土豆妮

Birtch Corporation acquires 25% of the common stock of TRQ Inc. on January 1, 2002. TRQ subsequently reports net income for the full year of $700,000, and pays a cash dividend equal to 30 percent of the reported income.

Assuming the equity method of accounting is used, what will be the reported investment income for Birtch?

A) $175,000.

B) $60,000.

C) $115,000.

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Click for Answer and Explanation

Under the equity method, dividends are not included as income to the acquirer. ($700,000 × 0.25) = $175,000 will be the reported investment income for Birtch.

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Assuming the equity method of accounting is used, What will be the cash flow received by Birtch, due to their investment in TRQ during 2002?

A) $52,500.

B) $227,500.

C) $65,400.

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The cash flow to Birtch will be ($700,000)(0.30)(0.25) = $52,500.

土豆妮

Mashburn Company acquired 25% of the 100,000 outstanding shares of Humm Co. on January 1 for $250,000 in cash. Humm Co. earned $1 per share and had a dividend payout ratio of 40%. As of December 31, Humm Co. shares were trading in the open market at $12 per share. Calculate the income statement treatment of the Humm Co. investment as of December 31.

A) $25,000.

B) $75,000.

C) $10,000.

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Under the equity method, the investor recognizes its pro-rata share of the affiliate's income on the income statement. Since Mashburn owns 25,000 shares of Humm and Humm earned $1, the income statement impact of the investment is $25,000.

土豆妮

Which of the following statements regarding qualifying special purpose entities (QSPE) is most accurate?

A) Under IFRS, the sponsor can avoid consolidating asset securitizations by creating a QSPE.

B) A QSPE can hold only certain financial and non-financial assets.

C) The QSPE has total control of the assets transferred from the sponsor.

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A QSPE can only hold financial assets (and the assets are usually receivables). As a legally separate, independent entity, the QSPE has total control of the assets transferred from the sponsor. Previously, under U.S. GAAP, the sponsor could avoid consolidating asset securitizations by creating a QSPE. QSPEs are no longer permitted under U.S. GAAP or IFRS.

土豆妮

Which of the following statements about variable interest entities (VIE) are correct or incorrect?

Statement #1	One potential benefit of a VIE is a lower cost of capital since the assets and liabilities of the VIE are isolated in the event the sponsor experiences financial difficulties.
Statement #2	The organizational form of a VIE must be either a partnership or a joint venture and it is necessary for the VIE to have separate management and employees.

A) Both are correct.

B) Both are incorrect.

C) Only one is correct.

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Statement #1 is a correct statement. A lower cost of capital is a potential benefit of forming a VIE. Statement #2 is an incorrect statement. The organizational form can be a corporation, partnership, joint venture or trust. It is not necessary for the VIE to have separate management and employees

土豆妮

Maverick Incorporated formed a special purpose entity (SPE) to purchase and lease a 50,000 acre ranch. The SPE financed 95% of the purchase price with debt. The remaining 5% was financed with equity capital received from two separate independent investors. The lender would not make the loan without Maverick’s guarantee. How should Maverick treat the SPE in its financial statements if Maverick is the lessee?

A) Maverick must consolidate the SPE.

B) No firm must consolidate the SPE.

C) Each equity investor must proportionately consolidate the SPE.

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The 5% at-risk equity investment is not sufficient to support the activities of the SPE without Maverick’s guarantee. Thus, the SPE is considered a variable interest entity (VIE). Since Maverick is responsible for the guarantee, Maverick is the primary beneficiary and must consolidate the SPE.

土豆妮

Which of the following statements about special purpose entities (SPE) are correct or incorrect?

Statement #1:	The sponsor usually maintains the decision-making power and voting control over the SPE.
Statement #2:	The equity owners of an SPE usually receive a rate of return that is tied to the performance of the SPE.

A) Both are incorrect.

B) Both are correct.

C) Only one is correct.

