Chapter 17 Self-Study Quiz with Answers

ANALYSIS OF MULTIPLE-CHOICE TYPE QUESTIONS
1. (L.O. 1) An investor purchased bonds with a face amount of $100,000 between interest payment dates. The investor purchased the bonds at 102, paid incidental costs of $1,500, and paid accrued interest for three months of $2,500. The amount to record as the cost of this long-term investment in bonds is: a. $100,000. b. $102,000. c. $103,500. d. $106,000. $ 102,000 1,500 $ 103.500

Explanation: The cost is determined as follows: Purchase price (102% x $100,000 par) Incidental costs to acquire Total acquisition cost of investment

The cost of an investment includes its purchase price and all incidental costs to acquire the item, such as brokerage commissions and taxes. Any accrued interest is to be recorded by a debit to Interest Receivable or by a debit to Interest Revenue; it is not an element of the investment’s cost. Accrued interest increases the cash outlay to acquire an investment but does not increase the investment’s cost. (Solution = c.) 2. (L.O. 1) Refer to the facts in Question I above. The amount of cash outlay required to acquire the investment is: a. $100,000. b. $102,000. c. $103,500. d. $106,000.

Explanation: The amount of cash required to acquire the investment is determined as follows: Purchase price (102% x $100,000 par) $ 102,000 Incidental costs to acquire 1,500 Total acquisition cost of investment 103,500 Accrued interest for three months 2,500 Total cash required to acquire investment $~106~,QQQ (Solution = d.) 3. (L.O. 1) When an investor’s accounting period ends on a date that does not coincide with an interest receipt date for bonds held as an investment, the investor must: a. make an adjusting entry to debit Interest Receivable and to credit Interest Revenue for the amount of interest accrued since the last interest receipt date. b. notify the issuer and request that a special payment be made for the appropriate portion of the interest period. c. make an adjusting entry to debit Interest Receivable and to credit Interest Revenue for the total amount of interest to be received at the next interest receipt date. d. do nothing special and ignore the fact that the accounting period does not

coincide with the bond’s interest period. Approach: Think of the requirements of the accrual basis of accounting: revenues are to be recognized when they are earned and expenses are to be recognized (recorded and reported) when they are incurred. Interest is earned by the passage of time and is usually collected after the time period for which it pertains. Thus, to comply with the revenue recognition principle, an adjusting entry is necessary to record the accrued revenue (revenue earned but not yet received). (Solution = a.) 4. (L.a. 1) The market value of Security A exceeds its cost, and the market value of Security B is less than its cost at a balance sheet date. Both securities are held as investments in debt securities; Security A is classified as trading and Security B is classified as available-for-sale. How should each of these assets be reported on the balance sheet? SecurityA Security B a. Market value Market value b. Amortized costAmortized cost c. Amortized costMarket value d. Market valueAmortized cost

Approach and Explanation: Mentally review the accounting requirements for debt securities. They are summarized in Illustration 17-I. Investments in debt and equity securities classified as trading or available-for-sale are to be reported at fair value. Market value, if one is available, is used as a measure of fair value. Investments in debt securities classified as held-to-maturity are to be reported at amortized cost. (Solution =a.) 5. (L.a. 1) At December 31, 2006, Bithlo Corporation reported the following for its portfolio of investment in marketable debt securities: Investment in bonds, at cost $ 400,000 Less securities fair value adjustment 39,000 $361 .000 At December 31, 2007 the market value of the portfolio was $389,000. The cost remained at $400,000. Under what circumstances would Bithlo report a $28,000 credit on its income statement for 2007 as a result of the increase in the market price of the investment in 2007? a. When the security is classified in the trading category. b. When the security is classified in the available-for-sale category. c. When the security is classified in the held-to-maturity category. d. No circumstances would call for such a credit of $28,000 on the 2007 income statement. Approach and Explanation: Quickly review the guidelines in accounting for an investment in debt securities; they are: Trading category: Report at fair value on the balance sheet. Changes in fair value are reported on the income statement. Available-for-sale category: Report at fair value on the balance sheet. Changes in fair value are reflected in a separate component of stockholders’ equity rather than as a component of income. Held-to-maturity category: Report at amortized cost on the balance sheet. Changes in fair value are ignored. (Solution = a.)

6.

