Net sales $ 6,250,000

Cost of sales (3,750,000)

Gross profit 2,500,000

Selling and administrative expenses (1,260,500) [A] Operating income 1,239,500 Other income (and expenses): Interest expense (122,500) Other gains and (losses): Loss on sale of equipment (225,000) Gain on extinguishment of debt 130,000 [B] Income before income tax 1,022,000

Income tax expense (306,600) [$1,022,000 x .30%]

Income from continuing operations 715,400

Income (loss) from discontinued operations (87,500) [C] Extraordinary gain (loss) (490,000) [D] Not applicable -

Net income $ 137,900

[A] "Revised" selling and administrative expenses: $1,260,500

$180,000 cost ÷ 10 year life = $18,000 per year depreciation

x 2 yrs$36,000 accumulated depreciation

$144,000 book value ÷ Remaining life 3 years = $48,000Selling and administrative expense $1,212,500Revised depreciation expense 48,000

$1,260,500

[B] Gain on extinguishment of debt: $130,000

Because the company has an ongoing policy of extinguishing long-term debt prior to its maturity date,these events cannot be considered "extraordinary" as they are certainly not unusual (and may also befrequent) with respect to the company's operations. The gain on extinguishment of debt, therefore,would be reported in income from continuing operations, NOT net of tax.

[C] Income (loss) from discontinued operations: ($87,500)

Impairment loss of component's assets $ (25,000)Component's Year 3 net losses (100,000)Total losses on discontinued component (125,000)Tax savings [30% x $125,000] 37,500Loss from discontinued operations $ (87,500)

Note: The losses anticipated for future periods are not recognized until they occur.

[D] Extraordinary gain (loss): ($490,000)

As indicated in note [B], the gain on extinguishment of debt is not an extraordinary item; however, the lossincurred due to the earthquake (which is a rare occurrence in the location of the plant) is considered anextraordinary item and is reported net of tax.

Loss from earthquake $ (700,000)

Tax savings [30% x $700,000] 210,000Extraordinary loss $ (490,000)

1. Accounting principle change (retrospective application effect on retained earnings)The cumulative effect of a change in accounting principle is shown on the statement of retained earnings asan adjustment of the beginning balance of the earliest year presented.

2. Income from continuing operationsSettlement of material litigation is to be reported in the income from continuing operations section of theincome statement, as although it is likely an infrequent event, it is not considered unusual in nature.

3. Extraordinary itemsA prohibition of a product line by the government would be deemed an extraordinary event in a businessunder U.S. GAAP as it is certainly unusual in nature and happens infrequently. Note that IFRS prohibits therecognition of gains and losses as extraordinary.

4. Income from continuing operationsWhile a material gain on the sale of a factory building is a rather infrequent event, it is not consideredunusual in nature for a company to have this type of transaction; therefore, it is reported in the income fromcontinuing operations section of the income statement.

5. Income from continuing operationsA change from the double-declining balance method of depreciation to the straight-line method ofdepreciation is a change in accounting estimate effected by a change in accounting principle. This type ofchange is reported prospectively, and all activity is reported through income form continuing operations. There is no separate or special reporting of the effect of the change. The change in method is simplyimplemented, and the depreciation under the straight-line method is reported as expense in income fromcontinuing operations for the first quarter.

6. Discontinued operationsThe results of operations of a component of an entity will be reported in the discontinued operations sectionof the income statement if the component is deemed to have met all criteria for the "held for sale"classification.

7. Income from continuing operationsA loss from a major strike by employees, while infrequent and likely material, is not considered anextraordinary event, as it is not unusual for a company's employees to go on strike. This loss would bereported in the income from continuing operations section of the income statement.

8. Income from continuing operationsIn order for information to be presented as a component of discontinued operations in the incomestatement, it must be information for a qualifying component of the business, which is the lowest level forwhich operations and cash flows can be clearly distinguished, both operationally and for financial reportingpurposes, from the rest of the entity. A dress line in women's clothing would not qualify as a component;therefore, the revenue from the discontinued dress line would be reported in the income from continuingoperations section of the income statement.

9. Income from continuing operationsMaterial flood damage to a building that is located in a flood plain that floods every two years is notconsidered an infrequent or unusual event; therefore, the loss is reported in the income from continuingoperations section of the income statement.

10. Income from continuing operationsA change in the service life of an asset is a change in estimate, which is implemented in the current yearand reported in the income from continuing operations section of the income statement.

11. Income from continuing operationsWhen the extinguishment of long-term debt is a common management strategy of a company, thetransaction is not deemed to be unusual; therefore, it cannot be reported in the section for extraordinary

items. The gain or loss would be reported in the income from continuing operations section of the incomestatement.

12. Extraordinary itemsThe occurrence of an earthquake in Wisconsin in an unusual and infrequent event (as this state rarelyexperiences earthquakes); therefore, the loss from destruction of a warehouse (likely material) is reported inthe extraordinary items section of the income statement (not permitted under IFRS).

13. Income from continuing operationsA material write-down of inventory, while likely infrequent, is not considered unusual in nature for abusiness; therefore, the loss cannot be reported in the extraordinary items section of the incomestatement. The loss would be reported in the income from continuing operations section of the incomestatement.

14. Discontinued operationsThe results of operations of a component of an entity will be reported in the discontinued operations sectionof the income statement if the component is a subsidiary that has already been sold.

Year 1 Year 2

Impairment Gain/(Loss) (500,000) 0

Operating Gain/(Loss) (700,000) (200,000)

Gain/(Loss) on Disposal 0 380,000

Income Tax Benefit/(Expense) 360,000 (54,000)

Total Gain/(Loss) from Discontinued Operations (840,000) 126,000

Income/loss from an operating segment of a company that is held for sale or sold during the current period mustbe reported, net of tax, in the period incurred. An operating segment is considered to be a component of an entity.At December 31, Year 1, the segment has not been sold, but will still be accounted for as a discontinuedoperation because it meets the held for sale requirement. Impairment Loss The impairment loss for Year 1 is $500,000 and represents the difference between the book value and fair value ofthe segment at December 31, Year 1. Even though the division sold for a higher price in Year 2, the $2,500,000represents the best available information as of December 31, Year 1. There is no impairment loss at December 31, Year 2 because the segment was sold in Year 2. Operating Loss Operating losses are recognized in full in the period incurred. In Year 1, the operating loss for the entire year isincluded in discontinued operations, even though the decision to dispose was not made until July 1. Gain from Disposal There is no gain or loss on disposal in Year 1 because the segment was not sold until Year 2. The gain on disposal in Year 2 is $380,000 ($3,200,000 sales price - $320,000 brokers fee - $2,500,000 bookvalue of segment). Income Tax Benefit (Expense) In Year 1, the company records income tax benefit of $360,000 ($1,200,000 net loss from discontinued operationsx 30%). In Year 2, the company records income tax expense of $54,000 ($180,000 net gain from discontinuedoperations x 30%).

1. Change in Accounting Principle, Prospective A change from FIFO to LIFO is a change in accounting principle that is accounted for prospectively, like a changein accounting estimate because it is too difficult to calculate the cumulative effect of the change. 2. Correction of an Accounting Error, Restate Prior Periods The income tax basis of accounting is a non-GAAP method. A change from a non-GAAP method of accountingto a GAAP method of accounting is considered to be an error correction under GAAP. An error correction isaccounted for by restating all prior periods presented and adjusting the beginning retained earnings of the earliestperiod presented. 3. Change in Accounting Entity, Retrospective A change in accounting entity occurs when an entity has changed composition as a result of consolidation or abusiness combination. When Goose presents it consolidated financial statements that include Gosling, it willrestate any prior period financial statements presented for comparative purposes to also reflect the consolidationof Gosling. Under U.S. GAAP, this restatement is referred to as a retrospective adjustment. 4. Not an Acceptable Change in Accounting, No Change While the change in reporting construction contracts is a change in accounting principle, an accounting principlemay be changed only if required by GAAP or if the alternative is preferable and more fairly presents theinformation. A change in accounting principle is not acceptable if it done in order increase earnings and the stockprice of the company. 5. Change in Accounting Estimate, Prospective Since the company booked a liability in the previous year based on the best information available at the time, thesubsequent settlement is accounted for prospectively as a change in accounting estimate. Previous financialstatements are not restated.

Axl, Bruce, Diddy, and Elvis are reportable segments because they each have 10% of at least one of thefollowing criteria: 10% of Revenue Test – Diddy, Elvis An operating segment meets the size test if its reported revenue, including both sales to outsiders andintersegment sales is 10% or more of the combined revenue, internal and external, of all reporting segments. Combined revenue is $165,000 ($105,000 external + $60,000 intersegment). Diddy and Elvis have revenues inexcess of $16,500 ($165,000 x 10%). 10% of Reported Profit or Loss Test – Axl, Elvis An operating segment meets the size test if the absolute amount of its reported profit or loss is 10% or more ofthe greater, in absolute amount, of

1. The combined reported profit of all operating segments that did not report a loss2. The combined reported loss of all reporting segments that did report a loss.

The combined profit of all reporting segments that did not report a loss is $58,000 ($0 + $5,000 + $3,000 +$50,000). The combined loss of all reporting segments that reported a loss is $9,000. $58,000 is greater than$9,000, so a segment is deemed reportable if the absolute amount of its profit or loss exceeds $5,800 ($58,000 x10%). Axl, with a loss of $9,000, and Elvis, with income of $50,000, meet this criteria.

10% of Reported Assets Test – Bruce, Elvis

A segment meets the size test if its assets are 10% or more of the combined assets of all reporting segments. Combined assets are $87,000. Bruce and Elvis have assets in excess of $8,700 ($87,000 x 10%).

75% Reporting Sufficiency Test

The total external revenue of operating segments, as determined above, must constitute 75% of total externalrevenue. Total external revenue is $105,000. Reportable segments have external revenue of $90,000 (10,000 +10,000 + 70,000), which is 86% of the total external sales.

1. Correct No adjustment is necessary. Under both IFRS and U.S. GAAP, “available for sale” marketable securities aremarked-to-market at period end with the unrealized gain or loss recorded in the other comprehensive incomeaccount. In the scenario above, the reclassified marketable securities would have generated an unrealized gain of$750,000 in OCI.

2. Incorrect, Increase (accumulated) other comprehensive IncomeThe $65,000 related to the effective portion of the cash flow hedge would be recorded in other comprehensiveincome. The ineffective portion of the cash flow hedge should have been reported in the income statement. Thecompany erroneously netted the effective and ineffective portions together with this amount reported in othercomprehensive income. To correct this error, (accumulated) other comprehensive income should be increased by$13,000.

3. CorrectNo adjustment is necessary. Under IFRS, the company can choose to use the cost or revaluation model. RCselected the revaluation model and properly reported the $895,000 excess of fair value over carrying value as arevaluation surplus in other comprehensive income.

4. Incorrect, Increase (accumulated) other comprehensive IncomeRC properly recorded the actuarial gain in other comprehensive income in the prior fiscal year. Under IFRS theactuarial gain should remain in other comprehensive income without being reclassified to the income statement. To correct this error, (accumulated) other comprehensive income should be increased by $10,000.

5. Incorrect, Increase (accumulated) other comprehensive IncomeThe first part of the closing process is correct as the company closed net income to retained earnings. However,other comprehensive income should be closed to the accumulated other comprehensive income account, which isa component of stockholders’ equity. To correct this error, (accumulated) other comprehensive income should beincreased by the amount of other comprehensive income reported for the current period (not given).

6. Correct No adjustment is necessary. RC completed an effective foreign currency hedge in the third quarter of the fiscalyear properly reflecting the $65,000 translation gain in other comprehensive income. Because the foreigncurrency transaction was liquidated in the following quarter, it is proper to remove the prior translation gainreported in other comprehensive income in the fourth quarter when the investment was terminated.

Source of answer for this question:

FASB ASC 470-50-45-1

Keyword: Extinguishment of debt

The idea behind this type of question is to correct net income for Year 1, Year 2, and Year 3 and to correct thebalance sheet at December 31, Year 3. Individual corrections may affect only the three years of the incomestatement, or they may go beyond that, in which case they affect the balance sheet. The keys to this kind ofquestion are: (1) to determine what should have been done for a fact situation; (2) to determine what was done(and it was probably done wrong or there would not be much of a question); and then (3) to figure what has to bedone to correct or adjust what was done to what should have been done. The answers to these questions referto them as the "Correct Accounting" and the "Original Accounting."

Further, please note that this simulation in total is much longer than you should see on the CPA exam. Itwould be difficult, if not impossible, to work a simulation this long in the "allotted" time on the exam. Thissimulation is meant as a learning tool.

For each item, the original accounting and the correct accounting are provided. The question asks you to"Identify the correction to net income in each of the years presented and to the balance sheet in the final yearby entering the appropriate amount in the shaded cell." The adjustments/corrections are provided for you in the"correction" line of the explanations.

QUESTION 1This question deals with the incorrect recording of a sale. The company incorrectly accounted for thetransaction on the cash basis, overstating sales and income in Year 3, the year of receipt, and understatingsales and income in Year 2, the year of the proper accrual. As the receivable was collected prior to the Year 3balance sheet date, there is no impact on the balance sheet.

To correct the error, sales are increased (credited) in Year 2 when the sales should have been recorded anddecreased (debited) in Year 3 when the sales were actually (incorrectly) recorded.

INCOM E STATEM ENT YEAR 3 BALANCE SHEET Year 1 Year 2 Year 3 Debit Credit

Original Accounting – Sales (2,000)

CORRECTIO N (2,000) 2,000 -- --

Correct Accounting – Accruedsales

(2,000) -- -- --

The "Correction" line is represented by the shaded line.

QUESTION 2This question deals with the incorrect capitalizing of freight-out (covered in lecture F4). The companyinappropriately accounted for freight-out as an inventory item. Freight-out is a selling expense that should beaccounted for as a period cost at the time incurred. [Note that freight-in is a proper inventory cost.] Thecompany uses the FIFO method of inventory and maintains a safety stock equal to 50% of the current yearpurchases. What this means is that only half of the current year purchases is sold each year; the other half ofthe purchases carries over to the next year and is sold first (and shipped) in that year. For example, freight-outfor Year 1 was $50,000. The full $50,000 should have been expensed in Year 1, but it was not; only $25,000was expensed (from the goods that were actually sold).

Although the company overstates its inventory, it does expense (and thereby reduce) net income for the cost ofgoods sold that is recognized. The adjustment to each year's net income is the difference between theaccounting that should have occurred (expensing the entire amount) and the amount that had already beenrecorded as cost of goods sold expense.

INCOM E STATEM ENT YEAR 3 BALANCE SHEET Year 1 Year 2 Year 3 Debit CreditItems to note: Freight-out capitalized asinventory

50,000 150,000 300,000 150,000

Original Accounting Cost of goods sold, currentyear

25,000 75,000 150,000

Cost of goods sold, prior year 25,000 75,000

CORRECTIO N 25,000 50,000 75,000 -- 150,000

Correct Accounting

Expense freight-out (periodexpense)

50,000 150,000 300,000 -- 150,000

• The correction is to add $25,000 of expense to Year 1. [Note that the "freight-out capitalized" line is justinformation and is not part of the "footing" of the column.] The total correction is the additional $25,000. The "Original Accounting" plus the "Correction" equals the "Correct Accounting" for Year 1.

• In Year 2, $150,000 should have been expensed, but only $75,000 of the $150,000 was. In addition, the$25,000 from Year 1 was expensed in Year 2 when it should have been expensed in Year 1. That meansthat $100,000 was expensed when $150,000 should have been. The correction is to add $50,000 ofexpense to Year 2.

• In Year 3, $300,000 should have been expensed, but only $150,000 of the $300,000 was. In addition, the$75,000 from Year 2 was expensed in Year 3 when it should have been expensed in Year 2. That meansthat $225,000 was expensed when $300,000 should have been. The correction is to add $75,000 ofexpense to Year 3.

• At December 31, Year 3, there was $150,000 still in inventory that should have been expensed and notcapitalized. Inventory is adjusted by that amount (as a credit).

QUESTION 3This question deals with discontinued operations (covered in F1). Losses associated with discontinuedoperations should be accounted for in the years in which they occur. Components that are held for sale or thathave already been sold (or otherwise disposed of) would be charged with an impairment loss that would berecognized once the conditions for disposal or held for sale status are met. Operating losses related to thecomponent are recognized in the year in which they occur. Estimated losses related to subsequent periods arenot accrued. All that has to be done here is to move the $150,000 of Year 3 operating loss from Year 2 to Year3. The correction is the difference between the amount recognized and what should have been recognized. Because the asset was disposed of before 12/31/Year 3, there is no effect on the balance sheet.

INCOM E STATEM ENT YEAR 3 BALANCESHEET

Year 1 Year 2 Year 3 Debit CreditOriginal Accounting

Discontinued operationslosses & disposal:

Impairment loss 100,000 Year 2 operating loss 75,000 Year 3 estimated operatingloss

150,000

CORRECTIO N (150,000) 150,000 -- --

Correct Accounting Impairment loss 100,000 Year 2 operating loss 75,000 Year 3 operating loss 150,000 -- --

QUESTION 4This question deals with a change in accounting principle inseparable from a change in accounting estimate(covered in F1). A change in accounting principle inseparable from a change in accounting estimate should beaccounted for as a change in accounting estimate. The change should be handled prospectively in income.

