2014ER FAR Simulations Solutions - PG PDF

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 = $48,000

Selling and administrative expense $1,212,500
Revised 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 be
frequent) 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] 37,500
Loss 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 loss
incurred due to the earthquake (which is a rare occurrence in the location of the plant) is considered an
extraordinary item and is reported net of tax.
Loss from earthquake $ (700,000)

Tax savings [30% x $700,000] 210,000
Extraordinary 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 as
an adjustment of the beginning balance of the earliest year presented.
2. Income from continuing operations

Settlement of material litigation is to be reported in the income from continuing operations section of the
income statement, as although it is likely an infrequent event, it is not considered unusual in nature.
3. Extraordinary items
A prohibition of a product line by the government would be deemed an extraordinary event in a business
under U.S. GAAP as it is certainly unusual in nature and happens infrequently. Note that IFRS prohibits the
recognition of gains and losses as extraordinary.

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

A change from the double-declining balance method of depreciation to the straight-line method of
depreciation is a change in accounting estimate effected by a change in accounting principle. This type of
change 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 simply
implemented, and the depreciation under the straight-line method is reported as expense in income from
continuing operations for the first quarter.
6. Discontinued operations
The results of operations of a component of an entity will be reported in the discontinued operations section
of the income statement if the component is deemed to have met all criteria for the "held for sale"
classification.

A loss from a major strike by employees, while infrequent and likely material, is not considered an
extraordinary event, as it is not unusual for a company's employees to go on strike. This loss would be
reported in the income from continuing operations section of the income statement.

In order for information to be presented as a component of discontinued operations in the income
statement, it must be information for a qualifying component of the business, which is the lowest level for
which operations and cash flows can be clearly distinguished, both operationally and for financial reporting
purposes, 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 continuing
operations section of the income statement.

Material flood damage to a building that is located in a flood plain that floods every two years is not
considered an infrequent or unusual event; therefore, the loss is reported in the income from continuing
operations section of the income statement.

A change in the service life of an asset is a change in estimate, which is implemented in the current year
and reported in the income from continuing operations section of the income statement.

When the extinguishment of long-term debt is a common management strategy of a company, the
transaction 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 income
statement.
12. Extraordinary items

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

A material write-down of inventory, while likely infrequent, is not considered unusual in nature for a
business; therefore, the loss cannot be reported in the extraordinary items section of the income
statement. The loss would be reported in the income from continuing operations section of the income
statement.
14. Discontinued operations

The results of operations of a component of an entity will be reported in the discontinued operations section
of 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 must
be 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 discontinued
operation 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 of
the segment at December 31, Year 1. Even though the division sold for a higher price in Year 2, the $2,500,000
represents 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 is
included 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 book
value 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 operations
x 30%). In Year 2, the company records income tax expense of $54,000 ($180,000 net gain from discontinued
operations 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 change
in 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 accounting
to a GAAP method of accounting is considered to be an error correction under GAAP. An error correction is
accounted for by restating all prior periods presented and adjusting the beginning retained earnings of the earliest
period 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 a
business combination. When Goose presents it consolidated financial statements that include Gosling, it will
restate any prior period financial statements presented for comparative purposes to also reflect the consolidation
of 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 principle
may be changed only if required by GAAP or if the alternative is preferable and more fairly presents the
information. A change in accounting principle is not acceptable if it done in order increase earnings and the stock
price 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, the
subsequent settlement is accounted for prospectively as a change in accounting estimate. Previous financial
statements are not restated.
Axl, Bruce, Diddy, and Elvis are reportable segments because they each have 10% of at least one of the
following criteria:
10% of Revenue Test Diddy, Elvis
An operating segment meets the size test if its reported revenue, including both sales to outsiders and
intersegment 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 in
excess 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 of
the greater, in absolute amount, of
1. The combined reported profit of all operating segments that did not report a loss
2. 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 x
10%). 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 external
revenue. 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 are
marked-to-market at period end with the unrealized gain or loss recorded in the other comprehensive income
account. 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 Income

The $65,000 related to the effective portion of the cash flow hedge would be recorded in other comprehensive
income. The ineffective portion of the cash flow hedge should have been reported in the income statement. The
company erroneously netted the effective and ineffective portions together with this amount reported in other
comprehensive income. To correct this error, (accumulated) other comprehensive income should be increased by
$13,000.
3. Correct
No adjustment is necessary. Under IFRS, the company can choose to use the cost or revaluation model. RC
selected the revaluation model and properly reported the $895,000 excess of fair value over carrying value as a
revaluation surplus in other comprehensive income.

RC properly recorded the actuarial gain in other comprehensive income in the prior fiscal year. Under IFRS the
actuarial 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.

The 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 is
a component of stockholders equity. To correct this error, (accumulated) other comprehensive income should be
increased 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 fiscal
year properly reflecting the $65,000 translation gain in other comprehensive income. Because the foreign
currency transaction was liquidated in the following quarter, it is proper to remove the prior translation gain
reported 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 the
balance sheet at December 31, Year 3. Individual corrections may affect only the three years of the income
statement, or they may go beyond that, in which case they affect the balance sheet. The keys to this kind of
question 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 be
done to correct or adjust what was done to what should have been done. The answers to these questions refer
to 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. It
would be difficult, if not impossible, to work a simulation this long in the "allotted" time on the exam. This
simulation 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 year
by entering the appropriate amount in the shaded cell." The adjustments/corrections are provided for you in the
"correction" line of the explanations.
QUESTION 1
This question deals with the incorrect recording of a sale. The company incorrectly accounted for the
transaction on the cash basis, overstating sales and income in Year 3, the year of receipt, and understating
sales and income in Year 2, the year of the proper accrual. As the receivable was collected prior to the Year 3
balance 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 and
decreased (debited) in Year 3 when the sales were actually (incorrectly) recorded.
INCOM E ST AT EM ENT YEAR 3 BAL ANCE SHEET

Year 1 Year 2 Year 3 Debit Credit
Original Accounting Sales (2,000)
C O R R EC T I O N (2,000) 2,000 -- --
Correct Accounting Accrued (2,000) -- -- --

sales
The "Correction" line is represented by the shaded line.
QUESTION 2
This question deals with the incorrect capitalizing of freight-out (covered in lecture F4). The company
inappropriately accounted for freight-out as an inventory item. Freight-out is a selling expense that should be
accounted for as a period cost at the time incurred. [Note that freight-in is a proper inventory cost.] The
company uses the FIFO method of inventory and maintains a safety stock equal to 50% of the current year
purchases. What this means is that only half of the current year purchases is sold each year; the other half of
the purchases carries over to the next year and is sold first (and shipped) in that year. For example, freight-out
for Year 1 was $50,000. The full $50,000 should have been expensed in Year 1, but it was not; only $25,000
was 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 of
goods sold that is recognized. The adjustment to each year's net income is the difference between the
accounting that should have occurred (expensing the entire amount) and the amount that had already been
recorded as cost of goods sold expense.
INCOM E ST AT EM ENT YEA R 3 BAL ANCE SHEET

Items to note:
Freight-out capitalized as 50,000 150,000 300,000 150,000
inventory
Original Accounting
Cost of goods sold, current 25,000 75,000 150,000
year
Cost of goods sold, prior year 25,000 75,000
C O R R EC T I O N 25,000 50,000 75,000 -- 150,000
Correct Accounting
Expense freight-out (period 50,000 150,000 300,000 -- 150,000
expense)
The correction is to add $25,000 of expense to Year 1. [Note that the "freight-out capitalized" line is just
information 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 means
that $100,000 was expensed when $150,000 should have been. The correction is to add $50,000 of
expense 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 means
that $225,000 was expensed when $300,000 should have been. The correction is to add $75,000 of
expense to Year 3.
At December 31, Year 3, there was $150,000 still in inventory that should have been expensed and not
capitalized. Inventory is adjusted by that amount (as a credit).
QUESTION 3
This question deals with discontinued operations (covered in F1). Losses associated with discontinued
operations should be accounted for in the years in which they occur. Components that are held for sale or that
have already been sold (or otherwise disposed of) would be charged with an impairment loss that would be
recognized once the conditions for disposal or held for sale status are met. Operating losses related to the
component are recognized in the year in which they occur. Estimated losses related to subsequent periods are
not accrued. All that has to be done here is to move the $150,000 of Year 3 operating loss from Year 2 to Year
3. 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 ST A T EM ENT YEA R 3 BAL ANCE

