assets section of its December 31, 20x5, consolidated balance sheet, Cobb
should report accounts receivable from investees in the total amount of:
A. $180,000
B. $255,000
C. $275,000
D. $535,000
Correct!
The amount of accounts receivable reported by Cobb from investees is $275,000. The amount
of receivable from Vick ($260,000) would be eliminated against the payable to Cobb as
brought onto the consolidating worksheet from Vick's balance sheet. The amounts receivable
from Hill ($75,000) and Ward ($200,000) would not be eliminated, because since Cobb does
not have controlling interest in either firm, they would not be consolidated with Cobb. Both
would be accounted for using the equity method of accounting, which does not eliminate
intercompany receivables/payables. Since the amounts due from Hill ($75,000) and Ward
($200,000) would not be eliminated, they would show as accounts receivable in the
consolidated balance sheet (total = $275,000).
Lion, Inc. owns 60% of Gray Corp.'s common stock. On December 31, 2005, Gray owes Lion
$400,000 for a cash advance.
In preparing the consolidated balance sheet on that date, what amount of the advance
should be eliminated?
A. $400,000
B. $240,000
C. $160,000
D. $0
Correct!
When consolidated statements are prepared, 100% of all reciprocal accounts are eliminated
regardless of the ownership fraction. Thus, the whole $400,000 must be eliminated.
Which of the following can be overstated on consolidated financial statements if

intercompany inventory balances on-hand at the end of a period are not eliminated?
Consolidated Income Consolidated Loss

Yes Yes
Yes No
No Yes
No No
Correct!
Either consolidated income or consolidated loss could be overstated on consolidated

statements as a result of failure to eliminate intercompany inventory balances. An
overstatement of income would result if the goods were sold by the selling affiliate at a price
greater than the cost to the selling affiliate. An overstatement of loss would result if the goods
were sold by the selling affiliate at a price less than the cost to the selling affiliate.
Pine Company acquired goods for resale from its manufacturing subsidiary, Strawco, at
Strawco's cost to manufacture of $12,000. Pine subsequently resold the goods to a
nonaffiliate for $18,000. Which one of the following is the amount of the elimination that
will be needed as a result of the intercompany inventory transaction?
A. $-0-
B. $6,000
C. $12,000
D. $18,000
Correct!
Even though the intercompany inventory sale from Strawco to Pine was at no profit or loss (at
Strawco's cost to manufacture), the intercompany sale and purchase, nevertheless, must be
eliminated. Otherwise, consolidated sales and purchases (cost of goods sold) will be
overstated. Therefore, the elimination related to the intercompany inventory transaction will
be for $12,000, the cost of the sale from Strawco to Pine.
During 200X, Papa Company sold inventory, which cost it $18,000, to its subsidiary,
Sonnyco, for $27,000. At the end of 200X, Sonnyco had $9,000 of the intercompany goods
still on its books. The balance had been resold to unaffiliated customers for $24,000. Which
one of the following is the amount of intercompany sales that should be eliminated for 200X
consolidated statements?
A. $27,000
B. $24,000
C. $18,000
D. $12,000
Correct!
Since only the transaction between Papa and Sonnyco is an intercompany transaction, only the
amount of that transaction, $27,000, will be eliminated. The purchase of inventory by Papa
and the sale by Sonnyco are both with non-affiliates. Therefore, those transaction amounts
would not be eliminated.
one of the following is the amount of ending inventory that should be eliminated for
consolidated statements?
A. $3,000
B. $6,000
C. $9,000
D. $15,000
Correct!
With a cost from non-affiliates of $18,000 and an intercompany selling price of $27,000, there
is a $9,000 intercompany profit on the inventory transaction. Therefore, $9,000 profit/$27,000
cost to the buying affiliate results in a one third profit in ending inventory. Since the ending
inventory at the buying affiliate's cost is $9,000, 1/3 x $9,000 = $3,000 is the intercompany
profit in ending inventory and the amount that would have to be eliminated.
Which one of the following will occur on consolidated financial statements if an

intercompany inventory transaction is not eliminated?
A. An understatement of sales.
B. An overstatement of sales.
C. An understatement of purchases.
D. An overstatement of accounts receivable.
Correct!
If an intercompany inventory transaction is not eliminated in the consolidating process,

consolidated financial statements would show an overstatement of sales. Sales would be
overstated by the amount of the intercompany sales reported by the selling affiliate. All
intercompany sales and related purchases must be eliminated, even if they do not result in a
profit or loss.
one of the following is the correct amount of profit or loss that would be recognized in the
consolidated statements for 200X?
A. $6,000
B. $9,000
C. $12,000
D. $15,000
Correct!
With an intercompany selling price of $27,000 and $9,000 of those goods on-hand at year-
end, one third of the cost from non-affiliates is still on-hand and should not be included in the
cost of goods sold. That amount is $6,000 (i.e., 1/3 x $18,000 = $6,000). Therefore, the
consolidated profit that should be recognized for 200X is the selling price to non-affiliates
($24,000) less the cost of that inventory from non-affiliates ($18,000 - $6,000 = $12,000), or
$24,000 - $12,000 = $12,000.
Water Co. owns 80% of the outstanding common stock of Fire Co. On December 31, 2005,
Fire sold equipment to Water at a price in excess of Fire's carrying amount but less than its
original cost. On a consolidated balance sheet on December 31, 2005, the carrying amount
of the equipment should be reported at:
A. Water's original cost.
B. Fire's original cost.
C. Water's original cost less Fire's recorded gain.
D. Water's original cost less 80% of Fire's recorded gain.
Correct!
The individual books of Water and Fire would record this transaction as if they were
independent companies. Fire would remove the asset and record a gain. Water would put the
asset on its books at cost.
The problem is that they are not independent companies, and therefore, no real sale took
place. The gain that was recorded must therefore be eliminated on the consolidated books. The
net result is that the asset will be on the books at Water's original cost less Fire's recorded
gain.
An intercompany depreciable fixed asset transaction resulted in an intercompany gain.

Which one of the following is least likely to be reflected in the consolidated financial
statements prepared at the end of the period in which the intercompany transaction
occurred?
A. Consolidated income will be less than the sum of the incomes of the separate companies
being combined.
B. Consolidated assets will be less than the sum of the assets of the separate companies being
combined.
C. Consolidated depreciation expense will be more than the sum depreciation expense of the
separate companies being combined.
D. Consolidated accumulated depreciation will be more than the sum of accumulated
depreciation of the separate companies being combined.
Correct!
Consolidated depreciation expense will be less, not more, than the sum of depreciation
expense of the separate companies being combined. Because the intercompany transaction
resulted in a gain, the buying affiliate will have the asset on its books with the intercompany
gain included in its carrying value and will depreciate that value on its books. For consolidated
purposes, that depreciation on the intercompany gain will be eliminated, resulting in less
depreciation expense than the sum of the depreciation expense of the separate companies.
Assume that on January 2, Company P recognized a $3,000 gain on the sale of a depreciable
fixed asset to its subsidiary, Company S. Company S will depreciate the asset using
straight-line depreciation over the remaining three-year life of the asset. What amount of
intercompany gain will be eliminated from P's retained earnings at the end of the year
following the year of the intercompany fixed asset transactions?
A. $- 0 -
B. $1,000
C. $2,000
D. $3,000
Correct!
The amount of intercompany gain to be eliminated at the end of the year following the year of
the intercompany fixed asset sale is $2,000. At the end of the year of the intercompany sale,
depreciation taken by the buying affiliate on the $3,000 inter-company gain will be $1,000
($3,000/3 years). As a consequence, $1,000 of the $3,000 intercompany gain will have been
properly recognized, leaving only $2,000 to eliminate at the end of the second year.
Depreciation expense taken on the intercompany gain for the second year will confirm another
$1,000 of the intercompany gain, and depreciation expense taken on the intercompany gain
for the third year will confirm the last $1,000 of the intercompany gain.
Which of the following can be overstated on consolidated financial statements if
intercompany fixed asset balances on-hand at the end of a period are not eliminated?
Consolidated Income Consolidated Loss

No No
No Yes
Yes No
Yes Yes
Correct!
Either consolidated income or consolidated loss could be overstated on consolidated

statements as a result of failure to eliminate intercompany fixed asset balances. An
overstatement of income would result if the assets were sold by the selling affiliate at a price
greater than the carrying value to the selling affiliate. An overstatement of loss would result if
the assets were sold by the selling affiliate at a price less than the carrying value to the selling
affiliate.
Scroll, Inc., a wholly owned subsidiary of Pirn, Inc., began operations on January 1, 2005.
The following information is from the condensed 2005 income statements of Pirn and
Scroll:
Pirn Scroll
Sale to Scroll $100,000 $-
Sales to others 400,000 300,000
500,000 300,000
Cost of goods sold:
Acquired from Pirn - 80,000
Acquired from others 350,000 190,000
Gross profit 150,000 30,000
Depreciation 40,000 10,000
Other expenses 60,000 15,000
Income from operations 50,000 5,000
Gain on sale of equipment to Scroll 12,000 -
Income before income taxes $38,000 $5,000
 Sales by Pirn to Scroll are made on the same terms as those made to third parties.
 Equipment purchased by Scroll from Pirn for $36,000 on January 1, 2005, is
depreciated using the straight-line method over four years.
What amount should be reported as depreciation expense in Pirn's 2005 consolidated

income statement?
A. $50,000
B. $47,000
C. $44,000
D. $41,000
Correct!
The gain on the equipment sold to Scroll must be eliminated, since it was not sold outside the
consolidated entity. With the elimination of the gain, one must also eliminate the depreciation
of the gain that Scroll would have been booking (based on their higher purchase price). This
excess depreciation is $3,000 a year ($12,000 gain/4 years).
This would reduce the total consolidated depreciation from $50,000 ($40,000+$10,000) to
$47,000.
Zest Co. owns 100% of Cinn, Inc. On January 2, 1999, Zest sold equipment with an original
cost of $80,000 and a carrying amount of $48,000 to Cinn for $72,000. Zest had been
depreciating the equipment over a five-year period using straight-line depreciation with no
residual value. Cinn is using straight-line depreciation over three years with no residual
value. In Zest's December 31, 1999, consolidating worksheet, by what amount should
depreciation expense be decreased?
A. $0
B. $8,000
C. $16,000
D. $24,000
Correct!
There are two ways to approach this solution. First, take the difference in carrying values
72,000-48,000 = 24,000. The 24,000 is the incremental amount Cinn carries the equipment
over the carrying amount of Zest. The 24,000/3 = 8,000
OR, compute the depreciation for each company:
Cinn is 72,000/3 = 24,000
Zest is 80,000/5 = 16,000
Since Cinn is 100% owned by Zest, the equipment cannot be depreciated by a greater amount
through an intracompany sale. The difference is 24,000 - 16,000 = 8,000.
For consolidated purposes, what effect will the intercompany sale of a fixed asset at a profit
or at a loss have on depreciation expense recognized by the buying affiliate?
At a Profit At a Loss
Overstate Overstate
Overstate Understate
Understate Overstate
Understate Understate
Correct!
An intercompany sale of a fixed asset at a profit will result in the buying affiliate overstating
depreciation expense by the amount of depreciation taken on the intercompany profit, and an
intercompany sale at a loss will result in an understatement of depreciation expense taken by
the buying affiliate. When an intercompany sale of a fixed asset results in a loss, the carrying
value of the asset will be understated by the amount of the loss. As a result, depreciation
expense taken by the buying affiliate will be understated by the amount of depreciation that
would have been taken on the intercompany loss.
Which one of the following is not a characteristic of intercompany bonds?

A. Intercompany bonds may occur on the date of a business combination or subsequent to a
business combination.
B. When bonds become intercompany, it is as though the bonds have been retired for
consolidated purposes.
C. Intercompany bonds can result in the recognition of a gain or a loss for consolidating
purposes.
D. When bonds become intercompany, they are written off of the books of the issuing affiliate
and the investing affiliate.
Correct!
The liability and investment related to intercompany bonds are eliminated only on the
consolidating worksheet. They are not written off the books of either the issuing or the
investing affiliate. From the perspective of the separate companies, the liability and investment
related to the bonds continue to exist, but for consolidated purposes, they have been
constructive retired.
In which of the following ownership arrangements would intercompany bonds exist?

Parent Owns Subsidiary Bonds Subsidiary Owns Parent Bonds
Yes Yes
Yes No
No Yes
No No
Correct!
Intercompany bonds exist when one affiliate to be consolidated owns the bonds of another
affiliate to be consolidated. Thus, intercompany bonds would exist when a parent owns a
subsidiary's bonds, when a subsidiary owns a parent's bonds, or when one subsidiary owns the
bonds of another subsidiary that will be consolidated.
In which of the following cases will the elimination of intercompany bonds always result in
a gain on constructive retirement?
Issuing Affiliate Has Buying Affiliate Has
Premium Premium
Premium Discount
Discount Premium
Discount Discount
Correct!
When the issuing affiliate has a premium on the bond liability and the buying affiliate has a
discount on the bond investment, the elimination of the bond liability against the bond
investment will result in a gain on constructive retirement. If the bonds are issued at a
premium, the issuing firm received a greater amount for the bonds than face value. In
addition, if the buying affiliate acquired the bonds at a discount, it paid less than face value for
the bonds. Therefore, the elimination of the payable against the investment in the
consolidating process must result in a gain on constructive retirement.
On December 31, 2008, Pico acquired $250,000 par value of the outstanding $1,000,000
bonds of its subsidiary, Sico, in the market for $200,000. On that date, Sico had a $100,000
premium on its total bond liability.
Which one of the following is the net amount of gain or loss that will be recognized by Pico
in its December 31, 2008, consolidated financial statements as a result of its intercompany
bonds?
A. $25,000
B. $50,000
C. $75,000
D. $150,000
Correct!
In the elimination of intercompany bonds, the intercompany bond liability at par will be
eliminated against the intercompany bond investment at par. Therefore, the gain or loss
recognized as a result of constructive retirement of intercompany bonds is the net of the
premium or discount on the bond liability and the premium or discount on the bond
investment. In this case, there is a total $100,000 premium on the bond liability, but because
only one-fourth ($250,000/$1,000,000 = 1/4) of the bonds are intercompany, only one fourth
of the premium is eliminated. Thus, $25,000 of premium on the bond liability (a credit) will be
eliminated against the $50,000 discount on the bond investment (also a credit). As a result of
eliminating the two credits ($25,000 + $50,000 = $75,000), a $75,000 gain on constructive
retirement will be recognized.
Which one of the following is the net carrying value of Sico's total bond liability?
A. $900,000
B. $1,000,000
C. $1,050,000
D. $1,100,000
Correct!
A premium on a bond liability results from the sale of the bonds at a price in excess of par
(face) value. Therefore, a premium would be added to par value to get net carrying value.
Sico's premium on its bond liability ($100,000) should be added to the par (or face) value of
its bond liability ($1,000,000) to determine the net carrying value of the liability. Thus, the
answer should be $1,000,000 par value + $100,000 premium = $1,100,000 net carrying
value.
Which one of the following is the amount of premium or discount on Pico's investment in
Sico's bonds?
A. $250,000 premium
B. $100,000 premium
C. $50,000 premium
D. $50,000 discount
Correct!
The premium or discount on a bond investment is the difference between the par value of the
bonds and the price paid for the bonds in the market. If the price paid is more than par value,
there is a premium on the bond investment. If the price paid is less than par value, there is a
discount on the bond investment. In this case, the price paid for the investment ($200,000) is
less than the par value of the bonds ($250,000) by $50,000. Therefore, there is a $50,000
discount on Pico's investment.
bonds of its subsidiary, Sico, in the market for $200,000. At that date, Sico had a $100,000
Assume each company maintains its premium or discount in a separate account. Which one
of the following will be the intercompany bond elimination entry made on the December 31,
2008 consolidating worksheet?
A. DR: Bonds Payable