The company changed to the cost recovery method of recognizing revenue, which means that it will onlyrecognize profit after all the costs have been recovered. Recall that with a profit margin of 50%, this means thatthere is $300,000 in profit and $300,000 in costs. The company expects to collect $200,000 per year beginningin Year 1. Therefore, with the cost recovery method, the company would recognize $0 profit in Year 1 (i.e., theentire collection of $200,000 would go against the cost recovery), $100,000 profit in Year 2 ($100,000 of the$200,000 collected would go against the cost recovery), and $200,000 profit in Year 3 (as the costs wererecovered 100% in Year 2, all of the collections in Year 3 would be revenue).

Note that the facts tell us that the company did not account for the change in accounting principle that wasinseparable from a change in estimate; therefore, the original accounting as installment sales still exists on thebooks of the company.

Let's look at the details of the transaction. The original sale was $600,000, with $200,000 scheduled to becollected each year. With a 50% profit margin and the installment method, $100,000 of profit would have beenrecognized each year. This was part of the original accounting. Note that the receivable was collected before12/31/Year 3, so there is no impact on the balance sheet.

INCOM E STATEM ENT YEAR 3 BALANCESHEET

Year 1 Year 2 Year 3 Debit CreditOriginal Accounting

Installment sale accounting: Year 1 profit recognition (100,000) Year 2 profit recognition (100,000) Year 3 profit recognition (100,000)

CORRECTIO N 100,000 (100,000) -- --

Correct Accounting

Account for prospectively: Year 1 profit recognition -- Year 2 profit recognition (100,000) Year 3 profit recognition (200,000) -- --

QUESTION 5This question deals with amortization of software costs (covered in F2). The question states two things: (1) theuseful life of the software is 4 years and (2) the amount of sales is realized at 10% of expected lifetime saleseach year. The question appears to contradict itself because if the software has a useful life of 4 years, then itis expected that 25% of the sales would occur in each year. The question goes on to say, however, that 10%of expected lifetime sales is expected to be realized each year, which would seem to indicate the companybelieves the sales to exist over 10 years. For these purposes, we are going to assume that the company'saccounting estimates are correct (for whatever reason).

Software costs are capitalized once technological feasibility is established and are then amortized using thegreater of the straight-line amortization over the useful life of the software or the percentage of estimated salesachieved. The useful life of four years requires amortization of one-quarter (or 25%) of the cost, while sales arerealized at only 10% of total projected sales. The company's method of amortization understated theamortization by $30,000 per year and overstated the capitalized software by $90,000.

INCOM E STATEM ENT YEAR 3 BALANCE SHEET Year 1 Year 2 Year 3 Debit Credit

Original Accounting

Amortize cost based on sales Amortization of cost 20,000 20,000 20,000 Remaining book value (200,000- 60,000)

140,000

CORRECTIO N 30,000 30,000 30,000 -- 90,000

Correct Accounting

Account for software development costs and amortize on a straight-line basis or percentage of sales,whichever is greater.Amortization of cost 50,000 50,000 50,000 Remaining book value (200,000- 150,000)

50,000

The $30,000 Debit in Year 1, Year 2, and Year 3 adjusts the amortization to the correct amounts, and the$90,000 Credit for the Year 3 balance sheet adjusts the $140,000 that was originally recorded to its correct$50,000 amount.

QUESTION 6This question deals with revenue recognition (covered in F2). To properly match earnings with the periodbenefited, revenues should be recognized when earned, not when received. Subscription revenues thatrepresent an advance payment over a three-year period should be recognized to the extent that obligations havebeen fulfilled in the year of receipt, with the remainder recorded as deferred revenue. The company's accountingoverstated revenue in the year of receipt, and did not properly establish a liability.

INCOM E STATEM ENT YEAR 3 BALANCE SHEET Year 1 Year 2 Year 3 Debit Credit

Original Accounting Recognize revenue whenreceived

Subscription revenues (150,000)

CORRECTIO N 100,000 100,000

Correct Accounting Recognition of revenue whenearned

Subscription revenue Deferred revenue (150,000 -$50,000)

(50,000) 100,000

QUESTION 7This question deals with inventory (covered in F4). In this question, inventory sitting in a warehouse wasimproperly included in cost of goods sold even though the goods had not been sold. Risks of ownership pass tothe buyer upon receipt when goods are shipped FOB destination. Risks of ownership pass to the buyer upondelivery to a common carrier under FOB shipping point. In this case, since the goods were shipped FOBdestination, title had not passed to the buyer and the goods should properly have been included in inventory. Restoration of inventory accounts and elimination of cost of goods sold are required adjustments.

INCOM E STATEM ENT YEAR 3 BALANCE SHEET Year 1 Year 2 Year 3 Debit CreditOriginal Accounting Improperly excluded inventory Cost of goods sold 50,000

CORRECTIO N (50,000) 50,000

Correct Accounting Account for costs of inventory forwhich company still has title

Cost of goods sold -- Inventory 50,000

SUMMARYA recap of the correction adjustments is as follows:

QuestionYear 1 Debits

(Credits)Year 2 Debits

(Credits)Year 3 Debits

(Credits)

YEAR 3 BALANCE SHEET

Debit Credit

Book income ($10,000) $6,000 ($85,000) $0 $01 (2,000) 2,000 2 25,000 50,000 75,000 150,0003 (150,000) 150,000 4 100,000 (100,000) 5 30,000 30,000 30,000 90,0006 100,000 100,000

7 (50,000) 50,000

Corrected netincome

145,000 (66,000) 122,000

Balance SheetAdjustments

50,000 340,000

Note that each numbered line, including the total adjustments line, shows a net total of debits and credits equalto zero. All that is being done in each year is that the numbers are moved around.

JE#1

Accounts receivable $20,000

Sales $20,000

To adjust to accrual basis sales revenue, the sales that were made in Year 1 but not yet collected at the end ofthe year are added to the sales already booked for the year under the cash basis. The amount uncollected atyear-end is accounts receivable.

JE#2

Inventory $12,000

Accounts payable $12,000

Cost of sales $2,000

Accounts payable $2,000

Purchases made on the cash basis of accounting are not recorded until the invoice is paid. Since $12,000 of thegoods are still on hand, the amount is recorded under the accrual basis with inventory as a debit and accountspayable as a credit.

The $2,000 of goods sold but not yet paid for is recorded under the accrual basis with a debit to cost of sales anda credit to accounts payable.

JE#3

Factory equipment $5,000

Small tools expense $5,000

Depreciation expense $1,000

Accumulated depreciation $1,000

The asset purchase of $5,000 was recorded as small tools expense under the cash basis. Under the accrualbasis, the tools need to be reported as fixed assets with a debit to the factory equipment account. Depreciationis calculated on a straight line basis for one year and totals $1,000.

JE #4

Prepaid insurance $1,200

Administrative expenses $1,200

The insurance policy included as an administrative expense is for one year, from July 1, Year 1 to June 30, Year2. Since six months are still to run on the policy, prepaid insurance of $1,200 ($2,400 x 6/12) should be reportedunder the accrual basis.

JE #5

Accounts receivable $500

Cash $500

Under the accrual basis, the bad check would be reported as accounts receivable since it was not paid as ofDecember 31, Year 1.

JE #6

Bad debt expense $900

Allowance for uncollectible accounts $900

The bad debt expense account is calculated based on 1.5% of sales for the year. Sales revenue for the year is$60,000, after including the sales in JE #1. Bad debt expense is $900 ($60,000 x 1.5%).

JE #7

Payroll expense $1,300

Accrued payroll $1,300

Since the company pays its employees seven days after the end of the pay period and the last pay date recordedby the company was December 31st (for time worked through December 24th), under the accrual basis thecompany has to record accrued payroll for the additional one week that was worked in Year 1 and will be paid onJanuary 7th, Year 2.

JE #8

Income tax expense $1,000

Income tax payable $1,000

On the accrual basis, the company will record the tax liability based on the income shown in the Year 1 accrualbasis income statement. The taxable income is calculated as follows:

Cash basis pretax income (from trial balance) $ (1,000)JE #1 - Sales 20,000 JE #2 - Cost of sales (2,000)JE #3 - Small tools 5,000 JE #3 - Depreciation expense (1,000)JE #4 - Administrative expenses 1,200 JE #6 - Bad debt expense (900)JE #7 - Payroll expense (1,300)Taxable Income $20,000

Total income tax expense = $20,000 x 25% = $5,000 Income tax payable = Total income tax expense - Estimated tax payments = $5,000 - 4,000 = $1,000

The estimated income tax payments offset the total income tax expense and the remaining $1,000 is unpaid atyear-end and shown as income tax payable.

Under installment accounting, profit is recognized when cash is collected.

Gross profit on income statement – Year 1: $20,000

Gross profit = Sales – Cost of sales $120,000 - $60,000 = $60,000

Gross profit rate = Gross profit / Sales $60,000/$120,000 = 50%

Gross profit on income statement = Cash collections x Gross profit rate $40,000 x 50% = $20,000

Deferred gross profit – Year 1: $40,000

Deferred gross profit = Gross profit rate x Ending installment receivable 50% x ($120,000 - $40,000) = $40,000

Gross profit on income statement – Year 2: $108,000

Gross profit = Sales – Cost of sales Year 1: $120,000 - $60,000 = $60,000 Year 2: $200,000 - $80,000 = $120,000

Gross profit rate = Gross profit / Sales Year 1: $60,000/$120,000 = 50% Year 2: $120,000/$200,000 = 60%

Gross profit on income statement = Cash collections x Gross Profit rate Year 1: $60,000 x 50% = $30,000 Year 2: $130,000 x 60% = $78,000

Total Gross profit - Year 2 = $108,000

Deferred Gross Profit – Year 2: $52,000

Deferred gross profit = GP Rate x Receivable Year 1: 50% x ($120,000-$40,000-$60,000) = $10,000 Year 2: 60% x ($200,000-$130,000) = $42,000

Under the cost recovery method, no profit is recognized until all costs have been recovered. Cash collections arefirst applied to the recovery of product costs. Collections after all costs have been recovered are recognized asprofit.

Gross profit on income statement - Year 1: $0

No gross profit is recognized in Year 1 because the Year 1 cost of sales of $60,000 is not recovered during Year1.

Deferred gross profit - End of Year 1: $60,000

Total gross profit = $120,000 - $60,000 = $60,000

All gross profit is deferred at the end of Year 1 because the $60,000 cost of sales has not been recovered.

Gross profit on income statement - Year 2: $90,000

From the Year 1 sales, $60,000 was collected in Year 2, for cumulative cash collections of $100,000 ($40,000 inYear 1 + $60,000 in Year 2).

Year 2 recognized gross profit on Year 1 sales = $100,000 cash collections - $60,000 cost of sales = $40,000

Year 2 costs of $80,000 are fully recovered since the company collected $130,000 of the Year 2 installmentsales.

Year 2 recognized gross profit on Year 2 sales = $130,000 cash collections - $80,000 cost of sales = $50,000

Total Gross Profit = $40,000 + $50,000 = $90,000

Deferred gross profit - End of Year 2: $90,000

Total gross profit on Year 1 sales = $120,000 - $60,000 = $60,000

Gross profit on Year 1 sales recognized in Year 2 = $40,000

Deferred gross profit on Year 1 sales at the end of Year 2 = $60,000 - $40,000 = $20,000

Total gross profit on Year 2 sales = $200,000 - $80,000 = $120,000

Gross profit on Year 2 sales recognized in Year 2 = $50,000

Deferred gross profit on Year 2 sales at the end of Year 2 = $120,000 - $50,000 = $70,000

Total deferred gross profit - end of Year 2 = $20,000 + $70,000 = $90,000

1. $26,000,000License Cost $28,000,000Add: Legal Fee 1,600,000Add: Regulation Fees 400,000Initial Carry Value $30,000,000Less: Y1 Amortization (2,000,000)Carrying Value End Y1 $28,000,000Less: Y2 Amortization (2,000,000)Carrying Value End Y2 $26,000,000

2. $4,769,231Carrying Value End Y2 $26,000,000Less: Impairment Charge (3,000,000)Adjusted Carrying Value $23,000,000Amortization Periods ÷ 13Amortization Expense $1,769,231Impairment Charge 3,000,000Total Expense in Y3 $4,769,231

3. $1,400,000Initial Carrying Value $30,000,000Less: Y1 Amortization (2,000,000)Carrying Value End Y1 $28,000,000Less: Fair Value End Y1 (26,600,000)Revaluation Loss Y1 $1,400,000

Carrying Value - Beg Y2 $26,600,000Remaining Periods ÷ 14New Annual Amortization $1,900,000

Carrying Value - Beg Y2 $26,600,000Less: Y2 Amortization (1,900,000)Carrying Value End Y2 $24,700,000

Fair Value End Y2 $26,300,000Carrying Value End Y2 24,700,000Revaluation Gain Y2 $1,600,000*

* The year 2 income statement recognizes a reversal of the $1,400,000 revaluation loss reported in year 1, withthe $200,000 remainder recognized on the balance sheet as a revaluation surplus in the other comprehensiveincome account.

Part 1:

1. $98,500. Money market instruments are considered cash equivalents, as they are easily converted intocash and represent short-term instruments that are very low risk in terms of potential loss of principal. Cash and money market instruments should be included in this total.

2. $39,000. The current value of the TBR stock (3,000 shares at $13 per share) should be included. Theoriginal purchase price is relevant in terms of calculating the unrealized gain or loss (which will be reflectedon the Statement of Changes in Net Worth), but will not be presented on the Statement of FinancialCondition. In addition, HYL stock will not be included here because the stock was sold and no longerrepresents an asset in Tames’ portfolio.

3. $9,150. Bond investments are monetary assets and should be valued based on the present value ofprojected cash receipts. Each bond is currently worth $915 and he has purchased 10 bonds. So the totalvalue should be $9,150 (bonds payable of $10,000 less $850 bond discount.

4. $225,000. The original purchase price and original mortgage are not relevant for the current year’sStatement of Financial Condition. The current value of $225,000 is what will be listed as an asset. Thecurrent value of the mortgage of $190,000 will be listed as a liability.

5. $50,000. The current value of $50,000 is all that is relevant for the Assets section of this statement. Theoutstanding principal owed of $35,000 will be listed as a liability.

6. $35,000. Life insurance should be listed at its cash surrender value of $40,000 less the $5,000 loan that isoutstanding on the policy. The fair value and face value are not included here.

7. $300,000. When a business interest is deemed to be “large,” ($300,000 relative to his overall assetportfolio would be considered large/significant) the interest should be presented on a “net” basis. The valueof the business is $1.5 million ($4 million in assets - $2.5 million in liabilities). Tames’ holds a 20% interestvalued at $300,000 ( $1,500,000 X 20%).

8. $275,000. Only the pension plan benefits that are vested should be included as an asset.

Part 2:

1. Current values for stock investments are listed as assets on the Statement of Financial Condition. Originalcost data is used to determine unrealized and realized gains or losses, but it is not listed specifically undereither statement and is not required to be disclosed.

2. Realized and unrealized gains and losses on investments will appear on the Statement of Changes in NetWorth.

3. Estimated taxes owed (based on when the stock currently held is actually sold) will appear as a liability onthe Statement of Financial Condition.

4. Realized gains and losses on the sale of property will appear on the Statement of Changes in Net Worth.5. Interest rate details on an outstanding mortgage will be listed as a Disclosure.6. Principal outstanding on student loans will be listed as a liability on the Statement of Financial Condition.7. While a pay down of principal will reflect as a decrease in the liability itself, interest paid on principal owed

will be reflected on the Statement of Changes in Net Worth. 8. Nonvested pension plan benefits may be listed as a Disclosure, but will not be included on either

statement. Vested pension plan benefits will be listed as an asset on the Statement of FinancialCondition.

9. The face amount on a life insurance policy will be included in a Disclosures area. The cash surrender value(less any loans payable) will be included on the Statement of Financial Condition.

AJE#1Dr. Prepaid expenses $5,000

Cr. Rent expense $5,000

The rent expense attributable to year 3 that has been paid in year 2 is a prepaid item as of December 31, year 2.

AJE#2Dr. Depreciation expense $1,500

Cr. Accumulated depreciation - pp&e $1,500

Depreciation is calculated on the original cost of $20,000, less salvage value of $5,000 over a 10 year useful life.

AJE#3Dr. Bad debt expense $750

Cr. Allowance for doubtful accounts $750

Bad debt expense is estimated to be .25% of the Sales amount of $300,000.

AJE#4Dr. Allowance for doubtful accounts $855

Cr. Accounts receivable $855

When a specific account is written off, the allowance account is reduced (debit) and the receivable is removed fromAccounts receivable (credit).

AJE#5Dr. Insurance expense $650

Cr. Prepaid expenses $650

Insurance expense for the year ended December 31, year 2 that has been posted to Prepaid expenses needs to beadjusted to an expense account.

AJE#6Dr. Interest receivable $300

Cr. Interest income $300

Interest income that has been earned in Year 2 is shown as income even though it has not as yet been received(accrual concept).