SHEET
Original Accounting
Discontinued operations
losses & disposal:
Impairment loss 100,000
Year 2 operating loss 75,000
Year 3 estimated operating 150,000
loss
C O R R EC T I O N (150,000) 150,000 -- --
Correct Accounting
Impairment loss 100,000
Year 2 operating loss 75,000
Year 3 operating loss 150,000 -- --
QUESTION 4
This 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 be
accounted 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 only
recognize profit after all the costs have been recovered. Recall that with a profit margin of 50%, this means that
there is $300,000 in profit and $300,000 in costs. The company expects to collect $200,000 per year beginning
in Year 1. Therefore, with the cost recovery method, the company would recognize $0 profit in Year 1 (i.e., the
entire 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 were
recovered 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 was
inseparable from a change in estimate; therefore, the original accounting as installment sales still exists on the
books of the company.
Let's look at the details of the transaction. The original sale was $600,000, with $200,000 scheduled to be
collected each year. With a 50% profit margin and the installment method, $100,000 of profit would have been
recognized each year. This was part of the original accounting. Note that the receivable was collected before
12/31/Year 3, so there is no impact on the balance sheet.
INCOM E ST A T EM ENT YEAR 3 BAL ANC E

SHEET
Original Accounting
Installment sale accounting:
Year 1 profit recognition (100,000)
C O R R EC T I O N 100,000 (100,000) -- --
Correct Accounting
Account for prospectively:
Year 1 profit recognition --
Year 3 profit recognition (200,000) -- --
QUESTION 5
This question deals with amortization of software costs (covered in F2). The question states two things: (1) the
useful life of the software is 4 years and (2) the amount of sales is realized at 10% of expected lifetime sales
each year. The question appears to contradict itself because if the software has a useful life of 4 years, then it
is 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 company
believes the sales to exist over 10 years. For these purposes, we are going to assume that the company's
accounting estimates are correct (for whatever reason).
Software costs are capitalized once technological feasibility is established and are then amortized using the
greater of the straight-line amortization over the useful life of the software or the percentage of estimated sales
achieved. The useful life of four years requires amortization of one-quarter (or 25%) of the cost, while sales are
realized at only 10% of total projected sales. The company's method of amortization understated the
amortization by $30,000 per year and overstated the capitalized software by $90,000.
INCOM E ST AT EM ENT YEA R 3 BAL ANCE SHEET

Original Accounting
Amortize cost b ased on sales
Amortization of cost 20,000 20,000 20,000
Remaining book value (200,000 140,000
- 60,000)
C O R R EC T I O N 30,000 30,000 30,000 -- 90,000
Correct Accounting
Account for software development costs and amortize on a straight-line b asis or percentage of sales,
whichever is greater.
Amortization of cost 50,000 50,000 50,000
Remaining book value (200,000 50,000
- 150,000)
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 6
This question deals with revenue recognition (covered in F2). To properly match earnings with the period
benefited, revenues should be recognized when earned, not when received. Subscription revenues that
represent an advance payment over a three-year period should be recognized to the extent that obligations have
been fulfilled in the year of receipt, with the remainder recorded as deferred revenue. The company's accounting
overstated revenue in the year of receipt, and did not properly establish a liability.

Original Accounting
Recognize revenue when
received
Subscription revenues (150,000)
C O R R EC T I O N 100,000 100,000
Correct Accounting
Recognition of revenue when
earned
Subscription revenue
Deferred revenue (150,000 - (50,000) 100,000
$50,000)
QUESTION 7
This question deals with inventory (covered in F4). In this question, inventory sitting in a warehouse was
improperly included in cost of goods sold even though the goods had not been sold. Risks of ownership pass to
the buyer upon receipt when goods are shipped FOB destination. Risks of ownership pass to the buyer upon
delivery to a common carrier under FOB shipping point. In this case, since the goods were shipped FOB
destination, 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.

Original Accounting
Improperly excluded inventory
Cost of goods sold 50,000
C O R R EC T I O N (50,000) 50,000
Correct Accounting
Account for costs of inventory for
which company still has title
Cost of goods sold --
Inventory 50,000
SUMMARY
A recap of the correction adjustments is as follows:
YEAR 3 BAL A NCE SHEET

Year 1 Debits Year 2 Debits Year 3 Debits
Debit Credit
Question (Credits) (Credits) (Credits)
Book income ($10,000) $6,000 ($85,000) $0 $0
1 (2,000) 2,000
2 25,000 50,000 75,000 150,000
3 (150,000) 150,000
4 100,000 (100,000)
5 30,000 30,000 30,000 90,000
6 100,000 100,000
7 (50,000) 50,000
Corrected net 145,000 (66,000) 122,000
income
Balance Sheet 50,000 340,000
Adjustments
Note that each numbered line, including the total adjustments line, shows a net total of debits and credits equal
to 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 of
the year are added to the sales already booked for the year under the cash basis. The amount uncollected at
year-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 the
goods are still on hand, the amount is recorded under the accrual basis with inventory as a debit and accounts
payable 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 and
a 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 accrual
basis, the tools need to be reported as fixed assets with a debit to the factory equipment account. Depreciation
is 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, Year
2. Since six months are still to run on the policy, prepaid insurance of $1,200 ($2,400 x 6/12) should be reported
under 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 of
December 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 recorded
by the company was December 31st (for time worked through December 24th), under the accrual basis the
company has to record accrued payroll for the additional one week that was worked in Year 1 and will be paid on
January 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 accrual
basis 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 at
year-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 are
first applied to the recovery of product costs. Collections after all costs have been recovered are recognized as
profit.
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 Year
1.
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 in
Year 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 installment
sales.
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. $26,000,000
License Cost $28,000,000
Add: Legal Fee 1,600,000
Add: Regulation Fees 400,000
Initial Carry Value $30,000,000
Less: Y1 Amortization (2,000,000)
Carrying Value End Y1 $28,000,000
2. $4,769,231
Less: Impairment Charge (3,000,000)
Adjusted Carrying Value $23,000,000
Amortization Periods 13
Amortization Expense $1,769,231
Impairment Charge 3,000,000
Total Expense in Y3 $4,769,231
3. $1,400,000
Initial Carrying Value $30,000,000
Less: Fair Value End Y1 (26,600,000)
Revaluation Loss Y1 $1,400,000
Carrying Value - Beg Y2 $26,600,000

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

Fair Value End Y2 $26,300,000

Carrying Value End Y2 24,700,000
Revaluation Gain Y2 $1,600,000*
* The year 2 income statement recognizes a reversal of the $1,400,000 revaluation loss reported in year 1, with
the $200,000 remainder recognized on the balance sheet as a revaluation surplus in the other comprehensive
income account.
Part 1:
1. $98,500. Money market instruments are considered cash equivalents, as they are easily converted into
cash 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. The
original purchase price is relevant in terms of calculating the unrealized gain or loss (which will be reflected
on the Statement of Changes in Net Worth), but will not be presented on the Statement of Financial
Condition. In addition, HYL stock will not be included here because the stock was sold and no longer
represents an asset in Tames portfolio.
3. $9,150. Bond investments are monetary assets and should be valued based on the present value of
projected cash receipts. Each bond is currently worth $915 and he has purchased 10 bonds. So the total
value 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 years
Statement of Financial Condition. The current value of $225,000 is what will be listed as an asset. The
current 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. The
outstanding 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 is
outstanding 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 asset
portfolio would be considered large/significant) the interest should be presented on a net basis. The value
of the business is $1.5 million ($4 million in assets - $2.5 million in liabilities). Tames holds a 20% interest
valued 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. Original
cost data is used to determine unrealized and realized gains or losses, but it is not listed specifically under
either 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 Net
Worth.
3. Estimated taxes owed (based on when the stock currently held is actually sold) will appear as a liability on
the 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 Financial
Condition.
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#1
Dr. 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#2
Dr. 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#3
Dr. 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#4
Dr. 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 from
Accounts receivable (credit).
AJE#5
Dr. 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 be
adjusted to an expense account.
AJE#6
Dr. 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#7
Dr. 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 the
expense and payable account is $1,000, an additional $2,000 is needed to adjust the amount to the balance at year
end. It would appear that JRM Co. made a tax accrual of $1,000 earlier in the year.
April 1, year 1
Dr. Patents $50,000

