ACC 603 Advanced Accounting Theory Exam # 2

Name: Stephanie Stevens Date: 11/8/11

Instructor: J. Winter

This is a take home exam. You can only use your textbook, notes, PowerPoint materials and homework exercises. You are to complete this exam independently. You are not entitled to seek outside consultation in the completion of this exam. This exam needs to be returned to me no later than, Friday, November 11, 2011 by midnight. MULTIPLE CHOICE/TRUE-FALSE/FILL IN THE BLANK: (Total Point Value 50 Circle the answer of the best response) 1) Consolidated financial statements are typically prepared when one company has a controlling 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) Such control is likely to be temporary d) The two companies are in unrelated industries such as manufacturing and real estate 2) Theoretically, which of the following could be accounted for as a deferred charge, reduction of the related debt liability or an expense of the period of borrowing? a) Discount on bonds payable. b) Premium on bonds payable. c) Bond issue costs. d) Loss on extinguishment of debt. 3) After being held for 30 days, a 90 day 15% interest bearing note receivable was discounted at M & T Bank at 18%. The proceeds received from the bank upon discounting would be the: a) Maturity value less the discount at 18%. b) Maturity value plus the discount at 18%. c) Face value less the discount at 18%. d) Face value plus the discount at 18%.

4) Mike Inc. purchased certain fixed assets under a deferred payment contract on December 31, 2010. The agreement was to pay $20,000 at the time of purchase and $20,000 at the end of each of the next five years. The fixed assets should be valued at: a) The present value of a $20,000 ordinary annuity for 5 years. b) $120,000. c) $120,000 less imputed interest. d) $120,000 plus imputed interest. 5) Dex Co. has entered into a joint venture with an affiliate to secure access to additional inventory. Under the joint venture agreement, Dex will purchase the output of the venture at prices negotiated on an arms length basis. Which of the following is (are) required to be disclosed about the related party transaction? I. The amount due to the affiliate at the balance sheet date II. The dollar amount of the purchase during the year a) I only b) II only c) Both I and II d) Neither I not II

6) PQR Corp. acquired 100% of the outstanding common shares of STU Corp. in an acquisition transaction. The cost of the acquisition exceeded the fair value of the identifiable assets and assumed liabilities. The general guideline for assigning amounts to inventories acquired provide for: a) Raw materials to be valued at original cost b) Work in process to be valued at the estimated selling prices of finished goods, less both costs to complete and cost of disposal c) Finished goods to be valued at replacement cost d) Finished goods to be valued at estimated selling prices, less both costs of disposal and a reasonable profit allowance 7) Assets acquired in a lump sum purchase are valued based on: a) Their assessed valuation. b) Their relative fair market values. c) Their present value of their future cash flows. d) Their cost plus the difference between their cost and fair market values. 8) Research and development expense for a given period includes: a) The full cost of a newly acquired operational asset that has an alternative future use. b) Depreciation on a research and development facility. c) Research and development conducted on a contract basis for another entity. d) Patent filing and legal costs. 9) In June 2011 Northern Retailers sold refundable merchandise coupons. Northern received $10 for each coupon redeemable from July 1 to December 31, 2011 for merchandise with a retail price of $11. At June 30, 2011, how should Northern report these coupon transactions? a) Unearned revenues at the merchandises retail price b) Unearned revenues at the cash received amount c) Revenues at the merchandises retail price d) Revenues at the cash received amount 10) Recognition of impairment for tangible operational assets is required if book value exceeds: a) Market value b) Present value of expected cash flows c) Undiscounted expected cash flows d) Accumulated depreciation 11) The equity method is in many ways a partial consolidation. a) True b) False 12) A company using the group depreciation method for its delivery trucks retired one its trucks due to damage before the average service life of the group was reached. An insurance recovery was received. The net book value of these group asset accounts would be decreased by the: a) Original cost of the truck b) Original cost of the truck less the insurance recovery received c) Original cost of the truck less depreciation on the truck to the date of retirement d) Insurance recovery received 13) For trading securities, unrealized holding gains and losses are included in earnings: a) Only at the end of the fiscal year. b) On each reporting date. c) Only when they exceed 10% of the underlying investment. d) Based on a vote of the board of directors. 14) Sabres Corp began operations in 2010. Included in their 2010 financial statements were bad debt expenses of $1,400 and profit from an installment note of $2,600. For tax purposes, the bad debts will be deducted currently