AJE#7Dr. Tax expense $2,000

Cr. Taxes payable $2,000

Income tax expense for the year of $3,000 for Year 2 is shown as an expense for the year. Since the amount in theexpense and payable account is $1,000, an additional $2,000 is needed to adjust the amount to the balance at yearend. It would appear that JRM Co. made a tax accrual of $1,000 earlier in the year.

April 1, year 1

Dr. Patents $50,000Cr. Cash $50,000

The cost of purchasing a patent from an outside source for $50,000 is capitalized as an intangible asset. The$35,000 in development costs incurred by DD Co. is research and development which is a direct charge toexpense.

July 1, year 1

Dr. Equipment $79,000Cr. Cash $79,000

Research and development costs are a direct charge to income EXCEPT for materials or equipment that havealternate future uses. Because the equipment qualifies under this rule, the amount capitalized is the original costplus any expenditure directly related to the acquisition of the asset.

October 1, year 1

Dr. Legal Expense $25,000Cr. Cash $25,000

Legal fees for an unsuccessful defense of a trademark are an expense. Legal fees for a successful defense of thetrademark are added to the asset value of the trademark.

December 31, year 1

Dr. Amortization Expenses $3,750Cr. Accumulated Amortization - Patent $3,750

A patent is amortized over the shorter of its estimated useful life or its remaining useful life. Amortization is on astraight line basis: $50,000/10 years x 9/12.

December 31, year 1

Dr. Research and Development Expense $7,900Cr. Accumulated Depreciation $7,900

Depreciation expense is calculated on the capitalized amount of $79,000. Depreciation is on the straight linebasis: 79,000/5 year x 6/12. Because the equipment is currently used for research and development, thedepreciation is charged to research and development expense.

December 31, year 1

No entry required

Goodwill amortization is a two step process. First, since the carrying value of the identifiable net assets exceedsthe fair value, there is a potential for impairment. Second, the amount of goodwill loss is measured by comparingthe implied fair value of the goodwill to the carrying amount of that goodwill. If the implied fair value is less than itscarrying amount, a goodwill loss is recognized. In this case, the implied fair value is higher so no goodwill

impairment is recognized.

Source of the answer for this question:

FASB ASC 915-10-20 Glossary

Keyword: Development stage entity

Note: The solution to this research question states that the guidance for identifying a development stageenterprise can be found in ASC 915-10-20 Glossary. Because there are no paragraph numbers in 915-10-20and the word “Glossary” is not a paragraph reference, the answer to this question should be entered as follows:FASB ASC 915-10-20

Solution:1) DR Valuation account, Smith Co. $10,000 CR Unrealized gain on trading securities $10,000

2) DR Unrealized loss on trading securities $15,000 CR Valuation account, Jones Co. $15,000

3) DR Unrealized loss on available for sale securities $25,000 CR Valuation account, Williams Co. $25,000

4) DR Unrealized loss on available for sale securities $15,000 CR Valuation account, Gores Co. $15,000

Year 2 Journal Entries:

5) DR Unrealized loss on trading securities $ 5,000 CR Valuation account, Smith Co $ 5,000

6) DR Valuation account, Jones Co. $10,000 CR Unrealized gain on trading securities $10,000

7) DR Cash $255,000 DR Valuation account, Jones Co. 25,000 DR Realized loss on available for sale security 15,000 CR Unrealized loss on available for sale security 25,000 CR Available for sale security, Williams Co. 270,000

8) DR Valuation account, Gores Co. $30,000 CR Unrealized gain on available for sales security $30,000

9) DR Held to maturity security, Martin Co. $1,400,000 CR Cash $1,400,000

10) DR Impairment Loss $ 150,000 CR Held to maturity security, Martin Co. $ 150,000

Solution 1. Cost Method The investor (Big) accounts for the investment using the cost method if the investor does not have the ability toexercise significant influence over the investee. Even though Big owns over 20% of Small, the remaining stock isowned by one individual and control would be retained by the majority shareholder and his family who controls theBoard. 2. Consolidation The partnership is a variable interest entity for the following reasons:

1. The activities of the partnership are conducted on behalf of Big2. Big's voting rights are small in proportion to the focus of the partnership on Big, and3. Big's voting rights (20%) are out of line with Big's variable interest in the partnership ($20,000,000 /

$25,000,000 = 80%).

Big is the primary beneficiary of the partnership/VIE and must consolidate the partnership/VIE. 3. Equity Method The equity method is used if the investor can exercise significant influence over the investee and holds 50% orless of the voting stock. At December 31, Year 1, Big is the largest shareholder of Little Ladies and controls theBoard of Directors. The stock ownership percentage, which is now 28%, is a guideline that would reinforce thecorrect answer; however, the control supersedes the ownership percentage. 4. Consolidation The investor should prepare consolidated financial statements whenever the investor has control (over 50%ownership) of the subsidiary. Big would consolidate the operations of Shared into their consolidated financialstatements. Even though Big consults with and gets input from the 49% shareholder, there is nothing in the factsof the question that would imply that Big does not have control. 5. Consolidation Because Big owns over 50% of the stock of Petite, it has control of Petite and should consolidate Petite’soperations into its consolidated financial statements. A different location, different industry, different year end,and no daily business relationship would not change the control as a result of majority investment.

1. $369,000; $39,000 Under the equity method, the investment is originally recorded at the price paid to acquire the investment.

DR Investment in Rhodes $330,000CR Cash $330,000

The investment is subsequently adjusted as the net assets of the investee change through the earning ofincome and payment of dividends. The investment account increases by the investor's share of the investee'snet income. Barnes' Year 1 share of Rhodes' income is calculated as follows: Rhodes' net income $150,000 Percent owned by Barnes 30% Share of income before adjustment $ 45,000 Amortization of higher equipment values ($100,000 x 30% ÷ 5 years) ($ 6,000) Equity in 30% of Rhodes' income) $ 39,000

DR Investment in Rhodes $ 39,000CR Rhodes (investee) income $ 39,000

Investment in Rhodes = $330,000 + $39,000 = $369,000Rhodes (investee) income = $39,000 2. $6,600; $9,000 Barnes should record the 10% stock dividend received from Rhodes with a memorandum entry that reduces theper share cost of the Rhodes stock owned. Barnes will still own 30% of Rhodes after the stock dividend. Barnes' Year 2 share of Rhodes' income is calculated as follows: Rhodes' net income $50,000 Percent owned by Barnes 30% Share of income before adjustment $ 15,000 Amortization of higher equipment values ($100,000 x 30% ÷ 5 years) ($ 6,000) Equity in 30% of Rhodes' income $ 9,000

DR Investment in Rhodes $ 9,000CR Rhodes (investee) income $ 9,000

The distribution of dividends by Rhodes reduces the investment balance on Barnes' books by $2,400 ($8,000 x30%).

DR Cash $ 2,400CR Investment in Rhodes $ 2,400

Neither the earnings or dividends of Barnes affect the investment or income account.

Investment in Rhodes = $9,000 - $2,400 = $6,600 Rhodes (investee) income = $9,000

U.S. GAAP - $220,000; $450,000

Under U.S. GAAP, the full goodwill method is required. Under the full goodwill method, goodwill is the differencebetween the fair value of the subsidiary and the fair value of the subsidiary's net assets:

Acquisition price paid by Billy for 70% of Wheels $1,050,000 Fair value of 100% of Wheels ($1,050,000 ÷ 70%) $1,500,000

Book value of Wheels' net assets $ 900,000Fair value adjustment - land 100,000 Fair value adjustment - inventory 80,000 Fair value of in-process R&D 200,000Fair value of Wheels' net assets $1,280,000

Full Goodwill Method = $1,500,000 - $1,280,000 = $220,000

Under the full goodwill method, noncontrolling interest is the fair value of the subsidiary times the noncontrollinginterest percentage:

Noncontrolling Interest = $1,500,000 x 30% = $450,000

IFRS - $154,000; $384,000

Under the IFRS partial goodwill method, goodwill is the difference between the acquisition price and the fairvalue of the subsidiary net assets acquired.

Acquisition price paid by Billy for 70% of Wheels $1,050,000 Book value of Wheels' net assets $ 900,000 Fair value adjustment - land 100,000 Fair value adjustment - inventory 80,000 Fair value - in-process R&D 200,000 Fair value of Wheels' net assets $1,280,000

Fair value of Wheels net assets acquired = $1,280,000 x 70% = $896,000

Partial Goodwill = $1,050,000 - $896,000 = $154,000

Under the partial goodwill method, noncontrolling interest is the fair value of the subsidiary's net assets timesthe noncontrolling interest percentage:

Noncontrolling Interest = $1,280,000 x 30% = $384,000

Explanation:

SITUATION 1

The gain or loss on the intercompany sale of a depreciable asset is unrealized from a consolidated financialstatement perspective until the asset is sold to an outsider. An elimination entry in the period of the saleeliminates the intercompany gain/loss and adjusts the asset and accumulated depreciation to their originalbalance on the date of sale:DR Gain on sale 40,000CR Accumulated depreciation 15,000CR Depreciation expense 5,000CR Equipment 20,000

Gain on Sale, $40,000 Debit

Since Peterson sold the equipment to Silver, a 100% subsidiary, the gain of $40,000 is eliminated. It wasoriginally entered in the books of Peterson as a credit and is calculated as the sales price of the asset of$120,000, less the net book value of $80,000 ($100,000 cost less accumulated depreciation on 1/1/Y3 of$20,000).

Accumulated Depreciation, $15,000 Credit

The accumulated depreciation for the consolidated group at December 31, Yr 3 is based on the original cost of$100,000. Three years of accumulated straight line depreciation is $30,000.

The accumulated depreciation shown by the separate companies is as follows:

$0 for Peterson since the accumulated depreciation was removed as part of the journal entry recorded atthe time of the sale.

$15,000 for Silver Corp., based on one year of straight-line depreciation ($120,000/8 years).

The eliminating journal entry raises the accumulated depreciation from $15,000 to the correct amount of $30,000.

Depreciation Expense, $5,000 Credit

The correct amount of depreciation expense for Year 3 is $10,000 based on the original purchase of the asset byPeterson ($100,000 cost to Peterson / 10 years = $10,000). Silver Corp. recorded depreciation of $15,000 basedon their purchase of the asset at the beginning of Year3 ($120,000 cost to Silver / 8 years = $15,000).

The eliminating journal entry reduces the depreciation from $15,000 to the correct amount of $10,000.

Equipment, $20,000 Credit

The original cost of the equipment to Peterson is $100,000. The $120,000 cost of the asset to Silver must bereduced to the original amount paid by Peterson.

SITUATION 2

When affiliated companies sell inventory to one another, the total amount of the intercompany sale and cost ofgoods sold is eliminated when preparing consolidated financial statements. In addition, the intercompany profitmust be eliminated from the ending inventory and cost of goods sold of the group.DR Sales 50,000CR Inventory 8,000CR Cost of goods sold 42,000

Sales, $50,000 Debit

The gross sale amount of Peterson's sale to Silver is eliminated.

Inventory, $8,000 Credit

40% of the goods sold by Peterson are still in the ending inventory of Silver. The original cost of this inventory onPeterson's books was $12,000 ($30,000 x 40%). The inventory is on Silver's books at the cost to Silver of $20,000($50,000 x 40%).

The reduction of inventory adjusts the $20,000 inventory on the books of Silver to the correct amount of $12,000,the original cost to Peterson.

Cost of Goods Sold, $42,000 Credit

The entire amount of Peterson's cost of goods sold is eliminated. This amount is $30,000.In addition, Silver's cost of sales is based on the price paid to Peterson for the inventory. The additional cost Silverpaid is $20,000 ($50,000 intercompany sales price - $30,000 cost of goods sold). The amount that was soldrepresents 60% of $20,000, so that another $12,000 needs to be eliminated to show the cost of goods sold basedon the original cost to Peterson.

1. Eliminate investment in subsidiaryJournal entry:

DR Common stock $600,000

DR Additional paid-in capital 100,000

DR Retained earnings 50,000

CR Investment in subsidiary $1,760,000

DR Plant & equipment $950,000

DR Goodwill 60,000

Remember to use the CARINBIG mnemonic to ensure that you eliminate all the appropriate accounts:

Common stock – Eliminate the par value of the common stock of the subsidiary at the date of the acquisition;the par value of the common stock is taken directly from the trial balance.

Additional paid-in capital – Eliminate the additional paid-in capital of the subsidiary at the date of acquisition;the additional paid-in capital is taken directly from the trial balance.

Retained earnings – Eliminate the retained earnings of the subsidiary at the date of acquisition; amount istaken directly from the trial balance.

Investment – Eliminate the Parent Company's investment in Subsidiary.

Noncontrolling Interest – In this instance, it is not applicable as it was a 100% acquisition.

Balance sheet adjusted to fair value – Increase or decrease the book value of the subsidiary's plant andequipment to equal its FV.

Identifiable intangible assets recorded at fair value – No identifiable intangibles are identified in this problem.

Goodwill – Establish a goodwill account as necessary.

2. Record incremental increase in depreciation

Journal entry:

DR Depreciation expense $316,667

CR Accumulated depreciation $316,667

Additional depreciation is calculated as follows:

Fair value adjustment to equipment $950,000Useful life (divide by) 3Annual depreciation $316,667

3. Record adjustments to goodwill

Journal entry:

DR Impairment expense $2,000

CR Goodwill $2,000

The goodwill suffered a $2,000 impairment according to the situation tab. Goodwill is not amortized.

4. Eliminate intercompany transactions associated with the income statement

Journal entry:

DR Dividend income from subsidiary $10,000

CR Dividends paid $10,000

Eliminate intercompany transactions associated with the income statement. The only income statement

related intercompany transaction is the payment of the dividends by the subsidiary.

5. Eliminate intercompany transactions associated with the balance sheetJournal entry:

DR Intercompany payable $30,000

CR Intercompany receivable $30,000

Eliminate intercompany transactions on the balance sheet. The only intercompany transaction is thepayable and receivable as identified in the facts.

Source of answer for this question:

FASB ASC 323-30-25-1

Keyword: Unincorporated joint ventures

Solution

Adjustments AmountsBalance per Bank $9,225 Deposits in transit 8,400 Outstanding checks (11,550) Incorrect check amount (450) Actual Cash Balance - March 31 $5,625 Balance per Books $3,640 Bad check (265) NSF check fee (30) Credit card processing fee (1,240) Fee rebate 20 April rent check 3,500Actual Cash Balance - March 31 $5,625

Deposit in transit - 8,400: The deposit of $8,400 made on March 31st was correctly posted to the accounting records inMarch and is processed and recognized by the bank in April.

Outstanding checks - (11,550): Check #21063 is correctly shown as a disbursement by the company in March and shouldclear in April. If the check has still not cleared by the end of April, the company may want to consider further investigation.

Incorrect check amount - (450): The check to the farmer’s market was correctly recorded by the company. The bankcashed the check for the incorrect amount and will remit the $450 shortfall to the payee in April. This amount reduces theactual cash balance in the bank reconciliation.

Bad check - (265): The bad check of $265 deposited by the company has not been recorded and should be adjusted on thebooks in March.

NSF fee - (30): The NSF fee of $30 has not been recorded and should be adjusted on Gemini ’s books in March.

Payroll withdrawal: The payroll withdrawal was made by the payroll service in March. The company also properlyrecorded the withdrawal in March, so no adjustment is necessary.

Credit card processing fee - (1,240): The credit card processing fee is $1,240 ($62,000x2%). The amount was deducted bythe bank as the deposits were being made. Because it has not yet been recorded on the books of the company, Geminineeds to reduce the cash balance by $1,240.

Fee rebate - 20: The fee rebate of $20 is an addition to the books of the company on March 31st.

April rent check - 3,500: Since the rent check is still in the possession of Gemini Markets as of March 31st, the companyhas incorrectly shown this amount as a reduction of the bank balance. The check amount should be added back to cash. The rent check is not an outstanding check at March 31st since it was not sent or delivered in March.

Solution and Explanation

A) $1,570,000

The purchase price of the inventory is reduced by the $30,000 discount that the company received. The freight inon the shipment of $100,000 is added to the cost of the inventory purchased.

B) $750,000

Since the goods were shipped FOB shipping point, title passes to the buyer when the common carrier picks upthe goods to be shipped. The goods are included in Party Supply ’s inventory until they are in the possession ofthe common carrier.

C) ($3,500,000)

The average cost of sales is 70% (one minus the gross margin, ie 30%) of the sales price. Since sales forDecember were $5,000,000, the cost of sales would be $3,500,000.

D) $210,000

Since the inventory was in the possession of Party Supply at December 31 and not transferred to the shipper, thegoods are still part of the inventory of the company.The sale of $300,000 needs to be removed from the accounting records and the $210,000 cost of the sale (70% x$300,000) is reversed and the goods restored to inventory.

E) ($25,000)

In a consignment arrangement, Party Supply includes the goods in their inventory until such time that the goodsare sold to a third party. When the original shipment was made, there was no change in the company ’sinventory. Since 25% of the goods were sold before the end of the year, inventory is reduced by $25,000.

F) $20,000

The amount of goods stored in the public warehouse is already included in the inventory total. Shipping costsbetween the warehouses is considered to be an inventory cost. The rent on the warehouse is a period expenseand is not part of inventory.

G) ($46,000)

Inventory is reduced to the lower of cost or market and any probable loss sustained is recorded in the period inwhich the loss occurred. The amount of the loss is measured as the difference between the cost of $50,000 andthe realizable value net of selling costs of $4,000.