Discount on Bond Investment
Loss on Constructive Retirement
CR: Investment in Bonds
Premium on Bonds Payable
B. DR: Bonds Payable
Gain on Constructive Retirement
C. DR: Bonds Payable
D. DR: Investment in Bonds
CR: Bonds Payable
Correct!
The Investment in Bonds (a debit balance, so it will be credited) and the Bonds Payable (a
credit balance, so it will be debited) will be eliminated against each other at par value
($250,000). The Discount on Bond Investment $50,000 (a credit balance, so it will be debited)
and the Premium on Bonds Payable $25,000 (a credit balance, so it will be debited) will be
eliminated resulting in a Gain on Constructive Retirement of $75,000, a credit balance.
Therefore, the correct entry would be:
DR: Bonds Payable
When intercompany bonds exist, will the amounts shown on the consolidated statements be
more or less than the sum of the accounts shown on the separate financial statements for
the following accounts?
Consolidated > or < Separate Accounts?
Bonds Payable Investment in Bonds Interest Income Interest Expense

More More More More
More Less More Less
Less More Less More
Less Less Less Less

Correct!
As a result of intercompany bonds, in the consolidating process, the bond liability (bonds
payable) and the investment in bonds will be eliminated against each other. In addition, since
the bonds are intercompany and eliminated for consolidating purposes, any interest income
and interest expense associated with the bonds will be eliminated against each other.
Therefore, all of the listed accounts will be less for consolidated purposes than the sum of the
accounts shown on the separate financial statements.
Which one of the following accounts will not be affected by the investment eliminating
entry?
A. Parent's investment in subsidiary.
B. Subsidiary's cash.
C. Subsidiary's common stock.
D. Subsidiary's retained earnings.
Correct!
The investment eliminating entry does not affect the subsidiary's cash account. In the
investment eliminating entry, the parent's investment in its subsidiary will be eliminated
against the parent's claim to the subsidiary's shareholders' equity accounts; the subsidiary's
cash account is not an element in the entry. Any shareholders' equity not owned by the parent
will be assigned to non-controlling (minority) interest in the subsidiary.
Dean Co. acquired 100% of Morey Corp. prior to 2005. During 2005, the individual
companies included in their financial statements the following:
Dean Morey
Officers' salaries $75,000 $50,000
Officers' expenses 20,000 10,000
Loans to officers 125,000 50,000
Intercompany sales 150,000 -
What amount should be reported as related party disclosures in the notes to Dean's 2005
consolidated financial statements?
A. $150,000
B. $155,000
C. $175,000
D. $330,000
Correct!
!) Loans to officers are an example of a transaction warranting disclosure as a related party

transaction. The sum of the loans to officers is $175,000 ($125,000 + $50,000). Dean owns
100% of Morey. From the point of view of the consolidated entity, both loans are to related
parties. The other amounts are either ordinary expenses or intercompany amounts, neither of
which requires separate disclosure.
Assume an intercompany inventory transaction results in a profit to the selling affiliate. If
at year-end, the intercompany inventory is still held by the buying affiliate, will the amount
in the consolidated statements for the following accounts be more or less than the amounts
shown on the separate books of the affiliated entities?
Consolidated > or < Separate Accounts?
Inventory Profit
More More
More Less
Less More
Less Less
Correct!
If an intercompany inventory transaction results in a profit, and the goods are still on-hand at
the end of the period, both the profit made by the selling affiliate and the inventory carrying
value on the books of the buying affiliate will be overstated by the amount of the intercompany
profit. On the consolidating worksheet, the intercompany profit will be eliminated from both
accounts, and as a result, both consolidated profit and consolidated inventory will be less than
on the separate books.
As a result of an investment eliminating entry, which one of the following could be on

consolidated financial statements but not on the financial statements of the separate
entities?
A. Investment in subsidiary.
B. Common stock.
C. Non-controlling (minority) interest.
D. Retained earnings.
Correct!
As a result of the investment eliminating entry, the subsidiary's shareholders equity accounts
will be either eliminated against the parent's investment in the subsidiary or assigned to non-
controlling interest. If the parent owns less than 100% of the subsidiary, the amount assigned
to those shareholders will be recognized on the consolidated financial statements as non-
controlling interest.
Which one of the following would be the eliminating entry for cash dividends paid by a
subsidiary to its parent when the parent accounts for its investment in the subsidiary using
the cost method?
A. DR: Dividend Income
CR: Cash
B. DR: Investment in Subsidiary
CR: Subsidiary's Retained Earnings
C. DR: Investment in Subsidiary
CR: Cash
D. DR: Dividend Income
CR: Subsidiary's Retained Earnings
Correct!
The correct DR is to Dividend Income to reverse (eliminate) the dividend income recognized by
the parent when the subsidiary declared the dividend. The correct CR is to Subsidiary's
Retained Earnings to reverse (eliminate) the reduction in retained earnings recognized by the
subsidiary when it declared the dividend.
If an intercompany fixed asset transaction for cash results in a gain to the selling affiliate,
at the end of the period of the transaction, which one of the following accounts is most
likely to be increased as a result of the elimination of the intercompany fixed asset
transaction?
A. Gain on asset sale.
B. Depreciation expense.
C. Accumulated depreciation.
D. Cash
Correct!
As a result of the intercompany sale of a fixed asset, the selling affiliate will write off its
accumulated depreciation on the asset sold (as well as the asset itself). Consequently, the
accumulated depreciation brought onto the consolidating worksheet will understate
accumulated depreciation. The amount written off will be reestablished (increased) as part of
the elimination of the intercompany fixed asset transaction.
Jane Co. owns 90% of the common stock of Dun Corp. and 100% of the common stock of
Beech Corp. On December 30, Dun and Beech each declared a cash dividend of $100,000 for
the current year. What is the total amount of dividends that should be reported in the
December 31 consolidated financial statements of Jane and its subsidiaries, Dun and
Beech?
A. $ 10,000
B. $100,000
C. $190,000
D. $200,000
Correct!
All intercompany dividends should be eliminated in the preparation of consolidated financial

statements; dividends to nonaffiliates should be reported in the consolidated financial
statements. Jane owns 90% of Dun and 100% of Beech. Therefore, 90% of Dun's dividends
will be intercompany and should be eliminated (and 10% reported as dividends), and 100% of
Beech's dividends should be eliminated. Thus, the calculation would be:
Total dividends declared = $200,000
(Dun = $100,000 + Beech = $100,000)
Dun's dividends $100,000 x 90% eliminated = $ 90,000
Beech's dividends $100,000 x 100% eliminated = 100,000
Total dividends eliminated = 190,000
Dividends reported in consolidated financial statements = $ 10,000
In the preparation of combined financial statements, would the following issues be treated
in the same way as when preparing consolidated financial statements or in a different way?
Minority Interest Foreign Operations Different Fiscal Periods
Different Different Different
Different Same Same
Same Same Different
Same Same Same
Correct!
According to Accounting Research Bulletin # 51 (Para. 22), if problems associated with

minority interest, foreign operations, different fiscal periods, or income taxes occur in the
preparation of combined financial statements, they should be treated in the same manner as in
the preparation of consolidated financial statements. Therefore, all three items should be
treated in the same manner as in consolidated statements.
Combined statements may be used to present the results of operations of:

Unconsolidated subsidiaries Companies under common management
Yes Yes
Yes No
No Yes
No No
Correct!
Combined financial statements are used when consolidated statements are not appropriate to
accomplish much the same purpose. It is done when there is a non-consolidated sub or a
group of companies owned by a common shareholder.
Nolan owns 100% of the capital stock of both Twill Corp. and Webb Corp.
Twill purchases merchandise inventory from Webb at 140% of Webb's cost. During 2004,
merchandise that cost Webb $40,000 was sold to Twill. Twill sold all of this merchandise to
unrelated customers for $81,200 during 2004. In preparing combined financial statements
for 2004, Nolan's bookkeeper disregarded the common ownership of Twill and Webb.
By what amount was unadjusted revenue overstated in the combined income statement for
2004?
A. $16,000
B. $40,000
C. $56,000
D. $81,200
Correct!
Since all the goods have been sold outside the combined entity, income recognition is correct.
However, sales and cost of goods sold have been recorded at two different points (i.e., the
sale from Webb to Twill and the sale from Twill to outsiders). To the combined entity, Webb's
cost of merchandise (the original cost to the combined entity) is what is needed for cost of
goods sold, and Twill's sales (the amount the merchandise was sold for outside the combined
entity) is needed for sales.
This means that the sale from Webb to Twill and the cost of goods recorded by Twill need to be
eliminated. That amount is $56,000 (computed as $40,000 cost to Webb x transfer price to
Twill of 140% of cost = $56,000).
The following information pertains to shipments of merchandise from Home Office to

Branch during 2007:
Home Office's cost of merchandise $160,000
Intracompany billing 200,000
Sales by Branch 250,000
Unsold merchandise at Branch on December 31, 2007 20,000
In the combined income statement of Home Office and Branch for the year ended December
31, 2007, what amount of the above transactions should be included in sales?
A. $250,000
B. $230,000
C. $200,000
D. $180,000
Correct!
The amount that should be included in sales is the amount of sales with unrelated parties. In
this case, that is the $250,000 sales by Branch to unaffiliated entities.
Mr. Allen owns all of the common stock of Astro Company and 80% of the common stock of
Bio Company. Astro owns the remaining 20% interest in Bio's common stock, for which it
paid $8,000, and which it carries at cost, because there is no ready market for Bio's stock.
The condensed balance sheets for Astro and Bio as of December 31, 2007, were:
Astro Bio
Assets $300,000 120,000
Liabilities $100,000 $60,000
Common Stock 50,000 40,000
Retained Earnings 150,000 20,000
Total $300,000 120,000
What amount should be reported as total owner's equity in a combined balance sheet for
Astro and Bio as of December 31, 2007?
A. $260,000
B. $252,000
C. $212,000
D. $200,000
Correct!
The correct answer is Astro's equity of $200,000 plus Bio's equity of $60,000, less Astro's
investment in Bio of $8,000, or $200,000 + $60,000 - $8,000 = $252,000. Astro's investment
in Bio must be eliminated to prevent double counting of the $8,000 - once as an investment on
Astro's books and again as net assets (to which the investment has a claim) on Bio's books.
Nolan owns 100% of the capital stock of both Twill Corp. and Webb Corp. Twill purchases
merchandise inventory from Webb at 140% of Webb's cost. During 2007, merchandise that
cost Webb $40,000 was sold to Twill. Twill sold all of this merchandise to unrelated
customers for $81,200 during 2007. In preparing combined financial statements for 2007,
Nolan's bookkeeper disregarded the common ownership of Twill and Webb.
What amount should be eliminated from cost of goods sold in the combined income
statement for 2007?
A. $56,000
B. $40,000
C. $24,000
D. $16,000
Correct!
The amount at which Webb sold the inventory to Twill ($40,000 x 1.40 = $56,000) will be the
amount of cost of goods sold to Twill and should be eliminated in combining the financial
statements of Webb and Twill. The cost of goods to Webb ($40,000) is the cost from an
unrelated entity and should be the cost of goods sold for the combined entity. Since both the
$40,000 cost of goods to Webb and the $56,000 cost of goods to Twill will be on the combining
worksheet, the cost of goods to Twill (from Webb) must be eliminated, leaving only the
$40,000 cost from a nonaffiliate.
Combined statements may be used to present the results of operation of:
Companies under common management Commonly controlled companies
No Yes
Yes No
No No
Yes Yes
Correct!
Combined financial statements are used (when consolidated statements are not appropriate)
to show the aggregate results both for companies under common management and for
companies under common control (and for unconsolidated subsidiaries).
Dean Co. acquired 100% of Morey Corp. prior to 2005. During 2005, the individual
companies included in their financial statements the following:
Dean Morey
Officers' salaries $75,000 $50,000
Officers' expenses 20,000 10,000
Loans to officers 125,000 50,000
Intercompany sales 150,000 -
What amount should be reported as related party disclosures in the notes to Dean's 2005
consolidated financial statements?
A. $150,000
B. $155,000
C. $175,000
D. $330,000
Correct!
!) Loans to officers are an example of a transaction warranting disclosure as a related party

transaction. The sum of the loans to officers is $175,000 ($125,000 + $50,000). Dean owns
100% of Morey. From the point of view of the consolidated entity, both loans are to related
parties. The other amounts are either ordinary expenses or intercompany amounts, neither of
which requires separate disclosure.
During 2008, Popco acquired 80% of the voting stock of Sonco in a legal acquisition. Which
one of the following is least likely to be a type of intercompany balance that results from
transactions between Popco and Sonco during 2009?
A. Receivable.
B. Inventory.
C. Goodwill.
D. Revenue.
Correct!
Goodwill will occur on the date of a business combination as a result of the parent paying more
for its investment in a subsidiary than the fair value of identifiable net assets acquired.
Goodwill does not occur as a result of operating period transactions between a parent and its
subsidiaries.
Lecture 3
Which one of the following is not a characteristic of derivative instruments?
A. Derivative instruments are a form of financial instrument.
B. All derivative instruments have the same accounting requirements.
C. Derivative instruments can be used for hedging purposes.
D. Derivative instruments can be used to hedge foreign currency risk.
Correct!
All derivative instruments do not have the same accounting requirements. The appropriate
accounting requirements depend on the specific purpose of holding or issuing the derivative
instrument.
For financial accounting purposes, which one of the following is not a type of hedge carried
out using derivatives?
A. Fair value.
B. Cash flow.
C. Speculative.
D. Foreign currency.
Correct!
When derivatives are used for speculative purposes, the intent is not to hedge an existing
position, because there is no existing position to hedge. Rather, when used for speculative
purposes, the intent is to make a profit.
Which one of the following is not a characteristic of financial instruments?
A. Financial instruments include derivative instruments.
B. Certain disclosure requirements apply to all financial instruments.

