Preview Extract
Chapter 8
Investments in Equity Securities
Multiple Choice Questions
1. Equity investments are:
a. investments in bonds of a corporation.
b. investments that pay dividends, not interest.
c. classified as long-term liabilities.
d. marketed by the SEC to any investor who wishes to buy bonds of a public company.
Answer: B
2. Investments in equity securities are current assets if:
a. they can be sold and converted into cash on demand and a ready market exists.
b. the fair market value can’t be determined.
c. management intends to convert them into common stock within one year.
d. management owns less than 50% of the outstanding stock.
Answer: A
3. Income from trading and available-for-sale equity securities is recognized when:
a. dividends are received from the investee due to the uncertainty of payment.
b. dividends are declared by the investee.
c. adjusting entries are made to record fair value adjustments.
d. the investee reports profits for the accounting period.
Answer: B
4. When a company accounts for an investment under the purchase method of accounting,
a. the book value of the subsidiary's assets is added to the parent company's assets.
b. the book value of the subsidiary's liabilities is added to the parent company's liabilities.
c. the company obviously owns more than 50% of the stock of the investee.
d. a year-end adjustment is made to increase or decrease the carrying value of the investment
to fair market value.
Answer: C
5. Trading securities are:
a. readily marketable investments that management intends to hold for extended periods.
b. always short-term investments.
c. current assets that require the equity method of accounting for investments.
d. actively ‘traded’ on the open market, but can’t be sold until they mature.
Answer: B
6. Available-for-sale securities are:
a. actively ‘traded’ on the open market, but can’t be sold until they mature.
b. readily marketable investments that management intends to sell for short-term profits.
c. always short-term investments in common stock.
d. adjusted to fair value at yearend.
Answer: D
7. Trading securities:
a. are recorded on the balance sheet at market value.
b. may have unrealized gains or losses on the balance sheet associated with price increases or
decreases.
c. are listed as long-term assets.
d. Both a and b are correct.
Answer: A
8. Benson Incorporated owns 32% of Denver Company's outstanding voting stock. Benson
Incorporated should account for its investment in Denver using the:
a. fair value method.
b. cost method.
c. consolidation procedure.
d. equity method.
Answer: D
9. Dewey Inc. owns 64% of Felicity Corporation’s outstanding voting stock. Dewey should
account for its investment in Felicity using the:
a. fair value method.
b. cost method.
c. consolidation procedure.
d. mark-to-market method
Answer: C
10. During 2010, the market price of trading securities declined. Which one of the following
correctly reflects the effects on the financial statements as a result?
a. Current ratio and earnings per share decrease.
b. Current ratio and earnings per share increase.
c. Current ratio is unchanged and earnings per share increases.
d. Current ratio increases and earnings per share are unchanged.
Answer: A
11. Available-for-sale securities:
a. are reported on the balance sheet at original cost.
b. may have unrealized price increases or decreases, which increase or decrease shareholders’
equity.
c. are reported in the shareholders’ equity section of the balance sheet at fair value.
d. may have unrealized gains or losses on the income statement associated with price
increases or decreases.
Answer: B
12. When a company recognizes unrealized losses on trading securities, its earnings per
share:
a. decreases.
b. increases.
c. is not affected.
d. may increase or decrease depending on the related market value.
Answer: A
13. Torborg Corp. purchased available-for-sale securities from Hensley Company on
December 23 for $3,000. On December 31, the market value of those securities is $3,600.
Which one of the following journal entries is appropriate on December 31?
Answer: C
14. Trading securities of Sanchez Inc. were purchased by Hayden Company on December 14
for $1,000. On December 31, the market value of those securities is $1,300. Which one of the
following adjusting journal entries is appropriate at December 31?
Answer: B
15. On November 10, 2011, Clark Inc. purchased shares of Landon Corp. for $100,000 and
shares of Norris Incorporated for $50,000. At the end of 2011, the fair market value of the
stock of Landon was $80,000 and for Norris Incorporated was $65,000. How should Clark
Inc. recognize these changes in market price?
a. As a net unrealized loss of $20,000.
b. As a net unrealized gain of $15,000.
c. As a net unrealized loss of $5,000.
d. No adjustment is required since the total fair value is higher than the total original cost.
Answer: C
16. Which one of the following is True of the equity method?
a. The income recognized by the investor is based on the percentage of stock ownership and
the amount of earnings reported by the investee.
b. Market value adjustments are made at yearend.
c. The receipt of dividends increases net income on the investor's financial statements.
d. The percent of ownership must be greater than 50% to apply this method.
Answer: A
17. The recognition of unrealized gains on available-for-sale investments
a. increases the current ratio.
b. decreases the current ratio.
c. does not affect the current ratio.
d. increases the current ratio if the investment is classified as current, otherwise it has no
effect.
Answer: D
18. An investor owns trading equity securities in Noah Company. Noah Company declared
dividends of $300 during July. What entry is required in August when the dividends are
received?
Answer: A
19. Which one of the following journal entries is appropriate for an investor who owns shortterm equity securities when dividends of $500 have been declared on those equity securities?
Answer: D
20. Which one of the following correctly reflects the effects on the financial statements
caused by the increase in the market price of long-term available-for-sale securities?
a. Current ratio is unchanged and earnings per share increases.
b. Current ratio and earnings per share increase.
c. Current ratio and earnings per share are unchanged.
d. Current ratio is unchanged and earnings per share decreases.
Answer: C
21. Trading securities were purchased on April 1 for $900. On December 31, the market value
of those securities is $700. Which of the following is part of the adjusting entry necessary on
December 31?
a. Debit Unrealized Loss on Trading Securities for $700
b. Debit Realized Loss on Trading Securities for $200
c. Credit Trading Securities for $200
d. Credit Unrealized Loss on Trading Securities for $200
Answer: C
22. Available-for-sale securities were purchased on May 2 for $1,000. On December 31, the
market value of those securities is $1,100. Which of the following is part of the adjusting
entry necessary on December 31?
a. Debit Unrealized Gain on Available-for-Sale Securities for $1,100
b. Debit Realized Gain on Available-for-Sale Securities for $100
c. Credit Available-for-Sale Securities for $100
d. Credit Unrealized Gain on Available-for-Sale Securities for $100
Answer: D
23. The recognition of unrealized losses on trading securities:
a. decreases the quick and current ratios.
b. increases the quick and current ratios.
c. does not affect the quick ratio, but decreases the current ratio.
d. does not affect the current ratio, but decreases the quick ratio.