(L.O. 3) ABC Studios holds four available-for-sale equity securities at December 31, 2007. They are all classified as long-term investments. All securities were purchased in 2007. The portfolio of securities appears as follows at December 31, 2007: Cost Market Value Difference Barbara Walters Corp.$100,000 $ 80,000 $(20,000) Harry Reasoner Corp.220,000 230,000 10,000 David Brinkley Corp. 210,000 150,000 (60,000) Hugh Downs Corp. 140,000 145,000 5,000 Totals $670.000 $605,000 $(65.000) Assuming the decline in the market value of David Brinkley Corp. stock is considered to be other than temporary, the amounts of realized loss and unrealized loss to report as a component of net income for the year ending December 31, 2007 are: Realized Loss Unrealized Loss a. $60,000 $5,000 b. $60,000 $0 c. $0 $65,000 d. $0 $60,000

Explanation: A decline in fair value that is other than temporary is referred to as an impairment. Regardless of the category in which the security is classified, the security is written down to fair value. The amount of the writedown is accounted for as a realized loss and, therefore, included in net income. The fair value at the date of writedown is used as a new cost basis for the security. Temporary changes in the fair value of securities in the available-for-sale category are reflected as a component of other comprehensive income and in a separate stockholders’ equity account rather than a component of net income. Thus, the $60,000 reduction in market value of David Brinkley Corp. stock is recorded as an impairment (charge to the income statement as a realized loss) and the remaining net unrealized loss [($20,000) + $10,000 + $5,000 = ($5,000)] is reported as a component of other comprehensive income and as a separate component of stockholders’ equity and not a component of net income. (Solution =b.) TIP If the same facts above were for securities classified in the trading category, the answer would be nau because the temporary changes ui fair value of a trading portfolio are recognized as an element of net income

7.

(L.O. 3) During 2006, Colquitt Company purchased 4,000 shares of Eichner Corp. common stock for $63,000 as an available-for-sale investment. The fair value of these shares was $60,000 at December 31, 2006. Colquitt sold all of the Eichner stock for $17 per share on December 3, 2007, incurring $2,800 in brokerage commissions. Colquitt Company should report a realized gain on the sale of stock in 2007 of: a. $8,000. b. $5,200. c. $5,000. d. $2,200.

Explanation: The gain is computed as follows: Selling price ($17 x 4,000 shares) Cost of sale—commissions Net proceeds (or net selling price) Cost Realized gain on sale

$ 68,000

(2,800) 65,200 63,000 $ 2,200

(Solution = d.)

The valuation account balance existing at the end of 2006 would have no effect on this computation. 8. (L.O. 3) On its December 31, 2006 balance sheet, Simpson Company appropriately reported a $4,000 credit balance in its Securities Fair Value Adjustment (Available-forSale) account. There was no change during 2007 in the composition of Simpson’s portfolio of marketable equity securities held as available-for-sale securities. The following information pertains to that portfolio: Security Cost Fair value at 12/31/07 A $ 50,000 $ 65,000 B 40,000 38,000 C 70,000 50,000 $160,000 $153,000 What amount of unrealized loss on these securities should be included in Simpson’s shareholders’ equity section of the balance sheet at December 31, 2007? a. $0 b. $3,000 c. $4,000 d. $7,000 Explanation: The Securities Fair Value Adjustment (Available-for-Sale) account would be increased by $3,000 to a $7,000 credit balance; hence the Unrealized Holding Gain or Loss account would be also adjusted to a $7,000 debit balance. The Unrealized Holding Gain or Loss account is reported as a separate line item in stockholders’ equity; it reflects the net unrealized loss of $7,000 on this portfolio ($160,000 cost $153,000 fair value = $7,000). It is one possible component of Accumulated Other Comprehensive Income. (Solution = d.)
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TIP

9.

(L.O. 3) Refer to the facts of Question 8 above. The amount of unrealized loss to appear as a component of comprehensive income for the year ending December 31, 2007 is: a. $0. b. $3,000. c. $4,000. d. $7,000.