C. Financial instruments can be used for hedging purposes.
D. All financial instruments have the same accounting requirements.
Correct!
All financial instruments do not have the same accounting requirements. Because financial
instruments cover a variety of assets and liabilities, and are used for different purposes, there
are different accounting requirements for different financial instruments, including derivatives.
Which of the following accounts would reflect the existence of a financial instrument(s)?
Investments in Investments in Bonds
Debt Securities Equity Securities Payable
Yes Yes Yes
Yes Yes No
Yes No Yes
No No Yes
Correct!
Both contracts that result in the exchange of cash (debt securities - both investments and
obligations) and evidence of ownership interest in an entity (equity securities) are financial
instruments.
Which one of the following is not a financial instrument?
A. Cash.
B. Investment in another entity.
C. Derivative instruments.
D. All contracts.
Correct!
Not all contracts are financial instruments. Only contracts that have certain features are
financial instruments. Those features include: (1) they result in the exchange of cash or an
ownership interest in an entity, and (2) both (a) impose on one entity a contractual obligation
to deliver cash or another financial instrument and (b) convey to a second entity a contractual
right to receive cash or another financial instrument. For example, a contract to exchange
commodities would not be a financial instrument.
Which of the following statements concerning contracts that are financial instruments
is/are correct?
I. They result in the exchange of cash or ownership interest in an entity.

II. They impose on one entity a contractual obligation and grant another entity a
contractual right.
III. They must be settled within one year or the operating cycle, whichever is longer.
A. I only.
B. II only.
C. I and II only.
D. I, II, and III.
Correct!
Both Statements I and II are correct; Statement III is incorrect. Contracts that are financial
instruments both result in the exchange of cash or an ownership interest (Statement I) and
impose on one entity a contractual obligation and grant to another entity a contractual right
(Statement II). Statement III is incorrect; contracts that are financial instruments do not have
to be settled within one year or the operating cycle, whichever is longer.
Which of the following is a category of financial assets under IFRS for which there is not a
comparable category under U.S. GAAP?
A. Instruments held available-for-sale.
B. Loans and receivables.
C. Instruments held to maturity.
D. Instruments for which changes in value are reported in profit/loss.
Correct!
U.S. GAAP does not have a category of financial assets for loans and receivables; IFRS does
have such a category.
Under IFRS, which one of the following instruments is most likely to be treated in its
entirety as a financial liability?
A. Convertible debt.
B. Convertible preferred stock.
C. Redeemable preferred stock.
D. Common stock with a preemptive right.
Correct!
Under IFRS, redeemable preferred stock would likely be treated in its entirety as a financial
liability because the stock can be redeemed (repurchased) by the issuing corporation at its
discretion. Since the preferred shares can be redeemed at the discretion of the issuing
corporation, it is not treated as equity, but rather as a liability.
Which of the following describes an "accounting mismatch" as that expression is used in
IFRS?
A. Debts don't equal credits.
B. Liabilities exceed assets.
C. Related assets and liabilities are valued using different measures.
D. The value of a hedging instrument does not equal the value of the hedged item.
Correct!
An "accounting mismatch" refers to a circumstance where related assets and liabilities are
valued using different measures.
Which of the following is the correct accounting measurement and treatment under IFRS
for assets classified as "Loans and Receivables"?
A. Amortized cost, with interest and amortization recognized in current income.
B. Amortized cost, with interest and amortization recognized in other comprehensive income.
C. Fair value, with changes in fair value recognized in current income.
D. Fair value, with changes in fair value recognized in other comprehensive income.
Correct!
Financial assets classified as "Loans and Receivables" are measured at amortized cost, with
interest and amortization related to the instrument recognized in current income. This
treatment is the same as the treatment under U.S. GAAP for investments held to maturity.
In measuring an impairment loss for a financial asset under U.S. GAAP and under IFRS, the
carrying value of the financial asset would be compared to:
Under U.S. GAAP Under IFRS

Fair value Fair value
Fair value Recoverable amount
Recoverable amount Fair value
Recoverable amount Recoverable amount
Correct!
Under U.S. GAAP, an impairment loss on a financial asset is measured as the difference
between the carrying value and the fair value of the asset; under IFRS, an impairment loss on
a financial asset is measured as the difference between the carrying value and the recoverable
amount of the asset.
When a concentration of credit risk must be disclosed and the exact amount is uncertain,
which one of the following amounts must be disclosed?
A. Minimum amount at risk.
B. Current period average amount at risk.
C. Historic average amount at risk.
D. Maximum amount at risk.
Correct!
When a concentration of credit risk exists, the maximum amount at risk must be disclosed.
The maximum amount is measured as the gross fair value of all financial instruments that
would be lost if the other parties fail completely to perform according to the terms of the
contract(s) and assuming any collateral was of no value.
Where in its financial statements should a company disclose information about its
concentration of credit risks?
A. No disclosure is required.
B. The notes to the financial statements.
C. Supplementary information to the financial statements.
D. Management's report to shareholders.
Correct!
An entity may make required disclosures about concentrations of credit risk in either the notes
to the financial statements or in the body of the financial statements. Since "The body of the
financial statements" is not a choice, the notes to the financial statements is the only correct
choice.
If it is not practicable for an entity to estimate the fair value of a financial instrument,
which of the following should be disclosed?
I. Information pertinent to estimating the fair value of the instrument.

II. The reasons it is not practicable to estimate fair value.
A. I only.
B. II only.
C. Both I and II.

Correct!
When it is not practicable for an entity to estimate the fair value of a financial instrument, both
information pertinent to estimating the fair value of the instrument and the reasons it is not
practicable to estimate fair value must be provided.
Whether recognized or unrecognized in an entity's financial statements, disclosure of the

fair values of the entity's financial instruments is required when:
A. It is practicable to estimate those values.
B. The entity maintains accurate cost records.
C. Aggregate fair values are material to the entity.
D. Individual fair values are material to the entity.
Correct!
Disclosure of the fair values of an entity's financial instruments is required when it is

practicable to estimate those fair values.
Fair value disclosure of financial instruments may be made in the:

Body of Footnotes to
Financial Statements Financial Statements
Yes Yes
Yes No
No Yes
No No
Correct!
Fair value disclosure of financial instruments may be made in either the body of the financial
statements or in the footnotes to the financial statements. If in the footnotes, one note must
show fair values and carrying amounts for all financial instruments.
Which one of the following is not a financial instrument?
A. Cash.
B. Investment in another entity.
C. Derivative instruments.
D. All contracts.
Correct!
Not all contracts are financial instruments. Only contracts that have certain features are
financial instruments. Those features include: (1) they result in the exchange of cash or an
ownership interest in an entity, and (2) both (a) impose on one entity a contractual obligation
to deliver cash or another financial instrument and (b) convey to a second entity a contractual
right to receive cash or another financial instrument. For example, a contract to exchange
commodities would not be a financial instrument.
Lecture 4
Which one of the following is not a characteristic of a derivative?
A. A derivative is a financial instrument or similar contract.
B. A derivative requires contractual satisfaction by delivery of the subject matter of the contract.
C. A derivative identifies a specific price, rate, or other monetary measure.
D. A derivative identifies a specific quantity or other quantitative unit of measure.
Correct!
A derivative does not require contractual satisfaction by delivery of the subject matter of the
contract. Specifically, the terms of a derivative require or permit the contract to be settled with
cash or an asset readily convertible to cash, in lieu of physical delivery of the subject matter of
the contract. In addition, a derivative includes an underlying, a notional amount, and requires
no initial net investment or one that is less than normally would be required.
The determination of the value or settlement amount of a derivative instrument involves a

calculation, which uses
I. An underlying.
II. A notional amount.
A. I only.
B. II only.
C. Both I and II.
Correct!
Both the underlying (e.g., price) and notional amount (e.g., quantity) are used in the
determination of the value or settlement amount of a derivative instrument. Typically, the
value is the result of multiplying the underlying by the notional amount.
Which of the following is the characteristic of a perfect hedge?
A. No possibility of future gain or loss.
B. No possibility of future gain only.
C. No possibility of future loss only.
D. The possibility of future gain and no future loss.
Correct!
Hedging is a risk management strategy which involves making an investment (the hedge) so
as to offset (or counter) another investment (the hedged item) so that a loss on one
investment (the hedged item) would be offset (at least in part) by a gain on the other
investment (the hedge), and vice versa. A perfect hedge is achieved when the hedge
investment has a 100% inverse correlation to the initial investment (hedged item) so that
there is no possibility of future gain or loss. A perfect hedge rarely exists.
A derivative financial instrument is best described as:

A. Evidence of an ownership interest in an entity such as shares of common stock.
B. A contract that has its settlement value tied to an underlying notional amount.
C. A contract that conveys to a second entity a right to receive cash from a first entity.
D. A contract that conveys to a second entity a right to future collections on accounts receivable
from a first entity.
Correct!
A contract that has it settlement value tied to an underlying notional amount best describes a
derivative financial instrument. The value or settlement amount of a derivative is the amount
determined by the multiplication (or other arithmetical calculation) of a notional amount and
an underlying. Simply put, a derivative instrument is a special class of financial instrument
which derives its value from the value of some other financial instrument or variable.
Assume Instco acquires an option to buy (a call option) 100 shares of Opco for $50 per
share when the market price of Opco is $45 per share and that Instco paid a premium of
$1.00 per share to acquire the options. Which one of the following is the total notional
amount related to Instco's options?
A. 100 shares.
B. $5,000.00
C. $4,500.00
D. $100.00
Correct!
Stock options are derivatives; they derive their value from the value of the stock to which the
option applies. The notional amount of a derivative is a specified unit of measure, in this case
the total number of options (100) acquired by Instco. The specified price of those options
would be the underlying.
Assume Instco acquires an option to buy (a call option) 100 shares of Opco for $50 per
share when the market price of Opco is $45 per share and that Instco paid a premium of
$1.00 per share to acquire the options. Which one of the following is the underlying related
to Instco's options?
A. 100 shares.
B. $1.00 per option.
C. $45.00 per option.
D. $50.00 per option.
Correct!
Stock options are derivatives; they derive their value from the value of the stock to which the
option applies. The underlying of a derivative is a specified price, rate, or other monetary
variable, in this case the (strike) price of each option, $50.00.
Which of the following statements, if either, concerning differences between U.S. GAAP and
IFRS in accounting for hedges is/are correct?
I. IFRS permits hedging a forecasted business combination that is subject to foreign

exchange risk; U.S. GAAP does not permit hedging in that case.
II. IFRS permits hedging part of the life of a hedged item; U.S. GAAP does not permit
hedging of part of the life of a hedged item.
A. I only.
B. II only.
C. Both I and II.
Correct!
Both Statement I and Statement II are correct. IFRS permits (1) hedging a forecasted
business combination that is subject to foreign exchange risk, and (2) hedging part of the life
of a hedged item. U.S. GAAP does not permit hedging in either case.
Which one of the following is an item for which risk associated with the item cannot be
hedged for accounting purposes?
A. Foreign currency risk of a net investment in a foreign operation.
B. Fair value of an investment accounted for using the equity method of accounting.
C. Credit risk of investments classified as held for trading.
D. Overall change in the fair value of a non-financial asset.
Correct!
The fair value of an investment accounted for using the equity method of accounting is
specifically excluded as being eligible to be hedged for accounting purposes under U.S. GAAP.
Hedges of foreign currency risks can be the hedge of:
Fair Value Cash Flows

Yes Yes
Yes No
No Yes
No No
Correct!
The risks associated with a foreign currency that can be hedged can be either the risk to fair
value in the foreign currency or the risk to cash flows in the foreign currency.
Which of the following are basic kinds of risks that can be hedged for accounting purposes?
Fair Value Cash Flows

Yes Yes
Yes No
No Yes
No No
Correct!
The two basic kinds of risks that can be hedged for accounting purposes are fair value risks
and cash flow risks.
Which of the following statements, if either, concerning accounting for derivative financial
instruments is/are correct?
I. Derivative instruments can be used only for hedging purposes.
II. Derivative instruments can be used only to hedge fair value.

A. I only.
B. II only.
C. Both I and II.
Correct!
Neither Statement I nor Statement II is correct. Derivative instruments can be used not only
for hedging purposes (Statement I), but also for speculative purposes. In addition, derivative
instruments can be used not only to hedge fair value (Statement II), but also to hedge cash
flows.
On December 1, 2008, Speco acquired a stock option for more than the then-current market
price. Speco intended to hold it for approximately 90 days and hoped to sell it at a profit. On
December 31, 2008, the fair value of the option was $2,000. On February 28, 2009, the
option was sold in the market by Speco for $1,800.
Which one of the following is the amount of gain or loss recognized on the derivative by
Speco in its 2009 net income?
A. $ -0-
B. $200
C. $1,800
D. $2,000
Correct!
Since Speco acquired the stock option for profit-making purposes, not as a hedging
instrument, any gain or loss in fair value which occurred during each period would be
recognized in net income of the period during which fair value changed. In this case, that
would be $2,000 for 2008 and $200 for 2009 (The 2009 amount is computed as the fair value
at the beginning of 2009 of $2,000 less the fair value February 28, 2009, of $1,800, creating a
loss of $200 for 2009).
Assume that at the end of its fiscal year a firm determined that a derivative instrument
which it had acquired at the beginning of the year as a fair value hedge no longer qualified
as a hedge of fair value for accounting purposes. How will a gain in the value of the
derivative instrument that occurred during the year be reported?
A. As a deferred credit.
B. As an item of other comprehensive income.
C. As an item in net income.
D. As an item of discontinued operations.