Answer: A
24. Which of the following correctly reflects the effects on the financial statements caused by
the increase in market price of trading securities?
a. Current ratio and earnings per share decrease.
b. Current ratio and earnings per share increase.
c. Current ratio is unchanged but earnings per share decrease.
d. Current ratio decreases and earnings per share are unchanged.
Answer: B
25. The recognition of realized losses on short-term available-for-sale securities
a. increases the current ratio.
b. decreases working capital.
c. decreases comprehensive income.
d. decreases the debt/equity ratio.
Answer: B
26. Which one of the following is an area of subjectivity which opens the incentive of
window dressing to management as it relates to investments?
a. The timing of when an investment is sold.
b. The proclamation of the intention to sell an investment within the next year.
c. The determination of the percentage of stock acquired.
d. Whether management has available cash to acquire investments.
Answer: B
27. The cost method of accounting for long-term equity investments is typically used when:
a. between 20% and 50% of the investee company is owned.
b. over 50% of the investee company is owned.
c. at least 20% of the investee company is owned.
d. None of the above is a consideration in choosing the cost method.
Answer: D
28. Which one of the following correctly reflects the effects on the financial statements
caused by dividends declared on trading securities owned by a firm?
a. Current ratio decreases.
b. Earnings per share increases.
c. Current ratio is unchanged.
d. Earnings per share is unchanged.
Answer: B
29. The equity method of accounting for long-term equity investments is typically used when:
a. less than 20% of the investee company is owned.
b. between 20% and 50% of the investee company is owned.
c. over 50% of the investee company is owned.
d. any amount over 20% is acquired.
Answer: B
30. The consolidation procedure of accounting for long-term equity investments is typically
used:
a. when less than 20% of the investee company is owned.
b. in situations when over 50% of the investee company is owned.
c. only when 100% of the investee company is owned.
d. when between 20% and 50% of the investee company is owned.
Answer: B
31. Walsh Company purchased 1,000 shares of Pierce Company for $20 per share and
classified the investment as trading securities. At the end of the year, the fair market value of
the investment was $23 per share. How should Walsh recognize this change?
a. Debit the investment account by $23,000.
b. Credit the investment account by $3,000.
c. Report an unrealized gain on the income statement.
d. Show an unrealized loss on the balance sheet.
Answer: C
32. Which one of the following correctly reflects the effects on the financial statements
caused by a decrease in the market price of long-term available-for-sale securities?
a. Current ratio decreases.
b. Earnings per share increases.
c. Current ratio increases.
d. Earnings per share remains unchanged.
Answer: D
33. The recognition of unrealized gains on marketable securities:
a. depends on the classification of the securities.
b. causes net income to increase regardless of the securities’ classification.
c. causes earnings per share to increase regardless of the securities’ classification.
d. is a primary concern under the equity method.
Answer: A
34. Which one of the following must be met prior to classifying an investment as current?
a. It must be an equity security accounted for under the equity method.
b. The percentage of ownership must be greater than 50%.
c. The investment must be readily marketable.
d. Management must intend to hold the investment for an undetermined time period.
Answer: C
35. Trading securities are held primarily for the purpose of:
a. anticipated increases in value over extended time periods.
b. increasing the current ratio.
c. window dressing the balance sheet.
d. generating profits on short-term price increases.
Answer: D
36. Which one of the following correctly reflects the effects on the financial statements of the
investor caused by dividends declared on trading securities?
a. Current ratio increases
b. Working capital decreases
c. Revenue and assets decrease
d. Assets increase and shareholders’ equity decreases
Answer: A
37. Camber Corp. owns 10% of Nova Corp’s outstanding voting stock. Camber should
account for its long-term equity investment in Nova Corp. using the:
a. market value method if the stock is not traded on the market.
b. cost method if the stock is traded on the market.
c. cost method if the stock is not traded on the market.
d. equity method if the stock is traded on the market.
Answer: C
38. Which one of the following is evidence of a ready market?
a. The stock was purchased at a negotiated price from an outside party.
b. The security is actively traded on a public stock exchange.
c. A privately held corporation issued the stock.
d. The stock was purchased from an outside investor.
Answer: B
39. An unrealized holding gain or loss that relates to trading securities represents:
a. an undervalued investment.
b. the profit or loss made when the trading securities were sold.
c. the total dividends received from the investee company during the year.
d. the extent to which an investor’s wealth increased or decreased due to holding the
investment.
Answer: D
40. All of the following statements are True regarding comprehensive income except:
a. Comprehensive income includes all nonowner-related changes in shareholders’ equity that
do not appear on the income statement and are not reflected in the balance of retained
earnings.
b. Comprehensive income includes adjustments to shareholders’ equity for holding gains
associated with available-for-sale securities.
c. Comprehensive income includes adjustments to shareholders’ equity for holding losses
associated with available-for-sale securities..
d. Comprehensive income must be reported in a specific format established by the FASB.
Answer: D
41. A controlling interest in another company:
a. exists whenever the relationship between the investor and investee gives the investor
significant influence.
b. requires the parent to prepare consolidated financial statements.
c. is evidence that a merger will soon occur.
d. can be as low as 20 percent.
Answer: B
42. Why might chief executives react very positively to current goodwill accounting?
a. Goodwill increases in value.
b. Goodwill is amortized creating expenses that reduce net income, enabling a company to
pay less income tax.
c. Its amortization increases earnings per share.
d. Goodwill is no longer amortized so income is greater than prior accounting requirements.
Answer: D
43. James Corporation purchased 100% of the common stock of Rashaad Corporation for $50
million. James must account for this investment as:
a. an available-for-sale security.
b. an acquisition that requires consolidation accounting.
c. a trading security.
d. an equity security investment.
Answer: B
44. Decuzzi, Inc. paid $10,000 for a stock investment and classified it as available-for-sale.
On December 31, 2011, the company appropriately recognized an unrealized increase of
$3,000. The stock is reported on Decuzzi’s balance sheet at December 31, 2011 at:
a. $10,000.
b. $13,000.
c. $7,000.
d. Not enough information to determine.