Solution

Part 1:

Machinery and Equipment ScheduleDescription Amount

Opening Balance - January 1, Year 2 190,000Molding machine 36,000Replacement motor 16,000Super DP 54,000Sale of old drill press (40,000)Ending Balance - December 31, Year 2 256,000

The opening balance consists of $150,000 for the precision tooling machine and $40,000 for the drill press, for a total of$190,000 .

The molding machine is recorded at the cost of $36,000.

The replacement motor for $12,000 and the installation of $4,000 are added as fixed assets since the motor significantlyincreases the usefulness of the machine, for a total of $16,000. The maintenance agreement is not considered to be a fixedasset. The payment at the front end of the agreement would be a prepaid expense, not a fixed asset.

The Super DP is recorded at the cost of $54,000.

The old drill press is removed from the fixed asset schedule at the asset ’s original cost of $40,000.

Part 2:

Asset Description

DepreciationBase

UsefulLife

AnnualDepreciation

DepreciationYear 2

Tooling Machine $120,000 5 $24,000 $24,000Drill Press 40,000 5 8,000 6,000Molding Machine 36,000 9 4,000 3,000Replacement motor 16,000 4 4,000 2,000Maintenance Agreement 0 Super DP 54,000 4 13,500 3,375

Total Depreciation Expense $38,375

The tooling machine has a depreciation base of $120,000 (the cost of $150,000 less the salvage value of $30,000). The assethas a useful life of 5 years, so the depreciation for the entire year is $24,000 ($120,000/5).

The drill press has a depreciation base of $40,000 and a useful life of 5 years, so the annual depreciation is $8,000($40,000/5). Since the asset was sold in September, 9 months of depreciation are taken. The amount of depreciation is$6,000 ($8,000 x 9/12).

The molding machine has a depreciation base of $36,000 and a useful life of 9 years, so the annual depreciation is $4,000($36,000/9). The amount of depreciation from April through December is $3,000 ($4000 x 9/12).

The replacement motor has a depreciation base of $16,000 and a useful life of 4 years, which is the remaining life of thetooling machine on which the motor was installed. The annual depreciation is $4,000 ($16,000/4) and the depreciation fromJuly through December is $2,000 ($4,000 x 6/12).

There is no depreciation on the maintenance agreement because it is not a fixed asset.

The Super DP has a depreciation base of $54,000 and a useful life of 4 years, so the annual depreciation is $13,500 and thedepreciation from October through December is $3,375 ($13,500 x 3/12). The change in the estimated useful life of the assetwas determined in Year 2 and should be used to calculate the depreciation for Year 2.

Tax depreciation is not considered when calculating depreciation on the books of the company.

Part 3:

Accumulated Depreciation ScheduleDescription Amount

Opening Balance - January 1, Year 2 16,000Depreciation expense 38,375Sale of old drill press (12,000) Ending Balance - December 31, Year 2 42,375

The opening balance consists of $10,000 on the precision tooling machine and $6,000 on the drill press, for a total of$16,000.

The depreciation expense of $38,375 is the calculated total from the previous schedule.

The old drill press is removed from the accumulated depreciation account at the cumulative amount of depreciation takenon the asset when it was sold. The accumulated depreciation is $6,000 through Year 1 and an additional $6,000 for Year 2,for a total of $12,000.

Explanation:Construction period interest should be capitalized (based on the weighted average of accumulated expenditures)as part of the cost of producing fixed assets.Weighted average of accumulated expenditures for year 2: $360,000The weighted average amount of accumulated expenditures (WAAE) for year 2 is calculated as follows: $130,000 1/1-3/31/Y2 3 months $ 390,000 $370,000 4/1-9/30/Y2 6 2,220,000 $570,000 10/1-12/31/Y2 3 1,710,000 $4,320,000/12 months Weighted average of accumulated expenditures $360,000

Interest incurred for all borrowings for year 2: $67,000The interest expense is calculated as follows: $300,000 Loan 12% $36,000 $100,000 10% 10,000 $300,000 7% 21,000 Total interest for the year $67,000 All loans were payable throughout Year 2.

Avoidable interest for year 2, $40,650The amount of avoidable interest is the interest that would not have been incurred if the construction project hadnot taken place: Interest on construction note borrowings: $300,000 construction note x 12% = $36,000 Interest on other borrowings used for construction: Total WAAE $360,000 Less: Construction note funds (300,000) Other borrowings used for construction 60,000Weighted-average interest rate on other borrowings: ($10,000 + $21,000)/($100,000 + $300,000) = 7.75% Interest on other borrowings used for construction = $60,000 x 7.75% = $4,650 Avoidable interest = $36,000 + $4,650 = $40,650

Interest capitalized for Year 2, $40,650Capitalized interest cannot exceed the actual interest incurred for the period. The capitalized interest for year 2is $40,650 because the avoidable interest of $40,650 is less than the interest incurred of $67,000. Interest expense for Year 2, $26,350The interest expense is the amount to be shown on the income statement and is the difference between the totalinterest of $67,000 and the capitalized interest of $40,650.

1. $600,000

Cash paid $ 800,000Mortgage assumed 200,000Total purchase price 1,000,000Allocation to building 60%Cost of building $ 600,000

Note: Although the valuation on the realty tax bill is not used for financial statement purposes, the realtytax bill is often the best evidence available for obtaining the allocation percentages for land and building.

2. $370,000 In an exchange that lacks commercial substance, record the asset received on the balance sheet as the

net book value (NBV) of the asset surrendered, minus any boot received (or plus any boot paid) in thetransaction, plus any gain recognized (or minus any loss recognized) on the transaction. In this case, arealized gain of $130,000 exists [$450,000 - $320,000], but it is not reported (recognized) because cashwas paid in an exchange that lacks commercial substance (i.e., the gain is deferred). NBV of asset surrendered $320,000Boot paid 50,000Recorded amount of new land (doesnot exceed FV of $500,000) $370,000

Journal entry:

DR New Land $370,000CR Cash $ 50,000CR NBV of old land 320,000

3. $315,000Exchanges of nonmonetary assets should be categorized into one of two groups: those which have"commercial substance" and those which lack "commercial substance." If the exchange lacks commercialsubstance, boot is received and a gain is realized, a portion or all of the gain will be reported (recognized). In this case, boot received is less than 25% of the total consideration received, so a proportional gain isrecorded, as follows: $50,000 / $500,000 = 10%

Realized gain = $500,000 Fair value received

(350,000) NBV on Club's books

$150,000

Reported (recognized) gain = $150,000

x 10%

$15,000

Journal entry:

DR Cash $ 50,000DR New land 315,000CR NBV of old land $350,000CR Gain on exchange 15,000

Balance sheet:

NBV of asset surrendered $350,000

Less: Boot received (50,000) Add: Gain recognized 15,000 $315,000

1. $90,000

Rule: Salvage value is subtracted from cost under the straight-line method to arrive at depreciable base.

Cost of machine $864,000

Estimated salvage value (144,000)

Depreciable base $720,000

Depreciation each year (divided by 8) $ 90,000

2. $162,000Rule: Double declining balance method is at twice the straight-line rate (in this case twice 12.5% or 25%). However,DDB does not subtract salvage value to arrive at depreciable base. Thus, cost is the depreciable base.

Cost of machine $864,000

Depreciation Year 1 (at 25%) (216,000)

Net book value at beginning of Year 1 $648,000

Depreciation Year 2 (at 25%) $162,000

3. $140,000

Rule: Salvage value is subtracted from cost under the sum-of-the-years'-digits method to arrive at depreciable base. The denominator for the SYD fraction is 36 (1 + 2 + 3 + 4 + 5 + 6 + 7 + 8).

Cost of machine $864,000

Estimated salvage value (144,000)

Depreciable base $720,000

Year 2 fraction x (7/36)

Depreciation expense for Year 2 $140,000

4. $120,000

Rule: Salvage value is subtracted from cost under the units of production method to arrive at depreciable base.

Cost of machine $864,000

Estimated salvage value (144,000)

Depreciable base $720,000

Year 2 fraction x (300,000/1,800,000)

Depreciation expense for Year 2 $120,000

Source of answer for this question:

FASB ASC 360-10-35-17

Keyword: Measurement of impairment loss

The $12,000 receivable deemed uncollectible because the customer declared bankruptcy should be written-off(debit the allowance and credit AR) and the $5,000 receivable collected but not removed from AR should berecognized as a cash receipt (debit cash and credit AR). This will reduce the AR balance in the "over 90 days"aging category due to the ages of these balances. After these adjustments, the allowance for doubtfulaccounts can be calculated using the new aging percentages, as follows:

Total 0-30 days 31-60 days 61-90 days Over 90AR 677,000 225,000 240,000 127,000 85,000Adjustments (17,000) 0 0 0 (17,000)Adjusted AR 660,000 225,000 240,000 127,000 68,000Estimated % 3% 11% 25% 62%Allowance 107,060 6,750 26,400 31,750 42,160

Bad debt expense is calculated as follows: Beginning allowance $62,000- Write-offs (31,000)+ Recoveries 4,000Allowance before adjustment $35,000Bad debt expense 72,060Ending allowance $107,060 The bad debt expense is recorded with the following JE: DR Bad debt expense 72,060CR Allowance for doubtful accounts 72,060

1. Capitalize and depreciate

The cost of the parking lot is to be capitalized and depreciated over its useful life consistent with thematching principle. The asset is a physical asset used in a trade or business with a useful life greater thanone year.

2. Expense at time incurred

The cost of painting the ceiling tiles and hallways should be expensed as incurred as it is maintenance toan existing asset and is ordinary repair and maintenance expense.

3. Capitalize and depreciate

The cost of replacing the cooling system with a more modern fuel efficient model should be capitalized anddepreciated over its useful life. The accounting entry would be to remove the original cost and relatedaccumulated depreciation of the old unit and capitalize the replacement and depreciate it accordingly.

4. Capitalize and depreciate

The cost of the 15 new computers should be capitalized and depreciated over their useful lives consistentwith the matching principle. These assets are physical assets used in a trade or business with a useful lifegreater than one year.

5. Capitalize and amortize

The cost of this intangible asset should be capitalized and amortized over its useful life of 5 yearsconsistent with the matching principle.

6. Expense at time incurred

The cost of replacing the windows should be expensed as ordinary repair and maintenance expense. Thisis not treated as an extraordinary repair, which would be capitalized if the life of the asset is extended or theefficiency is improved.

Capitalized cost of the land: $404,000The cost of land includes: Purchase price, brokers commissions, title and recording fees, legal fees, clearingbrush and trees, site development, cost of demolition of existing building, less any proceeds from the sale ofexisting building, timber, etc. Land improvements are excluded from the cost of land as they are depreciableassets and land is not.

Purchase priceDemolition of existing structures on propertyProceeds from the sale of scrap from the old building on the siteLegal fees incurred to purchase the property and paid at settlement

Capitalized cost of the land

$325,000120,000(65,000) 24,000

$404,000

Capitalized cost of warehouse: $316,000The capitalized cost of the warehouse includes the interest incurred during the construction period per FASBASC 835.20.25.3. Construction period interest should be capitalized (based on the weighted average ofaccumulated expenditures) for buildings, machinery or land improvements constructed by the company.

Interest incurred from 3/15 through 8/31Total cost of labor, materials, and overhead to construct thewarehouse

Capitalized cost of warehouse

$ 11,000 305,000

$316,000

Capitalized cost of new machine: $41,800The capitalized cost of the new machine includes all cost necessary to acquire the machine and get it to thelocation and condition for its intended use. These costs include: invoice price less discounts, freight in,installation charges, sales and excise taxes and interest during construction period.

Finance charges on a loan to purchase the machine are expensed as finance expense.

Cost of machineSales tax paid on machineInstallation cost

Capitalized cost of new machine

$36,0002,100

3,700$41,800

1. Depreciation expense using straight-line method

The formula to calculate depreciation using the straight line method of depreciation is to take thedepreciable base (cost less salvage) and divide it by the estimated useful life. In this question the cost ofthe equipment includes the purchase price of $43,600 and the $3,400 cost to install it. Thus annualdepreciation is calculated as:

Step 1: (($43,600 + 3,400) - $6,000) / 8 years

Step 2: ($47,000 - 6,000) / 8 years

Step 3: $41,000 / 8 years = $5,125

Once the annual depreciation is calculated, simply multiply it by the % of the year the unit was in servicefor the given year. In this question you would multiply the $5,125 by 75% for Year 1 and by 100% for Year2.

Year 1: ¾ year ($5,125 x 75%) = $3,844

Year 2: Full year ($5,125 x 100%) = $5,125

2. Depreciation expense using double declining balance method

The formula to calculate depreciation using the double declining balance is double the straight line ratewithout consideration of salvage value. The first year's rate is applied to the NBV and in succeeding years,the same percentage is applied to the remaining book value. Once the annual depreciation is calculated,simply multiply it by the % of the year the unit was in service for that given year. No allowance is made forsalvage value because the method always leaves a remaining balance, which should never be belowsalvage.

Year 1: 75% x $11,750 = $8,813

Year 2: (25% x $11,750) + (75% x $8,813) = $9,547

Year Double SL% NBVDepreciation

Expense Year 1 Year 2

1

2

25%

25%

$47,000

$35,250

$11,750

$8,813

75% 25%

75%

Furniture sold gain or loss recognized: ($300)

The calculation to determine the gain or loss is a two step calculation. First, calculate the NBV by taking theoriginal cost less accumulated depreciation. Then subtract the NBV from the sales price to get the gain orloss.

Original cost of the furnitureAccumulated depreciationNet book value

Sale priceLess NBVLoss on sale

$13,000(11,500)$ 1,500

$ 1,200 (1,500) ($300)

Pickup truck exchange gain or loss recognized: $-0-

In an exchange of received non-monetary assets lacking commercial substance, gains are not recognized if noboot (cash) is received.

Equipment destroyed gain or loss recognized: $1,000

The calculation to determine the gain or loss is a two step calculation. First calculate the NBV by taking theoriginal cost less accumulated depreciation. Then subtract the NBV from the insurance proceeds received toget the gain or loss.

Original cost of the equipmentAccumulated depreciationNet book value

Insurance proceedsLess NBVGain on sale

$17,500 (3,500)

$14,000

$15,000 (14,000)$ 1,000

Source of answer for this question:

FASB ASC 835-20-50-1

Keyword: Capitalization of interest

Compounding Periods - Principal (cell B2): 10The bond is a 5-year bond that pays interest semi-annually, so the number of compounding periods is equal to10 (5 years x 2 interest payments per year = 10 periods).

Compounding Periods - Interest (cell B3): 10The bond is a 5-year bond that pays interest semi-annually, so the number of compounding periods is equal to10 (5 years x 2 interest payments per year = 10 periods).

Interest Rate - Principal (cell C2): 0.040The market rate of interest on the date the bond was issued was 8%. Because the bond pays interest semi-annually, the semi-annual market rate of 4% (8% annual rate / 2 interest payments per year = 4%) is used tocalculate the present value of the principal payment.

Interest Rate - Interest (cell C3): 0.040The market rate of interest on the date the bond was issued was 8%. Because the bond pays interest semi-annually, the semi-annual market rate of 4% (8% annual rate / 2 interest payments per year = 4%) is used tocalculate the present value of the interest payments.

Payment Amount - Principal (cell D2): $1,000,000The principal payment amount is the $1,000,000 face amount of the bond. This is the amount that would havebeen paid to investors on the maturity date of December 31, Year 5 if the bonds had not been called on June 30,Year 2.

Payment Amount - Interest (cell D3): $50,000The semi-annual interest payment is calculated using the 10% stated rate and not the 8% market rate:

Interest payments = Face amount x Stated rate (semi-annual) = $1,000,000 x (10%/2) = $50,000

Note: The following cells calculate automatically.

Present Value - Principal (cell F2): $675,560The present value of the principal is found using the following formula:

D2 x E2 = $1,000,000 principal x 0.67556 PV factor = $675,560

Present Value - Interest (cell F3): $405,545The present value of the interest is found using the following formula:

D3 x E3 = $50,000 interest payment x 8.11090 PV factor = $405,545

Bond Issue Price (cell F4): $1,081,105Bond issue price = $675,560 PV principal + $405,545 PV interest = $1,081,105

Bond Issue Price (cell F2): $1,081,105The bond issue price of $1,081,105 was calculated in the "Bond Issue Price" tab (cell F4).

Dates of Interest Payments (cells A3 - A12)The bond pays 10 semi-annual intetest payments beginning on June 30, Year 1. The interest payment datesare:

06/30/Y112/31/Y106/30/Y212/31/Y206/30/Y312/31/Y306/30/Y412/31/Y406/30/Y512/31/Y5

Formula for Cell B3 - Interest Payment - 6/30/Y1: 0.05 x G2The interest payment of $50,000 is equal to the face amount of the bond (cell G2) times the semi-annual statedrate of 5% (10% stated rate / 2 interest periods per year).

Formula for Cell C3 - Interest Expense - 6/30/Y1: 0.04 x F2The interest expense of $43,244 on 6/30/Y1 is the beginning carrying amount of the bond (cell F2) times thesemi-annual market rate of 4% (8% market rate / 2 interest periods per year).