and the profit from the installment sale will be recognized in 2011. The enacted tax rates are 30% for 2010 and 25% for 2011. In its income statement, what amount would Sabres Corp report as deferred income tax expense? Answer: 300 (2600-1400*.25) 15) The cost of promotional offers should be recorded as expenses in the accounting period when the offers are redeemed by customers. a) True. b) False. 16) Trading on the equity is likely to be a good financial strategy for stockholders of companies having: a) Cyclical high and low amounts of reported earnings b) Steady amount of reported earnings c) Volatile fluctuation in reported earnings over short periods of time d) Steadily declining amounts of reported earnings 17) When bonds include detachable warrants, what is the appropriate accounting for the cash proceeds from the bond issue? a) The proceeds from the bond issue are allocated between the bonds and the warrants on the basis of their relative market values. b) The proceeds from the bond issue are allocated between the bonds and the warrants on the basis of their relative face values. c) A nominal amount is allocated to the warrants. d) All of the proceeds are allocated to the bonds. 18) When a long term note is given for equipment, the amount considered as paid for the equipment is: a) The invoice price. b) The wholesale price. c) The present value of cash outflows discounted at the stated rate. d) The present value of the note payments discounted at the market rate. 19) Which of the following causes a permanent difference between taxable income and financial accounting income? a) The useful life of an asset is 10 years, the asset is depreciated over 7 years for tax purposes b) Rent received in advance is taxable upon receipt c) A life insurance premium paid by the corporation on a policy that names the corporation as the beneficiary d) A penalty paid to a bank when a CD is cashed before its maturity date 20) For reporting purposes, current deferred tax assets and current deferred tax liabilities are: a) Netted against one another on the balance sheet. b) Reported separately on the balance sheet. c) Reflected only in the footnotes. d) Combined respectively with non-current deferred tax assets and non-current deferred tax liabilities on the balance sheet. 21) Giant Corp. entered into a troubled debt restructuring agreement with First Niagara Bank. First Niagara agreed to accept land with a carrying amount of $85k and a fair value of $120k in exchange for a note with a carrying amount of $185k. What amount should Giant Corp report as a gain from extinguishment of debt in its income statement from this transaction? Answer: 65,000 22) The tax effect of a net operating loss carryback (NOL) usually: a) Results in a current receivable at the end of the NOL year.