Cr. 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 to
expense.
July 1, year 1
Dr. Equipment $79,000

Cr. Cash $79,000
Research and development costs are a direct charge to income EXCEPT for materials or equipment that have
alternate future uses. Because the equipment qualifies under this rule, the amount capitalized is the original cost
plus any expenditure directly related to the acquisition of the asset.
October 1, year 1
Dr. Legal Expense $25,000

Cr. Cash $25,000
Legal fees for an unsuccessful defense of a trademark are an expense. Legal fees for a successful defense of the
trademark are added to the asset value of the trademark.
December 31, year 1
Dr. Amortization Expenses $3,750

Cr. 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 a
straight line basis: $50,000/10 years x 9/12.
December 31, year 1
Dr. Research and Development Expense $7,900

Cr. Accumulated Depreciation $7,900
Depreciation expense is calculated on the capitalized amount of $79,000. Depreciation is on the straight line
basis: 79,000/5 year x 6/12. Because the equipment is currently used for research and development, the
depreciation 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 exceeds
the fair value, there is a potential for impairment. Second, the amount of goodwill loss is measured by comparing
the implied fair value of the goodwill to the carrying amount of that goodwill. If the implied fair value is less than its
carrying 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 stage
enterprise can be found in ASC 915-10-20 Glossary. Because there are no paragraph numbers in 915-10-20
and 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 to
exercise significant influence over the investee. Even though Big owns over 20% of Small, the remaining stock is
owned by one individual and control would be retained by the majority shareholder and his family who controls the
Board.
2. Consolidation
The partnership is a variable interest entity for the following reasons:
1. The activities of the partnership are conducted on behalf of Big

2. Big's voting rights are small in proportion to the focus of the partnership on Big, and
3. 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% or
less of the voting stock. At December 31, Year 1, Big is the largest shareholder of Little Ladies and controls the
Board of Directors. The stock ownership percentage, which is now 28%, is a guideline that would reinforce the
correct 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 financial
statements. Even though Big consults with and gets input from the 49% shareholder, there is nothing in the facts
of 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 Petites
operations 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 $330,000

CR Cash $330,000
The investment is subsequently adjusted as the net assets of the investee change through the earning of
income and payment of dividends. The investment account increases by the investor's share of the investee's
net 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 $ 39,000

CR Rhodes (investee) income $ 39,000
Investment in Rhodes = $330,000 + $39,000 = $369,000

Rhodes (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 the
per 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 $ 9,000

CR Rhodes (investee) income $ 9,000
The distribution of dividends by Rhodes reduces the investment balance on Barnes' books by $2,400 ($8,000 x
30%).
DR Cash $ 2,400
CR 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 difference
between 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 $ 900,000

Fair value adjustment - land 100,000
Fair value adjustment - inventory 80,000
Fair value of in-process R&D 200,000
Fair 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 noncontrolling
interest 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 fair
value 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 times
the 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 financial
statement perspective until the asset is sold to an outsider. An elimination entry in the period of the sale
eliminates the intercompany gain/loss and adjusts the asset and accumulated depreciation to their original
balance on the date of sale:
DR Gain on sale 40,000
CR Accumulated depreciation 15,000
CR Depreciation expense 5,000
CR 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 was
originally 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 at
the 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 by
Peterson ($100,000 cost to Peterson / 10 years = $10,000). Silver Corp. recorded depreciation of $15,000 based
on 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 be
reduced 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 of
goods sold is eliminated when preparing consolidated financial statements. In addition, the intercompany profit
must be eliminated from the ending inventory and cost of goods sold of the group.
DR Sales 50,000
CR Inventory 8,000
CR 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 on
Peterson'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 Silver
paid is $20,000 ($50,000 intercompany sales price - $30,000 cost of goods sold). The amount that was sold
represents 60% of $20,000, so that another $12,000 needs to be eliminated to show the cost of goods sold based
on the original cost to Peterson.
1. Eliminate investment in subsidiary
Journal 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 is
taken 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 and
equipment 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 $950,000

Useful life (divide by) 3
Annual 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 sheet

Journal entry:
DR Intercompany payable $30,000

CR Intercompany receivable $30,000
Eliminate intercompany transactions on the balance sheet. The only intercompany transaction is the
payable and receivable as identified in the facts.
FASB ASC 323-30-25-1
Keyword: Unincorporated joint ventures
Solution
Adjustments Amounts
Balance 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 3,500
Actual 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 in
March 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 should
clear 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 farmers market was correctly recorded by the company. The bank
cashed the check for the incorrect amount and will remit the $450 shortfall to the payee in April. This amount reduces the
actual 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 the
books 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 properly
recorded 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 by
the bank as the deposits were being made. Because it has not yet been recorded on the books of the company, Gemini
needs 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 company
has 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 in
on 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 up
the goods to be shipped. The goods are included in Party Supply s inventory until they are in the possession of
the 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 for
December 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, the
goods 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 goods
are sold to a third party. When the original shipment was made, there was no change in the company s
inventory. 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 costs
between the warehouses is considered to be an inventory cost. The rent on the warehouse is a period expense
and 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 in
which the loss occurred. The amount of the loss is measured as the difference between the cost of $50,000 and
the realizable value net of selling costs of $4,000.
Solution
Part 1:
Machinery and Equipment Schedule

Description Amount
Opening Balance - January 1, Year 2 190,000
Molding machine 36,000
Replacement motor 16,000
Super DP 54,000
Sale 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 significantly
increases the usefulness of the machine, for a total of $16,000. The maintenance agreement is not considered to be a fixed
asset. 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:
Depreciation Useful Annual Depreciation

Asset Base Life Depreciation Year 2
Description
Tooling Machine $120,000 5 $24,000 $24,000
Drill Press 40,000 5 8,000 6,000
Molding Machine 36,000 9 4,000 3,000
Replacement motor 16,000 4 4,000 2,000
Maintenance 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 asset
has 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 the
tooling machine on which the motor was installed. The annual depreciation is $4,000 ($16,000/4) and the depreciation from
July 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 the
depreciation from October through December is $3,375 ($13,500 x 3/12). The change in the estimated useful life of the asset
was 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 Schedule

Description Amount
Opening Balance - January 1, Year 2 16,000
Depreciation expense 38,375
Sale 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 taken
on 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: $360,000
The 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: $67,000

The 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, $40,650

The amount of avoidable interest is the interest that would not have been incurred if the construction project had
not 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 60,000
Weighted-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, $40,650

Capitalized interest cannot exceed the actual interest incurred for the period. The capitalized interest for year 2
is $40,650 because the avoidable interest of $40,650 is less than the interest incurred of $67,000.
Interest expense for Year 2, $26,350

The interest expense is the amount to be shown on the income statement and is the difference between the total
interest of $67,000 and the capitalized interest of $40,650.
1. $600,000
Cash paid $ 800,000

Mortgage assumed 200,000
Total purchase price 1,000,000
Allocation 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 realty
tax 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 the
transaction, plus any gain recognized (or minus any loss recognized) on the transaction. In this case, a
realized gain of $130,000 exists [$450,000 - $320,000], but it is not reported (recognized) because cash
was paid in an exchange that lacks commercial substance (i.e., the gain is deferred).
NBV of asset surrendered $320,000

Boot paid 50,000
Recorded amount of new land (does
not exceed FV of $500,000) $370,000
Journal entry:
DR New Land $370,000
CR Cash $ 50,000
CR NBV of old land 320,000
3. $315,000
Exchanges 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 commercial
substance, 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 is
recorded, 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 $ 50,000
DR New land 315,000
CR NBV of old land $350,000
CR 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. $162,000
Rule: 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.