Answer: B
45. Which one of the following investments would most likely be held the shortest period of
time?
a. Available-for-sale debt securities
b. Available-for-sale equity securities
c. Trading securities
d. An investment as a result of a merger
Answer: C
46. Multinational US companies usually have a number of foreign subsidiaries with financial
statements expressed in foreign currency. When the consolidated financial statements are
prepared, to combine the financial statements of the US parent and all of its subsidiaries, the
consolidation process involves multiple steps. Which of the following statements about the
combining process and the resultant consolidated financial statements is always True for
multinational US companies?
a. The foreign subsidiaries are separated into three categories, each of which receives
different treatment.
b. The foreign entity’s financial statements are converted into dollars.
c. Foreign currency translation adjustments have no effect on cash flows.
d. The foreign currency translation adjustments are included in consolidated income.
Answer: B
47. Which of the following statements about Special Purpose Entities (SPEs) is not True?
a. SPEs can take on various legal forms, like corporations or partnerships.
b. It can be difficult to determine who actually controls an SPE.
c. Management can structure a transaction using an SPE in such a manner that the accounting
treatment fails to reflect the economic substance of the transaction.
d. SPEs have been used to mislead investors.
Answer: A
48. Carmen Corporation purchased a 40% interest in Sahara Inc. on January 1, 2010, paying
$200,000 for 40% of the outstanding voting stock of Sahara Inc. For its year ended December
31, 2010, Sahara Inc. reported net income of $40,000. On December 31, 2010, Carmen
received a dividend payment from Sahara in the amount of $1,000. As a result of its
ownership interest in Sahara, the financial statements for Carmen Corporation for the year
ended December 31, 2010 will reflect which of the following:
a. An asset in the amount of $200,000.
b. Revenue of $1,000.
c. Cash flows from operations of $1,000.
d. Revenue of $16,000.
Answer: D
49. Before adjusting its current investments in equity securities, Caldwell Company has total
current assets and current liabilities of $45,000 and $15,000, respectively. During the current
year, Caldwell has net income of $243,750 with 75,000 shares of common stock outstanding.
This amount excludes the effects of yearend adjustments related to the investments. Included
in current assets are trading securities recorded at their original cost of $13,000. However, the
current market value of those securities is $4,000 at yearend. If Caldwell properly accounts
for trading securities, what is Caldwell’s current ratio before and after the investment
adjustment?
a. 3.0 and 2.1
b. 3.0 and 3.3
c. 3.0 and 3.6
d. 3.0 and 2.4
Answer: D
Current ratio before = $45,000/$15,000 = 3.0
Current ratio after = $36,000/$15,000 = 2.4
50. Before adjusting its current investments in equity securities, Caldwell Company has total
current assets and current liabilities of $45,000 and $15,000, respectively. During the current
year, Caldwell has net income of $243,750 with 75,000 shares of common stock outstanding.
This amount excludes the effects of yearend adjustments related to the investments. Included
in current assets are trading securities recorded at their original cost of $13,000. However, the
current market value of those securities is $4,000 at yearend. If Caldwell properly accounts
for trading securities, what is Caldwell’s earnings per share amount before and after the
investment adjustment, respectively?
a. $3.25 and $3.00
b. $3.25 and $3.13
c. $3.25 and $3.37
d. $3.25 and $2.77
Answer: B
Earnings per share = $243,750/75,000 = $3.25
Earnings per share = $234,750/75,000 = $3.13
51. On January 2, 2010, Pfizer Co. purchased 22% of Wiley Company's voting stock for
$150,000. During 2010, Wiley recorded income of $102,000 and paid total dividends of
$27,000. Pfizer uses the equity method to account for this investment. What is Pfizer’s
income from the Wiley investment?
a. $27,000
b. $28,380
c. $22,440
d. $33,000
Answer: C
2010 investment income = $102,000 × 22% = $22,440
52. On January 2, 2010, Pfizer Co. purchased 22% of Wiley Company's voting stock for
$150,000. During 2010, Wiley recorded income of $102,000 and paid total dividends of
$27,000. Pfizer uses the equity method to account for this investment. What is the December
31, 2010, balance sheet value of its long-term equity investment in Wiley?
a. $178,380
b. $225,000
c. $150,000
d. $166,500
Answer: D
2010 investment income = $102,000 x 22% = $22,440
December 31, 2010, investment in Wiley Company
= $150,000 + $22,440 – ($27,000 x 22%) = $166,500
53. If Howard Company’s balance sheet amount of goodwill is $20,000 and the fair market
value of the goodwill is estimated to be $25,000, which of the following entries would be
recorded in Howard’s books?
Answer: D
54. On December 31, 2010, available-for-sale securities with an original cost of $15,000 have
a carrying value on the balance sheet equal to their market value of $20,000. On January 5,
2011, those securities are sold for $18,000. Which of the following would be part of the
appropriate entry to record the sale of the available-for-sale securities?
a. A credit to Realized Gain on Available-for-Sale Securities for $5,000.
b. A debit to Unrealized Price Increase on Available-for Sale Securities for $3,000.
c. A debit to Unrealized Price Increase on Available-for Sale Securities for $5,000.
d. A credit to Available-for Sale Securities for $15,000.
Answer: C
55. On January 2, 2010, Dellgate Corp. purchased 27% of Galaxy Corporation's voting stock
for $125,000. During 2010, Galaxy recorded income of $214,000 and paid total dividends of
$17,000. Dellgate uses the cost method to account for this investment. What is the December
31, 2010, balance sheet value of Dellgate’s long-term equity investment in Galaxy?
a. $125,000
b. $178,190
c. $187,370
d. $86,940
Answer: A
December 31, 2010, investment in Galaxy Corporation = $125,000
56. The following information related to the marketable security investments of Solo
Company. Securities held on December 31, 2009, as described in the table below. AAA and
BBB are classified as trading securities and CCC is classified as an available-for-sale
security.
Early in 2010, Solo sold all of its investment in AAA securities for $36 per share.