b) Is subject to a valuation allowance. c) Is reflected as a deferred tax asset at the end of the NOL year. d) Is reflected as a deferred tax liability at the end of the NOL year. 23) Yankee Corp.s 2011 dividend revenue included only part of the dividends received from its MLB Corp investment. Yankee Corp. has an investment in MLB Corp that it intends to hold indefinitely. The balance of the dividend reduced Yankees carrying amount for its MLB investment. This reflects the fact that Yankee accounts for its MLB investment as: a) An available for sale investment and only a portion of MLBs 2011 dividends represent earnings after Yankees acquisition. b) An available for sale investment and its carrying amount exceeded the proportionate share of MLBs market value. c) An equity investment and Yankee incurred a loss in 2011. d) An equity investment and its carrying amount exceeded the proportionate share of MLBs market value 24) Bonds payable issued with scheduled maturities at various date are called: Serial bonds Term bonds a) No Yes b) No No c) Yes No d) Yes Yes 25) Which of the following statements concerning patents is correct? a) Legal costs incurred to successfully defend an internally developed patent should be capitalized and amortized over the patents remaining economic life b) Legal fees and other direct costs incurred in registering a patent should be capitalized and amortized on a straight line basis over a five year period c) Research and development contract services purchased from others and used to develop a patented manufacturing process should be capitalized and amortized over the patents economic life d) Research and development costs incurred to develop a patented item should be capitalized and amortized on a straight line basis over seventeen years QUALITATIVE ANALYSIS: (Total Point Value 50) You must complete questions 1, 2 & 3 and any two of the other six listed questions. You can also complete one additional question for extra credit. 1.Below are four independent, material and unrelated situations involving accounting changes. Each change occurs during 2010 before any adjusting or closing entries were prepared. Assume a tax rate of 40% and any tax effects are adjusted through the deferred tax asset or liability account. Discuss and evaluate the type of accounting change, briefly describe any steps that should be taken to appropriately report the situation, if you wish to complete journal entries to document the change, please feel free to do so. a) On December 31, 2000, Laurie Inc. acquired its office building at a cost of $8,000,000. It has been depreciated on a straight-line basis assuming a useful life of 40 years and no salvage value. Plans were finalized in 2010 to relocate the company headquarters at the end of 2011. The vacated office building will have a salvage value at that time of $2,800,000. The company would realize a loss of the salvage value minus the carrying value. 8,000,000/40= 200,000 2,200,000 (200,000 * 11) years of depreciation 8,000,000-2,200,000= 5,800,000 The company would realize a loss of the salvage value minus the carrying value (5,800,000-2,800,000 = 3,000,000). The loss would be recorded on the income statement under disposal of equipment which is under the assumption that the vacant building is permanently withdrawn from economic uses and has no further economic benefits expected from its disposal. (IAS 40.66 and 40.69) The tax effect of this would be a deferred tax asset of 3,000,000 recorded on the balance sheet assuming it was not used against income in 2010. If it was used for 2010 then it would be carried to 2011 and would offset against income earned within 2011.

Cash received from sale Loss on sale of asset Accumulated Depreciation Credit sold asset

2.8 M 3M 2.2 M 8M

b.) At the beginning of 2004, Sam Corp. purchased office equipment at a cost of $1,200,000. Its useful life was estimated to be ten years with no salvage value. The equipment has been depreciated by the sum-of-the-years digits method. On January 1, 2010, the company changed to the straight-line method. 1200000 0.181818 218181.8 1200000 1200000 1200000 1200000 1200000 0.163636 0.145455 0.127273 0.109091 0.090909 196363.6 174545.5 152727.3 130909.1 109090.9 981818.2 You would start with a denominator of 55 (1+2+3+4+5+6+7+8+9+10) The accumulated depreciation is 981818.2 When the company chooses to switch to straight line for the financial statement you would have to show this change in one entry in the current year between extraordinary items and net income, net of tax. This entry is to equal the difference between all prior years accounting sum of years method depreciation to the new straight line accounting change. Previously issued accounting statements do no need to be changed unless it is the result of an error, and for this case it is not. 1,200,000/10= 120,000*6=720,000-981,818= 261,818 The change of methods would yield a difference of 261,818 more depreciation applied with the sum of years method. Therefore the company would report 261,818 increases in income (*. 40 =104,727 net of tax) to net income on their financial statements. This change in method would have no effect on taxes because this is only a book acceptable method and would not be used for tax purposes. c.) John Company changed its inventory cost method to LIFO from FIFO at the beginning of 2010 for both financial statement and income tax purposes. Under FIFO, the inventory at January 1, 2010 was estimated to be $15 million. A LIFO reserve at the end of 2010 was calculated to be $706,000. Since this is a change in estimate; the changes will be treated prospectively and therefore there will yield no changes in prior periods financial statements. The company will make these changes as they go forward and treat inventory evaluation with the LIFO method from then on. According to GAAP this change in reporting can only be made in the period of the change and forthcoming periods. d.) Karl Inc. introduced a new line of auto covers in 2009 that carry a one-year warranty against manufacturers defects. Based on industry experience, warranty costs are expected to approximate 4% of sales. Sales of the covers in 2009 were $1,500,000. Warranty expense and warranty liability of $60,000 was recorded in 2009. In late 2010, the companys claims experience was evaluated and it was determined that claims were far fewer than expected and 3% rather than 4% was recommended. Sales of the covers in 2010 amounted to $3,200,000 and warranty expenditures in 2010 totaled $72,000. Due to the sales and the previous year this company now expects to have a warranty liability of 3% as opposed to their original 4% predictions. The sales in 2009 were 1,500,000 and based on the new predetermined warranty rate they will have record an estimated warranty liability of 60,000. At the end of the year actual expenditures are 72,000. This overestimate amounts to 12,000. 2. On July 1, 2010, Dynamic Corporation purchased for cash 40% of the outstanding capital stock of Cart Company. Dynamic has a fiscal year end of October 31st and Cart has a fiscal year end of March 31st. On October 31st, it has not yet been determined by Dynamic conclusively whether it has the ability to significantly influence Carts business operation. Cart Companys stock is actively traded on the NASDAQ exchange reported its net income for the period ended October 31st to Dynamic. Cart also paid cash dividends on September 15 th and December 15th to