Formula for Cell D3 - Decrease in Carrying Amount of Bonds - 6/30/Y1: C3 - B3The $6,756 decrease in the carrying amount of the bonds on 6/30/Y1 is the difference between the interestexpense of $43,244 (cell C3) and the interest payment of $50,000 (Cell B3).

Formula for Cell E3 - Unamortized Premium - 6/30/Y1: E2 + D3The unamortized premium of $74,349 on 6/30/Y1 is the sum of the $81,105 unamortized premium on 1/1/Y1(cell E2) and the $6,756 decrease in the carrying amount of the bond (cell D3).

Formula for Cell F3 - Carrying Amount of Bonds - 6/30/Y1: F2 + D3The $1,074,349 carrying amount of the bonds on 6/30/Y1 is the sum of the beginning carrying amount of$1,081,105 (cell F2) and the $6,756 decrease in the carrying amount of the bonds on 6/30/Y1 (cell D3).

Note: The resulting amortization table will be off by about $5.00.

Carrying Amount of DebtThe $1,060,016 carrying amount of the debt on June 30, Year 2. The carrying amount is equal to the$1,000,000 face amount of the bond plus the $60,016 unamortized premium. Payment Due at Call DateLyndhurst paid the bondholders a call price of 102, which is 102% of the face amount:

$1,000,000 x 102% = $1,020,000 Amount of Gain or (Loss)The gain is the difference between the carrying amount of the debt and the amount paid by the company to callthe bond:

$1,060,016 - $1,020,000 = $40,016 Indicate "Gain" or "Loss"Lyndhurst will report a gain because the amount paid to retire the debt is less than the book value of thedebt.

I = Increase D = Decrease N = No Effect

Transaction JournalEntries

Bonddiscount

Bondpremium

Bondspayable

Commonstock

Additionalpaid-incapital

Retainedearnings

1. Cash Discount

Bonds payable I N I N N N

2. Cash Bonds payable Premium N I I N N N

3. Bonds payable Premium

Common stockAdditional paid-incapital N D D I I N

4. CashDiscount

Bonds payableAPIC (stockwarrants) I N I N I N

5. Retained earnings Common stock Additional paid-incapital N N N I I D

1. Because the nominal interest rate is below market, the bonds will sell at a discount.2. The amount in excess of face is recorded as a premium. Under U.S. GAAP, no separate entry is made for

the convertibility feature because it is not separable from the bonds.3. Under the book value method (which is GAAP), the stock issued is valued at the book value of the bonds

being converted. There is no gain or loss recognized.4. The value of the warrants is credited to Additional paid-in-capital. Because the combination of bonds and

warrants were issued for an amount equal to the face amount of the bonds, the bonds without the warrantsmust be valued at a discount.

5. A stock dividend merely reclassifies amounts from Retained earnings to Common stock and APIC at the fairvalue on the declaration date.

Answers:

1. Record the journal entry for the issuance of the convertible bonds on January 1,Year 1. Select “no entry” if no journal entry is required on this date.

Account Debit CreditCash $ 825,500 Bond Issue Cost 50,000 Bonds Payable $ 800,000Premium on Bonds Payable 75,500

Explanation:

Cash is debited for $825,500 calculated as follows:

Bonds $800,000 (800 bonds X $1,000)

Bond Premium 75,500

Bond Issue Costs (50,000)

Cash $825,500

Bond issue cost is an asset amortized over the life of the bond. The premium isalso amortized over the life of the bond.

2. Record the journal entries on June 30, Year 1 to recognize interest expense andthe amortization of the bond issue cost for the first six months of Year 1.

Account Debit CreditInterest Expense $ 13,133 Premium on Bonds Payable 2,867 Cash $ 16,000

Account Debit CreditBond Issuance Expense $ 2,500 Bond Issue Cost $ 2,500

Explanation:

Bond interest paid (credit to cash) = $800,000 X .02 = $ 16,000.

Bond interest expense = $875,500 X 1.5% = $13,133.

Bond premium amortization = $16,000 - $ 13,133 = $2,867.

Record six months of bond issuance expense amortization = $50,000/20 periods =

$2,500.

3. Record the journal entries on December 31, Year 1 to recognize interestexpense and the amortization of the bond issue cost expense for the second half ofYear 1.

Account Debit CreditInterest Expense $ 13,090 Premium on Bonds Payable 2,910 Cash $ 16,000

Account Debit CreditBond Issuance Expense $ 2,500 Bond Issue Cost $ 2,500

Explanation:

Bond interest paid (credit to cash) = $800,000 X .02 = $ 16,000.

Bond interest expense = ($875,500 - $ 2,867) X 1.5% = $ 13,090.

Bond premium amortization = $16,000 - $ 13,090 = $2,910.

Record six months of bond issuance expense amortization = $50,000/20 periods =$2,500.

4. Assume that the bonds are converted on January 1, Year 2 and Acorn uses thebook value method to account for the conversion of bonds into common stock. Record the journal entry for the conversion.

Account Debit CreditBonds Payable $ 800,000 Unamortized Premium on BondsPayable

69,723

Common Stock $ 80,000Unamortized Bond Issue Costs 45,000Additional Paid In Capital 744,723

Explanation:

Bonds payable = $800,000 face value

Unamortized premium on bonds payable = $75,500 - $2,867 - $2,910 = $69,723

Unamortized bond issue costs = $50,000 - $2,500 - $2,500 = $45,000

Common stock at par value = 800 bonds x 5 shares/bond x $20.00 par value =$80,000

Additional paid in capital = $744,723 (squeeze)

5. Assume that the bonds are converted on January 1, Year 2 and Acorn uses themarket value method to account for the conversion of bonds into common stock. Assume the market price of the common stock on the date of conversion was $250.00 per share. Record the journal entry for the conversion.

Account Debit CreditBonds Payable $ 800,000 Unamortized Premium on BondsPayable

69,723

Loss on bond conversion 175,277 Common Stock $ 80,000 Unamortized Bond IssueCosts

45,000

Additional Paid In Capital 920,000

Explanation:

Bonds payable = $800,000 face value

Unamortized premium on bonds payable = $75,500 - $2,867 - $2,910 = $69,723

Unamortized bond issue costs = $50,000 - $2,500 - $2,500 = $45,000

Common stock at par value = 800 bonds x 5 shares/bond x $20.00 par value =$80,000

Common stock at market value = 800 bonds X 5 shares/bond X $250.00 marketvalue = $1,000,000

Additional paid in capital = $1,000,000 - $80,000 = $920,000

Loss on bond conversion is calculated as follows:

Market price of stock $1,000,000

Unamortized bond issue costs 45,000

Book value of Bonds ($869,723)

Loss $175,277

Source of answer for this question:

FASB ASC 470-20-40-16

Keyword: Convertible debt and inducement offer

PART 1:Amount Over(under)funded

Funded status – Plan A ($225,000) UnderfundedFunded status – Plan B $550,000 OverfundedFunded status – Plan C ($450,000) Underfunded

The funded status of a pension plan is calculated as:

Funded status = Fair value of plan assets – Projected benefit obligation

Funded status – Plan A = $1,900,000 – $2,125,000 = ($225,000) underfundedFunded status – Plan B = $2,500,000 – $1,950,000 = $550,000 overfundedFunded status – Plan C = $125,000 – $575,000 = ($450,000) underfunded

If the fair value of the pension plan assets exceeds the PBO, the pension plan is overfunded. If the PBO exceedsthe fair value of the pension plan assets, the pension plan is underfunded.

PART 2:Pension benefit asset – current $0Pension benefit asset – noncurrent $550,000Pension benefit liability – current $25,000Pension benefit liability – noncurrent $650,000

For balance sheet reporting purposes under U.S. GAAP, all overfunded pension plans are aggregated andreported in total as a noncurrent asset. Because Plan B is SuretoPass' only overfunded pension plan, thecompany will report a noncurrent pension benefit asset of $550,000. No current assets are reported under definedbenefit pension plan accounting rules.

Under U.S. GAAP, all underfunded pension plans are also aggregrated and reported as a current liability (to theextent that the expected benefits payable in the next 12 months exceed the fair value of the plan's assets), anoncurrent liability or both. SuretoPass has two underfunded pension plans: Plan A and Plan C. The total fundedstatus of these underfunded pension plans is $675,000 ($225,000 + $450,000). Because Plan C has plan assetstotaling $125,000, but expects to pay benefits of $150,000 in Year 2, SuretoPass must report a current pensionbenefit liability of $25,000 ($125,000 – $150,000) at 12/31/Year 1. The remaining $650,000 is reported as anoncurrent liability.

Solution:

1. $941,000

Service Cost-Year 5 $920,000 GivenInterest Cost 189,300 3,155,000 x 6%Return on Plan Assets (182,050) 3,310,000 x 5.5%Amortization of Prior Service Cost 13,750 275,000/20Amortization of (Gain)/Loss: 0 (See the note below)Pension expense $941,000

Note: There are two components of the amortization of gains/losses. The first component is the differencebetween actual versus expected returns (if expected returns are used to calculate pension expense). Thesecond component relates to any actuarial changes that result in gains or losses for the company.

While there is a difference between actual return versus expected return in Year 5, the actual difference will bebooked to other comprehensive income (OCI) at the end of Year 5 and subsequently amortized beginning inYear 6. Pension expense will not be impacted until amortization begins.

In terms of actuarial gains/losses, Look Ahead Co. has a balance in OCI for the unrecognized actuarial loss of$220,000 at the end of Year 4. This amount will be amortized using the corridor approach, which entailscomparing the unrecognized balance to a threshold equal to 10% of the greater of the fair value of plan assetsor the pension benefit obligation at the end of Year 4. For Look Ahead Co., the fair value of plan assets of$3,310,000 is greater than the pension benefit obligation of $3,155,000. 10% of $3,310,000 is $331,000, which isgreater than the unrecognized balance of $220,000. If the unrecognized balance is less than this 10%corridor (as it is here in Year 5), there will be no amortization.

2. $(33,100)

When a company uses the expected return on plan assets in calculating pension expense, a gain/loss willoccur if there is a difference between the actual return and the expected return. The company can choose toeither book this difference directly to the income statement in the period incurred or book it to othercomprehensive income and amortize it as part of pension expense.

For Look Ahead Co., the actual return of 4.5% is less than the expected return of 5.5%. As a result, LookAhead has a loss of $33,100 [$3,310,000 x (4.5% - 5.5%) = $(33,100)]. The company has chosen to recognizethis loss in the current period.

3. Decrease

Interest cost will decrease due to the decrease in the discount rate, resulting in pension expense decreasing.

4. Decrease

The increase in the average remaining service life will decrease the annual amortization of prior service cost,which will decrease pension expense.

5. Remain the Same

Since Look Ahead Co. uses the expected rate of return on plan assets, an actual rate of return lower than 4.5%will result in an even larger spread between actual versus expected return. This will increase the company ’spension loss, which will increase amortization beginning next year , but will have no impact on pension

expense in Year 5.

Solutions:

Part 1: Funded Status

Classification: Noncurrent AssetAmount: $105,000

Fair value of plan assets, 12/31/Y4 $975,000PBO 12/31/Y4 ($870,000)Funded Status $105,000

Under U.S. GAAP, all positive funded status pension plans are reported as noncurrent assets .

Part 2: Journal Entries

1. Contribution to the Plan

Account Debit CreditPension Benefit Asset 175,000 Cash 175,000

2. Service/Interest Cost

Account Debit CreditNet Periodic Pension Cost 158,600 Pension Benefit Asset 158,600Deferred Tax Asset 63,440 Deferred Tax Benefit – Income Statement 63,440

Calculations: Service Cost = $125,000 (given) Interest Cost = $840,000 x 4% = $33,600 Total = $125,000 + $33,600 = $158,600 Deferred Tax Asset = $158,600 x 40% = $63,440

3. Return on Plan Assets (expected)

Account Debit CreditPension Benefit Asset 41,400 Net Periodic Pension Cost 41,400Deferred Tax Expense – Income Statement 16,560 Deferred Tax Liability 16,560

Calculations: Return = $920,000 x 4.5% = $41,400 Deferred Tax Liability = $41,400 x 40% = $16,560

4. Amortization of Prior Service Cost

Account Debit CreditNet Periodic Pension Cost 19,000

Other Comprehensive Income 19,000Deferred Tax Benefit – OCI 7,600 Deferred Tax Benefit – Income Statement 7,600

Calculations: Amortization = $285,000/15 years = $19,000 Deferred Tax Benefit = $19,000 x 40% = $7,600

5. Gain (in the current period)

Account Debit CreditPension Benefit Asset 4,600 Other Comprehensive Income $4,600Deferred Tax Expense – OCI 1,840 Deferred Tax Liability 1,840

A gain is recognized in OCI because the actual return on plan assets exceeds the expected return.

Calculations: Gain = (5% - 4.5%) x $920,000 = $4,600 Deferred Tax Liability = $4,600 x 40% = $1,840

1. Temporary timing difference, liability, noncurrentTax return depreciation in excess of financial statement depreciation produces a financial statementasset basis greater than the tax basis. Since the tax benefit of the basis has already been used, theasset is balanced with a deferred tax liability. The difference will ultimately reverse since the asset willultimately be depreciated to zero. If applicable, deferred tax assets and liabilities are generally classified the same as the related asset orliability. Fixed assets are noncurrent. Accordingly, the deferred tax liability identified for this transactionis also noncurrent.

2. Temporary timing difference, asset, currentRevenues collected in advance and taxed at the time of receipt result in revenue recognition on the taxreturn in advance of revenue recognition on the financial statements. Since the company will ultimatelyrecognize financial statement revenue for which it will have already paid taxes, the financial statementsshould reflect a deferred tax asset. The difference will ultimately reverse in a subsequent period sincethe collected revenue will be recognized upon completion of the earnings process.If they do not relate directly to an asset or liability account, deferred tax assets and liabilities aregenerally classified in a manner consistent with the transaction that created them or when they areanticipated to reverse. For financial statement purposes, revenues will be recognized in the next periodand are, therefore, current. Accordingly, the deferred tax asset identified for this transaction is alsocurrent.

3. Permanent difference, no financial statement presentationTax exempt revenue is never recognized for tax purposes because the difference will never reverse. Thedifference is considered permanent and receives no deferred tax treatment.Permanent differences do not receive deferred tax treatment. The inclusions of noncurrent asset andnoncurrent liability selections in the popup window represent nonsense distracters.

4. Temporary timing difference, asset, currentWarranty expenses are accrued for purposes of financial statement presentation but only deducted on thetax return when paid. The existence of expenses recognized on the financial statements for which therewill be a later tax benefit (when paid) generates a deferred tax asset. Since the warranty expense willpaid out at some point, the difference will ultimately reverse and is considered temporary.If they do not relate directly to an asset or liability account, deferred tax assets and liabilities aregenerally classified in a manner consistent with the transaction that created them or when they areanticipated to reverse. The warranty expenses relate to one-year warranties that are expected to beincurred or paid out in the next period and are, therefore, current. Accordingly, the deferred tax assetidentified for this transaction is also current.

5. Temporary timing difference, liability, currentExpenses paid in advance and taxed at the time of payment result in expense recognition on the taxreturn in advance of cost expiration on the financial statements. Since the company will ultimatelyrecognize financial statement expense for which it will have already derived a tax benefit, the financialstatements should reflect a deferred tax liability to offset the prepaid expense asset. The difference willultimately reverse in a subsequent period since the collected cost will expire.If they do not relate directly to an asset or liability account, deferred tax assets and liabilities aregenerally classified in a manner consistent with the transaction that created them or when they areanticipated to reverse. Expenses prepaid for a year should be recognized in the next period and are,therefore, current. Accordingly, the deferred tax liability identified for this transaction is also current.

6. Temporary timing difference, liability, noncurrentEquity method accounting requires the parent company to account for undistributed earnings as revenue. Since subsidiary earnings are taxed at the time of distribution, revenue is recognized for book purposes inadvance of any tax liability. Undistributed earnings recognized by the parent corporation results in adeferred tax liability since the parent company, presumably, will ultimately receive distribution ofsubsidiary earnings and will incur a tax liability. The difference will ultimately reverse in a subsequentperiod since the parent has significant influence over the subsidiary's operations and will requiredistribution of earnings.If they do not relate directly to an asset or liability account, deferred tax assets and liabilities aregenerally classified in a manner consistent with the transaction that created them or when they areanticipated to reverse. These undistributed earnings will be paid to the parent over multiple years (greaterthan one-year in the future) and are, therefore, noncurrent. Accordingly, the deferred tax liability identifiedfor this transaction is also noncurrent.

7. Temporary timing difference, asset, noncurrent

Organizational expenses are immediately recognized for purposes of financial statement presentation butare amortized for tax purposes over multiple years. The existence of expenses recognized on thefinancial statements for which there will only be a later tax benefit (when amortized) generates a deferredtax asset. Since the organizational expense will be fully amortized at some point, the difference willultimately reverse and is considered temporary.If applicable, deferred tax assets and liabilities are generally classified the same as the related asset orliability. Organizational costs amortize over multiple years and are, therefore, noncurrent. Accordingly,the deferred tax asset identified for this transaction is also noncurrent.