The journal entry to record the 2009 revaluation of the AAA securities would be:
Answer: A
57. The following information related to the marketable security investments of Solo
Company. Securities held on December 31, 2009, as described in the table below. AAA and
BBB are classified as trading securities and CCC is classified as an available-for-sale
security.
Early in 2010, the company sold 50 shares of BBB for $26 per share. During 2010, Solo
received dividends of $3 per share on the remaining 200 shares of BBB. The per-share
market value of BBB on December 31, 2010 was $24. During 2011, Solo sold the remaining
200 shares of BBB stock for $26 per share.
The journal entry to record the 2009 revaluation of the BBB securities would be:
Answer: B
58. The following information related to the marketable security investments of Solo
Company. Securities held on December 31, 2009, as described in the table below. AAA and
BBB are classified as trading securities and CCC is classified as an available-for-sale
security.
During 2010, Solo received word that dividends of $2.50 per share were declared, but not yet
received on the 150 shares of CCC stock. The per-share market value of CCC on December
31, 2010, was $18. During 2011, Solo sold 150 shares of CCC for $22 per share.
The journal entry to record the 2009 revaluation of the CCC securities would be:
Answer: D
59. The following information related to the marketable security investments of Solo
Company. Securities held on December 31, 2009, as described in the table below. AAA and
BBB are classified as trading securities and CCC is classified as an available-for-sale
security.
Early in 2010, Solo sold all of its investment in AAA securities for $36 per share.
The journal entry to record the 100 shares of AAA stock sold in 2010 will include:
a. A debit to Trading Securities for $3,400.
b. A credit to Unrealized Loss on Trading Securities for $200.
c. A credit to Realized Loss on Sale of Trading Securities for $200.
d. A credit to Realized Gain on Sale of Trading Securities for $200.
Answer: D
60. The following information related to the marketable security investments of Solo
Company. Securities held on December 31, 2009, as described in the table below. AAA and
BBB are classified as trading securities and CCC is classified as an available-for-sale
security.
Early in 2010, the company sold 50 shares of BBB for $26 per share.
The journal entry to record the 50 shares of BBB stock sold in 2010 will include:
a. A credit to Trading Securities for $1,400.
b. A credit to Unrealized Loss on Trading Securities for $100.
c. A credit to Realized Loss on Sale of Trading Securities for $100.
d. A debit to Realized Gain on Sale of Trading Securities for $100.
Answer: A
61. The following information related to the marketable security investments of Solo
Company. Securities held on December 31, 2009, as described in the table below. AAA and
BBB are classified as trading securities and CCC is classified as an available-for-sale
security.
Early in 2010, the company sold 50 shares of BBB for $26 per share. During 2010, Solo
received dividends of $3 per share on the remaining 200 shares of BBB, and dividends of
$2.50 per share were declared, but not yet received on the 150 shares of CCC stock. The pershare market values of BBB and CCC on December 31, 2010, were $24 and $18,
respectively. During 2011, Solo sold the remaining 200 shares of BBB stock for $26 per share
and the 150 shares of CCC for $22 per share.
The journal entry to record the dividends received on the BBB securities and the dividends
declared on the CCC stock in 2010 will include:
a. A credit to Dividend Revenue for $975.
b. A credit to Dividend Payable for $375.
c. A credit to Cash for $600.
d. A debit to Dividend Expense for $375.
Answer: A
62. The following information related to the marketable security investments of Solo
Company. Securities held on December 31, 2009, as described in the table below. AAA and
BBB are classified as trading securities and CCC is classified as an available-for-sale
security.
Early in 2010, the company sold 50 shares of BBB for $26 per share. During 2010, Solo
received dividends of $3 per share on the remaining 200 shares of BBB, and dividends of
$2.50 per share were declared, but not yet received on the 150 shares of CCC stock. The pershare market values of BBB and CCC on December 31, 2010, were $24 and $18,
respectively. During 2011, Solo sold the remaining 200 shares of BBB stock for $26 per share
and the 150 shares of CCC for $22 per share.
The journal entry to record the revaluation of BBB shares in 2010 is:
Answer: B
63. The following information related to the marketable security investments of Solo
Company. Securities held on December 31, 2009, as described in the table below. AAA and
BBB are classified as trading securities and CCC is classified as an available-for-sale
security.
During 2010, Solo received word that dividends of $2.50 per share were declared, but not yet
received on the 150 shares of CCC stock. The per-share market value of CCC on December
31, 2010, was $18. During 2011, Solo sold 150 shares of CCC for $22 per share.
The journal entry to record the revaluation of CCC shares in 2010 is:
Answer: B
64. The following information related to the marketable security investments of Solo
Company. Securities held on December 31, 2009, as described in the table below. AAA and
BBB are classified as trading securities and CCC is classified as an available-for-sale
security.
Early in 2010, the company sold 50 shares of BBB for $26 per share. During 2010, Solo
received dividends of $3 per share on the remaining 200 shares of BBB. The per-share
market value of BBB on December 31, 2010, was $24. During 2011, Solo sold the remaining
200 shares of BBB stock for $26 per share.
The journal entry to record the sale of 200 shares of BBB stock in 2011 is:
Answer: C
65. The following information related to the marketable security investments of Solo
Company. Securities held on December 31, 2009, as described in the table below. AAA and
BBB are classified as trading securities and CCC is classified as an available-for-sale
security.
During 2010, Solo received word that dividends of $$2.50 per share were declared, but not
yet received on the 150 shares of CCC stock. The per-share market value of CCC on
December 31, 2010, was $18. During 2011, Solo sold 150 shares of CCC for $22 per share.
The journal entry to record the sale of 150 shares of CCC stock in 2011 would include:
a. A debit to Cash for $2,700.
b. A debit to Unrealized Price Increase on Available-for-Sale Securities for $300.
c. A debit to Unrealized Gain on Available-for-Sale Securities for $900.
d. A debit to Available-for-Sale Securities for $3,300.
Answer: B
Matching Questions
1. Each transaction numbered 1 through 5 below involves an equity security originally
acquired at a cost of $1,000. Identify the effect each transaction has on the current ratio and
earnings per share by selecting from the effects listed in a through f. You may use each letter
more than once or not at all.