Explanation: The $3,000 change in fair value during the current year goes on the comprehensive income statement for the year; whereas, the $7,000 net change in fair value since the acquisition date is reflected as a separate component of stockholders’ equity. Because the change in fair value this period was a decrease, it appears as an unrealized holding loss (a debit) on the comprehensive income statement. Because the total fair value of the investment securities is less than the total cost, the $7,000 difference represents a net unrealized holding loss. The $7,000 appears as a separate component in stockholders’ equity; in this case it is a debit item (contra stockholders’ equity). 10. (L.O. 4) An investor has a long-term investment in stocks. Regular cash dividends received by the investor are recorded as: Fair Value Method Equity Method a. Income Income b. A reduction of the investment A reduction of the investment c. Income A reduction of the investment d. A reduction of the investment Income

Approach and Explanation: Write down the journal entry to record the receipt of cash dividends (other than liquidating dividends) under both the fair value and equity methods. Observe the effects of the entries. Find the answer selection that correctly describes those effects. Fair Value Method Equity Method Cash XX Cash XX Dividend Revenue XX Investment in Investee Stock XX (Solution = c.) 11. (L.O. 4) The Higgins Corporation purchased 6,000 shares of common stock of the Barnett Corporation for $40 per share on January 2, 2007. The Barnett Corporation had 60,000 shares of common stock outstanding during 2007, paid cash dividends of $30,000 during 2007, and reported net income of $120,000 for 2007. The Higgins Corporation should report revenue from investment for 2007 in the amount of: a. $3,000. b. $9,000. c. $12,000. d. $15,000.

Explanation: Because the Higgins Corporation owns only 10% of the outstanding common stock of the investee, it is assumed that Higgins Corporation cannot exercise significant influence over the financing and operating policies of the investee and must keep track of the cost of the investment and use the fair value method to report the investment. Using the fair value method, the investor will report dividend revenue equal to the amount of cash dividends received during the period. ($30,000 X 10% = $3,000). (Solution = a.) 12. (L.a. 4) When the equity method is used to account for an investment in common stock of another corporation, the journal entry on the investor’s books to record the receipt of cash dividends from the investee will: a. include a debit to Cash and a credit to Dividend Revenue. b. reduce the carrying value of the investment. c. increase the carrying value of the investment. d. be the same journal entry that would be recorded if the cost method were used to account for the investment.

Explanation: The journal entry will be a debit to Cash and a credit to Investment in Stock. The credit portion of this entry reduces the balance of the investment account and, therefore, it reduces the carrying value of the investment. (Solution = b.) 13. (L.O. 7) A debt security is transferred from one category to another. Generally acceptable accounting principles require that for this particular reclassification (1) the security be transferred at fair value at the date of transfer, and (2) the unrealized gain or loss at the date of transfer currently carried as a separate component of stockholders’ equity be amortized over the remaining life of the security. What type of transfer is being described? a. transfer from trading to available-for-sale b. transfer from available-for-sale to trading c. transfer from held-to-maturity to available-for-sale d. transfer from available-forsale to held-to-maturity

Approach: Mentally review the accounting requirements for transfers from one

investment category to another. Refer to Illustration 17-5 for a summary of these requirements. (Solution = d.) 14. (L.O. 7) An investment in debt or equity securities may be transferred from one category to another. Assuming the fair value differs from cost at the date of transfer, which of the following will immediately result in reporting an amount on the income statement? I. Transfer from available-for-sale to trading. II. Transfer from held-to-maturity to available-for-sale. III. Transfer from available-for-sale to held-to-maturity. a. item I only b. items c. items d. items e. items I and II only I and Ill only II and III only I, II, and III

Approach and Explanation: Mentally review the accounting requirements for transfers from one investment category to another. Also review the effects of those requirements. Refer to Illustration 17-5 for a summary of those requirements. (Solution = a.) *15 (L.a. 9) Derivatives such as forwards and options are assets and liabilities and should be reported in the balance sheet at: a. zero. b. historical cost. c. the creator’s book value. d. fair value. Explanation: Derivatives such as forwards and options are assets and liabilities and should be reported in the balance sheet at fair value. Relying on some other basis of valuation, such as historical cost, does not make sense because many derivatives have a historical cost of zero. (Solution = d.) *16 (L.a. 10) A call option gives the holder the: a. b. c. d. right to buy an item at a present (or exercise) price. obligation to buy an item at a present (or exercise) price. right to sell an item at a present (or exercise) price. obligation to sell an item at a present (or exercise) price.

Explanation: A call option gives the holder the right, but not the obligation, to buy at a present price (often referred to as the strike price or the exercise price). A put option gives the holder the option (right) to sell an item at a present (exercise) price. (Solution = a.)

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