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).

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.

Year 2 fraction x (300,000/1,800,000)
Depreciation expense for Year 2 $120,000
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 be
recognized 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 doubtful
accounts can be calculated using the new aging percentages, as follows:
Total 0-30 days 31-60 days 61-90 days Over 90

AR 677,000 225,000 240,000 127,000 85,000
Adjustments (17,000) 0 0 0 (17,000)
Adjusted AR 660,000 225,000 240,000 127,000 68,000
Estimated % 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 4,000
Allowance before adjustment $35,000
Bad debt expense 72,060
Ending allowance $107,060
The bad debt expense is recorded with the following JE:

DR Bad debt expense 72,060
CR 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 the
matching principle. The asset is a physical asset used in a trade or business with a useful life greater than
one year.
2. Expense at time incurred

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

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

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

The cost of this intangible asset should be capitalized and amortized over its useful life of 5 years
consistent with the matching principle.
6. Expense at time incurred

The cost of replacing the windows should be expensed as ordinary repair and maintenance expense. This
is not treated as an extraordinary repair, which would be capitalized if the life of the asset is extended or the
efficiency is improved.
Capitalized cost of the land: $404,000
The cost of land includes: Purchase price, brokers commissions, title and recording fees, legal fees, clearing
brush and trees, site development, cost of demolition of existing building, less any proceeds from the sale of
existing building, timber, etc. Land improvements are excluded from the cost of land as they are depreciable
assets and land is not.
Purchase price $325,000

Demolition of existing structures on property 120,000
Proceeds from the sale of scrap from the old building on the site (65,000)
Legal fees incurred to purchase the property and paid at settlement 24,000
Capitalized cost of the land $404,000
Capitalized cost of warehouse: $316,000

The capitalized cost of the warehouse includes the interest incurred during the construction period per FASB
ASC 835.20.25.3. Construction period interest should be capitalized (based on the weighted average of
accumulated expenditures) for buildings, machinery or land improvements constructed by the company.
Interest incurred from 3/15 through 8/31 $ 11,000

Total cost of labor, materials, and overhead to construct the 305,000
warehouse $316,000
Capitalized cost of warehouse
Capitalized cost of new machine: $41,800

The capitalized cost of the new machine includes all cost necessary to acquire the machine and get it to the
location 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.

Sales tax paid on machine 2,100
Installation cost 3,700
Capitalized cost of new machine $41,800
1. Depreciation expense using straight-line method
The formula to calculate depreciation using the straight line method of depreciation is to take the
depreciable base (cost less salvage) and divide it by the estimated useful life. In this question the cost of
the equipment includes the purchase price of $43,600 and the $3,400 cost to install it. Thus annual
depreciation 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 service
for the given year. In this question you would multiply the $5,125 by 75% for Year 1 and by 100% for Year
2.
Year 1: 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 rate
without 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 for
salvage value because the method always leaves a remaining balance, which should never be below
salvage.
Year 1: 75% x $11,750 = $8,813
Year 2: (25% x $11,750) + (75% x $8,813) = $9,547
Depreciation
Year Doub le SL% NBV Expense Year 1 Year 2
1 25% $47,000 $11,750 75% 25%

2 25% $35,250 $8,813 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 the
original cost less accumulated depreciation. Then subtract the NBV from the sales price to get the gain or
loss.
Original cost of the furniture $13,000

Accumulated depreciation (11,500)
Net book value $ 1,500
Sale price $ 1,200

Less NBV (1,500)
Loss on sale ($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 no
boot (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 the
original cost less accumulated depreciation. Then subtract the NBV from the insurance proceeds received to
get the gain or loss.
Original cost of the equipment $17,500

Accumulated depreciation (3,500)
Net book value $14,000
Insurance proceeds $15,000

Less NBV (14,000)
Gain on sale $ 1,000
FASB ASC 835-20-50-1
Keyword: Capitalization of interest

Compounding Periods - Principal (cell B2): 10
The bond is a 5-year bond that pays interest semi-annually, so the number of compounding periods is equal to
10 (5 years x 2 interest payments per year = 10 periods).
Compounding Periods - Interest (cell B3): 10

The bond is a 5-year bond that pays interest semi-annually, so the number of compounding periods is equal to
10 (5 years x 2 interest payments per year = 10 periods).
Interest Rate - Principal (cell C2): 0.040

The 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 to
calculate the present value of the principal payment.
Interest Rate - Interest (cell C3): 0.040

The 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 to
calculate the present value of the interest payments.
Payment Amount - Principal (cell D2): $1,000,000

The principal payment amount is the $1,000,000 face amount of the bond. This is the amount that would have
been 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): $50,000

The 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): $675,560

The 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): $405,545

The 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): $1,081,105

Bond issue price = $675,560 PV principal + $405,545 PV interest = $1,081,105
Bond Issue Price (cell F2): $1,081,105
The 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 dates
are:
06/30/Y1
12/31/Y1
06/30/Y2
12/31/Y2
06/30/Y3
12/31/Y3
06/30/Y4
12/31/Y4
06/30/Y5
12/31/Y5
Formula for Cell B3 - Interest Payment - 6/30/Y1: 0.05 x G2
The interest payment of $50,000 is equal to the face amount of the bond (cell G2) times the semi-annual stated
rate of 5% (10% stated rate / 2 interest periods per year).
Formula for Cell C3 - Interest Expense - 6/30/Y1: 0.04 x F2

The interest expense of $43,244 on 6/30/Y1 is the beginning carrying amount of the bond (cell F2) times the
semi-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 - B3

The $6,756 decrease in the carrying amount of the bonds on 6/30/Y1 is the difference between the interest
expense of $43,244 (cell C3) and the interest payment of $50,000 (Cell B3).
Formula for Cell E3 - Unamortized Premium - 6/30/Y1: E2 + D3

The 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 + D3

The $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 Debt
The $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 Date

Lyndhurst 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 call
the 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 the
debt.
I = Increase D = Decrease N = No Effect
Additional
Transaction Journal Bond Bond Bonds Common paid-in Retained
Entries discount premium payable stock capital earnings
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 stock
Additional paid-in
capital N D D I I N
4. Cash
Discount
Bonds payable
APIC (stock
warrants) I N I N I N
5. Retained earnings
Common stock
Additional paid-in
N N N I I D
capital
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 warrants
must be valued at a discount.
5. A stock dividend merely reclassifies amounts from Retained earnings to Common stock and APIC at the fair
value 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 Credit

Cash $ 825,500
Bond Issue Cost 50,000
Bonds Payable $ 800,000
Premium 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 is
also amortized over the life of the bond.
2. Record the journal entries on June 30, Year 1 to recognize interest expense and
the amortization of the bond issue cost for the first six months of Year 1.

Interest Expense $ 13,133
Cash $ 16,000
Bond 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 interest

expense and the amortization of the bond issue cost expense for the second half of
Year 1.

Interest Expense $ 13,090
Cash $ 16,000

Bond 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 the
book value method to account for the conversion of bonds into common stock.
Record the journal entry for the conversion.

Unamortized Premium on Bonds 69,723
Payable
Common Stock $ 80,000
Unamortized Bond Issue Costs 45,000
Additional 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 the
market 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.