____ 1. Trading securities with a current balance sheet value of $1,200 are sold for $1,100.
____ 2. Trading securities with a current balance sheet value of $800 are sold for $800.
____ 3. Trading securities with a current balance sheet value of $1,200 are sold for $1,300.
____ 4. Available-for-sale securities have a market value of $800 at yearend.
____ 5. Available-for-sale securities have a market value of $1,200 at yearend.
Answer: 1. d 2. b 3. a 4. c 5. c
2. Each transaction listed in 1 through 4 relates to an investment in a long-term equity
security. Place the letter that corresponds to the effect (a through h) the transaction has on the
accounting equation in the space provided. You may use each letter more than once or not at
all.
____ 1. Under the cost method, the investee company declares a cash dividend.
____ 2. Under the equity method, the investee company declares a cash dividend.
____ 3. Under the cost method, the investee company recognizes net income.
____ 4. Under the equity method, the investee company recognizes net income.
Answer: 1. c 2. g 3. h 4. c
3. For each transaction numbered 1 through 4 below, identify which effect (a through f) the
transaction is most likely to cause. You may use each letter more than once or not at all.
_____ 1. The cost method is used for an investment in long-term equity securities, and the
investee company declares a cash dividend.
_____ 2. The equity method is used for an investment in long-term equity securities and the
investee company declares a cash dividend.
_____ 3. The cost method is used for an investment in long-term equity securities and the
investee company recognizes net income.
_____ 4. The equity method is used for an investment in long-term equity securities and the
investee company recognizes net income.
Answer: 1. a 2. d 3. e 4. c
4. Each transaction listed in 1 through 4 below relates to a long-term investment is equity
securities. Select the letters of the accounting effects (a through h) and place them in the
space provided. Transactions may have more than one answer.
_____ 1. Using the equity method the market price of the investment increases above its cost.
_____ 2. Using the cost method the market price of the investment increases above its cost.
_____ 3. Using the equity method, the investee company recognizes a net loss for the year.
_____ 4. An investment in a 40%-owned subsidiary is sold for more than its carrying value.
Answer: 1. h 2. h 3. e, f 4. a, c
5. For each transaction numbered 1 through 4 below, identify which effect (a through g)
would most likely occur as a result of the transaction. You may use each letter more than once
or not at all.
_____ 1. Trading equity securities are purchased for $1,000 cash.
_____ 2. Trading securities that cost $1,000 have a yearend market value of $800.
_____ 3. Trading securities that cost $1,000 have a yearend market value of $1,200.
_____ 4. Trading securities that cost $1,000 that have a current balance sheet value of $800
are sold for $900.
Answer: 1. f 2. d 3. a 4. a
6. For each transaction listed in 1 through 9, place the letter (a through g) of the best effect in
the space provided. You may use each letter more than once or not at all.
Answer: 1. g 2. e 3. b 4. b 5. e 6. g 7. b 8. f 9. c
Short Problems
1. Trading securities were purchased at a cost of $5,000. Their current market value is $4,000.
Prepare the December 31 adjusting journal entry.
Answer:
2. Prepare the December 31 journal entry that adjusts available-for-sale securities that were
purchased at a cost of $5,000 when current market value is $4,000.
Answer:
3. On December 31, the cost and market price of trading securities are $5,000 and $9,000,
respectively. Give the appropriate adjusting entry on December 31.
Answer:
4. On December 31, the cost and market price of available-for-sale securities are $5,000 and
$9,000, respectively. Give the appropriate adjusting entry on December 31.
Answer:
5. On December 31, 2010, available-for-sale securities with an original cost of $10,000 have
a carrying value on the balance sheet equal to their market value of $12,000. On January 5,
2011, those securities are sold for $11,000. Give the appropriate entry to record the sale of the
available-for-sale securities.
Answer:
6. On December 31, 2010, trading securities with an original cost of $45,000 have a market
value of $47,000. On January 11, 2011, those trading securities are sold for $51,000.
Determine the gains or losses in 2009 and 2010 associated with these trading securities.
Clearly label whether the gains or losses are realized or unrealized. Name the financial
statement on which each is reported.
Answer:
7. On December 31, 2010, available-for-sale securities with an original cost of $14,000 have
a carrying value on the balance sheet equal to their market value of $16,000. On January 11,
2011, those securities are sold for $18,000. Give the appropriate entry to record the sale of the
available-for-sale securities.
Answer:
8. On December 31, 2010, trading securities with an original cost of $10,000 have a carrying
value on the balance sheet equal to their market value of $12,000. On January 11, 2011, those
trading securities are sold for $15,000. Prepare the appropriate entry to record the sale of the
trading securities.
Answer:
9. On December 31, 2010, trading securities with an original cost of $10,000 have a carrying
value on the balance sheet equal to their market value of $12,000. On January 5, 2011, those
trading securities are sold for $10,000. Give the appropriate entry to record the sale of the
trading securities.
Answer:
10. On December 31, 2010, trading securities with an original cost of $45,000 have a market
value of $47,000. On January 5, 2011, those trading securities are sold for $41,000.
Determine the gains or losses in 2010 and 2011 associated with these trading securities.
Clearly label whether the gains or losses are realized or unrealized. Name the financial
statement on which each is reported.
Answer:
11. On December 31, 2010, available-for-sale securities with an original cost of $100,000
have a market value of $110,000. On January 11, 2011, the available-for-sale securities are
sold for $130,000. Determine the gains or losses in 2010 and 2011 associated with these
securities that must be reported on the income statements. Indicate whether the gains or
losses are realized or unrealized.
Answer:
12. On October 10, 2010, Marcus Inc. buys trading securities with an original cost of
$100,000. On December 31, 2010, they have a market value of $80,000. On March 9, 2011,
those securities are sold for $120,000. Determine the gains or losses in 2010 and 2011
associated with these trading securities that will be reported on the income statement. Indicate
whether the gains or losses are realized or unrealized.
Answer:
13. On January 4, 2010, Harrison Corp. purchased 26% of C Corporation's voting stock for
$100,000. During 2010, C recorded income of $200,000 and paid total dividends of $13,000.
Harrison uses the cost method to account for this investment. Calculate Harrison’s income
from the C investment and the December 31, 2010, balance sheet value of its long-term
equity investment in C.