Dynamic and its other stockholders. How should Dynamic report the above facts in its October 31, 2010 financial statements. Discuss the rationale for your answer. These are reported as equity securities available for sale, and they are listed on the balance sheet as current or noncurrent depending on what the company intends to do with these securities. These are non current because the company more than likely would like to exercise significant control and will not be rid of within the near future. The securities are recorded as FMV, and the difference between FMV and basis is recorded in other comprehensive income on the income statement as unrealized gain or loss. On the statement of cash flows it will be listed under investing activities. The dividends received are accounted for as a reduction of the investment value because dividends are a partial return of the investor's investment therefore reducing the overall capital in the security themselves. 3. You are the independent accountant assigned to the audit of Sara Company. The companys accountant, a fellow graduate of the accounting program you attended has prepared financial statements, which contained the following items: a) The balance sheet reports land at $100,000. Included in this amount is a piece of property purchased for a future warehouse site at a cost of $30,000 and a speculative land investment at a cost of $50,000. The 30,000 should be classified as a fixed asset under land because it will be used in the day to day operations of the business and plan to be held for long term. The 50,000 used for investment should be classified as noncurrent asset (fixed asset) recorded as real estate held for investment purposes. The remaining 20,000 is probably composed of legal fees, taxes when purchased, and other fees in the land transfer. The amount of these costs that are attributed to the land and will be capitalized as an expense, while the money attributed to the investment will be utilized as an expense. b) Current liabilities include $50,000 for long term debt that comes due in three months. The company has received a suitable firm commitment to refinance the debt for five years and intends to do so. If an enterprise intends to refinance short-term obligations on a long-term basis and demonstrates an ability to consummate the refinancing, the obligations should be excluded from current liabilities and classified as noncurrent. Under U.S. GAAP the ability to complete the refinancing may be demonstrated by a postbalance-sheet-date issuance of a long-term obligation or equity securities, or by entering into a financing agreement. Short-term obligations that are expected to be refinanced with long-term obligations can be reported as noncurrent liabilities only if the firm (a) intends to refinance on a long-term basis and (b) actually has demonstrated the ability to do so. Ability to refinance on a long-term basis can be demonstrated by either an existing refinancing agreement or by actual financing prior to the issuance of the financial statements. The refinancing agreement in this case limits the ability to refinance to 50,000 of the notes. The short term classification will be changed to long term liability and the amount excluded from the current liabilities in the full description of the finance agreement has to be disclosed in the financial statements or notes. c) Investments in marketable securities include $20,000 in short-term high-grade commercial paper which the company states is cash. Cash equivalents are very short-term investments that convert quickly into cash. Examples include money market funds, U.S. Treasury bills, certificates of deposit, and high-grade commercial paper. The first asset in the balance sheet then is called Cash and cash equivalents. Discuss the appropriate classification of the above items and how they should be disclosed in a financial statement. 5. Why do companies find the issuance of convertible bonds to be an attractive form of financing? Explain the rationale for this statement. (EXTRA CREDIT) Companies find convertible bonds to be attractive for financing because they have more potential to investors as well as provide internal benefits for the company beyond just raising capital. Bonds offer a fixed rate of return and are less volatile than the open market, meaning investors are guaranteed a certain return on their investment unlike that of common stock. Also, bond holders have a stake in the companys assets, unlike a stockholder. One of several advantages of using convertible bonds is a delayed dilution of common stock and EPS. Another is that the company is able to offer the bond at a lower rate, less than it would have to pay on a normal bond. Companies benefit because the fixed payout is driven by market prices, which leaves more operating income available to stockholders. In addition investors who own convertible bonds do not have voting rights within the company leaving control in the hands of stock holding investors. Another advantage