Unamortized Premium on Bonds 69,723
Payable
Loss on bond conversion 175,277
Common Stock $ 80,000
Unamortized Bond Issue 45,000
Costs
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 market

value = $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
FASB ASC 470-20-40-16
Keyword: Convertible debt and inducement offer

PART 1:
Amount Over(under)funded
Funded status Plan A ($225,000) Underfunded
Funded status Plan B $550,000 Overfunded
Funded 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) underfunded

Funded status Plan B = $2,500,000 $1,950,000 = $550,000 overfunded
Funded 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 exceeds
the fair value of the pension plan assets, the pension plan is underfunded.
PART 2:
Pension benefit asset current $0
Pension benefit asset noncurrent $550,000
Pension benefit liability current $25,000
Pension benefit liability noncurrent $650,000
For balance sheet reporting purposes under U.S. GAAP, all overfunded pension plans are aggregated and
reported in total as a noncurrent asset. Because Plan B is SuretoPass' only overfunded pension plan, the
company will report a noncurrent pension benefit asset of $550,000. No current assets are reported under defined
benefit pension plan accounting rules.
Under U.S. GAAP, all underfunded pension plans are also aggregrated and reported as a current liability (to the
extent that the expected benefits payable in the next 12 months exceed the fair value of the plan's assets), a
noncurrent liability or both. SuretoPass has two underfunded pension plans: Plan A and Plan C. The total funded
status of these underfunded pension plans is $675,000 ($225,000 + $450,000). Because Plan C has plan assets
totaling $125,000, but expects to pay benefits of $150,000 in Year 2, SuretoPass must report a current pension
benefit liability of $25,000 ($125,000 $150,000) at 12/31/Year 1. The remaining $650,000 is reported as a
noncurrent liability.
Solution:
1. $941,000
Service Cost-Year 5 $920,000 Given

Interest 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 13,750 275,000/20
Amortization 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 difference
between actual versus expected returns (if expected returns are used to calculate pension expense). The
second 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 be
booked to other comprehensive income (OCI) at the end of Year 5 and subsequently amortized beginning in
Year 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 entails
comparing the unrecognized balance to a threshold equal to 10% of the greater of the fair value of plan assets
or 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 is
greater 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 will
occur if there is a difference between the actual return and the expected return. The company can choose to
either book this difference directly to the income statement in the period incurred or book it to other
comprehensive 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, Look
Ahead has a loss of $33,100 [$3,310,000 x (4.5% - 5.5%) = $(33,100)]. The company has chosen to recognize
this 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 s
pension 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 Asset

Amount: $105,000
Fair value of plan assets, 12/31/Y4 $975,000

PBO 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

Pension Benefit Asset 175,000
Cash 175,000
2. Service/Interest Cost

Net Periodic Pension Cost 158,600
Deferred 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)

Deferred 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

Other Comprehensive Income 19,000
Deferred 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)

Other Comprehensive Income $4,600
Deferred 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, noncurrent
Tax return depreciation in excess of financial statement depreciation produces a financial statement
asset basis greater than the tax basis. Since the tax benefit of the basis has already been used, the
asset is balanced with a deferred tax liability. The difference will ultimately reverse since the asset will
ultimately be depreciated to zero.
If applicable, deferred tax assets and liabilities are generally classified the same as the related asset or
liability. Fixed assets are noncurrent. Accordingly, the deferred tax liability identified for this transaction
is also noncurrent.
2. Temporary timing difference, asset, current

Revenues collected in advance and taxed at the time of receipt result in revenue recognition on the tax
return in advance of revenue recognition on the financial statements. Since the company will ultimately
recognize financial statement revenue for which it will have already paid taxes, the financial statements
should reflect a deferred tax asset. The difference will ultimately reverse in a subsequent period since
the 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 are
generally classified in a manner consistent with the transaction that created them or when they are
anticipated to reverse. For financial statement purposes, revenues will be recognized in the next period
and are, therefore, current. Accordingly, the deferred tax asset identified for this transaction is also
current.
3. Permanent difference, no financial statement presentation

Tax exempt revenue is never recognized for tax purposes because the difference will never reverse. The
difference is considered permanent and receives no deferred tax treatment.
Permanent differences do not receive deferred tax treatment. The inclusions of noncurrent asset and
noncurrent liability selections in the popup window represent nonsense distracters.
4. Temporary timing difference, asset, current

Warranty expenses are accrued for purposes of financial statement presentation but only deducted on the
tax return when paid. The existence of expenses recognized on the financial statements for which there
will be a later tax benefit (when paid) generates a deferred tax asset. Since the warranty expense will
paid out at some point, the difference will ultimately reverse and is considered temporary.
anticipated to reverse. The warranty expenses relate to one-year warranties that are expected to be
incurred or paid out in the next period and are, therefore, current. Accordingly, the deferred tax asset
identified for this transaction is also current.
5. Temporary timing difference, liability, current

Expenses paid in advance and taxed at the time of payment result in expense recognition on the tax
return in advance of cost expiration on the financial statements. Since the company will ultimately
recognize financial statement expense for which it will have already derived a tax benefit, the financial
statements should reflect a deferred tax liability to offset the prepaid expense asset. The difference will
ultimately reverse in a subsequent period since the collected cost will expire.
anticipated 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, noncurrent

Equity 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 in
advance of any tax liability. Undistributed earnings recognized by the parent corporation results in a
deferred tax liability since the parent company, presumably, will ultimately receive distribution of
subsidiary earnings and will incur a tax liability. The difference will ultimately reverse in a subsequent
period since the parent has significant influence over the subsidiary's operations and will require
distribution of earnings.
anticipated to reverse. These undistributed earnings will be paid to the parent over multiple years (greater
than one-year in the future) and are, therefore, noncurrent. Accordingly, the deferred tax liability identified
for this transaction is also noncurrent.
7. Temporary timing difference, asset, noncurrent

Organizational expenses are immediately recognized for purposes of financial statement presentation but
are amortized for tax purposes over multiple years. The existence of expenses recognized on the
financial statements for which there will only be a later tax benefit (when amortized) generates a deferred
tax asset. Since the organizational expense will be fully amortized at some point, the difference will
ultimately reverse and is considered temporary.
If applicable, deferred tax assets and liabilities are generally classified the same as the related asset or
liability. 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 presentation

Key man life insurance premiums are never recognized for tax purposes so the difference will never
reverse. The difference is considered permanent and receives no deferred tax treatment.
Permanent differences do not receive deferred tax treatment. The inclusions of noncurrent asset and
noncurrent liability selections in the popup window represent nonsense distracters.
1. Increase financial statement tax expense
Identification of a deferred tax asset for which all or a part of the asset will not be realized will result in the
creation of a valuation account, decreasing the asset and increasing financial statement income tax
expense.
2. Increase financial statement tax expense

A deferred tax asset will only be realized if there will be future taxable income to which to apply a tax
benefit. The absence of future earnings will cause the company to create a valuation allowance and
thereby increase financial statement tax expense.
3. Decrease valuation allowance

The potential that a deferred tax asset, previously allowed for, no longer requires a valuation allowance will
cause the company to reverse the valuation allowance, thereby restoring the asset and decreasing
financial statement tax expense.
PART 1
Row 5: Allowance for doubtful accounts
$21,000 | $6,930 |
For GAAP purposes, Stanhope accounts for bad debts using the allowance method and has an Allowance for
Doubtful Accounts of $21,000. For tax purposes, the direct write-off method is used and no allowance is
recorded. Therefore, there is a $21,000 ($21,000 GAAP allowance - $0 tax allowance) temporary difference
between GAAP accounting and tax accounting. This $21,000 temporary difference represents future write-offs
that will be deducted for tax purposes when the write-offs actually occur. Future tax deductions result in deferred
tax 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 | | $253,110
A temporary difference exists because Stanhope is using the straight-line method for GAAP purposes and
accelerated methods for tax purposes. Because tax depreciation exceeds GAAP depreciation, this temporary
difference results in a deferred tax liability. The total temporary difference of $767,000 is equal to the difference
between 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 | | $2,640
A temporary difference exists because unrealized gains of $8,000 have been recognized in net income for GAAP
purposes, 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 tax
liability.
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 on
the following criteria:
1. Deferred tax items should be classified as current or noncurrent based on the classification of the related
asset 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 on
the 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 because
accounts receivable is a current asset. The $2,640 deferred tax liability related to the unrealized gain on trading
securities is classified as current because trading securities are (generally) classified as current. GAAP requires
that 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 accumulated
depreciation is classified as a noncurrent deferred tax liability because fixed assets as classified as noncurrent.
FASB ASC 740-10-35-4
Keyword: Changes in tax laws or changes in tax rates