Correct!
A derivative instrument that does not meet the requirements for hedging fair value may not be
accounted for as a fair value hedge. Such an instrument would be treated as though the
derivative was a speculative investment, and any gain (or loss) on the instrument would be
reported in current period net income. Specifically, the derivative instrument would be
adjusted to fair value at the end of the year (DR.) and a gain recognized (CR.) in current
period income.
On December 1, 2008, Speco acquired a stock option for more than the then-current market
price. Speco intended to hold the option for approximately 90 days and hoped to sell it at a
profit. On December 31, 2008, the fair value of the option was $2,000. On February 28,
2009, the option was sold in the market by Speco for $1,800.
Which one of the following is the amount of gain or loss recognized on the derivative by
Speco in its 2008 net income?
A. $ -0-
B. $200
C. $1,800
D. $2,000
Correct!
Since Speco acquired the stock option for profit-making purposes, not as a hedging
instrument, any gain or loss in fair value which occurred during each period would be
recognized in net income of the period during which the fair value changed. Also, since the
option cost was more than the market price at the date of purchase, it had no value at
acquisition. Thus, there would be a $2,000 gain for 2008 (and a $200 loss in 2009).
During 2008, an entity experienced a substantial loss on a derivative it had acquired for
speculative purposes on October 1, 2008. On December 31, 2008, the end of its fiscal year,
which one of the following, if any, is the kind of entry the entity would make for the
derivative?
A. DR: Derivative Investment

CR: Loss on Derivative Investment
B. DR: Derivative Investment
CR: Deferred Charge
C. DR: Loss on Derivative Investment
CR: Derivative Investment
D. No entry is required until the derivative is liquidated or expires.
Correct!
Since the derivative is for speculative purposes and suffered a loss during the period, that loss
should be recognized in current net income. Therefore, the correct entry is: DR: Loss on
Derivative Investment, which will be reported in current income, and CR: Derivative
Investment, which will reduce the carrying value of the investment to its year-end fair value.
On December 31, 200X, the end of its fiscal year, Smarti Company held a derivative
instrument which it had acquired for speculative purposes during November 200X. Since its
acquisition, the fair value of the derivative had increased materially. On December 31, how
should the increase in fair value of the derivative instrument be reported by Smarti in its
financial statements?
A. Recognized as a deferred credit until the instrument is settled.
B. Recognized in current net income for 200X.
C. Recognized as a component of other comprehensive income for 200X.
D. Disregarded until the instrument is settled.
Correct!
Since the derivative instrument was held for speculative purposes, any gain (or loss) resulting
from a change in the fair value of the instrument should be recognized in current income (i.e.,
income of the period of change in fair value).
A derivative designated as a fair value hedge must be:
I. Specifically identified to the asset, liability, or firm commitment being hedged.

II. Expected to be highly effective in offsetting changes in the fair value of the hedged item.
A. I only.
B. II only.
C. Both I and II.
Correct!
A derivative designated as a fair value hedge must both be expected to be highly effective in
offsetting changes in the fair value of the hedged item, and be specifically identified to the
asset, liability, or firm commitment being hedged.
On October 1, 2008, Buyco entered into a legally enforceable contract to acquire raw
material inventory in 180 days for $20,000. In order to mitigate the risk of a change in the
value of the raw materials, Buyco also entered into a qualified 180-day forward contract to
hedge the fair value of the raw materials. At December 31, 2008, the value of the raw
materials had decreased by $500, and the fair value of the futures contract had increased
by $480. On March 29, 2009, the date the raw materials were delivered to Buyco, they had
a fair value of $19,300, and the forward contract had a fair value of $700. Which one of the
following is the amount of net gain or loss that would be recognized on the raw materials
and related forward contract by Buyco in its 2008 net income?
A. $500
B. $480
C. $20
D. $ -0-
Correct!
Because Buyco entered into the forward contract (hedging instrument) to hedge the risk of
change in the fair value of the raw materials (hedged item), the change in fair value of the
forward contract during 2008 offsets the change in the fair value of the raw materials.
Specifically, the decrease in the value of the raw materials, $500, was offset by the increase in
the value of the forward contract of $480, so the net loss recognized in 2008 was $500 - $480
= $20, which is the correct answer.
following is the net gain or loss that would be recognized on the raw material and related
forward contract by Buyco in its 2009 net income?
A. $ -0-
B. $20
C. $200
D. $220
Correct!
forward contract during 2009 offsets the change in the fair value of the raw materials.
Specifically, the decrease in the value of the raw materials, $200 ($19,500 - $19,300 = $200),
was offset by the increase in the value of the forward contract of $220 ($700 - $480 = $220),
so the net gain recognized in 2009 was $220 - $200 = $20, which is the correct answer.
A derivative cannot be used as a fair value hedge for:
A. A recognized asset.
B. A recognized liability.
C. An unrecognized forecasted transaction.
D. An unrecognized firm commitment.
Correct!
For GAAP purposes, a derivative cannot be used to hedge the risk associated with an
unrecognized forecasted transaction, primarily because, since the transaction is only
"forecasted," there is no established fair value to hedge. A derivative can be used to hedge the
risk associated with a recognized asset, recognized liability, or unrecognized firm commitment,
but not an unrecognized forecasted transaction.
following is the amount by which the derivative is ineffective as a fair value hedge for
2008?
A. $980
B. $500
C. $480
D. $20
Correct!
forward contract offsets the change in the fair value of the raw materials. Since during 2008
the change in the value of the raw materials decreased more than the value of the forward
contract increased, the difference is the amount by which the derivative is ineffective as a fair
value hedge. Specifically, the decrease in the value of the raw materials, $500, was offset by
the increase in the value of the forward contract of $480, so the hedge was ineffective by $500
- $480 = $20, which is the correct answer.
following is the net gain or loss that would be recognized on the raw material and related
forward contract by Buyco over the life of the contract?
A. $ -0-
B. $20
C. $220
D. $700
Correct!
change in the fair value of the raw materials (hedged item), the change in the fair value of the
forward contract over the life of the contract offsets the change in the fair value of the raw
materials. Specifically, the decrease in the value of the raw materials, $700 ($20,000 -
$19,300 = $700), was offset by the increase in the value of the forward contract of $700
(given), so the net gain recognized over the life of the contract was $700 - $700 = $-0-, which
is the correct answer.
Which one of the following is least likely to be a characteristic of a firm commitment?
A. It is evidenced by a contractual obligation.
B. It can be the hedged item in a fair value hedge.
C. It has been recorded as an asset or liability.
D. It is subject to the risk of change in fair value.
Correct!
A firm commitment has not been recorded (yet) as an asset or liability. A firm commitment
occurs when an entity has a contractual obligation or contractual right, but no transaction has
been recorded (and no asset or liability recognized) because GAAP requirements for
recognition have not yet been met. Nevertheless, the subject matter of the firm commitment is
at risk of change in fair value and can be hedged.
Which one of the follo
wing is a characteristic of a forecasted transaction?
A. Is evidenced by a contractual right or obligation.
B. Can be a hedged item in a cash flow hedge.
C. Is the same as a firm commitment.
D. Is evidenced by a recorded asset or liability.
Correct!
A forecasted transaction can be the hedged item in a cash flow hedge. A forecasted
transaction is a planned or expected transaction which has not yet been recognized, but which
is subject to the risk of changes in related cash flow. As such, the cash flow (inflow or
outflow) associated with forecasted transactions can be hedged.
In a cash flow hedge, the item being hedged is measured using:
A. The nominal value of expected cash inflows.
B. The present value of expected cash inflows.
C. The nominal value of expected cash inflows or outflows.
D. The present value of expected cash inflows or outflows.
Correct!
The item being hedged in a cash flow hedge is measured using the present value of expected
cash inflows or cash outflows. The item being hedged in a cash flow hedge may be associated
with an asset, a liability, or a forecasted transaction. The value of such items is measured
using the present value of either cash inflows (e.g., receivable) or cash outflows (e.g.,
payable), depending on the nature of the item being hedged.
Which one of the following is not a characteristic of a cash flow hedge?
A. Can be used to hedge the risk of variability in cash flow of a forecasted transaction.
B. Measures the hedged item using the present value of expected cash flows.
C. The derivative used as the hedging instrument is measured at fair value.
D. All difference between the change in value of the hedged item and the change in value of the
hedging instrument is recognized in current income.
Correct!
All difference between the change in value of the hedged item and the change in value of the
hedging instrument is not recognized in current income. To the extent the change in the fair
value of the hedging instrument offsets the change in the fair value of the hedged item, the
hedge is effective, and that amount is recognized in other comprehensive income, not current
income. To the extent the change in the fair value of the hedging instrument is different than
the change in the fair value of the hedged item, the hedge is ineffective, and that amount is
recognized in current income.
Neron Co. has two derivatives related to two different financial instruments, instrument A
and instrument B, both of which are debt instruments. The derivative related to instrument
A is a fair value hedge, and the derivative related to instrument B is a cash flow hedge.
Neron experienced gains in the value of instruments A and B due to a change in interest
rates. Which of the gains should be reported by Neron in its income statement?
Gain in value of debt instrument A Gain in value of debt instrument B
Yes Yes
Yes No
No Yes
No No
Correct!
The gain on instrument A would be reported in Neron's income statement, but the gain on
instrument B would be reported in other comprehensive income in the statement of
comprehensive income. When the fair value of a financial instrument (instrument A) is
hedged, gains (and losses) from changes in the value of the hedged item and the hedging
instrument (derivative) are recognized in current income. When the cash flow of a financial
instrument (instrument B) is hedged, gains (and losses) from changes in the value of the
hedged item are recognized in other comprehensive income, along with the change in the
value of the hedging instrument (derivative) up to the change in amount of the hedged item.
Any change in the value of the hedging instrument in excess of the change in the hedged item
is recognized in current income.
Qualified derivatives may be used to hedge the cash flow associated with a/an:
Forecasted
Asset
Transaction
Yes Yes
Yes No
No Yes
No No
Correct!
Derivative instruments may be used to hedge the cash flows associated with assets, liabilities,
or forecasted transactions.
Which of the following statements concerning derivatives used as foreign currency hedges
is/are correct?
I. Can be used to hedge the risk of exchange rate changes on planned transactions.
II. Can be used to hedge the risk of exchange rate changes on available-for-sale
investments.
III. Can be used to hedge the risk of exchange rate changes on accounts receivable and
accounts payable.
A. I only.
B. I and II only.
C. II and III only.
D. I, II, and III.
Correct!
Foreign currency hedges can be used to hedge the risk of exchange rate changes on planned
(forecasted) transactions, available-for-sale investments, and accounts receivable/accounts
payable (and unrecognized firm commitments and net investments in foreign operations).
If a firm used a derivative to hedge the risk of exchange rate changes between the time a
liability is recorded and the time it is settled in a foreign currency, which one of the
following is being hedged?
A. Unrecognized firm commitment.
B. Forecasted transaction.
C. Recognized liability.
D. Net investment in a foreign entity.
Correct!
A foreign currency hedge of a recognized liability hedges the risk of exchange rate changes on
the cash flow (or fair value) of a liability between the time it is recorded (recognized) and the
time it is settled in a foreign currency.
Which of the following, if any, can be the risk being hedged in a foreign currency hedge?
Fair Value Cash Flow
Yes Yes
Yes No
No Yes
No No
Correct!
Foreign currency hedges may be either fair value or cash flow hedges. Foreign currency
hedges of unrecognized firm commitments, investments in available-for-sale securities, and
net investments in foreign operations are fair value hedges. Foreign currency hedges of
forecasted transactions are cash flow hedges. Additionally, foreign currency hedges of
recognized assets or liabilities may be treated either as fair value hedges or cash flow hedges,
depending on management's designation.
Which one of the following is not a characteristic of a foreign currency hedge?

A. Hedges the risk due to change in foreign currency exchange rates.
B. Can hedge net investments in a foreign entity.
C. Are all treated as fair value hedges.
D. Can be used to hedge forecasted intercompany transactions.
Correct!
All foreign currency hedges are not treated as fair value hedges. While foreign currency hedges
of unrecognized firm commitments, investments in available-for-sale securities, and net
investments in foreign operations are treated as fair value hedges, foreign currency hedges of
forecasted transactions are treated as cash flow hedges, and foreign currency hedges of
recognized assets or liabilities may be treated either as fair value hedges or cash flow hedges,
depending on management's designation.
Derivatives used for hedging purposes that require disclosure of reclassifications of

accumulated other comprehensive income are most likely related to which of the following
hedging purposes, if any?
I. Fair value hedges.
II. Cash flow hedges.
A. I only.
B. II only.
C. Both I and II.
Correct!
When derivatives are used as cash flow hedges, an amount of gain or loss can be deferred in
other comprehensive income and subsequently become part of accumulated other
comprehensive income. Amounts of accumulated other comprehensive income (on the hedging
instrument) will be reclassified to income when the hedged item affects income.
Specific disclosures are required for entities that:

Issue Derivatives Hold Derivatives
Yes Yes
Yes No
No Yes
No No
Correct!
Entities that either issue or hold derivatives (or other contracts used for hedging) must
disclose a considerable amount of information concerning their reasons for using derivatives
and the outcomes (e.g., gains/losses) of their accounting for the derivatives. Generally, these
disclosures must distinguish between instruments used for different purposes (e.g., fair value
hedges, cash flow hedges, etc.).
Which one of the following is not a required disclosure for derivatives used as fair value
hedges?
A. The amount of net gain or loss recognized in earnings during the period.
B. The location in the financial statements where any gain or loss is reported.
C. The net gain or loss in earnings from firm commitment hedges that no longer qualify for
hedge treatment.
D. The amount of gain or loss arising during the period that was deferred.
Correct!
When derivatives are used for fair value hedges, the amount of gain or loss arising during the
period that was deferred is not a required (or relevant) disclosure. When fair value hedges are
used, any resulting gain or loss is recognized in current income, not deferred.
Which of the following statements concerning disclosure requirements for derivatives used
as cash flow hedges is/are correct?
I. The net gain or loss recognized in earnings during the period must be disclosed.
II. The amount of gain or loss deferred in other comprehensive income must be disclosed.
III. A listing of derivatives used for cash flow hedges and the amount of each must be
disclosed.
A. I only.
B. I and II only.
C. I and III only.
D. I, II, and III.
Correct!
Both the net gain or loss recognized in earnings during the period (Statement I) and the
amount of gain or loss deferred in other comprehensive income (Statement II) must be
disclosed. Statement III is not a required disclosure.
An entity that issues or holds derivative instruments must disclose:
I. Its objectives for issuing or holding the derivative instruments.