8. Permanent difference, no financial statement presentationKey man life insurance premiums are never recognized for tax purposes so the difference will neverreverse. The difference is considered permanent and receives no deferred tax treatment.Permanent differences do not receive deferred tax treatment. The inclusions of noncurrent asset andnoncurrent liability selections in the popup window represent nonsense distracters.

1. Increase financial statement tax expenseIdentification of a deferred tax asset for which all or a part of the asset will not be realized will result in thecreation of a valuation account, decreasing the asset and increasing financial statement income taxexpense.

2. Increase financial statement tax expenseA deferred tax asset will only be realized if there will be future taxable income to which to apply a taxbenefit. The absence of future earnings will cause the company to create a valuation allowance andthereby increase financial statement tax expense.

3. Decrease valuation allowanceThe potential that a deferred tax asset, previously allowed for, no longer requires a valuation allowance willcause the company to reverse the valuation allowance, thereby restoring the asset and decreasingfinancial statement tax expense.

PART 1

Row 5: Allowance for doubtful accounts

$21,000 | $6,930 | Ø

For GAAP purposes, Stanhope accounts for bad debts using the allowance method and has an Allowance forDoubtful Accounts of $21,000. For tax purposes, the direct write-off method is used and no allowance isrecorded. Therefore, there is a $21,000 ($21,000 GAAP allowance - $0 tax allowance) temporary differencebetween GAAP accounting and tax accounting. This $21,000 temporary difference represents future write-offsthat will be deducted for tax purposes when the write-offs actually occur. Future tax deductions result in deferredtax assets.

The deferred tax asset to be reported is equal to the total temporary difference times the enacted future tax rate,which is the company's effective tax rate of 33%:

Deferred tax asset = $21,000 x 33% = $6,930

Row 6: Accumulated depreciation, excess of tax over GAAP

$767,000 | Ø | $253,110

A temporary difference exists because Stanhope is using the straight-line method for GAAP purposes andaccelerated methods for tax purposes. Because tax depreciation exceeds GAAP depreciation, this temporarydifference results in a deferred tax liability. The total temporary difference of $767,000 is equal to the differencebetween the GAAP accelerated depreciation of $1,510,000 and the tax accelerated depreciation of $2,277,000. The deferred tax liability is equal to the total temporary difference times the company's effective tax rate of 33%:

Deferred tax liability = $767,000 x 33% = $253,110

Row 7: Unrealized gain (loss) on trading securities

$8,000 | Ø | $2,640

A temporary difference exists because unrealized gains of $8,000 have been recognized in net income for GAAPpurposes, but for tax purposes, the gains will not be recognized as taxable income until the securities are sold. Because the gains represent future taxable income, the $8,000 temporary difference results in a deferred taxliability.

The deferred tax liability is equal to the total temporary difference times the company's effective tax rate of 33%:

Deferred tax liability = $8,000 x 33% = $2,640

PART 2

Under U.S. GAAP, deferred tax assets and deferred tax liabilities are classified as current or noncurrent based onthe following criteria:

1. Deferred tax items should be classified as current or noncurrent based on the classification of the relatedasset or liability for financial reporting purposes.

2. Deferred tax items not related to an asset or liability should be classified as current or noncurrent based onthe expected reversal date of the temporary difference.

Deferred taxes, current asset: $4,290

The $6,930 deferred tax asset related to the allowance for doubtful accounts is classified as current becauseaccounts receivable is a current asset. The $2,640 deferred tax liability related to the unrealized gain on tradingsecurities is classified as current because trading securities are (generally) classified as current. GAAP requiresthat current deferred tax assets be offset against current deferred tax liabilities and presented as one amount. Therefore, a net current deferred tax asset is reported on the balance sheet:

$6,930 current DTA - $2,640 current DTL = $4,290 current DTA

Deferred taxes, noncurrent liability: $253,110

The $253,110 deferred tax liability related to tax accumulated depreciation in excess of GAAP accumulateddepreciation is classified as a noncurrent deferred tax liability because fixed assets as classified as noncurrent.

Source of answer for this question:

FASB ASC 740-10-35-4

Keyword: Changes in tax laws or changes in tax rates

Source of answer for this question:

FASB ASC 740-10-45-15

Keyword: Change in tax rates

Row 3 - Issuance of shares for property:The number of shares issued and outstanding increases by the 13,000 shares issued in the exchange. The exchange is recorded at the marketvalue of the shares issued:

DR Land $169,000 (13,000 shares x $13/share)CR Common stock $13,000 (13,000 shares x $1 par)CR Additional paid in capital 156,000

Row 4 - Purchase of treasury stock:The treasury stock purchase reduces the number of shares outstanding by 21,000. Under the cost method, the repurchase is recorded as follows:

DR Treasury stock $252,000 (21,000 shares x $12/share)CR Cash $252,000

Row 5 - Property dividends distributed:Property dividends are recorded at the fair value of the property distributed, which requires the recognition of a $10,000 inventory loss ($55,000 FV -65,000 BV) at the time the dividend is declared. This loss is included in Quonset ’s net income for year 2.

DR Retained earnings $55,000 DR Loss on inventory 10,000 CR Inventory $65,000

Row 6 - Stock dividend issued:Generally, a small stock dividend (< 20-25% of shares outstanding) is recorded at the market value of the stock on the date the dividend is declared. However, as no market value is provided, the stock dividend must be recorded at par value. The total shares issued in the dividends is equal to 15%of the shares outstanding on July 1st: 15% x (850,000 + 13,000 - 21,000) = 126,300.

DR Retained earnings $126,300 (126,300 shares x $1 par)CR Common stock $126,300

Row 7 - Cash dividend:The total shareholders of record on December 15th equal 968,300 (850,000 + 13,000 - 21,000 + 126,300).

DR Retained earnings $968,300 (968,300 shares x $1 par)CR Dividend payable $968,300

Row 8 - Net income: Given Row 9 - Unrealized gain/loss on marketable securities classified as available-for-sale:The unrealized gain is booked to other comprehensive income:

DR Available-for-sale securities $95,000 CR Other comprehensive

income $95,000

1. Reissue 2,000 shares at $12.00 per share on January 15, Year 3

DR Cash $24,000CR Treasury stock $20,000CR APIC, treasury stock 4,000

2. Reissue 2,000 shares at $7.00 per share on October 13, Year 3

DR Cash $14,000DR APIC, treasury stock 4,000DR Retained earnings 2,000CR Treasury stock $20,000

The increase to cash is computed as follows:

Reissued shares $ 2,000Reissue price per share x 7 Debit to cash $14,000

Elimination of previous treasury stock transaction "gains" accounted for through additional paid-in capitalscheduled from the previous entry:

APIC, treasury stock $ 4,000

Accounting for any unabsorbed treasury stock loss through retained earnings after elimination of additionalpaid-in capital, treasury stock:

Treasury stock cost $ 20,000Cash received (14,000)Preliminary loss 6,000Previously recognized gains through APIC, treasury stock (4,000)Net loss to be accounted for through retained earnings $ 2,000

The elimination of treasury stock at cost is as follows:

Treasury stock $ 2,000Cost of reacquisition x 10 Credit to treasury stock $20,000

Treasury stock is valued at cost and eliminated at cost upon reissue.

3. Retire 1,000 shares on November 5, Year 3

DR Common stock $ 5,000DR Additional paid-in capital 10,000CR Treasury stock $10,000CR APIC, treasury stock 5,000

Retirement of par value of common shares computes as follows:

Retired common shares $1,000Par value x 5

Debit to common stock $5,000

Retirement of par value of common shares computes as follows:

Retired common shares $ 1,000

Original selling price $ 15Par value (5)APIC in excess of par, per share x 10 Debit to APIC $10,000

The elimination of treasury stock at cost is as follows:

Treasury stock $ 1,000Cost of reacquisition x 10 Credit to treasury stock $10,000

Treasury stock is valued at cost and eliminated at cost upon reissue.

Recognition of additional paid-in capital for retirement:

Valuation of original issue

Common stock at par per share $ 5 Additional paid-in capital per share 10 Total original cost $ 15Treasury stock at cost (10)APIC from stock retirement per share 5Number of shares retired x 1,000 Additional paid-in capital from retirement $ 5,000

Additional paid-in capital from retirement may be computed on a per share basis, as per above, or simplyplugged to bring the journal entry into balance.

Bayshore Industries, Inc.STATEMENT OF CASH FLOWS

For the year ended December 31, Year 2

Cash flows from operating activities:

Net income/loss 1,772,000Depreciation and amortization expense 447,700

Increase/decrease in trade receivables - net (1,463,000)Increase/decrease in inventory (594,000)Increase/decrease in prepaid expenses (18,000)

Gain/loss on property and equipment disposals (18,000)Increase/decrease in accounts payable and accrued expenses 475,800

Net cash provided by operating activities 602,500Cash flows from investing activities:

Purchases of property and equipment (400,000)

Proceeds from plant and equipment disposals 58,500Net cash used in investing activities (341,500)

Cash flows from financing activities: Proceeds from/repayment of line of credit 18,000

Repayment of long-term debt (27,000)Dividends paid (180,000)Net cash used by financing activities (189,000)

Net increase (decrease) in cash and cash equivalents 72,000Supplemental disclosures:

Interest paid 250,000Cash paid for income taxes 700,000

1. An indirect method statement of cash flows always starts with net income/loss. For this question, netincome is obtained from the statement of income and retained earnings. For other questions, it might haveto be calculated from an analysis of the retained earnings account, but that is not necessary for thisquestion because the amount is given.

2. Almost all indirect method statements of cash flow have a depreciation and amortization "add-back." Depreciation (and amortization) is sometimes given; for this question, it must be calculated, and it iscalculated from the accumulated depreciation from the balance sheets, the disposal of the equipment fromthe other information, and the information about amortization. The starting point is an Account AnalysisFormat of the accumulated depreciation account, as follows:

Beginning balance = $455,000 (from the Year 1 balance sheet)Add: Depreciation expense = plug (works out to be $440,500)Subtract: Disposal of building = (319,500) (from the additional information)Ending balance =$576,000 (from the Year 2 balance sheet)

For this question, the statement requires both depreciation and amortization. Amortization can bedetermined from the accumulated amortization balances from the balance sheets as $7,200 ($28,800 -$21,600). The total depreciation and amortization add back is thus $447,700 [$440,500 + $7,200].

Remember that depreciation and amortization are always add-backs under the indirect method becausethey were subtracted to get to net income in the first place. Now that we are working backwards from netincome for the statement of cash flows, they are added.

3. The next few line items on this indirect method statement of cash flows are differences in current assetsand liabilities. For this question, we can start with the change in accounts receivable, which is an increaseof $1,463,000 (identified directly from the given balance sheets). The next question is whether an increasein accounts receivable should be added or subtracted, and there are many different ways to rememberwhether to add or subtract. The one we will use for this question relates back to depreciation. Depreciationis a decrease in the balance of an asset. Depreciation is added back. A decrease in accounts receivablewould thus also be added back. An increase in accounts receivable, like the $1,463,000 in this question,

would be subtracted from net income to arrive at net cash provided by operations. Other increases anddecreases in current assets would work the same way.

Think about it this way: Cash is a debit balance account generally, correct? And, the balance sheet alwaysbalances (at least it should, and it always will on the CPA exam!). Therefore:

• If an account that generally has a debit balance is increased, then the net balance sheet effect oncash must be a decrease.

• If an account that generally has a debit balance is decreased, then the net balance sheet effect oncash must be an increase.

• If an account that generally has a credit balance is increased, then the net balance sheet effect oncash must be an increase.

• If an account that generally has a credit balance is decreased, then the net balance sheet effect oncash must be a decrease.

In short,

• A change in a debit balance account has the OPPOSITE effect on the net balance of cash.

• A change in a credit balance account has the SAME effect on the net balance of cash.

If you use another method to remember whether to add or subtract, use it. But you do need some methodso that these types of questions are easily answered by you on the CPA exam. The Becker Financial textdiscusses other methods in lecture F7.

4. The next line item is the change in inventory, which is an increase of $594,000 from the balance sheet. Anincrease in inventory (an asset and generally a debit balance account) would be subtracted, just like theincrease in accounts receivable.

5. The next line item is the change in prepaid expenses, which is an increase of $18,000 from the balancesheets. An increase in prepaid expenses (an asset generally a debit balance account) would besubtracted, just like the increases in accounts receivable and inventory.

6. The next line item is the gain or loss on disposal of property and equipment. For this question, the $18,000amount can be obtained from the income statement. For other questions, it might have to be calculated(original cost of $360,000 less accumulated depreciation of $319,500 = net book value of $40,500; the gainis the proceeds of $58,500 less net book value of $40,500 = $18,000). For this question, we verified theamount (and there was only one such disposal). Note that we really did not have to verify (as it was givento us), but we have done this for illustrative purposes.

Gains on disposals are subtracted because they were added to get to net income in the first place. Lossesare added because they were subtracted to get to net income in the first place. (It is a coincidence that the$18,000 for this line item is the same as the $18,000 for line item 10 and also, as will be discussed later,the $18,000 from the line of credit.)

Note: You have likely memorized that, for the indirect method, gains and losses are adjustments to netincome to arrive at net cash provided by operations, but they did enter into the net income calculation andthey may also have been a 100% cash transaction (i.e., a cash gain or loss). So, why are they adjustedout? Well, they are NOT from operations, right? And, the statement of cash flows also presents a sectionon investing activities. The total proceeds from the disposal of the asset must be shown in the investingactivities section. If the gain (or loss) were not adjusted out of the operating section, then the statementwould not balance if the entire proceeds were used in the investing section.

7. The next line item is the change in accounts payable and accrued expenses. These accounts are typicallycredit balance accounts. As discussed above in item (8), a change in a credit balance account has thesame net effect on the balance of cash. For this question, there is an increase of $475,800 from thebalance sheets. Therefore, the adjustment to net income to arrive at net cash provided by operations is toadd the increase (again, with assets, an increase is subtracted; with liabilities, an increase is added). Thatis the end of the operating activities section.

8/9. Not used.

10/11.

The next section is the investing activities section. Investing activities include buying something orinvesting in something. For this question, property and equipment was purchased, and property andequipment was sold. Purchases and sales must be reported separately (not netted). The calculationrequires another Account Analysis Format, this time, of the property and equipment account, as follows:

Beginning balance = $7,740,000 (from the Year 1 balance sheet)

Add: Acquisitions of equipment = plug (works out to be $400,000)Subtract: Disposal of building = (360,000) (from the additional information)Ending balance = $7,780,000 (from the Year 2 balance sheet)

Nothing else has to be done, except to realize that the cash flow from the disposal of the equipment is the$58,500 proceeds (obtained from the additional information). That is the end of the investing activitiessection.

12. Not used.

13. The next section is the financing activities section. Financing activities include borrowing, paying back,and buying/selling the company's own equity (and other equity transactions). For example, they includeobtaining financing, either from inside investors (stockholders) or from outside investors (creditors, etc.). For this question, there is an increase in the line of credit (which is short-term debt). More money wasborrowed, and it brought in $18,000 of cash flows to the company from financing activities (a positivenumber on the statement of cash flows).

14. Financing activities include borrowing, paying back, and buying/selling the company's own equity (andother equity transactions). For example, they include obtaining financing, either from inside investors(stockholders) or from outside investors (creditors, etc.). For this question, there is a $2,000 increase inthe current portion of long-term debt and a $29,000 decrease in long-term debt. The net decrease is a$27,000 decrease, so it is $27,000 of cash flows used for financing activities to pay down the debt (anegative number on the statement of cash flows).

15. Financing activities include borrowing, paying back, and buying/selling the company's own equity (andother equity transactions). For this question, there is no change in common stock or additional paid-incapital, so no stock was issued. However, there were dividends paid (information obtained from thestatement of income and retained earnings). The $180,000 dividends are cash flows out of the companyfrom financing activities, or paying the dividends to those who have invested in the company (a negativenumber on the statement of cash flows). That is the end of the financing activities section.

16. Not used.

17. For an indirect method statement of cash flows, there is always a supplemental disclosure of interest paid.(Note: interest paid is an amount that most readers of financial statements want to know. In the directmethod of the statement of cash flows, this amount is disclosed in the operations section as a separateline item; however, this is not the case on the indirect method, so a supplemental disclosure is required.) The interest expense from the income statement is $252,000, but it is the interest "paid" that is disclosedon the statement of cash flows. Often, it has to be calculated, but in this question, the $250,000 was givenin the additional information.

18. For an indirect method statement of cash flows, there is always a supplemental disclosure of income taxespaid. (Note: income taxes paid is an amount that most readers of financial statements want to know. Inthe direct method of the statement of cash flows, this amount is disclosed in the operations section as aseparate line item; however, this is not the case on the indirect method, so a supplemental disclosure isrequired.) The provision for income taxes from the income statement is $759,700, but it is the incometaxes "paid" that are disclosed on the statement of cash flows. Often, it has to be calculated, but in thisquestion, the $700,000 was given in the additional information.

The list was explained in the order in which the examiners provided the answers. There is no necessary orderto the items within each of the sections (operating, investing, and financing). The items have to be within thecorrect section, however.

The statement of cash flows is divided into three categories that display the sources and uses of cash and cashequivalents:

Operating – This section displays the cash effects of the line items that make up the calculation of netincome.

Investing – This section displays the cash effects of non-current asset transactions, such as purchasesand sales of fixed assets and investments and lending activities.