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 market
value of the shares issued:
DR Land $169,000 (13,000 s hares x $13/share)

CR Com m on s tock $13,000 (13,000 s hares 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 Treas ury stock $252,000 (21,000 s hares 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 Los s 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 Com m on s tock $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-s ale securities $95,000

CR Other com prehensive $95,000
incom e
1. Reissue 2,000 shares at $12.00 per share on January 15, Year 3
DR Cash $24,000
CR Treasury stock $20,000
CR APIC, treasury stock 4,000
2. Reissue 2,000 shares at $7.00 per share on October 13, Year 3
DR Cash $14,000
DR APIC, treasury stock 4,000
DR Retained earnings 2,000
The increase to cash is computed as follows:
Reissued shares $ 2,000

Reissue price per share x 7
Debit to cash $14,000
Elimination of previous treasury stock transaction "gains" accounted for through additional paid-in capital
scheduled from the previous entry:
APIC, treasury stock $ 4,000
Accounting for any unabsorbed treasury stock loss through retained earnings after elimination of additional
paid-in capital, treasury stock:
Treasury stock cost $ 20,000

Cash received (14,000)
Preliminary loss 6,000
Previously 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 $ 2,000

Cost 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 $ 5,000

DR Additional paid-in capital 10,000
CR APIC, treasury stock 5,000
Retirement of par value of common shares computes as follows:
Retired common shares $1,000

Par 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 $ 15
Par 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 $ 1,000

Cost 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 $ 15
Treasury stock at cost (10)
APIC from stock retirement per share 5
Number 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 simply
plugged 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 1,772,000
Depreciation 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 602,500
Cash flows from investing activities:
Purchases of property and equipment (400,000)
Proceeds from plant and equipment disposals 58,500
Net 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 72,000
Supplemental disclosures:
Interest paid 250,000
Cash paid for income taxes 700,000
1. An indirect method statement of cash flows always starts with net income/loss. For this question, net
income is obtained from the statement of income and retained earnings. For other questions, it might have
to be calculated from an analysis of the retained earnings account, but that is not necessary for this
question 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 is
calculated from the accumulated depreciation from the balance sheets, the disposal of the equipment from
the other information, and the information about amortization. The starting point is an Account Analysis
Format 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 be
determined 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 because
they were subtracted to get to net income in the first place. Now that we are working backwards from net
income 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 assets
and liabilities. For this question, we can start with the change in accounts receivable, which is an increase
of $1,463,000 (identified directly from the given balance sheets). The next question is whether an increase
in accounts receivable should be added or subtracted, and there are many different ways to remember
whether to add or subtract. The one we will use for this question relates back to depreciation. Depreciation
is a decrease in the balance of an asset. Depreciation is added back. A decrease in accounts receivable
would 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 and
decreases 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 always
balances (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 on
cash must be a decrease.
If an account that generally has a debit balance is decreased, then the net balance sheet effect on
cash must be an increase.
If an account that generally has a credit balance is increased, then the net balance sheet effect on
cash must be an increase.
If an account that generally has a credit balance is decreased, then the net balance sheet effect on
cash 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 method
so that these types of questions are easily answered by you on the CPA exam. The Becker Financial text
discusses 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. An
increase in inventory (an asset and generally a debit balance account) would be subtracted, just like the
increase in accounts receivable.
5. The next line item is the change in prepaid expenses, which is an increase of $18,000 from the balance
sheets. An increase in prepaid expenses (an asset generally a debit balance account) would be
subtracted, 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 $18,000
amount 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 gain
is the proceeds of $58,500 less net book value of $40,500 = $18,000). For this question, we verified the
amount (and there was only one such disposal). Note that we really did not have to verify (as it was given
to 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. Losses
are 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 net
income to arrive at net cash provided by operations, but they did enter into the net income calculation and
they may also have been a 100% cash transaction (i.e., a cash gain or loss). So, why are they adjusted
out? Well, they are NOT from operations, right? And, the statement of cash flows also presents a section
on investing activities. The total proceeds from the disposal of the asset must be shown in the investing
activities section. If the gain (or loss) were not adjusted out of the operating section, then the statement
would 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 typically
credit balance accounts. As discussed above in item (8), a change in a credit balance account has the
same net effect on the balance of cash. For this question, there is an increase of $475,800 from the
balance sheets. Therefore, the adjustment to net income to arrive at net cash provided by operations is to
add the increase (again, with assets, an increase is subtracted; with liabilities, an increase is added). That
is 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 or
investing in something. For this question, property and equipment was purchased, and property and
equipment was sold. Purchases and sales must be reported separately (not netted). The calculation
requires 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 activities
section.
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 include
obtaining 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 was
borrowed, and it brought in $18,000 of cash flows to the company from financing activities (a positive
number on the statement of cash flows).
14. Financing activities include borrowing, paying back, and buying/selling the company's own equity (and
other 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 in
the 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 (a
negative number on the statement of cash flows).
15. Financing activities include borrowing, paying back, and buying/selling the company's own equity (and
other equity transactions). For this question, there is no change in common stock or additional paid-in
capital, so no stock was issued. However, there were dividends paid (information obtained from the
statement of income and retained earnings). The $180,000 dividends are cash flows out of the company
from financing activities, or paying the dividends to those who have invested in the company (a negative
number 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 direct
method of the statement of cash flows, this amount is disclosed in the operations section as a separate
line 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 disclosed
on the statement of cash flows. Often, it has to be calculated, but in this question, the $250,000 was given
in the additional information.
18. For an indirect method statement of cash flows, there is always a supplemental disclosure of income taxes
paid. (Note: income taxes paid is an amount that most readers of financial statements want to know. In
the direct method of the statement of cash flows, this amount is disclosed in the operations section as a
separate line item; however, this is not the case on the indirect method, so a supplemental disclosure is
required.) The provision for income taxes from the income statement is $759,700, but it is the income
taxes "paid" that are disclosed on the statement of cash flows. Often, it has to be calculated, but in this
question, 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 order
to the items within each of the sections (operating, investing, and financing). The items have to be within the
correct section, however.
The statement of cash flows is divided into three categories that display the sources and uses of cash and cash
equivalents:
Operating This section displays the cash effects of the line items that make up the calculation of net
income.
Investing This section displays the cash effects of non-current asset transactions, such as purchases
and 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 selling
the equity of the company.
Solutions:
1. Operating activity
2. Investing activity
3. Investing activity
4. Financing activity

1. No Effect. Depreciation is an expense that does not require any outlay of cash. Depreciation expense for a
given 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 under
the direct method.
3. Increase. A decrease in accounts receivable implies that overall the company collected cash on its
outstanding 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 cash
payments 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 from
investing (CFI) inflow. Note that the loss itself would be an addition to net income under the indirect
method. 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 direct
method. 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 the
classification 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 1,295,000
Plus Increase in Inventory 21,700
Less Increase in Accounts Payable (14,100)
Cash Paid to Suppliers 1,302,600
Cash paid to employees:

Salaries and Wages Expense 460,400
Less 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 indirect
method:
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 14,100
Less Decrease in Deferred Revenue (6,200)
Plus Increase in Wages Payable 1,200
Plus Increase in Deferred Taxes 3,000
Plus 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 30,000
Plus Proceeds of Stock Issue 50,400
Less Dividends Paid (10,600)
69,800
Increase in cash and cash equivalents 19,500
Beginning cash and cash equivalents 37,300
Ending cash and cash equivalents 56,800
Record the journal entry and affected financial statements on the grant date, January 1, Year 1.