II. Information that distinguishes between derivative instruments for fair value hedge
purposes and those for cash flow hedge purposes.
A. I only.
B. II only.
C. Both I and II.

Correct!
A firm must both disclose its objectives for issuing or holding derivative instruments and
distinguish that information separately for instruments used for fair value hedge purposes and
those used for cash flow hedge purposes.
On December 31, 200X, the end of its fiscal year, Smarti Company held a derivative
instrument which it had acquired for speculative purposes during November 200X. Since its
acquisition, the fair value of the derivative had increased materially. On December 31, how
should the increase in fair value of the derivative instrument be reported by Smarti in its
financial statements?
A. Recognized as a deferred credit until the instrument is settled.
B. Recognized in current net income for 200X.
C. Recognized as a component of other comprehensive income for 200X.
D. Disregarded until the instrument is settled.
Correct!
Since the derivative instrument was held for speculative purposes, any gain (or loss) resulting
from a change in the fair value of the instrument should be recognized in current income (i.e.,
income of the period of change in fair value).
Lecture 5
Which one of the following is not a condition that has to be met in order for the transfer of a
financial asset to result in the surrender of control over the transferred asset?
A. The transferee has the unconstrained right to pledge or exchange the asset.
B. The transferred asset has been isolated from the transferor.
C. The transferred asset has been isolated from the transferor's creditors, except in the case of
bankruptcy.
D. The transfer agreement prohibits the transferor from repurchasing or redeeming the financial
asset, except at maturity.
Correct!
In order for surrender of control of a financial asset to occur, the transferred asset must be
isolated from the transferor's creditors, even in the case of bankruptcy, not except in the case
of bankruptcy. If the transferor enters bankruptcy, its creditors must not be able to obtain
restitution through a claim on the transferred financial asset.
Which of the following statements concerning the transfer and/or servicing of financial
assets is/are correct?
I. The determination of whether or not control has been surrendered underlies accounting
for both transfers and servicing of financial assets.
II. The disaggregation of financial assets (or liabilities) into separate component assets (or
liabilities) underlies accounting for both transfers and servicing of financial assets.
III. The determination of whether or not control has been surrendered underlies accounting
for transfers of financial assets, but not servicing of financial assets.
IV. The disaggregation of financial assets (or liabilities) into separate component assets (or
liabilities) underlies accounting for transfers of financial assets, but not servicing of
financial assets.
A. I only.
B. I and II only.
C. I and IV only.
D. II and III only.
Correct!
Both the determination of whether or not control has been surrendered (Statement I) and the
disaggregation of financial assets (and liabilities) into separate component assets (and
liabilities) (Statement II) apply to both the transfer and the servicing of financial assets.
Statements III and IV are not correct because both the concept of surrender of control and the
concept of disaggregation of assets (and liabilities) apply to both transfers and servicing of
financial assets.
In order for surrender of control of a financial asset to occur, one of the conditions is that
the transferred asset has to be isolated from which of the following entities?
Transferor Transferor's Creditors
No No
Yes No
No Yes
Yes Yes
Correct!
In order for surrender of control of a financial asset to occur, the transferred asset has to be
isolated from both the transferor and the transferor's creditors, even in case of bankruptcy.
Other conditions also apply.
Bigco, Inc. transferred long-term receivables with a carrying value of $500,000 to Banco for
$425,000 cash. Banco will collect interest on the receivables during the life of the
receivables, but Bigco is obligated to repurchase the receivables prior to their maturity.
What amount of receivables has Bigco surrendered control of for accounting purposes?
A. $ -0-
B. $75,000
C. $425,000
D. $500,000
Correct!
Surrender of control for accounting purposes requires that the transferor is not obligated to
repurchase the transferred assets prior to maturity. Thus, Bigco has not surrendered control
over any amount of transferred receivables.
Which of the following, if any, can be separated into financial components?

Financial Assets Financial Liabilities
Yes Yes
Yes No
No Yes
No No
Correct!
Both financial assets and financial liabilities can be separated into distinct components, each of
which can be a separate asset or liability, depending on its nature.
A financial asset is transferred with one component of the asset appropriately treated as
sold and another component appropriately treated as retained. How will the amount to be
written off as sold be determined?
A. Write off the fair value of the component sold.
B. Write off a portion of the asset carrying value based on the relative fair values of the
components.
C. Write off the portion of the asset carrying value left after deducting the fair value of the
retained interest.
D. Write off the present value of the cash flows of the component sold.
Correct!
The carrying amount of the asset before the transfer will be allocated to the component sold
and the component retained based on the relative fair values of the components at the date of
the transfer. The portion of the carrying value allocated to the component sold will be written
off.
Will a transferor have to allocate the carrying value of a financial asset when the transferor
retains an interest in the transferred asset or when the transferor does not retain an
interest in the transferred asset?
Allocate Carrying Value When:
Interest Retained No Interest Retained

Yes Yes
Yes No
No Yes
No No
Correct!
The transferor will have to allocate the carrying value of a financial asset when it is transferred
and the transferor retains an interest in the asset, but allocation of the carrying value is not
necessary when the transferor does not retain an interest in the asset. When no interest is
retained, the full carrying value of the asset will be written off by the transferor.
Which one of the following sets correctly reflects whether the transfer of a financial asset
should be treated as a sale or as a borrowing when control over the transferred financial
asset has been surrendered and when control has not been surrendered?
Control Surrendered Control Not Surrendered
Sale Sale
Sale Borrowing
Borrowing Sale
Borrowing Borrowing
Correct!
The transfer of a financial asset that results in surrender of control is treated as a sale of the
transferred asset, and the transfer of a financial asset that does not result in the surrender of
control is treated as a secured borrowing.
For accounting purposes, which one of the following is not a characteristic associated with
the transfer of financial assets?
A. If the transferor has surrendered control, the transfer can be a sale.
B. The transferred asset may consist of multiple components, some for which control has been
surrendered and others for which control has not been relinquished.
C. If the transferor has not surrendered control, the transfer is a secured borrowing.
D. When a financial asset is transferred, the entire asset must be treated either as sold or not
sold (i.e., retained).
Correct!
When a financial asset is transferred, the entire asset does not have to be treated as either
sold or not sold. The transferred asset may consist of two or more components, with control
surrendered for one or more component(s) and control not surrendered for one or more other
component(s). If the transferor has surrendered control over a component, the transfer of that
component is accounted for as a sale; if the transferor has not surrendered control over a
component, the transfer of that component is accounted for as a secured borrowing.
For accounting purposes, which one of the following circumstances would not be
considered the transfer of a financial asset?
A. The transfer of accounts receivable to a factor for cash.
B. The transfer of a bond investment to another unrelated investor for cash.
C. The transfer of a bond investment upon maturity to the issuing entity for cash.
D. The transfer of a stock investment to another unrelated investor for cash.
Correct!
The transfer of a bond investment to the issuing entity upon maturity of the bond would not be
considered the transfer of a financial asset for accounting purposes. Because the bond is being
transferred to the entity that issued the financial asset (at the time the bond matures), it is not
considered a transfer of a financial asset for accounting purposes.
Which one of the following is not associated with accounting for a transfer of a financial
asset treated as a sale by the transferor?
A. Derecognizing the asset(s) sold.
B. Recognizing asset(s) obtained or liability(ies) incurred.
C. Measuring assets and liabilities at fair value.
D. Deferring any gain or loss in other comprehensive income.
Correct!
Any gain or loss resulting from the transfer of financial assets would not be deferred in other
comprehensive income (outside net income) by the transferor, but rather would be recognized
in current income.
Which of the following statements concerning the transfer of financial assets that qualifies
as a sale is/are correct?
I. The transferor may retain an interest in the asset transferred.
II. The transferor may recognize a gain or a loss on the transfer.
III. The transferor's proceeds are decreased by any liability it incurs in the transfer.
A. I only.
B. II only.
C. I and II only.
D. I, II, and III.
Correct!
All three statements are correct. The transferor may retain an interest in the asset transferred
(Statement I), the transferor may recognize a gain or loss on the transfer (Statement II), and
the transferor's proceeds from the transfer are decreased by any liability incurred in the
transfer (Statement III).
Which one of the following is not associated with accounting for a transfer of a financial
asset treated as a purchase by the transferee?
A. Measuring assets and liabilities at fair value.
B. Recognizing any gain or loss on the transfer in current income.
C. Recognizing the asset(s) obtained.
D. Recognizing the liability(ies) incurred.
Correct!
In a transfer of a financial asset treated as a purchase by the transferee, no gain or loss would
be recognized by the transferee. The transferee is the recipient of the transferred asset. As
such, assets and liabilities recognized by the transferee would be recorded at fair value.
Bigco, Inc. transferred long-term receivables with a carrying value of $500,000 and a fair
value of $450,000 to Banco for $425,000 cash. Of the $450,000 fair value, $45,000 is
attributable to collection of future fees and penalties, which Bigco will retain. The surrender
of control requirements have been met, therefore the transfer qualifies as a sale. What
amount of loss should Bigco recognize at the time of the transfer?
A. $ -0-
B. $25,000
C. $50,000
D. $75,000
Correct!
Bigco's loss is the difference between the carrying value of the portion of the asset transferred
and the cash received for the transferred portion. In this case, the total carrying value of
$500,000 must be allocated between the portion of the asset surrendered and the portion
retained, based on relative fair values. The relative fair values are:
Amount Percent
Asset retained $ 45,000 10%
Asset transferred 405,000 __90_
Total fair value $450,000 100%
Therefore, the carrying value of the asset transferred is .90 x $500,000 = $450,000. The
resulting loss is carrying value transferred $450,000 - cash received $425,000 = $25,000 loss.
Under which of the following circumstances, if any, will a financial asset transferred in a
secured borrowing be written off by the transferor?
I. Transferee has the right to sell or repledge the asset.

II. Transferor has defaulted on the borrowing.
A. I only.
B. II only.
C. Both I and II.
Correct!
The transferor will write off a transferred asset in a secured borrowing only when (if) the
transferor defaults on the borrowing (Statement II). If that occurs, the transferee will
recognize the asset on its books.
If the transfer of a financial asset does not meet the requirements of surrender of control
by the transferor, how will it be treated by the transferor and by the transferee?
Transferor Transferee
Sale Purchase
Sale Secured Lending
Borrowing with Collateral Secured Lending
Borrowing with Collateral Purchase
Correct!
If the transfer of the financial asset does not meet the requirements of surrender of control by
the transferor, the transfer is a borrowing with collateral by the transferor and a secured
lending by the transferee (not a sale and purchase, respectively).
Which of the following statements, if any, identifies factors that enter into determining the
correct accounting treatment for a financial asset when the criteria for surrender of control
are not met?
I. Whether or not the transferee has the right to sell or repledge the asset.
II. Whether or not the debtor has defaulted on the obligation.
A. I only.
B. II only.
C. Both I and II.
Correct!
Both whether or not the transferee has the right to sell or repledge the transferred asset and
whether or not the debtor has defaulted on the obligation enter into determining the correct
account treatment when the surrender of control criteria are not met.
On February 1, Rayco transferred a bond it owned with a maturity value of $50,000 to

Dayco as security for a short-term loan from Dayco. By terms of the agreement, Dayco
cannot resell or otherwise use the bond except as collateral for its loan to Rayco. Rayco
defaulted on its repayment of the loan from Dayco on August 1 when the bond had a fair
value of $48,000. On what date and in what amount should Dayco recognize the bonds on
its books?
Recognize On Recognize
February 1 $50,000
February 1 $48,000
August 1 $50,000
August 1 $48,000
Correct!
Since the transfer of the bond is used only as security for the loan, and not as a sale of the
bond, Dayco would not recognize the bond on its books at the time of the transfer. The bond
would be recognized on Dayco's books on the date Rayco defaulted and at its fair value at that
time.
Which of the following characteristics is associated with the transfer of a financial asset
when surrender of control has not occurred?
A. The transfer will be treated as a sale of the asset by the transferor.
B. The transferor can recognize a gain or loss on the transfer.
C. The transferred asset will be treated as collateral held by the transferee.
D. The transfer will be treated as a purchase of the asset by the transferee.
Correct!
If surrender of control of the transferred asset has not occurred, the transfer will be treated as
a secured borrowing by the transferor and a lending with collateral by the transferee.
Which of the following is not a characteristic associated with the servicing of financial
assets?
A. The servicing function is inherent in all financial assets.
B. The right to service financial assets can result in either a separate asset or a separate liability.
C. If a servicing asset is retained as a component in a sale of a financial asset, the servicing