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Both statements are incorrect. The sponsor does not usually have voting control over the SPE; the activities of an SPE are specifically detailed in governing documents created at the origination of the SPE. The structure of the SPE transfers the risks and rewards from the equity owners to the variable interest owners. In return, the equity owners usually receive a fixed rate of return.

土豆妮

Evergreen Brothers is a large producer of bedding plants and shrubs that are sold to various retail nurseries and home improvement stores located across the western coast of the United States with approximately $85 million in annual sales. Evergreen grows its products at two facilities, one in Northern California and the other in the Southern part of the state. Each production facility currently distributes its products within an approximate 150 mile radius of its location. All aspects of the shipping and delivery of products have historically been provided by an independent, third-party distribution company.

Because of impressive growth in the company's sales over the past several years, management has decided to pursue plans to bring "in-house" the distribution of the company's products. They believe that the projected decreased freight costs as well as the increased efficiencies in more actively managing the distribution of their production should immediately yield increased profit margins. As an initial step, Evergreen has negotiated the price for ten delivery trucks, which could provide all distribution capacity needed for the company's Northern production facility for the upcoming season. Current plans are to continue the use of the independent distribution company for the needs of the firm's Southern facility for at least the next several years.

Under advice from the company's CFO, Evergreen has created a new special purpose entity (SPE), QuickTime, Inc., which will serve as the entity that will purchase the trucks from the dealer. The purchase will be financed through a combination of debt and equity, with the dealer lending 75% of the total cost. The loan is collateralized by both the trucks and Evergreen's guarantee of the debt, as required by the dealer.

Evergreen has arranged for an outside investor to provide the remaining 25% of the upfront costs of the equipment in exchange for 100% of QuickTime's nonvoting stock. In addition, the outside investor is guaranteed an 8% annual return for the life of the financing term. At the end of seven years, QuickTime will be liquidated and Evergreen will have the option of purchasing the equipment for its fair value at that time. The proceeds of the liquidation will be used to repurchase the outside investor's stock at par value. In the event that the liquidation value is insufficient to buy back the outside investor's stock, Evergreen has committed to fund the shortfall.

Management has given its tentative approval of the project and the proposed structure. Questions remain, however, as to the effect of the creation of QuickTime on Evergreen's financial statements. With the relatively recent issuance of FASB Interpretation No. 46(R), "Consolidation of Variable Interest Entities" (FIN 46(R)), the management of Evergreen has not had prior experience with the new consolidation requirements for SPEs.

Which of the following statements regarding special purpose entities (SPEs) is least accurate?

A) An SPE can be formed to isolate specific assets from the sponsor, thus lowering the cost of capital by protecting the assets of the SPE in the event the sponsor experiences financial distress.

B) An SPE can be established as one of several legal forms, such as corporations, partnerships, or trusts, but must establish separate management from that of the sponsor.

C) In general, the equity investors in an SPE can expect to receive a limited rate of return on their investment in exchange for limited risk exposure.

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An SPE can take on one of many legal forms, but does not necessarily have to have separate management or employees from that of the sponsor.

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In exchange for providing lower-cost financing to an SPE, lenders typically require additional financial support from a sponsor, which may be in the form of additional collateral or guarantees. In return, the sponsor will typically receive which of the following risk and return profiles?

A) Pro-rata share of the actual risks and returns on the project.

B) Pro-rata share of the actual risk and a pre-determined fixed rate of return on the project.

C) Pro-rata share of the actual returns on the project and a pre-determined fixed level of risk on the project.

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By transferring the variability in the risk of a project to a sponsor, a lender can provide a lower cost of financing to the company that creates the SPE. In return, the sponsor will receive pro-rata profits or other residual interests in the project.

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According to FIN 46(R), if an SPE is to be considered a variable interest entity (VIE), it must meet which of the following conditions?

A) The SPE must be consolidated by the primary beneficiary, whose status as primary beneficiary is defined by the level of the firm's percentage of voting control.

B) The total at-risk equity of the SPE is not sufficient to finance the entity's activities without additional subordinated financial support.