Answer:
2010 dividend income from investment = $13,000 x 26% = $3,380
December 31, 2010, investment in C Corporation = $100,000
14. Before adjusting its current investments in equity securities, Apex Company has total
current assets and current liabilities of $23,000 and $12,000, respectively. During the current
year, Apex has net income of $200,000 with 50,000 shares of common stock outstanding.
This amount excludes the effects of yearend adjustments related to the investments. Included
in current assets are trading securities recorded at their original cost of $3,000. However, the
current market value of those securities is $4,000 at yearend. If Apex properly accounts for
trading securities, determine the effect on Apex’s current ratio and earnings per share.
Answer:
Current ratio before = $23,000/$12,000 = 1.92
Current ratio after = $24,000/$12,000 = 2.0
Earnings per share = $200,000/50,000 = $4.00
Earnings per share = $201,000/50,000 = $4.02
15. On December 31, 2010, trading securities with an original cost of $100,000 have a market
value of $109,000, and available-for-sale securities with an original cost of $45,000 have a
market value of $60,000. It is management’s intent to hold the available for sale securities
indefinitely. Fill in the partial balance sheet at December 31, 2010 provided below showing
the results of the investments. Clearly label whether any gains or losses are realized or
unrealized and clearly show the balance sheet classifications.
Answer:
16. Falcon, Inc. acquired 30% of Dodson Corporation for $100,000 on December 31, 2009.
During the calendar year 2010, Dodson had net earnings of $400,000 and paid total dividends
of $50,000. The fair value of Dodson Corporation’s stock at yearend was $160,000. Falcon
mistakenly recorded these transactions using the fair value method (available-for-sale
classification) rather than the equity method of accounting.
A. Determine the effect the error would have on the investment account at December 31,
2010.
B. Determine the effect the error would have on net income for the year ending December 31,
2010.
Answer:
A. Fair value method: $160,000
Equity method: $100,000 + ($400,000 x 30%) – ($50,000 x 30%) = $205,000
Net effect using fair value: Understatement of investment account = $45,000
B. Fair value method: $50,000 x 30% = $15,000
Equity method: $400,000 x 30% = $120,000
Net effect using fair value: Understatement of investment income = $105,000
17. On January 3, 2010, Blanton Co. purchased 24% of Martin Company's voting stock for
$100,000. During 2010, Martin recorded income of $90,000 and paid total dividends of
$15,000. Blanton uses the equity method to account for this investment. Calculate Blanton’s
income from the Martin investment and the December 31, 2010, balance sheet value of its
long-term equity investment in Martin. Show your work.
Answer:
2010 investment income = $90,000 x 24% = $21,600
December 31, 2010, investment in Martin Company
= $100,000 + $21,600 – ($15,000 x 24%) = $118,000
18. Before adjusting its current investments in equity securities, Patton Company has total
current assets and current liabilities of $200,000 and $60,000, respectively. During the current
year, Patton has net income of $20,000 before the effects of any market value adjustments
with 30,000 shares of common stock outstanding. Included in current assets are trading
securities recorded at their original cost of $100,000 and available-for-sale investments
recorded at their original cost of $7,000. The current market value of both investments
increased by 15%. Patton properly accounts for both securities.
A. Determine how Paton’s current ratio and earnings per share will be affected by the yearend
adjustments for its investments.
B. Determine how the current ratio and earnings per share will differ if the available-for-sale
investment is classified as long-term.
Answer:
Current ratio before = $200,000/$60,000 = 3.33
Current ratio after = [$200,000 + (15% x $100,000) + (15% x $7,000)]/$60,000 = 3.61
Earnings per share before = $20,000/30,000 = $0.67 per share
Earnings per share after = ($20,000 + $15,000)/30,000 = $1.17 per share
19. On November 30, 2010, Arnold Company purchased 100% of the outstanding voting
common stock of Compton Corporation for $100,000. At that date the fair market value of
Compton assets less liabilities was $80,000. What amount, if any, of goodwill must Arnold
recognize in connection with its purchase of Compton? Where should Arnold Company
report this amount?
Answer:
Goodwill = $100,000 – $80,000 = $20,000 reported as a long-term, intangible asset on the
balance sheet.
20. On April 1, 2010, Parrish Company purchased 90% of the outstanding voting common
stock of Hamilton Corporation for $400,000. At that date the fair market value of Hamilton’s
assets less liabilities was $200,000. What amount, if any, of goodwill must Parrish recognize
in its consolidated balance sheet on December 31, 2010? Show your work.
Answer:
Goodwill on 4/1 = $400,000 – (90% x $200,000) = $220,000
21. On January 1, 2010, Simpson Company purchased all of the assets and assumed all of the
liabilities of Dobson Company for $400,000. Dobson’s balance sheet showed total assets of
$450,000 and total liabilities of $210,000 of this date. An appraiser determined all assets
except for land are valued at fair market value. The land is worth $20,000 more than its book
value.
A. Calculate goodwill in connection with this business combination.
B. Prepare the journal entry to record the combination.
Answer:
22. On May 6, 2010, Galen Company purchased equity securities. At December 31, 2010,
three investments were still owned by Galen. The names, cost, and fair values at December
31, 2010, are indicated below.
The investments have clearly determinable fair values. Galen can’t exercise significant
influence on any of these investments. Galen has determined that the Guy stock will be held
until 2011. Galen intends to sell the Vernon stock by January 2, 2011, for short-term profits.
Galen has no idea how long it will hold the Nordic stock. Show how these investments and
any related yearend adjustments will be reported by completing the balance sheet below at
December 31, 2010.
Answer:
23. On December 31, 2010, Celtic Inc. acquired a 24% interest in Romano Corp. for
$100,000 and appropriately applied the equity method. During 2010, Romano had net income
of $400,000 and paid cash dividends of $50,000. How much will Celtic report for the year
ending December 31, 2011 on its income statement? Show your work.
Answer:
$400,000 x 24% = $96,000
24. On January 1, 2010, Danner Company purchased all of the assets and assumed all of the
liabilities of Clancy Company for cash of $80,000. Clancy’s balance sheet showed total assets
of $120,000 and total liabilities of $70,000. The equipment had a fair market value on the same
date of $10,000 instead of the $6,000 reported on the balance sheet. Calculate goodwill in
connection with this business combination. Prepare the journal entry to record the combination.