asset is measured as a portion of the carrying value of the transferred asset.
D. If a servicing asset is acquired in the market, the servicing asset is measured at fair value.
Correct!
When a servicing asset is retained as a component in a sale of a financial asset, the servicing
asset is not measured as a portion of the carrying value of the transferred asset, but rather at
fair value at the date of transfer of the financial asset.
Servco, a loan servicing agency, paid $60,000 to acquire a three-year right to service
$1,000,000 of Banco's loans. Servco will be entitled to a servicing fee of 1% of the interest
and fees collected during the three-year period. Servco expects its servicing fees to be:
Year 1 $40,000
Year 2 $30,000
Year 3 $10,000
Which one of the following is the amount of gross profit after amortization of the servicing
asset that Servco expects to earn over the three-year life of the service contract?
A. $ -0-
B. $10,000
C. $20,000
D. $80,000
Correct!
Over the three-year life of the contract, expected fees (revenues) are $80,000 ($40,000 +
$30,000 + $10,000 = $80,000). Total amortization (expense) will be $60,000, the full cost of
the servicing asset. Therefore, the expected gross profit is $80,000 - $60,000 = $20,000.
Servco, a loan servicing agency, paid $60,000 to acquire a three-year right to service
$1,000,000 of Banco's loans. Servco will be entitled to a servicing fee of 1% of the interest
and fees collected during the three-year period. Servco expects its servicing fees to be:
Year 1 $40,000
Year 2 30,000
Year3 10,000
Which one of the following is the amount of the $60,000 acquisition fee that Servco should
amortize during year 1?
A. $ -0-
B. $20,000
C. $30,000
D. $40,000
Correct!
Servco would record the $60,000 as a servicing asset and would amortize it in proportion to
and over the period of the estimated income. In this case, during year 1, $40,000 of the total
$80,000 estimated income would be earned. Therefore, 50% of the servicing asset would be
amortized in year 1. Thus, $60,000 x .50 = $30,000 amortization in year 1.
Recognized servicing assets should be assessed for impairment and servicing liabilities
should be assessed for understatement. In which of the following cases will an impairment
loss be recognized?
A. Servicing asset with carrying value less than fair value.
B. Servicing asset with fair value greater than carrying value.
C. Servicing liability with carrying value less than fair value.
D. Servicing liability with fair value less than carrying value.
Correct!
When a liability has a carrying value less than fair value, an unrealized loss exists. Adjusting
the carrying value of the liability to the higher fair value will result in a loss; DR: Impairment
Loss (+), CR: Liability (+).
On January 2, 2008, Fiserveco acquired a five-year right to service mortgage contracts for
which it paid $120,000. Fiserveco estimated that servicing and other fees would generate
$400,000 over the five-year period. During 2008, the contract generated $100,000 in
revenues. Which one of the following is the amount, if any, that Fiserveco should recognize
as an asset on January 2, 2008?
A. $ -0-
B. $100,000
C. $120,000
D. $400,000
Correct!
Since Fiserveco acquired the servicing rights asset in the market, it should recognize a
servicing asset at its fair value, which is the cost to Fiserveco in the market. Therefore, it
should recognize an asset of $120,000 on January 2, 2008
On January 2, 2008, Fiserveco acquired a five-year right to service mortgage contracts for
which it paid $120,000. Fiserveco estimated that servicing and other fees would generate
$400,000 over the five-year period. During 2008 the contract generated $100,000 in
revenues. Which one of the following is the amount of expense, if any, that Fiseerveco
should recognize in 2008 as amortization of its servicing asset?
A. $ -0-
B. $ 24,000
C. $ 30,000
D. $ 100,000
Correct!
Since Fiserveco acquired the servicing rights asset in the market, it should recognize a
servicing asset at its fair value, which is the cost to Fiserveco in the market. Therefore, it
should recognize an asset of $120,000 on January 2, 2008. That servicing asset should be
amortized each period over the life of the contract in the same proportion that period revenues
have to expected total revenues. During 2008, $100,000 of an expected $400,000 total
revenues was earned. Therefore, $100,000/$400,000, or ¼ of the servicing asset should be
amortized. One-fourth of $120,000 = $30,000, the correct answer.
Which of the following must the transferor of a financial asset disclose?
I. Assets pledged as collateral, either in the balance sheet or notes.
II. Detailed information about financial assets that have been securitized and sold.
A. I only.
B. II only.
C. Both I and II.
Correct!
The transferor of a financial asset must disclose both assets pledged as collateral, either in the
balance sheet or in the notes to the financial statements, and detailed information about
financial assets that have been securitized and sold.
Bilco has pledged financial assets as security for a loan from Banco. Which of the following
statements concerning disclosure of the pledged assets is correct?
A. Bilco is not required to separately disclose the assets pledged as security.
B. Bilco must disclose the assets pledged as security on the face of its balance sheet.
C. Bilco must disclose the assets pledged as security in the notes to its financial statements.
D. Bilco may disclose the assets pledged as security either on the face of its balance sheet or in
the notes to its financial statements.
Correct!
Bilco is required to separately disclose the assets pledged as security, and may do so either on
the face of its balance sheet or in the notes to its financial statements.
Specific disclosures in financial statements are required when an entity engages in:
Transfer of Financial Assets Servicing of Financial Assets
Yes Yes
Yes No
No Yes
No No
Correct!
An entity that engages in either the transfer of financial assets or the servicing of financial
assets must make specific disclosures in its financial statements.
Which of the following entities, if any, that engage in the transfer of financial assets is (are)
required to make disclosures about those transfers?
Transferor Transferee
Yes Yes
Yes No
No Yes
No No
Correct!
Both transferors and transferees that are parties to a transfer of financial assets are required
to make disclosures about those transfers.
Assume a creditor releases a debtor from being primarily responsible for a liability because
an unrelated third-party legally assumes the liability, with the original debtor becoming
secondarily liable for the obligation. Which of the following statements is correct?
I. The original debtor's liability has been extinguished.
II. The original debtor became a guarantor of the liability.
III. The original debtor may recognize a gain or loss on its release from the obligation.
A. II only.
B. I and II only.
C. I and III only.
D. I, II, and III.
Correct!
The original debtor's liability has been extinguished, the debtor has become a guarantor of the
liability now held by a third-party, and the original debtor may recognize a gain or loss on its
release from the obligation.
Sloco has a debt with a carrying value of $500,000 due to Topco. Because Topco is
concerned about Sloco's on-going ability to meet its debt obligation, it has agreed to Sloco's
proposal that Trico, an unrelated third-party, assume the debt, with Sloco becoming
secondarily liable. Sloco will transfer to Trico equipment with a current fair value of
$400,000 in exchange for Trico's assumption of its debt to Topco. Based on its objective
assessment as to Trico's likelihood of satisfying the debt obligation, Sloco estimates the
possibility of its secondary obligation for the debt has a fair value of $70,000.
What amount of gain or loss, if any, should Sloco recognize as a consequence of carrying
out its arrangement with Topco and Trico?
A. $ -0-
B. $30,000
C. $100,000
D. $170,000
Correct!
Sloco would recognize a gain or loss as the difference between the carrying value of its debt
and the fair value of consideration given to extinguish the debt, less any obligation incurred in
the arrangement. Therefore, Sloco would write off the carrying value of its debt ($500,000)
and the fair value of the equipment conveyed to Trico ($400,000) for a gross gain of
$100,000. That gross gain would be reduced by the guarantor obligation it would recognize of
$70,000. Thus, Sloco would recognize a net gain of $100,000 - $70,000 = $30,000.
Under which of the following conditions would a debtor be justified in writing off a
recognized liability?
I. The debtor is relieved from being the primary obligator by the creditor.
II. The debtor is relieved from being the primary obligator by a court ruling.
A. I only.
B. II only.
C. Both I and II.
Correct!
A debtor may write off a recognized liability if relieved from being the primary obligator by a
court or if the debtor is relieved from being the primary obligator by the creditor (or if the
debtor pays the creditor).
In which of the following circumstances would a debt liability likely not be considered
extinguished?
A. Debtor pays cash to fully satisfy the debt and cancels the debt instrument.
B. Debtor creates and fully funds an irrevocable trust to satisfy all obligations of the debt as they
become due.
C. Debtor pays cash to fully satisfy the debt and holds the debt instrument in its treasury.
D. Debtor performs services for the creditor that fully satisfy the debt and cancels the debt
instrument.
Correct!
Creating and funding an irrevocable trust to satisfy all obligation of the debt, called an
insubstance defeasance, would not cause the debt to be extinguished. Debt is extinguished
only if the debtor pays the creditor or is legally released from the debt by the creditor or the
law/courts.
A debtor can be legally released from its liability by:

Court Order Creditor Agreement
Yes Yes
Yes No
No Yes
No No
Correct!
A debtor can be legally released from its liability by either a court order (e.g., in bankruptcy)
or by agreement of the creditor.
Which one of the following sets correctly reflects whether the transfer of a financial asset
should be treated as a sale or as a borrowing when control over the transferred financial
asset has been surrendered and when control has not been surrendered?
Control Surrendered Control Not Surrendered
Sale Sale
Sale Borrowing
Borrowing Sale
Borrowing Borrowing
Correct!
The transfer of a financial asset that results in surrender of control is treated as a sale of the
transferred asset, and the transfer of a financial asset that does not result in the surrender of
control is treated as a secured borrowing.
Lecture 6
Snelling Co. did not record an accrual for a contingent loss, but disclosed the nature of the
contingency and the range of the possible loss.
How likely is the loss?
A. Remote.
B. Reasonably possible.
C. Probable.
D. Certain.
Correct!
Remote contingent losses may be disclosed in the footnotes, but there is no requirement to do
so. Probable contingent losses are accrued. Certain losses are no longer contingent losses.
When a loss is reasonably possible, it is footnoted. It is most likely that the loss is reasonably
possible when a range of losses is disclosed.
On April 1, 2003, Ash Corp. began offering a new product for sale under a one-year
warranty. Of the 5,000 units in inventory at April 1, 2003, 3,000 had been sold by June 30,
2003. Based on its experience with similar products, Ash estimated that the average
warranty cost per unit sold would be $8. Actual warranty costs incurred from April 1
through June 30, 2003, were $7,000. At June 30, 2003, what amount should Ash report as
estimated warranty liability?
A. $9,000
B. $16,000
C. $17,000
D. $33,000
Correct!
The ending warranty liability balance is the warranty expense recognized in that year based on
sales (this amount increases the liability), less the warranty costs actually incurred. Therefore,
the ending warranty liability is $17,000 [expense of ($8)3,000 - actual costs of $7,000].
Bell Co. is a defendant in a lawsuit that could result in a large payment to the plaintiff.
Bell's attorney believes that there is a 90% chance that Bell will lose the suit, and estimates
that the loss will be anywhere from $5,000,000 to $20,000,000 and possibly as much as
$30,000,000. None of the estimates is better than the others. What amount of liability
should Bell report on its balance sheet related to the lawsuit?
A. $ -0-
B. $5,000,000
C. $20,000,000
D. $30,000,000
Correct!
Correct! When no amount within the range of estimated loss amounts is more probable than
the others, the lowest amount in the range is recognized, provided that the loss is probable. A
90% probability is sufficient to meet the "probable and estimable" requirement of FAS 5 for
recognizing contingent liabilities.
On November 25, 2005, an explosion occurred at a Rex Co. plant, causing extensive
property damage to area buildings.
By March 10, 2006, claims had been asserted against Rex. Rex's management and counsel
concluded that it is probable Rex will be responsible for damages, and that $3,500,000
would be a reasonable estimate of its liability. Rex's $10,000,000 comprehensive public
liability policy has a $500,000 deductible clause.
Rex's December 31, 2005, financial statements, issued on March 25, 2006, should report
this item as:
A. A footnote disclosure indicating the probable loss of $3,500,000.
B. An accrued liability of $3,500,000.
C. An accrued liability of $500,000.
D. A footnote disclosure indicating the probable loss of $500,000.
Correct!
Contingent liabilities that are probable and estimable, like this one, must be recognized in the
accounts. The $500,000 deductible is the amount that will most likely have to be paid.
East Corp. manufactures stereo systems that carry a two-year warranty against defects.
Based on past experience, warranty costs are estimated at 4% of sales for the warranty
period.
During 2005, stereo system sales totaled $3,000,000, and warranty costs of $67,500 were
incurred.
In its income statement for the year ended December 31, 2005, East should report warranty
expense of:
A. $52,500
B. $60,000
C. $67,500
D. $120,000
Correct!
Warranty expense is recognized in the year of sale under the accrual accounting system.
Warranties are a part of the selling effort, and the associated expense should be recognized when
the liability is probable and estimable (in 2005). The actual repairs reduce the liability recognized
when the expense was recorded (in the year of sale).
The $120,000 of warranty expense in 2005 = .04(sales in 2005) = .04($3,000,000). The relevant
entries for 2005 are:
Warranty expense 120,000

Warranty liability 120,000
Warranty liability 67,500
Cash, parts, etc. 67,500
At December 31, 2004, Date Co. awaits judgment on a lawsuit for a competitor's
infringement of Date's patent. Legal counsel believes it is probable that Date will win the
suit and indicated the most likely award together with a range of possible awards.
How should the lawsuit be reported in Date's 2004 financial statements?
A. In note disclosure only.
B. By accrual for the most likely award.
C. By accrual for the lowest amount of the range of possible awards.
D. Neither in note disclosure nor by accrual.
Correct!
This is a gain contingency. Gain contingencies are footnoted at most, not accrued. To
recognize gain contingencies in the accounts would violate the conservatism constraint.
On February 5, 2005, an employee filed a $2,000,000 lawsuit against Steel Co. for damages
suffered when one of Steel's plants exploded on December 29, 2004.
Steel's legal counsel expects the company will lose the lawsuit and estimates the loss to be
between $500,000 and $1,000,000. The employee has offered to settle the lawsuit out of
court for $900,000, but Steel will not agree to the settlement.
In its December 31, 2004, balance sheet, what amount should Steel report as liability from
lawsuit?
A. $2,000,000
B. $1,000,000
C. $900,000
D. $500,000
Correct!
This is a recognized contingent liability because it is probable that a loss has occurred. When a
range of losses is possible, with no one point in the range more probable than the others, the
lower limit of the range is the amount recognized.
What is the underlying concept that supports the immediate recognition of a contingent
loss?
A. Substance over form.
B. Consistency.
C. Matching.
D. Conservatism.
Correct!
A contingent loss has not occurred as of the balance sheet date, but since it is probable and
estimable, and would result in lower income and net assets, the loss should be recognized. A
contingent gain that also is probable and estimable is not recognized. Thus, it is only the
direction of the effect of the item that causes the accounting treatment to be different.
This can only be explained by conservatism: under conditions of uncertainty, report lower
earnings and net assets. Uncertain gains are not allowed to be recognized because they may
raise the expectations of investors unnecessarily. Uncertain gains may not be realized.
During 2004, Gum Co. introduced a new product carrying a two-year warranty against
defects. The estimated warranty costs related to dollar sales are 2% within 12 months
following the sale and 4% in the second 12 months following the sale.
Sales and actual warranty expenditures for the years ended December 31, 2004 and 2005
are as follows:
Sales Actual warranty expenditures

2004 $150,000 $2,250
2005 250,000 7,500
$400,000 $9,750
========= =========
What amount should Gum report as estimated warranty liability in its December 31, 2005,
balance sheet?
A. $2,500
B. $4,250
C. $11,250
D. $14,250
Correct!
At Dec. 31, 2005, the total warranty liability accrued for the two years is 6% of sales (2% +
4%). This total is $24,000 (.06 x $400,000). Subtracting $9,750 of actual warranty
expenditures to the end of 2005 yields the $14,250 ending warranty liability.
Wall Co. sells a product under a two-year warranty. The estimated cost of warranty repairs
is 2% of net sales. During Wall's first two years in business, it made the following sales and
incurred the following warranty repair costs:
Year 1
Total sales $250,000
Total repair costs incurred 4,500
Year 2
Total sales $300,000
Total repair costs incurred 5,000
What amount should Wall report as warranty expense for year 2?
A. $1,000
B. $5,000
C. $5,900
D. $6,000
Correct!
The recognized warranty expense is based on sales in the period because a regular warranty is
part of the sales effort. The full cost of the warranty servicing is matched against sales in the
year of the sale. With sales of $300,000 in year 2, recognized warranty expense is 2% of that
amount or $6,000. At year-end, the firm is contingently liable for warranty claims service in
the amount of $6,000 for that year's sales. Warranty liability is credited for $6,000. As actual
repairs are made, the warranty liability is reduced. Some of the estimated $6,000 repair cost
may be included in the $5,000 amount of actual repair cost incurred in year 2.
Brite Corp. had the following liabilities at December 31, 2004:
Accounts payable $ 55,000