C) The equity investors in the VIE must bear all of the SPE's risk up to a pre-determined level as outlined in the governing documents.

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To qualify as a VIE under FIN 46(R), any one of four conditions must be met, one of which is the presence of an insufficient at-risk equity investment.

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In order to be considered a VIE under FIN 46(R), an entity must meet certain conditions. Which of the following statements about QuickTime is most accurate? Under FIN 46(R), QuickTime is:

A) not considered a VIE because the outside investor does not have any decision making rights.

B) considered a VIE because outside investors share the residual gains and losses at liquidation with Evergreen.

C) considered a VIE because the outside investor's capital contribution is not sufficient to finance QuickTime's operations.

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The outside investor contributed 25% of the necessary capital, but this was not sufficient because the dealer additionally required Evergreen's guarantee in order to close the deal. This condition satisfies the requirements established by FIN 46(R) in order to be classified as a VIE.

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As outlined in FIN 46(R), the primary beneficiary of a VIE is that entity which meets which of the following conditions?

A) Holds the majority voting control of the VIE and shares management with the VIE.

B) Holds the majority voting control of the VIE and has separate management from the VIE.

C) Has exposure to the majority of the loss risks or receives the majority of the residual benefits of the VIE.

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Unlike past accounting treatments of VIEs where consolidation was based upon voting control, FIN 46(R) recognizes the primary beneficiary of a VIE as that entity that absorbs the majority of the risks and enjoys the majority of the benefits of the VIE. The primary beneficiary is required to consolidate the VIE on their financial statements.

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Assuming that QuickTime is considered a VIE in accordance with FIN 46(R), which of the following statements regarding the consolidation of QuickTime on Evergreen's financial statements is most accurate?

A) The truck dealer is supplying the financing for the majority (75%) of QuickTime's debt, so Evergreen may not consolidate QuickTime on its financial statements.

B) Because the outside investor holds only nonvoting stock, Evergreen holds the majority controlling financial interest in QuickTime and must consolidate QuickTime on its financial statements.

C) Evergreen is exposed to the majority of QuickTime's risks and rewards, so Evergreen must consolidate QuickTime on its financial statements.

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Before the issuance of FIN 46(R), consolidation was based upon possession of voting control of an entity. FIN 46(R) uses a risk/reward approach when determining which firm must consolidate the VIE on its financial statements. Since Evergreen is the sole entity exposed to variability in QuickTime's net income, as well asset value, QuickTime should be consolidated on their financial statements.

土豆妮

James White is preparing for the Level 2 CFA exam and is concerned about his knowledge of accounting for marketable equity securities. He has the following data from a previous take-home assignment from his MBA program:

Security	Cost	2005 Value	2006 Value
ABC	$80	$75	$85
HIJ	$20	$30	$35
XYZ	$40	$20	$45

The portfolio includes 100 shares of each firm; the securities are classified as either held-to-maturity, available-for-sale, or trading securities.

Which of the following statements regarding the income statement and balance sheet treatment of securities classified as held-to-maturity is most accurate? They are carried at:

A) cost on the balance sheet and coupon receipts are considered income.

B) fair market value on the balance sheet with unrealized gains and losses excluded from income and reported as a separate component of shareholders' equity.

C) cost on the balance sheet with unrealized gains and losses reported in income.

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Accounting standards require a company to classify its securities into categories based upon the company's intent relative to the eventual disposition of the securities.

One of these categories, held-to-maturity securities, is composed of debt securities which a company has the positive intent and ability to hold to maturity. These securities are carried at the cost on the balance sheet and coupon receipts are considered income.

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Which of the following statements regarding the income statement and balance sheet treatment of securities classified as available-for-sale is most accurate? They are carried at:

A) cost on the balance sheet and coupon receipts are considered income.

B) fair market value on the balance sheet with unrealized gains and losses excluded from income and reported as a separate component of shareholders' equity.

C) fair market value on the balance sheet with unrealized gains and losses reported in income.

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Accounting standards require a company to classify its securities into categories based upon the company's intent relative to the eventual disposition of the securities.