Answer:
25. On December 31, 2010, Rory Corp. acquired an 18% interest in Batson Corp. for
$100,000 and appropriately applied the cost method. During 2011, Batson had net income of
$200,000 and paid cash dividends of $50,000. On the last day of 2011, Rory sold one-half of
its investment in Batson Corp. for $180,000. How much should Rory report on its income
statement for the year ending December 31, 2011? Show your work.
Answer:
Dividend income = $50,000 x 18% = $9,000
Gain on sale of investment = $180,000 – ($100,000 x 50%) = $130,000
26. York Corporation owns 25% of Carson, Inc. that it purchased on January 1, 2010, for
$100,000. York uses the cost method for accounting for its investment in Carson, Inc. During
2010, Carson, Inc. paid a total of $45,000 of dividends and recorded income of $200,000.
Determine how much York’s net income would differ if it used the equity method instead of
the cost method. Show your work.
Answer:
Cost method: $45,000 x 25% = $11,250
Equity method: $200,000 x 25% = $50,000
Difference = $38,750 more income under the equity method
27. On December 31, 2010, Tanner Corp. acquired a 20% interest in Gantry Corp. for
$800,000 and appropriately applied the equity method. During 2011, Gantry had net income
of $150,000 and paid cash dividends of $5,000. On last day of 2011, Tanner sold one-half of
its investment in Gantry Corp. for $620,000. How much should Tanner report on its income
statement for the year ending December 31, 2011? Show your work.
Answer:
28. On January 2, 2011, Merton Co. acquired 30 percent of the outstanding voting common
stock of Tilton, Inc., at a cost of $50,000. With this investment, Merton has the ability to
exercise significant influence over Tilton, Inc. During 2011, Tilton, Inc. reported net income
of $110,000 and paid total cash dividends of $35,000. What amount should be reported as
investment and investment earnings by Merton for the year ending December 31, 2011?
Show your work.
Answer:
Investment = $50,000 + [(30% x 110,000) – (30% x $35,000) = $72,500
Investment earnings = (30% x $110,000) = $33,000
Short Essay Questions
1. Why should users be cautious when examining financial statements in which the company
has accounted for investments using the equity method?
Answer: The equity method requires accrual-based, year-end adjustments that cause net
income to differ from cash flows from operations. This increase in the investment account is
not equal to the amount of cash dividends received by the investor. Some call this misleading
since the investor will never really see any non-dividend cash from the investee company.
The equity method also ignores market value changes in the investee company. Unless price
decreases are considered permanent in nature, they are not recorded or reflected in the
carrying value of the investment on the investor's balance sheet under the equity method.
2. How is the purchase method used in accounting for business acquisitions?
Answer: The purchase method requires that assets and liabilities of an acquired subsidiary be
recorded on the balance sheet of the parent company at fair market value, and the difference
between the purchase price and the net fair market value of the subsidiary’s assets and
liabilities is recorded as goodwill.
3. How does the concept of "consolidated financial statements" relate to a business
acquisition?
Answer: A business acquisition occurs when the investing company acquires a controlling
interest (more than 50 percent of the voting stock) in another company. The investor accounts
for the investment using the equity method. At the end of the reporting period, the parent
company prepares consolidated financial statements, which combine the assets and liabilities
into financial statements of the parent and the subsidiary into one operating unit for reporting
purposes.
4. On November 1, 2009, Nova Company purchased short-term marketable equity securities
in Sandi Corporation and Exeter Corporation. The following valuation of Nationals' portfolio
in short-term investments on December 31, 2009 is:
Answer the following questions if you assume that only one of these short-term investments
is to be classified as trading, while the other will be classified as available-for-sale.
A. If Nova Company wants to maximize its 2009 earnings per share, which investment
should be classified as trading? Justify your choice.
B. If Nova Company desires to minimize its December 31, 2009, debt/equity ratio, which
investment should be classified as trading? Justify your choice.
Answer:
A. The market appreciation of investment in Sandi and Exeter is $5,000 and $15,000,
respectively. If the investment in Exeter is classified as trading, then Nova will recognize an
unrealized gain on its income statement of $15,000. Then the investment in Sandi will be
classified as available-for-sale and its $5,000 market appreciation is recognized as an
unrealized price increase which increases shareholders’ equity without affecting net income.
Therefore, by classifying Exeter as trading instead of Sandi, Nova Company will increase its
2009 income by $15,000.
B. The choice of which investment is trading or available-for-sale does not affect the
debt/equity ratio. The market appreciation of both short-term investments increases
shareholders’ equity independent of its classification. The only difference is that the market
appreciation of trading securities travels through the income statement on its way to retained
earnings, while that of available-for-sale securities goes directly to shareholders’ equity.
5. What are several features about the equity method that should cause financial report users
to view it carefully?
Answer:
• First, the equity method provides another reason why a company’s net income (loss) differs
from its cash flow from operations. The income recognized from the investee company rarely
equals the cash dividends received by the investor.
• Second, the equity method ignores price (market value) changes in the affiliate’s equity
securities. For example, price decreases, even if substantial, are not recognized on the
investor’s books. In fact, they may even be accompanied by the recognition of income and
the receipt of dividends if the affiliate reports positive income and declares dividends during
the period of the price decline.
• Third, the percentage of ownership (20 – 50%) is not always a valid indication of
“significant influence.” Influence comes in many different forms.
• Finally, using the equity method can be considered a method of off-balance-sheet financing
because it fails to reflect the liabilities of the affiliate on the balance sheet of the investor
company.
6. What is the concept of ‘non-controlling interest’?
Answer: Non-controlling interest is recognized when an investor purchases between 50 and
100 percent of the stock of another company at a price greater than the per-share market
value of the net assets. It is recognized because non-controlling shareholders own a portion of
the stock. It is reported on the consolidated balance sheet between the long-term liability and
the shareholders’ equity sections. The non-controlling interest is the interest held by outsiders
(100 percent less the percentage owned by the controlling interest).
7. What two criteria must be met for an investment in a security to be considered as current
on an investor’s balance sheet?
Answer: In order to classify an investment as current, it must be readily marketable—it can
be sold and converted into cash on demand—and management must intend to convert the
investment into cash within the time period of current assets, typically one year. The intention
to convert is much more difficult to determine objectively, especially in an environment in
which managers have incentives to ‘window dress’.