Unsecured notes, 8%, due 7-1-05 400,000
Accrued expenses 35,000
Contingent liability 450,000
Deferred income tax liability 25,000
Senior bonds, 7%, due 3-31-05 1,000,000
The contingent liability is an accrual for possible losses on a $1,000,000 lawsuit filed
against Brite. Brite's legal counsel expects the suit to be settled in 2006 and has estimated
that Brite will be liable for damages in the range of $450,000 to $750,000.
The deferred income tax liability is not related to an asset for financial reporting and is
expected to reverse in 2006.
What amount should Brite report in its December 31, 2004 balance sheet for current
liabilities?
A. $515,000
B. $940,000
C. $1,490,000
D. $1,515,000
Correct!
Current liabilities include:

Accounts payable $55,000
8% notes 400,000
Accrued expenses 35,000
7% bonds 1,000,000
Total current liabilities $1,490,000
The four items above are all due within one year of the balance sheet date and thus are
included in current liabilities.
The contingent liability, although shown in the correct amount, is not current as of 12/31/04
because it is not expected to be paid until 2006. The deferred tax liability is not related to an
asset, so it must be related to another liability.
The other liability could not be a current liability because the difference is not expected to
reverse until 2006. (Reversal would occur when the other liability is paid.)
Therefore, the deferred tax liability must be classified as noncurrent.
Management can estimate the amount of the loss that will occur if a foreign government
expropriates some company assets.
If expropriation is reasonably possible, a loss contingency should be:
A. Neither accrued as a liability nor disclosed.
B. Accrued as a liability but not disclosed.
C. Disclosed and accrued as a liability.
D. Disclosed but not accrued as a liability.
Correct!
A reasonably possible loss contingency is disclosed in the footnotes, but not recognized as a
liability.
Only when the contingent loss is both probable and estimable is the loss accrued (recognized).
Management can estimate the amount of loss that will occur if a foreign government
expropriates some company assets. If expropriation is reasonably possible, a loss
contingency should be:
A. Disclosed but not accrued as a liability.
B. Disclosed and accrued as a liability.
C. Accrued as a liability but not disclosed.
D. Neither accrued as a liability nor disclosed.
Correct!
This contingent liability is not probable, only reasonably possible. Therefore, only footnote
disclosure is mandated. Accrual requires a probable expropriation.
In 2003, a personal injury lawsuit was brought against Halsey Co.
Based on counsel's estimate, Halsey reported a $50,000 liability in its December 31, 2003,
balance sheet. In November 2004, Halsey received a favorable judgment, requiring the
plaintiff to reimburse Halsey for expenses of $30,000. The plaintiff has appealed the
decision, and Halsey's counsel is unable to predict the outcome of the appeal.
In its December 31, 2004, balance sheet, Halsey should report what amounts of asset and
liability related to these legal actions?
Asset Liability
$30,000 $50,000
$30,000 $0
$0 $20,000
$0 $0
Correct!
The contingent liability at the end of 2003 no longer exists.
It is not probable, given the facts in the question, that Halsey will be required to make any
payment in the lawsuit. The favorable judgment indicates a contingent gain (asset).
Contingent gains are not recognized in the accounts, but only footnoted.
Martin Pharmaceutical Co. is currently involved in two lawsuits. One is a class-action suit in
which consumers claim that one of Martin's best selling drugs caused severe health
problems. It is reasonably possible that Martin will lose the suit and have to pay $20 million
in damages. Martin is suing another company for false advertising and false claims against
Martin. It is probable that Martin will win the suit and be awarded $5 million in damages.
What amount should Martin report on its financial statements as a result of these two
lawsuits?
A. $0
B. $5 million income
C. $15 million expense.
D. $20 million expense.
Correct!
A contingent liability is recognized only when occurrence is probably and estimable. This class-
action suit is reasonably possible (a 50/50 chance) but not probable (a higher threshold).
Therefore, a liability for the class-action suit would not be accrued. Contingent assets are not
recognized until the amount is actually received, even if the outcome is probable and
estimable. Therefore, no asset is accrued for the suit where Martin may be awarded damages.
In May 2000, Caso Co. filed suit against Wayne, Inc. seeking $1,900,000 in damages for
patent infringement.
A court verdict in November 2003 awarded Caso $1,500,000 in damages, but Wayne's
appeal is not expected to be decided before 2005. Caso's counsel believes it is probable that
Caso will be successful against Wayne for an estimated amount in the range between
$800,000 and $1,100,000, with $1,000,000 considered the most likely amount.
What amount should Caso record as income from the lawsuit in the year ended December
31, 2003?
A. $ -0-
B. $800,000
C. $1,000,000
D. $1,500,000
Correct!
This is a gain contingency. These items are not recognized in the financial statements until the
contingency is removed. Thus, no income is recognized in 2003.
Hudson Corp. operates several factories that manufacture medical equipment. The factories
have a historical cost of $200 million. Near the end of the company's fiscal year, a change in
business climate related to a competitor's innovative products indicated to Hudson's
management that the $170 million carrying amount of the assets of one of Hudson's
factories may not be recoverable. Management identified cash flows from this factory and
estimated that the undiscounted future cash flows over the remaining useful life of the
factory would be $150 million. The fair value of the factory's assets is reliably estimated to
be $135 million. The change in business climate requires investigation of possible
impairment. Which of the following amounts is the impairment loss?
A. $15 million
B. $20 million
C. $35 million
D. $65 million
Correct!
Under U.S. GAAP, impairment testing is a two step process. The first step compares the assets'
carry value (CV) to its undiscounted cash flows (UCF). In this problem the CV < UCF; therefore
the asset is potentially impaired and we must go to the second step. The second step
compares the assets CV to its fair value (FV). In this problem the FV < CV and the asset is
written down to its FV. $170 million - $135 million = $35 million impairment loss.
Vadis Co. sells appliances that include a three-year warranty. Service calls under the
warranty are performed by an independent mechanic under a contract with Vadis. Based on
experience, warranty costs are estimated at $30 for each machine sold.
When should Vadis recognize these warranty costs?
A. Evenly over the life of the warranty.
B. When the service calls are performed.
C. When payments are made to the mechanic.
D. When the machines are sold.
Correct!
At the point of sale, Vadis has committed to service the products it sells. The firm has incurred
a recognized obligation at that point because it is both probable and estimable (FAS 5).
The cost of the warranty, therefore, is recognized in the year of sale. The cost (expense) is the
temporary account that measures the reduction in net assets from operations (earnings)
caused by the increase in the obligation.
A less acceptable explanation is that the warranty cost or expense should be matched against
the sales it helped to produce. Either explanation leads to the same result, however.
Grim Corporation operates a plant in a foreign country. It is probable that the plant will be
expropriated. However, the foreign government has indicated that Grim will receive a
definite amount of compensation for the plant.
The amount of compensation is less than the fair market value but exceeds the carrying
amount of the plant.
The contingency should be reported:
A. As a valuation allowance as a part of stockholders' equity.
B. As a fixed asset valuation allowance account.
C. In the notes to the financial statements.

D. In the income statement.
Correct!
This is a gain contingency. The possible gain is the difference between the compensation
amount and the carrying value of the plant. However, the gain is contingent on receipt of the
compensation. Gain contingencies are reported only in the notes and are not recognized in the
In June 2004, Northan Retailers sold refundable merchandise coupons. Northan received
$10 for each coupon redeemable from July 1 to December 31, 2004, for merchandise with a
retail price of $11. At June 30, 2004, how should Northan report these coupon transactions?
A. Unearned revenues at the merchandise's retail price.
B. Unearned revenues at the cash received amount.
C. Revenues at the merchandise's retail price.
D. Revenues at the cash received amount.
Correct!
The amounts received represent unearned revenue (a liability) because the merchandise has
not yet been provided to the customer. The cash received is an advance on future purchases
by customers. The customers have prepaid sales and have a claim on the firm for
merchandise. When the customers submit the coupons for redemption, the liability is
extinguished and sales are recorded.
The amount to be recorded for the liability (unearned revenue) can only be the amount
collected from the customer. The sales at redemption will be recorded at the $10 amount,
rather than $11. The firm is simply providing a discount price for a customer that is
committing to a purchase well ahead of delivery.
During 2005, Tedd Co. became involved in a tax dispute with the IRS. At December 31,
2005, Tedd's tax advisor believed that an unfavorable outcome was probable.
A reasonable estimate of additional taxes was $400,000 but could be as much as $600,000.
After the 2005 financial statements were issued, Tedd received and accepted an IRS
settlement offer of $450,000.
What amount of accrued liability should Tedd have reported in its December 31, 2005
balance sheet?
A. $400,000
B. $450,000
C. $500,000
D. $600,000
Correct!
When a contingent loss is both probable and estimable, it must be accrued. When only a range
of amounts can be estimated, rather than a point estimate, the lowest amount in the range is
accrued.
In this case, the low end of the range is $400,000, and that amount is accrued. The footnotes
will describe the entire range to indicate the firm's maximum exposure to loss. The actual
settlement offer amount was unknown before the statements were issued.
During 2005, Smith Co. filed suit against West, Inc. seeking damages for patent
infringement.
At December 31, 2005, Smith's legal counsel believed that it was probable that Smith would
be successful against West for an estimated amount in the range of $75,000 to $150,000,
with all amounts in the range considered equally likely. In March 2006, Smith was awarded
$100,000 and received full payment thereof.
In its 2005 financial statements, issued in February 2006, how should this award be
reported?
A. As a receivable and revenue of $100,000.
B. As a receivable and deferred revenue of $100,000.
C. As a disclosure of a contingent gain of $100,000.
D. As a disclosure of a contingent gain of an undetermined amount in the range of $75,000 to

$150,000.
Correct!
Contingent gains are not recognized in the accounts. At most, footnote disclosure is considered
acceptable reporting. This is the best answer because no amount in the range of possible
values is more likely than any other. The $100,000 amount was not known when the financial
statements were published.
Baker Co. sells consumer products that are packaged in boxes. Baker offered an
unbreakable glass in exchange for two box tops and $1 as a promotion during the current
year. The cost of the glass was $2.00. Baker estimated at the end of the year that it would
be probable that 50% of the box tops will be redeemed. Baker sold 100,000 boxes of the
product during the current year, and 40,000 box tops were redeemed during the year for
the glasses. What amount should Baker accrue as an estimated liability at the end of the
current year, related to the redemption of box tops?
A. $ -0-
B. $5,000
C. $20,000
D. $25,000
Correct!
This is a contingency that meets the criteria for a liability. The total estimated number of box
tops redeemed is 100,000 x 50% = 50,000.
Of these 50,000, 40,000 have been redeemed, leaving 10,000 box tops estimated to be
redeemed. It takes two box tops per glass, or 10,000/2 = 5,000 glasses.
At a cost of $1 per glass, the total cost is 5,000 X $1 = 5,000 as a liability.
On January 17, 2005, an explosion occurred at a Sims Co. plant, causing extensive property
damage to area buildings.
Although no claims had yet been asserted against Sims by March 10, 2005, Sims'
management and counsel concluded that it is likely that claims will be asserted and that it
is reasonably possible Sims will be responsible for damages. Sims' management believed
that $1,250,000 would be a reasonable estimate of its liability. Sims' $5,000,000
comprehensive public liability policy has a $250,000 deductible clause.
In Sims' December 31, 2004, financial statements, which were issued on March 25, 2005,
how should this item be reported?
A. As an accrued liability of $250,000.
B. As a footnote disclosure indicating the possible loss of $250,000.
C. As a footnote disclosure indicating the possible loss of $1,250,000.
D. No footnote disclosure or accrual is necessary.
Correct!
This contingent liability is not probable but only reasonably possible. Only probable contingent
liabilities are accrued. Reasonably possible contingent liabilities are footnoted.
The estimated loss is only $250,000 because the policy easily covers the estimated loss. Only
the deductible of $250,000 would have to be paid by Sims.
At December 31, 2005, Creole Co. was suing a competitor for patent infringement. The
award from the probable favorable outcome could be reasonably estimated.
Creole's 2005 financial statements should report the expected award as a:
A. Receivable and revenue.
B. Receivable and reduction of patent.
C. Receivable and deferred revenue.
D. Disclosure by footnote only.
Correct!
Contingent gains are gains that are dependent on the outcome of a future event. This is a
contingent gain because the outcome of the suit is not yet known. Contingent gains are not
recognized in the accounts, but rather are footnoted at most.
Conlon Co. is the plaintiff in a patent-infringement case. Conlon has a high probability of a
favorable outcome and can reasonably estimate the amount of the settlement. What is the
proper accounting treatment of the patent infringement case?
A. A gain contingency for the minimum estimated amount of the settlement.
B. A gain contingency for the estimated probable settlement.
C. Disclosure in the notes only.
D. No reporting is required at this time.
Correct!
If probable or reasonably possible, a gain contingency is disclosed in the notes to the financial
statements. Gain contingencies are not recognized, however. This particular gain contingency
is probable.
In 2003, a contract dispute between Dollis Co. and Brooks Co. was submitted to binding
arbitration.
In 2003, each party's attorney indicated privately that the probable award in Dollis' favor
could be reasonably estimated. In 2004, the arbitrator decided in favor of Dollis.
When should Dollis and Brooks recognize their respective gain and loss?
Dollis' gain Brooks' loss