Financing – This section displays the cash effects of borrowing, or paying back debt, and buying or sellingthe equity of the company.

Solutions:

1. Operating activity

2. Investing activity

3. Investing activity

4. Financing activity

5. Financing activity

6. Operating activity

7. Financing activity

8. Operating activity

9. Operating activity

10. Financing activity

1. No Effect. Depreciation is an expense that does not require any outlay of cash. Depreciation expense for agiven year is added to net income under the indirect method. Under the direct method, the amount itself(and the change from one year to the next) is not a component of cash flow from operating activities.

2. Decrease. Taxes paid, whether current or deferred, are a cash flow from operations (CFO) outflow underthe direct method.

3. Increase. A decrease in accounts receivable implies that overall the company collected cash on itsoutstanding credit sales, which will be an increase in cash flow from operating activities.

4. No effect. Gains are subtracted from net income under the indirect method. Under the direct method,gains are not included in the calculation of operating cash flow.

5. Decrease. This is a CFO outflow. A decrease in accounts payable implies that the company made cashpayments on amounts owed to vendors during the period.

6. No effect. The sale of an AFS security (assuming it is a non-current asset) produces a cash flow frominvesting (CFI) inflow. Note that the loss itself would be an addition to net income under the indirectmethod. However, the loss is not a component of the direct method calculation of operating cash flow.

7. Decrease. An increase in a prepaid expense is a cash outflow which would decrease CFO under the directmethod. Cash is paid in advance for rent prior to the warehouse being occupied or used by the company.

8. No effect. This is a cash flow from financing (CFF) outflow, regardless of whether the call price is above,below, or at par.

9. Decrease. Interest payments for debt outstanding represent a CFO outflow.

10. Increase. Under U.S. GAAP, interest received on an investment is a CFO inflow, regardless of theclassification of the investment.

11. Increase. Cash received that is not earned is a CFO inflow. It will be booked as a liability until it is earned.

12. Decrease. $40,000 of cash refunded to customers for returned goods will be an actual cash outflow.

Cash flows from operating activities Cash received from customers 1,939,100 Cash paid to suppliers (1,302,600) Cash paid to employees (459,200) Interest received 1,700 Dividends received 1,600 Interest paid (7,900) Income taxes paid (26,200) Trading security purchased (10,200) Other operating cash paid (94,600) Net cash provided by operating activities 41,700

Additional detail:

Cash received from customers:Sales 1,950,000

Less Increase in Accounts Receivable (4,700)Less Decrease in Deferred Revenue (6,200)Cash Received from Customers 1,939,100

Cash paid to suppliers:COGS 1,295,000Plus Increase in Inventory 21,700Less Increase in Accounts Payable (14,100)Cash Paid to Suppliers 1,302,600

Cash paid to employees:Salaries and Wages Expense 460,400Less Increase in Wages Payable (1,200)Cash Paid to Employees 459,200

Interest paid is equal to interest expense because all bonds outstanding were issued at par.

Operating cash paid is the combination of prepaid rent of 49,000 and administrative expenses of 45,600.

Additional Information for the candidate:

Net cash provided by operating activities under the indirectmethod:

Net Income 58,900 Plus Depreciation 53,800

Less Increase in Accounts Receivable (4,700)Less Increase in Inventory (21,700)Less Increase in Marketable Securities (10,200)Less Increase in Prepaid Expenses (49,000)Plus Increase in Accounts Payable 14,100Less Decrease in Deferred Revenue (6,200)Plus Increase in Wages Payable 1,200Plus Increase in Deferred Taxes 3,000Plus Increase in Income Taxes Payable 2,500 41,700

Net cash used by investing activities under the direct and indirect method:Increase in Gross PP&E (92,000)

(92,000)

Net cash provided by financing activities under the direct and indirect method:Proceeds of Bond Issue 30,000Plus Proceeds of Stock Issue 50,400Less Dividends Paid (10,600) 69,800

Increase in cash and cash equivalents 19,500Beginning cash and cash equivalents 37,300Ending cash and cash equivalents 56,800

Record the journal entry and affected financial statements on the grant date, January 1, Year 1.

Account Debit CreditNo entry required

Explanation: No entry is required when stock options are granted. There is no effect on shareholder’s equity atthe time of issuance and compensation expense is not recorded because the right to use the options has not yetbeen earned.

Record the journal entries to recognize compensation expense for Year 1, Year 2 and Year 3.

December 31, Year 1:

Account

Debit Credit

Compensation expense – Stock options 50,000 Additional paid-in capital – Stock options 50,000

December 31, Year 2:

Account

Debit Credit

Compensation expense – Stock options 50,000 Additional paid-in capital – Stock options 50,000

December 31, Year 3:

Account

Debit Credit

Compensation expense – Stock options 50,000 Additional paid-in capital – Stock options 50,000

Explanation: As time passes, compensation expense is recorded. One third of the total value of the options onthe grant date is recognized each year as compensation expense based on the three year vesting period for theoptions. Additional paid in capital is credited for the same amount as the compensation expense.

Record the journal entry and affected financial statements assuming one half of the options were exercisedJanuary 1, Year 4

Account

Debit Credit

Cash (25,000 X $30) 750,000 Additional Paid in Capital–stock options 75,000 Common stock (25,000 X $1.00) 25,000Additional Paid in Capital 800,000

Explanation: The debit to cash is based on the number of options exercised times the exercise price. Previouslyrecorded additional paid in capital (refer to question #2) is reversed (debited). Common stock is credited based onthe number of shares purchased (25,000) times par value. The remainder is credited to additional paid in capital.

Assume the options not exercised on January 1, Year 4 expired on March 31, Year 4. Record the journal entryneeded on March 31, Year 4 to record expiration of the stock options. Select “no entry” if no journal entry isrequired on this date.

Account

Debit Credit

Additional Paid in Capital – stock options $ 75,000 Additional Paid in Capital – expired stockoptions

$75,000

Explanation: The entry reflects reclassification of the capital from additional paid in capital – stock options toadditional paid in capital – expired stock options because the stock options have expired.

Source of answer for this question:

FASB ASC 230-10-45-22

Keyword: Cash flows and investing activities

Source of answer for this question:

FASB ASC 230-10-45-3

Keyword: Cash flow per share

Source of answer for this question:

FASB ASC 718-50-25-1

Keyword: Share purchase plan, compensation expense

1. Credit other financing sources General obligation bonds of a municipality are a source of funds other than revenue. Thus the proper

account that should be credited is Other financing sources as follows:

DR CashCR Other financing sources

2. Debit encumbrances control When approved purchase orders are issued, they are recognized in the budgetary accounting system in

order to encumber the funds (to put aside funds for that specific use). The appropriate entry is as follows:

DR Encumbrance controlCR Budgetary control

3. Debit expenditures control When supplies are received that had previously been ordered through a purchase order, the encumbrance

entry is reversed and the cost of supplies is recognized as a liability through the following series of entries:

DR Budgetary controlCR Encumbrance controlDR Expenditures controlCR Vouchers payable

4. Debit expenditures control General fund salaries and wages are recognized as expenditures of the period incurred. The appropriate

entry is as follows:

DR Expenditures controlCR Vouchers payable

5. Credit interfund revenues The Internal Service Fund is appropriate for a department of a municipality that provides services to other

departments. It is a proprietary type fund. The Internal Service Fund is much like a commercial businessusing accrual accounting. When the fund invoices the other departments for services used, it recognizesthe billing as operating revenue using the following entry:

DR Due from other fundsCR Interfund revenues

6. Debit deferred inflows of resources Inflows from a grant are not recognized as revenue until the expenditures for the intended purpose of the

grant are incurred. Thus when revenue from a previously awarded grant is earned, the entry would be asfollows:

DR Deferred inflows of resourcesCR Grant revenues

7. Credit deferred inflows of resources When property taxes are collected in advance of the fiscal period, they are recognized as deferred inflows of

resources.

DR Cash

CR Deferred inflows of resources 8. Credit appropriations control When adopted, a budget is a binding legal document. Thus, the budget is recorded in the accounting

system of the municipality using the following journal entry:

DR Estimated revenuesCR Appropriation control

9. Credit tax anticipation notes payable Tax anticipation notes represent short term financing secured by the city's taxing authority. Cities use this

type of financing when the timing of tax collections creates a cash flow issue. When the taxes arecollected, the notes are then paid off.

DR CashCR Tax anticipation notes payable

10. Credit budgetary control Since the budget of a municipality is a legal document and recorded in the accounting system, any excess

of estimated inflows over estimated outflows is credited to budgetary fund balance using the followingjournal entry:

DR Estimated revenuesCR AppropriationsCR Budgetary control

1. Special revenue Special revenue funds are set up to account for revenues from specific taxes or other earmarked sources

that are restricted or committed to finance particular activities for a government.

2. Permanent Permanent funds are used to report resources that are legally restricted to the extent that income, and not

principal, may be used for purposes that support the reporting government's programs.

3. Enterprise Enterprise funds are set up to account for the acquisition and operation of governmental facilities and

services that are intended to be primarily self- supported by user charges.

4. Capital project Capital projects funds are set up to account for resources used for the acquisition or construction of major

capital assets by a governmental unit, except those financed by proprietary or fiduciary funds.

5. Internal service Internal service funds are set up to account for goods and services provided by designated departments on

a fee basis to other departments and agencies within a single governmental unit or to other governmentalunits.

6. Agency Agency trust funds account for resources in the temporary custody of a governmental unit. Fees are

accounted for as a liability to another fund.

1. Component unit – discrete

The Winter Woods Library District is a component unit since it fails the SELF test. The entity is notfinancially independent since its budget is approved by the city. Since the district does not meet therequirements of a blended unit (governing boards are inseparable or the entity serves the serves the primarygovernment nearly exclusively) the district is a discretely presented component unit.

2. Component unit – blended

The Summer Marsh School District is a component unit since it fails the SELF test. The entity is notfinancially independent since it has its budget approved by the city and it surrenders all excess fees to thecity. The district also meets the requirements for blended presentation since the city council and the districtgoverning board is one and the same. The school district will be a blended component unit.

3. Component unit – blended

The Building Authority was established by the City to serve only the City exclusively. The authority may aswell be a city department. It is a blended component unit.

4. Primary government

The Autumn County Hospital Authority passes the SELF test and subcontracts its responsibilities. It is aspecial purpose governmental unit, but it is a primary government that will have its own stand-alone financialstatements.

1. Non-reciprocal | Transfer

The monies transferred by the Tourist Development fund to meet debt service requirements that are fullyanticipated by the budget represent a non-reciprocal transaction (the Tourist Development fund will never getthe money back) and would be accounted for as a transfer in the fund financial statements.

2. Non-reciprocal | Eliminated

The monies transferred between governmental funds (the Tourist Development Fund and Debt Service Fund)would be within the same category (governmental activities) in the government-wide financial statements. Thetransaction is still non-reciprocal, but it would be eliminated in the government-wide financial statements toavoid grossing up activity.

3. Reciprocal | Revenue

Charges made by an internal service fund are reciprocal (the internal service fund expects to be paid inexchange for services) and would be accounted for as revenue in the fund financial statements.

4. Non-Reciprocal | Eliminated

The General Fund paid costs on behalf of another fund and was reimbursed. The expenditures should havebeen accounted for in the capital projects fund. The reimbursement transaction is non-reciprocal (the generalfund expects the money back) but the reimbursement will net to zero. It will be eliminated and not bedisplayed on the financial statements.

1. Fiduciary fund financial statementsFiduciary funds are excluded from government-wide presentations and presented as fund financialstatements only.

2. Required supplementary informationInfrastructure reporting under the modified approach will be displayed as required supplementaryinformation.

3. Consolidated with governmental activities in the government-wide financial statementsActivities of governmental fund types are consolidated into the governmental activities column of thegovernment-wide financial statements. Fund financial statements are reconciled to the government widetotals.

4. Consolidated with governmental activities in the government-wide financial statementsInternal service funds are typically consolidated with Governmental Activities in the government-widefinancial statements if the internal service fund exclusively supports governmental activities. Key InternalService Fund data are used as reconciling items between fund and government-wide financial statements.

5. Agency fundsSpecial assessments for which a governmental entity assumes no responsibility are accounted for in anagency fund.

6. Required supplementary informationBudgetary displays are generally included in the required supplementary information section of thegovernment's financial statements although they MAY appear in the fund financial statements.

7. Optional supplementary informationBudget presentations are required supplementary displays while computations of variances from budget areoptional.

8. Management's discussion and analysisManagement's discussion and analysis will include a separate discussion of significant variances frombudget. MD&A is considered required supplementary information.

9. Optional supplementary informationPresentation of details of non-major funds is optional and would normally be included in a combiningfinancial statement of non-major funds as part of optional supplementary information.

10. Required footnote disclosureThe entity's definition of measurable and available used for revenue recognition is a required footnotedisclosure.

Fund balance 5,000,000

Capital assets used in governmental activities 2,375,000

Accumulated depreciation on capital assets used in governmentalactivities (425,000)

Long term debt obligations issued to finance governmental projects (3,700,000)

Internal service fund net position 375,000

Proprietary fund net position -0-

Fiduciary fund net position -0-

Net position, governmental activities 3,625,000

To reconcile the Fund Balance of Governmental Funds to the Net Position of Governmental Activities on thegovernment-wide financial statements, follow the GALS BARE mnemonic.

For differences between fund financial statement fund balances and government wide financial statement netposition related to measurement focus:

• Add governmental fund balances.

• Add assets used in governmental activities NET of accumulated depreciation.

• Subtract liabilities (long-term) not recorded on the fund financial statements.

• Add/subtract internal service fund net position.

For differences between fund financial statement fund balances and government-wide financial statement netposition related to basis of accounting:

• Add additional accounts receivable associated with revenue recognized under accrual vs. modifiedaccrual basis.

• Subtract additional accounts payable associated with expenses recognized under accrual vs. modifiedaccrual basis.

Net change in fund balance 750,000

Capital outlay expenditures 350,000

Debt service expenditures - principal 80,000

Debt service expenditures - interest -0-

Proceeds from issuance of long-term debt (1,250,000)

Net revenue from enterprise funds -0-

Net revenue from internal service funds 15,000

Change in net position for fiduciary funds -0-

Depreciation on general governmental assets (175,000)

Change in net position, governmental activities (230,000)

To reconcile the change in Fund Balance of Governmental Funds to the change in Net Position of GovernmentalActivities on the government-wide financial statements, follow the GOES BARE mnemonic.

For differences between changes in fund balance per fund financial statements and changes in net position pergovernmental activities on government-wide financial statements related to measurement focus:

• Add governmental changes in fund balances.

• Subtract other financing sources associated with new debt proceeds or capital leases.

• Add expenditures related to capital outlay in excess of depreciation and add expenditures related todebt service principal.

• Add/subtract internal service fund change in net position activity.

For differences between changes in fund balance per fund financial statements and changes in net position pergovernmental activities on government-wide financial statements related to basis of accounting

• Add additional accrued revenue associated with earnings recognized under accrual vs. modified accrualbasis.

• Subtract additional accrued expenses recognized under accrual vs. modified accrual basis.

Receipts from Customers:Accounts Receivable – Beginning 45,000 Revenues 95,000 Accounts Receivable – Ending (75,000)Receipts from customers 65,000

Payments to Suppliers:Inventory –Beginning 21,000 Other Operating Expenses (10,000)Inventory -Ending (35,000)Cash payments to suppliers (24,000)

Payments to Employees:Accounts Payable – Beginning 17,250 Personal Services/Contracted Services Expenses 60,000 Accounts Payable – Ending (29,000)Payments to Employees>/td> 48,250

1. Temporarily restricted - capital outlayAssets provided to a not for profit organization that are restricted for a purpose that can be met by therecipient organization are classified as temporarily restricted. The temporary restriction for the purpose ofasset construction is termed Temporarily Restricted - Capital Outlay.

2. Not classified as net assetsResources provided in conjunction with a conditional pledge represent a refundable advance that is recordedas a liability and is not a portion of net assets. There is no value to classify.

3. Not classified as net assetsConditional promises provided to a not-for-profit organization do not represent a receivable revenue or netassets until the conditions are met. The promise to provide funding contingent upon securing operatingfunding is conditional and would not be recorded.

4. Temporarily restricted - timeUnconditional promises to pay over a period of time are generally classified as temporarily restricted as totime until collection.

5. UnrestrictedCash received by a not-for-profit organization for any appropriate purpose within the context of the missionis deemed to be unrestricted.

6. Temporarily restricted - capital outlayAn unconditional donor restricted pledge whose restrictions can be satisfied by the actions of a not-for-profitorganization are temporarily restricted.

7. Temporarily restricted - purposeAn unconditional donor restricted contribution whose restrictions can be satisfied by the actions of a not-for-profit organization are temporarily restricted.

8. Permanently restrictedAn unconditional donor restricted contribution whose use is restricted to the generation of revenue streamsis classified as permanently restricted.

1. No change in unrestricted or restricted classifications The designation by the hospital's board of directors does not affect the classification of the asset as

unrestricted. Only an external donor's stipulation can cause an asset to be designated as temporarily orpermanently restricted.

2. Increase in unrestricted revenues, gains and other support The revenue is derived from investments, which are designated by the Board of Directors for a specific use

(unrestricted assets), the revenue from these investments is also available for use at for use at the Board'sdiscretion. Therefore, this transaction represents an increase in unrestricted revenues, gains and othersupport.