8. How do current accounting rules put U.S. corporations at a distinct disadvantage compared
to foreign corporations?
Answer: When a U.S. corporation wishes to bid against foreign buyers for acquisitions,
goodwill becomes a major issue. Companies using British GAAP do not recognize amortized
goodwill as an expense on the income statement. Instead, the amortization is a direct
reduction of shareholders’ equity, and does not appear to reduce earnings for the period. In
the U.S., many chief executives are hesitant to bid on foreign companies because
compensation is often based on earnings per share, which is reduced by goodwill
amortization.
9. On November 15, 2009, Torborg Company purchased short-term marketable equity
securities in Radar Corporation and Booker Corporation. The following valuation of Twins'
portfolio in short-term investments on December 31, 2009 is:
It is management policy that only one of its short-term investments can be classified as
trading, while the other, therefore, must be classified as available-for-sale. Because Torborg’s
2009 income exceeds market expectations and its 2010 income prospects are suspect, the
management desires to classify its short-term investments so that 2010 income is maximized.
On January 11, 2010, Torborg Company sells its investments in Radar and Booker for
$40,000 and $39,000, respectively.
In order to achieve management's desires, which investment should be classified as trading
and which as available-for-sale? Numerically justify your response.
Answer: The holding gains (losses) associated with a trading security are recognized during
the period of market price appreciation (depreciation). Therefore, when a trading security is
sold, the realized gain (loss) reflects only the market price increase (decrease) from the
beginning of the current accounting period. However, the holding gains and losses of an
available-for-sale security are not recognized until the security is sold. Thus, when an
available-for-sale security is sold, the realized gain (loss) is the total market price
appreciation (depreciation) from the date of purchase to the date of sale.
The following chart illustrates the unrealized and realized gains recognized in 2009 and 2010
resulting from the two possible classifications of investments in Radar and Booker:
It is obvious that if Torborg wants to maximize 2010 income, it should classify the security
with the greatest market appreciation in 2009 as available-for-sale. Therefore, Booker should
be classified as available-for-sale and Radar as trading.
10. On December 1, 2009, Fox Corporation purchased 10,000 common shares of Daniels
Corporation as a short-term investment. The valuations of these securities on December 31,
2009 are:
On the afternoon of December 31, 2009, the management of Fox is deciding whether to sell
its investment in Daniels before the 2009 statements are issued. However, it wants to avoid
any loss on the 2009 income statement associated with its short-term investment in Daniels.
A. What advice would you give the management of Fox if its investment in Daniels were
classified as trading? Justify your advice.
B. What advice would you give the management of Fox if its investment in Daniels were
classified as available-for-sale? Justify your advice.
Answer: A. If the short-term investment in Daniels is classified as a trading security, then
2009 net income is affected by the decision to sell or hold the security. The market price
decline of $30,000 will decrease 2009 net income. If sold, this decrease would be classified
as a realized loss. If not sold, it would be classified as an Unrealized Loss on Trading
Securities. The advice to management is to make the decision to sell or not to sell the
investment in Daniels based upon economic expectations of 2010, not how it would appear
on the income statement.
B. If the short-term investment in Daniels is classified as an available-for-sale security, then
2009 net income would be decreased by $30,000 if the decision to sell the security is
executed by the close of the market on December 31, 2009. If the short-term investment is
not sold, then the market price depreciation of $30,000 will not affect 2009 net income but
will decrease Fox’s shareholders’ equity. The market price decrease will be realized as a loss
only in the accounting period in which it is sold. If not sold, it would be classified as an
adjustment to equity. The advice to management is that if they want to keep the loss
associated with the market price decrease of its investment in Daniels off its 2009 income
statement, then they should not sell Daniels until 2010.
11. How does the concept of ‘merger’ differ from an ‘acquisition’?
Answer: A business acquisition occurs when the investing company acquires a controlling
interest (more than 50 percent of the voting stock) in another company. A merger, sometimes
called a business combination, occurs when two or more companies combine to form a
single, legal entity. In most mergers, the assets and liabilities of the smaller company are
merged into those of the larger, surviving company.
12. List the primary reasons a company might invest in equity securities. Explain how each of
these reasons helps to achieve the primary goal of a business entity—to make profit.
Answer: Companies make investments in equity securities for two basic reasons: (1) to earn
investment income in the form of dividends and stock price appreciation, and (2) to exert
influence or control over the Board of Directors and management of the investee company.
As dividends are declared, they may be recognized as dividend income on a company's
income statement. When a company accounts for equity investments under the mark-tomarket rules, end-of-period adjustments are made to recognize the increases or decreases
from the cost of the investment to the year-end market price. If the company has classified the
investment as a trading security, this change in value will be reported as an unrealized loss or
gain on the income statement. When a company makes an investment in order to exercise
significant influence over the management of an investee corporation, the hope is that the
investee will prove profitable in future periods, both in dividend distributions and in stock
price appreciation.
13. How does the concept of comprehensive income relate to accounting for investments?
Answer: FASB requires companies to provide disclosure of comprehensive income, which
includes all nonowner-related changes in shareholders’ equity that do not appear on the
income statement and are not reflected in the balance of retained earnings. One item that falls
into this category relates to adjustments made at the end of the accounting period for
investments classified as available-for-sale securities. Traditionally, this unrealized holding
gain or loss related to available-for-sale securities was reported under retained earnings in the
shareholders’ equity section of the balance sheet. The dollar amount of the unrealized gain or
loss is still included as part of shareholders’ equity, but now is re-labeled as ‘comprehensive
income’ and disclosed as such.
14. Magnolia Products has a trading security investment that has suffered a permanent market
value decline and is not expected to recover? What should it do in this case?
Answer: In such cases, the security should be written down to its market value, and a realized
loss that reduces net income should be recognized immediately whether the security is
classified as trading or available-for-sale. Determining a permanent decline is very subjective,
and GAAP provide very few guidelines. Perhaps the best way to assess such a decline is to
consider the financial condition of the firm that issued the security.
Test Bank for Financial Accounting: In an Economic Context
Jamie Pratt
9780470635292, 9781119537571, 9781119444367