2003 2003
2003 2004
2004 2003
2004 2004
Correct!
Both the gain and loss are contingent items at the end of 2003. Contingent losses are
recognized when probable and estimable - 2003 in this case. Contingent gains are not
recognized until realized - 2004 in this case.
Eagle Co. has cosigned the mortgage note on the home of its president, guaranteeing the
indebtedness in the event that the president should default. Eagle considers the likelihood
of default to be remote.
How should the guarantee be treated in Eagle's financial statements?
A. Disclosed only.
B. Accrued only.
C. Accrued and disclosed.
D. Neither accrued nor disclosed.
Correct!
In the interest of conservatism and disclosure, the guarantee should be disclosed. It is not
required to be accrued because the probability is remote that the firm will have to pay the
note.
Case Cereal Co. frequently distributes coupons to promote new products. On October 1,
2004, Case mailed 1,000,000 coupons for $.45 off each box of cereal purchased. Case
expects 120,000 of these coupons to be redeemed before the December 31, 2004,
expiration date. It takes 30 days from the redemption date for Case to receive the coupons
from the retailers. Case reimburses the retailers an additional $.05 for each coupon
redeemed. As of December 31, 2004, Case had paid retailers $25,000 related to these
coupons and had 50,000 coupons on hand that had not been processed for payment. What
amount should Case report as a liability for coupons in its December 31, 2004, balance
sheets?
A. $35,000
B. $29,000
C. $25,000
D. $22,500
Correct!
120,000 coupons expected to be redeemed x ($.45 + $.05) $60,000

Less amount already paid (25,000)
Liability at 12/31/91 $35,000
The 50,000 coupons on hand are included in the ending liability and account for $25,000 of the
total liability [50,000($.45 + $.05)]. The $25,000 already paid represents another 50,000
coupons [$25,000/($.45 + $.05)].
Therefore, another 20,000 coupons have yet to be redeemed out of a total of 120,000
redemptions. These 20,000 coupons account for the remaining $10,000 of the liability
[20,000($.45 + $.05)].
Dunn Trading Stamp Co. records stamp service revenue and provides for the cost of
redemptions in the year stamps are sold to licensees. Dunn's past experience indicates that
only 80% of the stamps sold to licensees will be redeemed. Dunn's liability for stamp
redemptions was $6,000,000 at December 31, 2005. Additional information for 2006 is as
follows:
Stamp service revenue from stamps sold to licensees $4,000,000
Cost of redemptions (stamps sold prior to 1/1/06) 2,750,000
If all the stamps sold in 2006 were presented for redemption in 2007, the redemption cost
would be $2,250,000. What amount should Dunn report as a liability for stamp redemptions
at December 31, 2006?
A. $7,250,000
B. $5,500,000
C. $5,050,000
D. $3,250,000
Correct!
Beginning liability balance $6,000,000

Plus estimated redemptions for 2006: .80($2,250,000) 1,800,000
Less actual redemptions in 2006 (2,750,000)
Equals ending liability balance $5,050,000
The firm estimates the redemption cost in the year of sale, much like a warranty liability. For
2006, this increases the redemption liability by $1,800,000. When actual redemptions occur,
the liability is extinguished at the cost of the redemptions ($2,750,000).
During 2004, Leader Corp. sued Cape Co. for patent infringement.
On December 31, 2004, Leader was awarded a $500,000 favorable judgment in the suit. On
that date, Cape offered to settle out of court for $300,000 and not appeal the judgment. In
February 2005, after the issuance of its 2004 financial statements, Leader agreed to the
out-of-court settlement and received a certified check for $300,000.
In its 2004 financial statements, how should Leader have reported these events?
A. As a gain of $300,000.
B. As a receivable and deferred credit of $300,000.
C. As a disclosure in the notes to the financial statements only.
D. It should not be reported in the financial statements.
Correct!
The decision was not made as of the balance sheet date. This is a gain contingency.
As of the balance sheet date, Leader may decide to contest the appeal should an appeal be
made, for example, or as of the balance sheet date, it may have been considering acceptance
of the settlement offer. Either way, there is a possibility of a gain for the firm as of the balance
sheet date.
Such contingencies are not recognized in the accounts, but rather are disclosed in the
footnotes.
During 2005, Haft Co. became involved in a tax dispute with the IRS.
At December 31, 2005, Haft's tax advisor believed that an unfavorable outcome was
probable. A reasonable estimate of additional taxes was $200,000 but could be as much as
$300,000. After the 2005 financial statements were issued, Haft received and accepted an
IRS settlement offer of $275,000.
What amount of accrued liability should Haft have reported in its December 31, 2005
balance sheet?
A. $200,000
B. $250,000
C. $275,000
D. $300,000
Correct!
When a range of possible losses is estimated, and no one amount is considered more probable
than the others, the lowest estimate is accrued, if also probable.
On November 1, 2004, Beni Corp. was awarded a judgment of $1,500,000 in connection

with a lawsuit. The decision is being appealed by the defendant, and it is expected that the
appeal process will be completed by the end of 2005.
Beni's attorney feels that it is highly probable that an award will be upheld on appeal, but
that the judgment may be reduced by an estimated 40%.
In addition to footnote disclosure, what amount should be reported as a receivable in Beni's

balance sheet at December 31, 2004?
A. $1,500,000
B. $900,000
C. $600,000
D. $ -0-
Correct!
This is a contingent asset or gain. Contingent assets are not recognized in the accounts.
This is a classic case of conservatism. If all the data were the same except that a loss was
expected, a loss would be accrued in the accounts.
On January 3, 2005, Ard Corp. owned a machine that had cost $60,000. The accumulated
depreciation was $50,000, estimated salvage value was $5,000, and fair market value was
$90,000.
On January 4, 2005, this machine was irreparably damaged by Rice Corp. and became
worthless. In October 2005, a court awarded damages of $90,000 against Rice in favor of
Ard. At December 31, 2005, the final outcome of this case was awaiting appeal and was,
therefore, uncertain.
However, in the opinion of Ard's attorney, Rice's appeal will be denied.
At December 31, 2005, what amount should Ard accrue for this gain contingency?
A. $90,000
B. $80,000
C. $75,000
D. $ -0-
Correct!
This is a gain contingency. Gain contingencies are not accrued in the accounts. At most they
are footnoted.
This is an example of conservatism. Probable and estimable contingencies are recognized in

the accounts if they are losses, but not if they are gains.
Invern, Inc. has a self-insurance plan.
Each year, retained earnings is appropriated for contingencies in an amount equal to

insurance premiums saved less recognized losses from lawsuits and other claims. As a
result of a 2005 accident, Invern is a defendant in a lawsuit in which it will probably have to
pay damages of $190,000.
What are the effects of this lawsuit's probable outcome on Invern's 2005 financial
statements?
A. An increase in expenses and no effect on liabilities.
B. An increase in both expenses and liabilities.
C. No effect on expenses and an increase in liabilities.
D. No effect on either expenses or liabilities.
Correct!
The information about self-insurance (which means no insurance) is irrelevant to the problem
except that if the firm loses the lawsuit, there will be no insurance coverage. This is a
contingent liability. It is probable, and the amount is estimable.
Therefore, expenses (or a loss) and a liability are recognized for $190,000.
During 2003, Manfred Corp. guaranteed a supplier's $500,000 loan from a bank.
On October 1, 2004, Manfred was notified that the supplier had defaulted on the loan and
filed for bankruptcy protection. Counsel believes Manfred will probably have to pay between
$250,000 and $450,000 under its guarantee.
As a result of the supplier's bankruptcy, Manfred entered into a contract in December 2004
to retool its machines so that Manfred could accept parts from other suppliers. Retooling
costs are estimated to be $300,000.
What amount should Manfred report as a liability in its December 31, 2004, balance sheet?
A. $250,000
B. $450,000
C. $550,000
D. $750,000
Correct!
The retooling costs are not part of the liability, but are rather a response to changing business
conditions. They most likely would be capitalized and amortized over their useful life. The
liability is a contingent liability.
The amount depends on the outcome of the bankruptcy proceedings. When a range of values
is estimated with no one value being more probable than the others, the lowest amount is
accrued. Thus, $250,000 is accrued as of the end of 2004.
Choose the correct statement regarding international accounting standards and U.S.
standards as they relate to contingent liabilities and similar items.
A. All provisions under international accounting standards are contingent liabilities under U.S.
standards.
B. Both sets of standards require discounting of estimated liabilities.
C. A possible obligation that requires a future event for confirmation is treated as a contingent
liability under both sets of standards.
D. Both sets of standards are essentially the same with regard to recognition of contingent
assets.
Correct!
This is the one situation where both sets of standards agree with respect to classifying
contingent liabilities. For international accounting standards, there are other situations calling
for the reporting of a contingent liability.
Which of the following is not a contingent liability under international accounting

standards?
A. A provision with a 60% chance of requiring an outflow of benefits, amount is estimable.
B. A provision with a 40% chance of requiring an outflow of benefits, amount is estimable.
C. A provision with a 90% chance of requiring an outflow of benefits, amount not estimable.
D. A possible obligation.
Correct!
A probable (< 50%) outflow of benefits is implied, and the amount is estimable. This is a
recognized liability for international accounting standards, not a contingent liability.
Choose the correct statement about international accounting standards as they relate to
contingent liabilities and similar items.
A. A provision that has a reasonably possible chance of requiring the outflow of benefits is
treated as a contingent liability.
B. Provisions are recognized only when there is greater than a 90% probability of an outflow of
benefits occurring.
C. A recognized provision is a contingent liability.
D. A provision for which it is probable that an outflow of benefits will be required is recognized,
even if it is not of estimable amount.
Correct!
A provision is a present obligation. This is one of the ways a liability can be treated as a
contingent liability under international standards. If the provision involved a probable outflow,
then it would be recognized, but would not be a contingent liability.
Which of the following is a recognized liability for both international accounting standards
and U.S. standards?
A. Regular warranty liability, 60% probability of occurring.
B. Obligation to provide rebates to customers, 90% probability of occurring.
C. Possible loss due to lawsuit, 60% probability of occurring.
D. Possible loss due to lawsuit, 40% probability of occurring.
Correct!
For international accounting standards, this is a recognized provision. For U.S. standards, it is
a recognized contingent liability.
A firm considers its regular warranty liability to be an existing liability of uncertain amount.
At year-end, the firm estimates that the amount required to extinguish its warranty liability
in the future is in the range of $20 to $60 million, with no amount more likely than any
other. Under the two sets of standards, what amount will be recognized?
International U.S.
40 40
40 20
20 20
0 40
Correct!
International accounting standards recognize the midpoint, whereas U.S. standards recognize
the low point.
Grim Corporation operates a plant in a foreign country. It is probable that the plant will be
expropriated. However, the foreign government has indicated that Grim will receive a
definite amount of compensation for the plant.
The amount of compensation is less than the fair market value but exceeds the carrying
amount of the plant.
The contingency should be reported:
A. As a valuation allowance as a part of stockholders' equity.
B. As a fixed asset valuation allowance account.
C. In the notes to the financial statements.
D. In the income statement.
Correct!
This is a gain contingency. The possible gain is the difference between the compensation
amount and the carrying value of the plant. However, the gain is contingent on receipt of the
compensation. Gain contingencies are reported only in the notes and are not recognized in the
Bell Co. is a defendant in a lawsuit that could result in a large payment to the plaintiff.
Bell's attorney believes that there is a 90% chance that Bell will lose the suit, and estimates
that the loss will be anywhere from $5,000,000 to $20,000,000 and possibly as much as
$30,000,000. None of the estimates is better than the others. What amount of liability
should Bell report on its balance sheet related to the lawsuit?
A. $ -0-
B. $5,000,000
C. $20,000,000
D. $30,000,000
Correct!
Correct! When no amount within the range of estimated loss amounts is more probable than
the others, the lowest amount in the range is recognized, provided that the loss is probable. A
90% probability is sufficient to meet the "probable and estimable" requirement of FAS 5 for
recognizing contingent liabilities.

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Week 7

Which one of the following is not necessarily a post-combination characteristic of a legal

B. A parent-subsidiary relationship exists.

D. The combining firms are under common economic control.

In Penn's consolidated financial statements, should consolidation accounting or equity

B. Consolidation used for both Sell and Vane.

D. Equity method used for both Sell and Vane.

B. Placo and Simco.

C. Kapco, Placo, and Simco.

C. The subsidiary is in bankruptcy.

Consolidated financial statements are based on the concept that:

B. I and II, only.

C. II and III, only.

Following a business combination accomplished through a legal acquisition, transactions

An intercompany investment elimination will be required in every consolidating process (to

C. Both I and II.

D. Neither I nor II.

The recorded assets and liabilities of Wall Corp.

Assets $2,000,000 $750,000

Liabilities $750,000 $400,000

Common stock 1,000,000 310,000

Retained earnings __250,000 __40,000

On the date of a business combination using acquisition accounting, the consolidated

B. Plant and Equipment

Which one of the following would be of concern in preparing consolidated financial

B. Whether or not goodwill resulted from the business combination.

Which one of the following is not a characteristic of consolidated financial statements

Which of the following financial statements, if any, prepared by a parent following an

C. Is used in lieu of an investment elimination entry.

D. Is recorded only on the consolidating worksheet.

C. Depreciation expense would be decreased, and no goodwill would be recognized.

D. Depreciation expense would be increased, and no goodwill would be recognized.

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

D. the parent's share of the subsidiary's net loss.

10/1 - 12/31/08 1/1 - 12/31/09

Liabilities and stockholders' equity

Liabilities and stockholders' equity

Consolidated financial statements are based on the concept that:

Which one of the following would be of concern in preparing consolidated financial

B. Whether or not goodwill resulted from the business combination.

Which of the following kinds of transactions should be eliminated in the consolidating

Parent to Subsidiary Subsidiary to Parent Subsidiary 1 Subsidiary 2

In the preparation of consolidated financial statement, which of the following sources of

Which one of the following is not a characteristic associated with intercompany

Parco to Subco Subco to Noco

The amount of intercompany payables to be eliminated is $50,000, the full amount of

Dividends declared by Pride Dividends declared by Simba

All intercompany receivables and payables should be eliminated in the preparation of a

Which of the following can be overstated on consolidated financial statements if

Consolidated Income Consolidated Loss

Either consolidated income or consolidated loss could be overstated on consolidated

Which one of the following will occur on consolidated financial statements if an

D. An overstatement of accounts receivable.

If an intercompany inventory transaction is not eliminated in the consolidating process,

B. Fire's original cost.

C. Water's original cost less Fire's recorded gain.

D. Water's original cost less 80% of Fire's recorded gain.

An intercompany depreciable fixed asset transaction resulted in an intercompany gain.

Consolidated Income Consolidated Loss

Either consolidated income or consolidated loss could be overstated on consolidated

What amount should be reported as depreciation expense in Pirn's 2005 consolidated

Which one of the following is not a characteristic of intercompany bonds?

In which of the following ownership arrangements would intercompany bonds exist?

Retained earnings 250,000 40,000