One of these categories, available-for-sale securities, may be sold to address the liquidity and other needs of a company. Debt and equity securities classified as available-for-sale are carried at fair market value on the balance sheet with unrealized gains and losses excluded from income and reported as a separate component of shareholders' equity.

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Which of the following statements regarding the income statement and balance sheet treatment of securities classified as trading securities is most accurate? They are carried at:

A) cost on the balance sheet with unrealized gains and losses reported in income.

B) fair market value on the balance sheet with unrealized gains and losses reported in income.

C) fair market value on the balance sheet with unrealized gains and losses excluded from income and reported as separate component of shareholders' equity.

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Accounting standards require a company to classify its securities into categories based upon the company's intent relative to the eventual disposition of the securities.

One of these categories, trading securities, is for debt and equity securities acquired for the purpose of selling them in the near term. These securities are measured at fair market value and are listed as current assets on the balance sheet. Unrealized and realized gains and losses are reported in income.

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If the securities are classified as trading securities the balance sheet value for the portfolio at year-end 2005 is:

A) $12,500, and record no gains or losses.

B) $14,000, and record no gains or losses.

C) $12,500, and record an unrealized loss of $1,500.

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The original portfolio cost was: $8,000 + $2,000 + $4,000 = $14,000

In 2005: $7,500 + $3,000 + $2,000 = $12,500

Thus we write the portfolio down by $1,500 and take an unrealized loss.

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If the securities are classified as trading securities the balance sheet value for the portfolio at year-end 2006 is:

A) $16,500, and record an unrealized gain over the past year of $2,500.

B) $14,000, and record an unrealized gain over the past year of $2,500.

C) $16,500, and record an unrealized gain over the past year of $4,000.

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The original portfolio cost was: $8,000 + $2,000 + $4,000 = $14,000

In 2005 the value of the portfolio was: $7,500 + $3,000 + $2,000 = $12,500

In 2006 the value of the portfolio was: $8,500 + $3,500 + $4,500 = $16,500

We write the balance sheet value up to current value and recognize an unrealized gain of $4,000.

土豆妮

Which of the following statements regarding asset securitizations and special purpose entities (SPEs) is most accurate?

A) When receivables are securitized, the sponsor reports the cash inflow as an investing activity in the cash flow statement.

B) The SPE usually issues debt to purchase receivables from the sponsor.

C) If the sponsor has no recourse, then the transaction is nothing more than a collateralized borrowing.

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SPEs are often created to securitize assets, usually receivables of the sponsor. Typically, the SPE issues debt to purchase the receivables from the sponsor and the debt is repaid as the receivables are collected.

When the receivables are securitized, the sponsor removes the receivables from the balance sheet and reports the cash inflow as an operating activity in the cash flow statement. If the sponsor still has recourse, the transaction is nothing more than a collateralized borrowing.

土豆妮

On January 9, 2006, Company X purchased $1,000,000 of government bonds and 100,000 shares of stock in Company S for $2,000,000. They are the first marketable securities purchased in the company's history. The company intends on holding the stock for the foreseeable future and holding the bonds to maturity. As of December 31, the bonds were valued at $900,000, and the stocks were valued at $2,200,000. The bonds paid $50,000 of interest and the stocks paid $20,000 of dividends. In 2006, Company S had earnings per share of $0.90.

The marketable securities balance amount shown on the balance sheet is:

A) $3,000,000.

B) $3,200,000.

C) $3,100,000.

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The bonds are classified as debt securities held-to-maturity and are valued at cost. The stocks are classified as debt and equity securities available for sale and are valued at market value.

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The impact of the marketable securities on net income is:

A) $270,000.

B) $140,000.

C) $70,000.

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The bonds are classified as debt securities held-to-maturity, and the income generated from them is $50,000. The stocks are classified as debt and equity securities available for sale, and although the increased value is reported as an asset, the gain is reported in the securities valuation account in the equity section and not on the income statement. The effect of the stocks on income is the $20,000 of dividends.