3. Increase in temporarily restricted net assets In the period in which the contribution for plant expansion is received, the donation is reflected as an

increase in temporarily restricted net assets on the statement of activities.

4. Increase in unrestricted revenues, gains and other support When the funds received for building expansion are used to acquire a building, the statement of activities

reflects an increase in total unrestricted revenues, gains and other support (satisfaction of equipmentacquisition restriction), as well as a decrease in temporarily restricted net assets (net assets released fromrestriction).

5. Increase in unrestricted revenues, gains and other support Nonprofit organizations may record the fair value of donated services if the following conditions are met:

1) The service creates or enhances non-financial assets2) The service requires (S) specialized skills provided by individuals possessing those skills and would

(O) otherwise be purchased if not provided by donation and be (ME) measured easily. Donatedservices are recorded SOME of the time.

Accounting firm services meet the requirements for recording as unrestricted revenues, gains and othersupport.

6. Increase in permanently restricted net assets The investment has donor imposed restrictions on how the investment income is to be used. The

investment is classified as permanently restricted while investment income is classified as temporarilyrestricted until expended.

1. $89,000 Contribution revenue is equal to the FMV of the gift at the time of the contribution. The fair value at the time

of receipt is correct.

2. $6,500Investment income represents a combination of both interest received as well as changes in market value.

Earned $ 9,500FMV/receipt (89,000)FMV/year end 86,000Earnings less change in value $ 6,500

3. $115,000 Community Service, Inc. will classify expenses as program expenses and supporting expenses. Support

will be further analyzed as either administration or fund-raising. The candidate is required to classify variousexpenses given in the problem and to arrive at program expense as follows:

Donated reading material $ 7,500Instructor salaries 25,000Director of Community Activities 60,000Subtotal 92,500Building rental - Amount allocable to programs($30,000 x 75%)

22,500

Total $115,000

In arriving at this answer, candidates are required to ignore the value of volunteer services, properly classifythe expenses associated with specific fund raising appeals as general administration (in keeping with thepolicy described in the situation), distinguish between administrative and fund-raising expenses listed as“Other cash operating expenses”, properly classify interest expenses as administrative expense andrecognize that principal liquidations are irrelevant to expense classifications for purposes of not-for-profitfinancial statements.

4. $2,750General fund-raising expenses. Community services will classify expenses associated with printing andmailing pledge cards as general fund-raising expense.

5. $-0- Income on long-term investments - unrestricted. Community Services has no long-term investments -

unrestricted according to the situation. No income would be recognized.

6. $-0- Community Services received donated hours from concerned citizens to serve meals to the homeless. The

skill levels required for this task failed to meet revenue recognition criteria (SOME). Community Servicesneed not recognize any revenue for contributed voluntary services of the type described.

1. O - Cash flows from operating activities Increases in Unrestricted Net Assets would be treated in a manner consistent with net income in

commercial accounting applications. Operating transactions of this character would be classified as cashflows from operating activities for purposes of the Statement of Cash Flows.

2. O - Cash flows from operating activities Cash received with matching conditions attached should be deferred. Deferred items (CLAD) should be

classified as cash flows from operations.

3. I - Cash flows from investing activitiesAcquisition of property is classified as cash flows from investing activities consistent with commercialaccounting.

4. F - Cash flows from financing activities Payments on debt represent cash used for financing activity consistent with commercial accounting.

5. I - Cash flows from investing activitiesAcquisition of equity of another organization is an investing activity consistent with commercial accounting.

6. O - Cash flows from operating activities Dividend income represents an increase in net assets and would be treated like an increase in net income

consistent with commercial accounting as an operating activity.

7. O - Cash flows from operating activities Interest payments on a short-term bank loan would be accounted for in determining the increase or

decrease in net assets. This activity would be classified as operating on the Statement of Cash Flowsconsistent with commercial applications.

8. O - Cash flows from operating activities Interest earnings would be accounted for in the Statement of Activity as an increase in Net Assets in the

appropriate category defined by the original bequest. Increases in Net Assets of this character are similarto elements of net income accounted for as cash flows from operating activities in the Statement of CashFlows in a commercial application.

1. None impacted | No classificationNothing happens when we receive a conditional promise. There is no asset, no liability and certainly norevenue and related net asset recognition.

2. Asset; Liability | No classificationThe day care provider has an asset, cash, and a liability called a refundable advance. The accountsimpacted will be asset and liability. No revenue is recognized. No net asset classification is impacted.

Dr. Cash $200,000 Cr. Refundable advance (liability) $200,000

3. Asset; Liability | Temporarily restrictedThe satisfaction of the condition makes the $200,000 refundable advance temporarily restricted net assets(we still need to build the day care center). The remaining $300,000 of the promise is recognized as areceivable and temporarily restricted revenue. So the liability is eliminated and we have assets andtemporarily restricted net assets.

Dr. Refundable advance $200,000 Dr. Pledge receivable 300,000 Cr. Revenue (temporarily restricted) $500,000

4. Asset | No classificationThe receivable becomes cash but it is still temporarily restricted until the building is built. The asset box ischecked because the pledge receivable decreases and cash increases (assets are impacted), but there isno change in total assets.

Dr. Cash $300,000 Cr. Pledge receivable $300,000

5. Asset | Unrestricted; Temporarily restrictedExpenditure of the temporarily restricted items on the day care construction required by the bequestcauses the temporarily restricted assets to be reclassified to Unrestricted.

Temporarily restricted net assets (note that temporarily restricted net assets decrease):

Dr. Temporarily restricted assets released $150,000 Cr. Temporarily restricted cash $150,000

Unrestricted

Dr. Unrestricted cash $150,000 Cr. Temporarily restricted assets released $150,000 Dr. Construction in progress $150,000 Cr. Unrestricted cash $150,000

1. $30,000

The legal services pass the SOME test. The attorney has a specialized skill, otherwise needed, that can bevalued. Barter will recognize revenue (and expense) in the full amount of $30,000.

2. $0

The volunteer services that provide companionship fail the SOME test. No specialized skills are required forthe work and, if not provided by volunteers, it would likely not be provided at all. Barter will not recognize anyrevenue or expense.

3. $25,000

Barter's revenues would include the value of the skilled carpenter since it passes the SOME test and thecarpenter "enhanced a physical asset." It would also include the unskilled labor associated with the projectsince the labor "enhanced a physical asset." Barter would recognize $25,000 in revenue ($13,000 +$12,000).

4. $100,000

The medical services pass the SOME test. They are partially defrayed ($20,000) so the revenue fromcontributed services would be $100,000 ($120,000 - $20,000).

Source of answer for this question:

FASB ASC 958-605-25-16

Keyword: Donated services

1. The underlying is $50/share.

2. The notional amount is 1,000 shares of ABC Company stock.

3. The initial net investment is the premium paid by XYZ of $1/share or $1,000.

4. The settlement amount is $50,000 ($50/share x 1,000 shares).

Settlement Options:

5. True

The option writer delivers 1,000 shares of ABC Company stock to XYZ in exchange for $50,000.

This is a settlement option for this option contract. The terms of the option allow XYZ to purchase 1,000shares of ABC stock from the option writer for $50,000 ($50/share).

6. True

The option writer can pay $10,000 to XYZ to settle the contract.

This is a settlement option for this option contract. Derivative instruments allow net settlement. In this case,the option writer must provide 1,000 shares of ABC stock to XYZ in exchange for $50,000. Because themarket price of the shares is $60,000 (1000 shares x $60/share market price) but the option writer has agreedto accept $50,000 from XYZ, the option writer has a loss of $10,000 on the option contract. Instead ofdelivering the actual shares to XYZ, the option writer can instead settle the contract by paying XYZ the$10,000. $10,000 is equal to the amount XYZ would realize if it paid $50,000 to the option writer for the 1,000shares and then sold those shares at the market price of $60/share.

7. False

The option writer has the option to pull out of the contract rather than incur a loss.

This is not a settlement option for this option contract. An option contract is called an option because thepurchaser (XYZ) has the "option" to not use the contract if the terms are unfavorable. For example, if themarket price of the ABC stock had stayed below $50 during the 30 days, then XYZ would not have exercisedthe option. The option writer does not have the "option" to pull out of the contract if the option terms becomeunfavorable. When the option writer sold the option to ABC, the option writer assumed the risk that it wouldincur a loss if the market price of ABC rose above $50 during the 30-day period.

1. The underlying is $1.44/£.

2. The notional amount is £100,000.

3. The initial net investment is $0. There is no initial net investment on forward contracts.

4. The settlement amount is $144,000 ($1.44/£ x £100,000).

Settlement Options:

5. True

XYZ receives $144,000 from the other party to the contract in exchange for £100,000.

This is a settlement option for this forward contract. The terms of the contract state that XYZ will deliver£100,000 and receive $144,000 (£100,000 x $1.44/£).

6. False

XYZ receives $152,000 from the other party to the contract in exchange for £100,000.

This is not a settlement option for this forward contract. The spot rate on the settlement date does notdetermine the amount XYZ will receive in exchange for the £100,000 under the forward contract. Because thespot rate of $1.52/£ is higher than the forward contract rate of $1.44/£, XYZ will actually get less for the£100,000 under the forward contract than XYZ would have received if XYZ had sold the £100,000 for the spotrate of $1.52/£ on February 28.

7. False

The other party to the contract pays $8,000 to XYZ.

This is not a settlement option for this forward contract. Although derivative instruments do permit a netsettlement, in this case the net settlement would be an $8,000 payment by XYZ to the other party to theforward contract. $8,000 represents XYZ's loss on the forward contract because under the contract termsXYZ must sell the £100,000 for $144,000 when the market value of the £100,000 is $152,000 (£100,000 x$1.52/£ spot rate). If XYZ makes the net settlement payment of $8,000 to the other party and then sells the£100,000 outside the contract for $152,000, the net amount XYZ will realize from the sale of the £100,000 willstill be $144,000 ($152,000 received - $8,000 paid on forward contract = $144,000).

1. Cash flow hedge | $0 | ($15,000)

The risk related to the variable-rate debt is that future interest payments (cash outflows) will increase asinterest rates increase. Therefore, the interest rate swap is a cash flow hedge in which the company receivesa floating rate of interest (essentially a reimbursement of the floating-rate interest paid on the debt) and pays afixed-rate of interest. This "converts" the floating-rate debt into fixed-rate debt. Because this is a cash flowhedge, the unrealized loss will be reported in other comprehensive income.

2. Fair value hedge | ($50) | $0

The risk faced by the company is that the fair value of the inventory will decrease. Therefore, the futurescontract is a fair value hedge and the gain on the futures contract will be reported in earnings, along with theoffsetting decrease in the fair value of the inventory for a net earnings impact of ($50) = $12,000 gain onderivative - $12,050 loss on inventory.

3. Foreign currency hedge of a net investment in foreign operations | $0 | $600

The risk faced by the company is that the value of the investment in the Japanese subsidiary will decrease asexchange rates change. Therefore, the forward contract is a foreign currency hedge of a net investment inforeign operations. Because the yen is the functional currency, the translation method is used to convert thesubsidiary's financial statements from the yen to the dollar and the cumulative translation loss is reported inother comprehensive income. The unrealized gain on the forward contract is also reported in othercomprehensive income, for a net impact on OCI of $600 ($100,000 gain on forward contract - $99,400cumulative translation loss).

1. November 1, Year 1

No journal entry.

2. December 31, Year 1

DR Cash flow hedge $60,000

CR Other comprehensive income $60,000

XYZ records a gain on the forward contract in OCI:

($79/barrel - $85/barrel) x 10,000 barrels = $60,000

A gain is recorded in OCI because XYZ has "locked in" the selling price of $85/barrel with the short positionin the forward contract and the forward price has fallen to $79/barrel.

3. January 31, Year 2

DR Cash flow hedge $80,000

CR Other comprehensive income $80,000

XYZ records a gain on the forward contract in OCI:

($71/barrel - $79/barrel) x 10,000 barrels = $80,000

A gain is recorded in OCI because the forward price has fallen from $79/barrel to $71/barrel and XYZ has ashort position in the forward contract.

DR Cash $140,000

CR Cash flow hedge $140,000

XYZ records the cash received from the net settlement of the cash flow hedge:

($71/barrel - $85/barrel) x 10,000 barrels = $140,000

4. February 1, Year 2

DR Accounts receivable $710,000

CR Sales revenue $710,000

XYZ records the sale of 10,000 barrels of oil for $71/barrel:

$71/barrel x 10,000 barrels = $710,000

DR Other comprehensive income $140,000

CR Gain on cash flow hedge $140,000

When the oil is sold, XYZ reclassifies the gain on the hedge from OCI to earnings. The net impact onearnings from the sales revenue plus the gain equals $850,000 ($710,000 + $140,000). The forward contractallowed XYZ to "lock in" the selling price of $85/barrel.

1. The asset (Asset Retirement Cost, ARC) is debited for $530,555, which is calculated as theestimated cost of $710,000 multiplied by the PV Factor of 0.74726 in order to discount it totoday’s dollars. The liability (Asset Retirement Obligation, ARO) is credited for the same$530,555.DR Asset Retirement Cost (ARC) 530,555CR Asset Retirement Obligation (ARO) 530,555

2. Accretion expense is calculated as the balance in the liability account multiplied by theaccretion rate. The beginning balance in the liability account is $530,555. Multiplying that by6% results in a Year 1 expense of $31,833 (rounded to the nearest dollar).

Year 1 Accretion Expense 31,833

3. There are two ways to derive the total accretion expense.

The fast way: Total estimated cost ($710,000) – Total depreciation ($530,555) = Total AccretionExpense ($179,445)The long way: Add individual accretion expenses for each of the five years .

Results for all five years are shown below:Year 1: 31,833.30 (530,555 x 6%)Year 2: 33,743.30 (530,555 + 31,833.30) x 6%Year 3: 35,767.90 (530,555 + 31,833.30 + 33,743.30) x 6%Year 4: 37,913.97 (530,555 + 31,833.30 + 33,743.30 + 35,767.90) x 6%Year 5: 40,186.53 [(530,555 + 31,833.30 + 33,743.30 + 35,767.90 + 37,913.97) x 6%] -2.28 (adjustment for rounding error)Total $179,445

Total Accretion Expense 179,445

4. Increase: The liability that is currently reflected at present value ($530,555) will be increasedevery year such that in 5 years, it will reflect the estimated asset retirement obligation of$710,000. The accretion rate of 6% is assessed every year on the liability that year, which isalways increasing.

5. Depreciation expense of $ 106,111 ($530,555 depreciated straight- line over 5 years) willbe booked, with an offsetting entry of $106,111 to accumulated depreciation. Accretionexpense of $31,833 (calculated earlier) will also be booked, with an offsetting increase to theARO liability account.

DR Depreciation Expense 106,111DR Accretion Expense 31,833CR ARO 31,833

CR Accumulated Depreciation 106,111

6. The balances are calculated as follows:

Accumulated Depreciation: 106,111 ($530,555/5)Net Asset Retirement Cost: 424,444 ($530,555 – $106,111)ARO: 562,388 ($530,555 + $31,833)

1. H - $2,250,000H Profit Distribution Total Partnership

Total Profit Y1 $4,000,000Guaranteed Bonus $400,000 (400,000) 10% X $4,000,000Interest on H Capital 600,000 (600,000) $30,000,000 X 2%= $600,000 Interest on J Capital (240,000) $12,000,000 X 2% = $240,000Interest on S Capital (360,000) $18,000,000 X 2% = $360,000Annual Salary to H 100,000 (100,000)Balance $1,100,000 $2,300,000Distribution of Remaining Profits:To H ($2,300,000 X 50%) $1,150,000Total Distribution to H $2,250,000

2. J - $800,000, S - $1,200,000, H - $2,000,000Adjusted Partnership Capital $80,000,000 ($60,000,000 + $20,000,000)20% of C Partnership Interest 16,000,000 ($80,000,000 X 20% interest)Amount Overpaid 4,000,000 ($20,000,000 - $16,000,000)Distribution per Profit/Loss %:J:(20% X $4,000,000) $800,000S:(30% X $4,000,000) $1,200,000H:(50% X $4,000,000) $2,000,000

3. J - $4,000,000, S - $6,000,000, H - $10,000,000, Goodwill - $20,000,000;

Determine Implied Value $100,000,000 ($20,000,000 X 5 = $100,000,000)Less: Total Capital Beg. Y2 80,000,000 ($12,000,000 + $18,000,000 + $30,000,000 + $20,000,000)Goodwill $20,000,000Existing Partners’ Capital:J Capital ($20,000,000 X 20%) $ 4,000,000S Capital ($20,000,000 X 30%) 6,000,000H Capital ($20,000,000 X 50%) 10,000,000

4. S - $26,500,000

Original S Capital Balance $18,000,000Add: Admission of Partner C 6,000,000Asset Adjustment of FMV to S Capital 2,500,000 ($110,000,000 -$100,000,000) X 25% Payoff to S Partner $26,500,000

Source of answer for this question:

FASB ASC 815-10-50-4C

Keyword: Derivative instrument gains

Source of answer for this question:

FASB ASC 450-20-25-8

Keyword: General loss contingency