of convertible bonds is that the interest is classified as an expense and can be written down off of net income which makes it an attractive way to raise capital. Convertible bonds also have the option to be transferred into common stock at the end of the lifecycle when the bond hits maturity. 6. What is the justification for a corporation determining income for financial reporting purposes differently than the way it is determined for tax purposes? There are many differ reasons for a corporation to determining income for financial reporting purposes differently than income for tax. One reason for the differences is the motives a company has in the presentation and preparation of these two reports. When a company makes its financial statements for reporting the users are investors, lenders, and creditors. This presentation of a companys financial position would want to look as profitable as possible; therefore a company will use different methods to make the company look profitable and capable of remaining in business. Companies will use different measures of depreciation and inventory controls in order to boost net income or improve certain stock holder valued ratios. For example a company using LIFO for tax purposes will turn into larger COGS and for financial reporting use FIFO because it will have the opposite effect on COGS and render a higher net income. For tax reporting on the other hand companies will use strategic accounting to limit the amount of taxes levied by governments. Companies will often use different types of valuation than that of the financial reporting because it will allow them to pay fewer taxes by lowering income or shifting certain income to non taxed classifications. Companies will also use tax efficiency planning to defer accrued income and decrease the amount of taxes due. 8. Explain what is meant by a subsequent event. Give two examples of a subsequent event and discuss how disclosure of such an item would be beneficial to a general user of a financial statement. FASB defines subsequent events in two different categories. The first; consist of events that provide additional evidence about conditions that existed at the balance sheet date. The second; consists of those events that provide evidence with respect to condition that did not exist at the balance sheet date but arose subsequent to that date. These events deemed necessary are ones that are material in nature, and should be issued as a footnote with the intended purpose of informing users of the statements about this event. This event would also be likely to have or already has had a significant impact on the financial position or capacity for the company to earn profits. One example of a subsequent event would be a loss suit that has either been settled or imposed upon a company. This information would be beneficial to users of the company because law suits can have major material impacts. Major Law suits can effect a company large negatives to their income or in some cases even bankrupt the company. There are two types of events: Type 1-Events that reveal conditions existing at or before the balance sheet date and require adjustment to the financial statements. Type 2-Events that reveal conditions arising after the balance sheet date and require disclosure in, but not adjustment to, the financial statements. Due to the severity of a lawsuit and the implications it can have to the companies operating income it is a very good example of a subsequent event. An example of this would be if a airplane creator is in the middle of a law suit for a faulty airplane. The plan has faulty parts and because of this people have been killed. The outcome of this law suit would be the end of the company. Large lawsuits, penalties, and a tainted brand will create circumstances impossible to the company to overcome. The second example is a permanent impairment of securities. If one company, lets say an engine company has significant influence over another company through owning stocks, maybe an airplane company, the impairment of the first company (engine company) could severely cripple the other company. If the engine company is bankrupt and must be dissolved, the stocks that the airplane company holds are now worthless or worth fractions of the carrying value, and therefore has no chance in recovering value of those stocks. This permanent impairment of the assets should be disclosed within a footnote of the airplane companys financial statement. This is due to the large capital investment the airplane has spent on the stock of the engine company. This would be an instance where a subsequent event has occurred and should be documented and reported.