No entry required
Explanation: No entry is required when stock options are granted. There is no effect on shareholders equity at
the time of issuance and compensation expense is not recorded because the right to use the options has not yet
been earned.
Record the journal entries to recognize compensation expense for Year 1, Year 2 and Year 3.
December 31, Year 1:
Debit Credit
Account
Compensation expense Stock options 50,000
Additional paid-in capital Stock options 50,000
Debit Credit
Account
Debit Credit
Account
Explanation: As time passes, compensation expense is recorded. One third of the total value of the options on
the grant date is recognized each year as compensation expense based on the three year vesting period for the
options. 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 exercised
January 1, Year 4
Debit Credit
Account
Cash (25,000 X $30) 750,000
Additional Paid in Capitalstock options 75,000
Common stock (25,000 X $1.00) 25,000
Additional Paid in Capital 800,000
Explanation: The debit to cash is based on the number of options exercised times the exercise price. Previously
recorded additional paid in capital (refer to question #2) is reversed (debited). Common stock is credited based on
the 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 entry
needed on March 31, Year 4 to record expiration of the stock options. Select no entry if no journal entry is
required on this date.
Debit Credit
Account
Additional Paid in Capital stock options $ 75,000
Additional Paid in Capital expired stock $75,000
options
Explanation: The entry reflects reclassification of the capital from additional paid in capital stock options to
additional paid in capital expired stock options because the stock options have expired.
FASB ASC 230-10-45-22
Keyword: Cash flows and investing activities

FASB ASC 230-10-45-3
Keyword: Cash flow per share

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 Cash
CR 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 control
CR 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 control
CR Encumbrance control
DR Expenditures control
CR 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 control
CR 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 business
using accrual accounting. When the fund invoices the other departments for services used, it recognizes
the billing as operating revenue using the following entry:
DR Due from other funds

CR 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 as
follows:
DR Deferred inflows of resources

CR 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 revenues
CR 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 are
collected, the notes are then paid off.
DR Cash
CR 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 following
journal entry:
DR Estimated revenues
CR Appropriations
CR 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 governmental
units.
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 not
financially independent since its budget is approved by the city. Since the district does not meet the
requirements of a blended unit (governing boards are inseparable or the entity serves the serves the primary
government 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 not
financially independent since it has its budget approved by the city and it surrenders all excess fees to the
city. The district also meets the requirements for blended presentation since the city council and the district
governing 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 as
well 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 a
special purpose governmental unit, but it is a primary government that will have its own stand-alone financial
statements.
1. Non-reciprocal | Transfer
The monies transferred by the Tourist Development fund to meet debt service requirements that are fully
anticipated by the budget represent a non-reciprocal transaction (the Tourist Development fund will never get
the 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. The
transaction is still non-reciprocal, but it would be eliminated in the government-wide financial statements to
avoid grossing up activity.
3. Reciprocal | Revenue
Charges made by an internal service fund are reciprocal (the internal service fund expects to be paid in
exchange 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 have
been accounted for in the capital projects fund. The reimbursement transaction is non-reciprocal (the general
fund expects the money back) but the reimbursement will net to zero. It will be eliminated and not be
displayed on the financial statements.
1. Fiduciary fund financial statements
Fiduciary funds are excluded from government-wide presentations and presented as fund financial
statements only.
2. Required supplementary information

Infrastructure reporting under the modified approach will be displayed as required supplementary
information.
3. Consolidated with governmental activities in the government-wide financial statements

Activities of governmental fund types are consolidated into the governmental activities column of the
government-wide financial statements. Fund financial statements are reconciled to the government wide
totals.
4. Consolidated with governmental activities in the government-wide financial statements

Internal service funds are typically consolidated with Governmental Activities in the government-wide
financial statements if the internal service fund exclusively supports governmental activities. Key Internal
Service Fund data are used as reconciling items between fund and government-wide financial statements.
5. Agency funds
Special assessments for which a governmental entity assumes no responsibility are accounted for in an
agency fund.
6. Required supplementary information

Budgetary displays are generally included in the required supplementary information section of the
government's financial statements although they MAY appear in the fund financial statements.
7. Optional supplementary information

Budget presentations are required supplementary displays while computations of variances from budget are
optional.
8. Management's discussion and analysis

Management's discussion and analysis will include a separate discussion of significant variances from
budget. MD&A is considered required supplementary information.
9. Optional supplementary information

Presentation of details of non-major funds is optional and would normally be included in a combining
financial statement of non-major funds as part of optional supplementary information.
10. Required footnote disclosure

The entity's definition of measurable and available used for revenue recognition is a required footnote
disclosure.
Fund b alance 5,000,000
Capital assets used in governmental activities 2,375,000
Accumulated depreciation on capital assets used in governmental
activities (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 the
government-wide financial statements, follow the GALS BARE mnemonic.
For differences between fund financial statement fund balances and government wide financial statement net
position 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 net
position related to basis of accounting:
Add additional accounts receivable associated with revenue recognized under accrual vs. modified
accrual basis.
Subtract additional accounts payable associated with expenses recognized under accrual vs. modified
accrual basis.
Net change in fund b alance 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 Governmental
Activities 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 per
governmental 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 to
debt 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 per
governmental activities on government-wide financial statements related to basis of accounting
Add additional accrued revenue associated with earnings recognized under accrual vs. modified accrual
basis.
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 outlay
Assets provided to a not for profit organization that are restricted for a purpose that can be met by the
recipient organization are classified as temporarily restricted. The temporary restriction for the purpose of
asset construction is termed Temporarily Restricted - Capital Outlay.
2. Not classified as net assets

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

Conditional promises provided to a not-for-profit organization do not represent a receivable revenue or net
assets until the conditions are met. The promise to provide funding contingent upon securing operating
funding is conditional and would not be recorded.
4. Temporarily restricted - time

Unconditional promises to pay over a period of time are generally classified as temporarily restricted as to
time until collection.
5. Unrestricted
Cash received by a not-for-profit organization for any appropriate purpose within the context of the mission
is deemed to be unrestricted.
6. Temporarily restricted - capital outlay

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

An unconditional donor restricted contribution whose restrictions can be satisfied by the actions of a not-for-
profit organization are temporarily restricted.
8. Permanently restricted
An unconditional donor restricted contribution whose use is restricted to the generation of revenue streams
is 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 or
permanently 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's
discretion. Therefore, this transaction represents an increase in unrestricted revenues, gains and other
support.
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.

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 equipment
acquisition restriction), as well as a decrease in temporarily restricted net assets (net assets released from
restriction).

Nonprofit organizations may record the fair value of donated services if the following conditions are met:
1) The service creates or enhances non-financial assets
2) 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. Donated
services are recorded SOME of the time.
Accounting firm services meet the requirements for recording as unrestricted revenues, gains and other
support.
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 temporarily
restricted 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. $6,500
Investment income represents a combination of both interest received as well as changes in market value.
Earned $ 9,500
FMV/receipt (89,000)
FMV/year end 86,000
Earnings 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 various
expenses given in the problem and to arrive at program expense as follows:
Donated reading material $ 7,500

Instructor salaries 25,000
Director of Community Activities 60,000
Subtotal 92,500
Building rental - Amount allocable to programs 22,500
($30,000 x 75%)
Total $115,000
In arriving at this answer, candidates are required to ignore the value of volunteer services, properly classify
the expenses associated with specific fund raising appeals as general administration (in keeping with the
policy described in the situation), distinguish between administrative and fund-raising expenses listed as
Other cash operating expenses, properly classify interest expenses as administrative expense and
recognize that principal liquidations are irrelevant to expense classifications for purposes of not-for-profit
financial statements.
4. $2,750
General fund-raising expenses. Community services will classify expenses associated with printing and
mailing 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 Services
need 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 cash
flows from operating activities for purposes of the Statement of Cash Flows.

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 activities

Acquisition of property is classified as cash flows from investing activities consistent with commercial
accounting.
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 activities

Acquisition of equity of another organization is an investing activity consistent with commercial accounting.

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.

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 Flows
consistent with commercial applications.

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 similar
to elements of net income accounted for as cash flows from operating activities in the Statement of Cash
Flows in a commercial application.
1. None impacted | No classification
Nothing happens when we receive a conditional promise. There is no asset, no liability and certainly no
revenue and related net asset recognition.
2. Asset; Liability | No classification

The day care provider has an asset, cash, and a liability called a refundable advance. The accounts
impacted 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 restricted

The 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 a
receivable and temporarily restricted revenue. So the liability is eliminated and we have assets and
temporarily restricted net assets.
Dr. Refundable advance $200,000

Dr. Pledge receivable 300,000
Cr. Revenue (temporarily restricted) $500,000
4. Asset | No classification
The receivable becomes cash but it is still temporarily restricted until the building is built. The asset box is
checked because the pledge receivable decreases and cash increases (assets are impacted), but there is
no change in total assets.
Dr. Cash $300,000

Cr. Pledge receivable $300,000
5. Asset | Unrestricted; Temporarily restricted

Expenditure of the temporarily restricted items on the day care construction required by the bequest
causes 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 be
valued. 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 for
the work and, if not provided by volunteers, it would likely not be provided at all. Barter will not recognize any
revenue or expense.
3. $25,000
Barter's revenues would include the value of the skilled carpenter since it passes the SOME test and the
carpenter "enhanced a physical asset." It would also include the unskilled labor associated with the project
since 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 from
contributed services would be $100,000 ($120,000 - $20,000).
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 1,000
shares 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 the
market price of the shares is $60,000 (1000 shares x $60/share market price) but the option writer has agreed
to accept $50,000 from XYZ, the option writer has a loss of $10,000 on the option contract. Instead of
delivering 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 1,000
shares 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 the
purchaser (XYZ) has the "option" to not use the contract if the terms are unfavorable. For example, if the
market price of the ABC stock had stayed below $50 during the 30 days, then XYZ would not have exercised
the option. The option writer does not have the "option" to pull out of the contract if the option terms become
unfavorable. When the option writer sold the option to ABC, the option writer assumed the risk that it would
incur 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 not
determine the amount XYZ will receive in exchange for the 100,000 under the forward contract. Because the
spot 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 spot
rate 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 net
settlement, in this case the net settlement would be an $8,000 payment by XYZ to the other party to the
forward contract. $8,000 represents XYZ's loss on the forward contract because under the contract terms
XYZ 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 will
still 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 as
interest rates increase. Therefore, the interest rate swap is a cash flow hedge in which the company receives
a floating rate of interest (essentially a reimbursement of the floating-rate interest paid on the debt) and pays a
fixed-rate of interest. This "converts" the floating-rate debt into fixed-rate debt. Because this is a cash flow
hedge, 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 futures
contract is a fair value hedge and the gain on the futures contract will be reported in earnings, along with the
offsetting decrease in the fair value of the inventory for a net earnings impact of ($50) = $12,000 gain on
derivative - $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 as
exchange rates change. Therefore, the forward contract is a foreign currency hedge of a net investment in
foreign operations. Because the yen is the functional currency, the translation method is used to convert the
subsidiary's financial statements from the yen to the dollar and the cumulative translation loss is reported in
other comprehensive income. The unrealized gain on the forward contract is also reported in other
comprehensive income, for a net impact on OCI of $600 ($100,000 gain on forward contract - $99,400
cumulative 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 position
in 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:
A gain is recorded in OCI because the forward price has fallen from $79/barrel to $71/barrel and XYZ has a
short 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:
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 on
earnings from the sales revenue plus the gain equals $850,000 ($710,000 + $140,000). The forward contract
allowed 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 the
estimated cost of $710,000 multiplied by the PV Factor of 0.74726 in order to discount it to
todays dollars. The liability (Asset Retirement Obligation, ARO) is credited for the same
$530,555.
DR Asset Retirement Cost (ARC) 530,555
CR Asset Retirement Obligation (ARO) 530,555
2. Accretion expense is calculated as the balance in the liability account multiplied by the
accretion rate. The beginning balance in the liability account is $530,555. Multiplying that by
6% 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 Accretion
Expense ($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 increased
every 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 is
always increasing.
5. Depreciation expense of $ 106,111 ($530,555 depreciated straight- line over 5 years) will
be booked, with an offsetting entry of $106,111 to accumulated depreciation. Accretion
expense of $31,833 (calculated earlier) will also be booked, with an offsetting increase to the
ARO liability account.
DR Depreciation Expense 106,111

DR Accretion Expense 31,833
CR 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 - $2,250,000
H Profit Distribution Total Partnership
Total Profit Y1 $4,000,000
Guaranteed Bonus $400,000 (400,000) 10% X $4,000,000
Interest 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% = $240,000
Interest on S Capital (360,000) $18,000,000 X 2% = $360,000
Annual Salary to H 100,000 (100,000)
Balance $1,100,000 $2,300,000
Distribution of Remaining Profits:
To H ($2,300,000 X 50%) $1,150,000
Total Distribution to H $2,250,000
2. J - $800,000, S - $1,200,000, H - $2,000,000

Adjusted 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) $800,000
S:(30% X $4,000,000) $1,200,000
H:(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 $20,000,000
Existing Partners Capital:
J Capital ($20,000,000 X 20%) $ 4,000,000
S Capital ($20,000,000 X 30%) 6,000,000
H Capital ($20,000,000 X 50%) 10,000,000
4. S - $26,500,000
Original S Capital Balance $18,000,000

Add: Admission of Partner C 6,000,000
Asset Adjustment of FMV to S Capital 2,500,000 ($110,000,000 -$100,000,000) X 25%
Payoff to S Partner $26,500,000
FASB ASC 815-10-50-4C
Keyword: Derivative instrument gains

FASB ASC 450-20-25-8
Keyword: General loss contingency

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Net sales $ 6,250,000

Cost of sales (3,750,000)

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

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

$144,000 book value Remaining life 3 years = $48,000

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

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

Impairment loss of component's assets $ (25,000)

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

Loss from earthquake $ (700,000)

2. Income from continuing operations

4. Income from continuing operations

5. Income from continuing operations

7. Income from continuing operations

8. Income from continuing operations

9. Income from continuing operations

10. Income from continuing operations

11. Income from continuing operations

12. Extraordinary items

13. Income from continuing operations

14. Discontinued operations

Gain from Disposal

Income Tax Benefit (Expense)

2. Correction of an Accounting Error, Restate Prior Periods

3. Change in Accounting Entity, Retrospective

4. Not an Acceptable Change in Accounting, No Change

5. Change in Accounting Estimate, Prospective

10% of Revenue Test Diddy, Elvis

10% of Reported Profit or Loss Test Axl, Elvis

10% of Reported Assets Test Bruce, Elvis

75% Reporting Sufficiency Test

2. Incorrect, Increase (accumulated) other comprehensive Income

4. Incorrect, Increase (accumulated) other comprehensive Income

5. Incorrect, Increase (accumulated) other comprehensive Income

FASB ASC 470-50-45-1

Keyword: Extinguishment of debt

INCOM E ST AT EM ENT YEAR 3 BAL ANCE SHEET

Correct Accounting Accrued (2,000) -- -- --

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

INCOM E ST AT EM ENT YEA R 3 BAL ANCE SHEET

INCOM E ST A T EM ENT YEA R 3 BAL ANCE

INCOM E ST A T EM ENT YEAR 3 BAL ANC E

INCOM E ST AT EM ENT YEA R 3 BAL ANCE SHEET

C O R R EC T I O N 30,000 30,000 30,000 -- 90,000

INCOM E ST AT EM ENT YEAR 3 BAL ANCE SHEET

INCOM E ST AT EM ENT YEAR 3 BAL ANCE SHEET

YEAR 3 BAL A NCE SHEET

Accounts receivable $20,000

Accounts payable $12,000

Cost of sales $2,000

Accounts payable $2,000

Factory equipment $5,000

Small tools expense $5,000

Depreciation expense $1,000

Accumulated depreciation $1,000

Prepaid insurance $1,200

Administrative expenses $1,200

Accounts receivable $500

Bad debt expense $900

Allowance for uncollectible accounts $900

Accrued payroll $1,300

Income tax expense $1,000

Income tax payable $1,000